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- Company X Value Based Management, Financial KPI February 2016Olegas Kasatkinas
- 2 Content 1. Value Based Management 3 2. Main Metrics and Ratio 4 3. NOPAT – Net Operation Profit After TAX 5 4. FCF – Free Cash Flow 7 5. WACC - Weighted Average Costs of Capital 9 6. Capital Structure Optimization 14 7. ROIC – Return on Invested Capital 16 8. EVA- Economic Value Added 22
- 3 VBM – Value Based Management Streamline Corporate Finance based on VBM: - Develop corporate strategy(the objective in decision makingscenarios is to maximize shareholder value) - Develop management performance measurement directlylinkedto shareholder wealth (the basic concept is that performance should be measured in terms of value added during the period) Value based management entails managing the balance sheet as well as the income statement,and balancing long- and short-term perspectives.
- 4 VBM- Main Metrics and Ratio Main metrics and ratios: - NOPAT – Net Operating Profit After Tax - FCF – Free Cash Flow - ROIC – Return On Invested Capital - WACC - Weighted AverageCosts of Capital - EVA – Economic Value Added NOPAT is a very handy number in finance: - It is the number from which you subtract investments (change in net working capital, net capital expenditures) to derivefree cash flow (FCF) in a discounted cash flow model; - it is the number from which you subtract a capital charge (investedcapital times the cost of capital) to calculate economic profit (EVA); - and it is the number that serves as the numerator of ROIC.
- 5 NOPAT – Net Operating Profit After Tax NOPAT is cash earnings if company capitalization would be unleveraged (that is, if it would not be any debt). NOPAT is a more accurate look at operating efficiency for leveraged companies. It does not include the tax savings many companies get because they have existing debt. NOPAT = EBIT x (1- Tax Rate) NOPAT = (Net Income + after-tax Interest Expense)
- 6 NOPAT - Net Operating Profit NOPAT uses operating income before taking interest payments into account. For this reason, NOPAT is a crucial measure in a variety of financial analyses because it gives a clearer view of operating efficiency - a view that is not clouded by how leveraged the company is or how big of a bank loan it was able to get. This is important, because those interest payments on debt reduce net income and thus reduce the company's tax expense. Year 2015 $6,132 $2,177 $8,309 $11,316 (1 - 20%) $544 $8,309 Interest x Tax Rate =(1 -Tax Rate) -EBIT Net Income NOPAT + Interest*(1 - Tax Rate) = NOPAT x Year 2014 $6,036 $2,614 $8,649 $11,989 (1 - 20%) $653 $8,649 Net Income + Interest x Tax Rate = NOPAT Interest*(1 - Tax Rate) = NOPAT EBIT x (1 -Tax Rate) - Year 2016 $9,055 $1,440 $10,495 $13,557 (1 - 20%) 360 $10,495 Net Income + Interest*(1 - Tax Rate) = NOPAT = NOPATEBIT x (1 -Tax Rate) - Interest x Tax Rate
- 7 FCF – Free Cash Flow The return that an investor in a private company should focus on is the spreadable cash that the company generates after allowing for payment of all expenses and taxes and all reinvestment requirements for working capital and capital expenditures. This amount, which is sometimes called Free Cash Flow (FCF), is the net cash flow on the capital invested in the business. It is computed as:
- 8 FCF – Free Cash Flow Curiously, net cash flow to invested capital appears on no financial statements, and private company owners almost never see it. But it represents the critical cash that can be taken from the business by debt and equity capital providers after all of the company's needs have been met. It is the capital providers' true return
- 9 WACC – Weighted Average Costs of Capital Proper investment choices must consider the risk or likelihood that the investment’s future will be achieved. This required rate of return is also known as costs of capital, or a discount rate. The required rate of return is the benchmark you must to achieve to create value. Because companies employ both debt capital and equity capital the costs of each of these capital sources must be computed. WACC is a weighted average of the after-tax costs of debt and costs of equity Where: Re = cost of equity Rd = cost of debt E = value of the firm's equity D = value of the firm's debt V = E + D = total value of the firm’s financing (equity and debt) E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate
- 10 WACC – Costs of Debt Costs of Debt is simply to obtain. This is annual interest on bank loan. However, this is a pretax cost of debt - companies can deduct interest expense from their tax bill, and reap a true cash benefit. The after-tax cost of debt is therefore lower. To obtain this number we multiple the pretax cost of debt by the so-called tax shield or (1- tax rate). Year 2014 12.0% (1 - 20%) 9.6% Pretax Costs fo Debt x (1 -Tax Rate) = After-Tax Costs of Debt Year 2015 12.0% (1 - 20%) 9.6% (1 -Tax Rate)x = After-Tax Costs of Debt Pretax Costs fo Debt Year 2016 18.0% (1 - 20%) 14.4% Pretax Costs fo Debt x (1 -Tax Rate) = After-Tax Costs of Debt
- 11 WACC – Costs of Equity We use capital asset pricing model (CAPM)to calculate costs of equity.According to thismodel the costsofequity isdetermined by three factors: the risk-free rate of return, the market-wide risk premium, and a β - risk adjustment that reflectseach company’s riskinessrelative to the average company.Ahigherbeta implies greaterrisk which,in turn,increasesthe expected return - and the expected return isthe same as the cost of equity.Beta,asa measure of risk, is a measure of the stock'ssensitivityto the overall market.A beta of 1.0 impliesthe stock will track closely with the market.A beta greaterthan 1.0 impliesthe stock ismore volatile than the market.The market risk premiumis the overall average excessreturn that investors in the market expect above that ofa risk-less investment like domestic treasury bonds,which for our calculation is 8%.There is always vigorousdebate overwhat the correct equity premiumis.We will use an equity premiumof32% Cost of Equity = Risk-Free Rate + Leverage Beta x Market Risk Premium Year 2014 8.0% 32% x 1.00 40.0% Risk - Free Rate + Premium x Beta = Costs of Equity Year 2015 8.0% 32% x 1.00 40.0% Risk - Free Rate + Premium x Beta = Costs of Equity Year 2016 8.0% 32% x 1.00 40.0% Risk - Free Rate + Premium x Beta = Costs of Equity
- 12 WACC –Cost of Debt vs Cost Of Equity You may have already noticed that debt is cheaper than equity. There are two reasons for this: first, the pretax cost of debt is lower because it has a prior claim on the company's assets. Second, it enjoys the tax shield (i.e. it is a tax- deductible charge), which is why a balance sheet totally devoid of debt may be suboptimal. Because debt is cheaper, by swapping some equity for debt, a company may be able to reduce its WACC. So why not swap all equity for debt? Well, that would be too risky; a company must service its debt, and a greater share of debt increases the risk of default and/or bankruptcy. Capital structure should be optimum.
- 13 WACC – Weighted Average Costs of Capital WACC significantly higher in 2016 due to borrowing rate increase in tenge from 12% to 18% and significant reduction of debt share in invested capital. Higher WACC means higher risk for investor and partly reflect difficulties in local economy. Weighted Average Costs of Capital 2014 Cost Share of Capital Weighted Costs Debt 9.6% x 82% = 7.83% Equity 40.0% x 18% = 7.36% WACC = 15.19% Weighted Average Costs of Capital 2015 Cost Share of Capital Weighted Costs Debt 9.6% x 84% = 8.05% Equity 40.0% x 16% = 6.47% WACC = 14.52% Weighted Average Costs of Capital 2016 Cost Share of Capital Weighted Costs Debt 14.4% x 61% = 8.80% Equity 40.0% x 39% = 15.54% WACC = 24.35%
- 14 Capital Structure Optimization A company’s balance sheet is the result of its financing and investment behavior. In this simplified context, the left-hand side of the balance sheet includes the uses of funds, cash holdings kept for liquidity needs or precautionary purposes and investments in net working capital and fixed assets made by the company (tangible and intangible). The right-hand side of the stylized balance sheet accounts instead for the different sources of funds for the company, broken down into equity and alternative types of financial debt – e.g. bank loans. Equity can build up from external investors who acquire a stake in the business, as well as from a company’s internal funds such as retained earnings accumulated after dividends have been paid to shareholders. A company is operating efficiently if the profit on its uses of funds (i.e. on the asset side) is at least equal to the cost of its sources of funds (i.e. the liabilities side). On the asset side, firms need to find the right balance between the necessity to maintain an adequate cushion of liquidity, to cover ordinary operations and to face future downturns or scarcity of funding, and the need to invest for growth. Large cash holdings, in fact, provide protection but generate low returns which depress overall profitability, as measured in terms of Return on Invested Capital (ROIC). On the liabilities side, instead, firms need to find the right balance between alternative sources of funds in order to optimize the capital structure and minimize its cost of financing, captured by the Weighted Average Cost of Capital (WACC) that is a function of the cost of debt, the level of the tax rate, the cost of equity and the relative weights of debt and equity.
- 15 Capital Structure – Debt to Equity Ratio The finance theory is not able to determine a universal formula which would enable an indication of a target optimal capital structure for a particular company. No formula exist to calculate optimal capital structure In such case lets take a logical approach. First we should avoid any extreme: it should not be 100% even debt or equity capital. Shareholder withdraw about 80% of equity capital at the beginning of each year as dividends. We can regulate only the size of debt capital or bank loan. It depends very much on debt collection and size of Trade receivable account. We can achieve maximum 45 days of trade receivable turnover. With assumption that company monthly turnover is $20M the balance of trade receivable account can be minimum $30M and outstanding debt to the bank about $10M So, the target for Company must be $10M debt capital and $10M equity capital or debt/equity ratio = 1 at the end of each year. After dividends payment this rate will increase ($10M+$8M)/($10M x (1-80%))=$18M/$2M=9 and each year company again should generate positive free cash flow to reduce this debt/equity ratio down to 1. Jan-14 Jan-15 Jan-16 Debt/Equity Raito 2.0 18.2 6.0
- 16 ROIC – Return on Invested Capital ROIC shows a company’s cash rate of return on capital (regardless of the capital structure of the company) it has put to work The numerator of ROIC is NOPAT, and denominator is invested capital. You can think of invested capital in two ways that are equal. First, it’s the amount of net assets a company needs to run its business. Alternatively, it’s the amount of financing creditors and shareholders need to supply to fund the net assets.
- 17 ROIC – Return on Invested Capital
- 18 ROIC – Return on Invested Capital It is important to measure not only profit but amount of capital employed to earn this profit. Return on investment is limited to dividends and appreciation in the stock value. Return on invested capital (ROIC) is one of the most fundamental financial metrics. When coupled with the weighed average cost of capital (WACC), ROIC becomes one of the most important drivers to value creation. The cost of capital represents the minimum rate of return (adjusted for risk) that a company must earn to create value for shareholders and debt holders. ROIC is measured against the cost of capital, which is what makes it such an important concept. Return On Invested Capital 2014 $8,649 $42,417 20.39% NOPAT / AVR IC - Cash = ROIC Return On Invested Capital 2015 $8,309 $32,986 25.19% NOPAT / AVR IC - Cash = ROIC Return On Invested Capital 2016 $10,495 $17,400 60.31% NOPAT / AVR IC - Cash = ROIC
- 19 ROIC – Return on Invested Capital ROIC can be decomposed into two parts (this is a modified version of what is known as a DuPont Analysis): The ratio of NOPAT/Sales, or NOPAT margin, is a measure of profit per unit. Sales/Invested Capital, or invested capital turnover, is a measure of capital efficiency. When you multiply the terms, sales cancel out and you are left with NOPAT/Invested Capital, or ROIC. ROIC DuPONT Analysis 2015 xROIC = NOPAT Invested Capital = NOPAT Revenue Revenue Invested Capital ROIC DuPONT Analysis 2015 $8,309 $8,309 $260,440 ROIC = = x $32,986 $260,440 $32,986 ROIC DuPONT Analysis 2015 ROIC = = x25.2% 3.2% 7.9 times
- 20 Spread ROIC – WACC When compared to WACC, ROIC can help determine whether or not a company creates value for its shareholders. If the ROIC of a company is higher than its WACC, it means that the company is a value creator. The ROIC-WACC spread is one of the most important metrics to assess the quality of a company. In today’s market, everybody talks about growth, but the fact is that growth is good only if a company is a value creator. Because if a company destroys value, growing will only make things worse. When ROIC is high, faster growth increases value, but when ROIC is lower than the company costs of capital, faster growth necessarily destroys value. High-ROIC companies should focus on growth, while low-ROIC companies should focus on improving returns before growing. ROIC - WACC spread 2014 20.39% 15.19% 5.20% ROIC - WACC = Spread ROIC - WACC spread 2015 25.19% 14.52% 10.67% = SpreadROIC - WACC ROIC - WACC spread 2016 60.31% 24.35% 35.97% ROIC - WACC = Spread
- 21 ROIC – Return on Invested Capital
- 22 ROIC, Growth, Investment and dividends Company growth must be supported by additional investment. It can be equity investment or debt investment. Equity reinvestment, seems to be, is not preferable. Debt investment should be minimized to minimize interest costs. So, we have only one option: support company growth by working capital optimization, means increase working capital turnover. Formula below represents calculation of optimal size of dividends to support further business growth or % of total net profit for distribution and reinvestment. Based on 2015 result and according to this calculation 75% of net profit could be distributed and 25% reinvested, accordingly in 2016 81% and 19%. Dividends distribution Growth D = x (1- ) ROIC Net Profit Dividends distribution 2015 6.64% D = $6.132 x (1- ) = 26.68% $4,605 Dividends distribution 2016 11.50% D = $9,055 x (1- ) = $7,328 60.31%
- 23 EVA – Economic Value Added There is a new and significantly better way to measure and maximize shareholder value that involves replacing traditional financial metrics and valuation tools with new ones. Economic Value Added (EVA) measures profit according to economic principles and for the purpose of managing a business, and not by following accounting conventions. It is computed as net operating profit after tax less a charge for typing up balance sheet capital. It consolidates income efficiency and assets management into one net profit score.
- 24 EVA – Economic Value Added Economic Profit 2014 $8,649 15.19% $42,417 $2,204 = Economic Profit NOPAT - WACC x AVR IC - Cash Economic Profit 2015 $8,309 14.52% $32,986 $3,520 = Economic Profit NOPAT - WACC x AVR IC - Cash Economic Profit 2016 $10,495 24.35% $17,400 $6,258 = Economic Profit NOPAT - WACC x AVR IC - Cash Economic profit is NOPAT minus a capital charge, which represents a sort of rental fee charged to the company for its use of capital. In other words, economic profit is the profits (or returns) our company must generate in order to satisfy the lenders and shareholders who have "rented" capital to the company. EVA is equal to NOPAT less a charge for capital or EVA = NOPAT – WACC x IC To create economic profit NOPAT should exceed a charge of capital.
- 25 EVA – Economic Value Added EVA = NOPAT – WACC x IC Lets little change presentation of this equation and replace NOPAT by ROIC ROIC = NOPAT/IC or NOPAT = ROIC x IC than EVA = ROIC x IC – WACC x IC = (ROIC-WACC) x IC The ROIC-WACC spread is one of the most important metrics to assess the quality of a company. if a company has a positive ROIC-WACC spread or alternatively has a positive EVA; it is a value creator. If the ROIC-WACC spread is negative or that the firm has a negative EVA, it is a value destroyer. Economic Spreadt 2014 5.2% $42,417 $2,204 ROIC - WACC + AVR IC - Cash = Economic profit Economic Spreadt 2015 10.7% $32,986 $3,520 ROIC - WACC x AVR IC - Cash = Economic profit Economic Spreadt 2016 36.0% $17,400 $6,258 ROIC - WACC + AVR IC - Cash = Economic profit
- 26 EVA – Economic Value Added Bigger isn't always better. The assumption that a company growing revenue, assets, employees, and profits becomes more valuable to its shareholders requires closer examination. Growth creates value only if adequate compensation exists for the incremental capital required to generate that growth. Focusing on where and how a business earns an adequate return on the capital employed, even if that means shrinking the business from a revenue or asset perspective, can create more value. Managers commonly focus on EBITDA growth, giving little consideration to the amount of capital required to achieve that growth. Ensuring that growth-oriented projects achieve acceptable returns should trump other decision criteria.
- 27 EVA – Economic Value Added Companies thrive when they create real economic value for their shareholders. Companies create value by investing capital at rates of return that exceed their costs of capital. The capital charge is computed by multiplying the costs of capital rate times the capital – that is, times the amount invested in the firm’s net business assets, which is all the assets used in the business, net of, or less, the money advanced by trade suppliers. That being the case, the more a company is able to finance its working capital with interest-free credit from its suppliers, the less capital it will need to obtain from lenders and shareholders, and the higher it’s EVA will be.
- 28 EVA – Economic Value Added It is real value in teaching team members about what goes into EVA and provide company-specific examples of how they can win. It’s the simplest way to spread financial literacy company-wide and stimulate a lot of good thinking around how to improve performance in ways that may not have occurred to anyone before that thinking in terms of EVA. On they understand that trade credit reduces the capital charge, for instance, employees will naturally lean on suppliers for better term without need for constant prodding from the CFO. A fundamental reason accounting is so flawed as a management and shareholder valuation tool is that accounting statement cater to lender rather than to owners. All else being equal, fewer assets mean more EVA, more real franchise value, and more wealth to the owners. The only true assets any company has is its ability to earn and increase EVA, which never appears on balance sheet. 2014 2015 2016 ROIC 20.4% 25.2% 60.3% Economic Spread 5.2% 10.7% 36.0% Economic Profit $2,204 $3,520 $6,258 $9,055 $1,440 $10,495 After-Tax Costs of Debt Costs of Equity 9.6% 40.0% 9.6% 14.4% 40.0% 40.0% Net Income Interest Tax Free NOPAT $6,132 $2,177 $8,309 $6,036 $2,614 $8,649 WACC 15.2% 14.5% 24.3% Debt Share Of Capital Equity Share of Capital 82% 18% 84% 16% 61% 39%
- 29 Company Financial KPI 2016 Financial KPI Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Forecast Moving Average DSO 62 62 58 58 58 58 58 58 58 58 58 58 NOPAT 8,318 8,364 8,293 8,397 8,572 8,778 9,126 9,775 10,524 10,795 10,519 10,495 Debt Investment 17,900 14,778 10,676 10,351 11,475 10,992 10,799 10,287 9,701 9,165 8,146 7,800 Equity Investment 2,959 3,611 4,206 4,971 5,668 6,443 7,260 8,072 8,875 9,804 10,654 11,410 ROIC 26.97% 29.47% 31.80% 34.49% 37.87% 39.86% 42.11% 46.55% 51.26% 53.98% 56.16% 60.31% WACC 14.90% 15.41% 15.98% 16.55% 17.19% 17.56% 17.88% 18.38% 18.86% 19.45% 20.37% 21.41% Economic Spread 12.07% 14.06% 15.82% 17.94% 20.68% 22.31% 24.23% 28.17% 32.40% 34.54% 35.79% 38.90% Accumulated AV 203 471 606 849 1,161 1,392 1,731 2,396 3,131 3,386 3,184 3,249
- Company X Thank you very much for your attention! Feb 2016Olegas Kasatkinas