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VALUATION WORKBOOK

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VALUATION WORKBOOK SEVENTH EDITION

McKinsey & Company Tim Koller Marc Goedhart David Wessels Michael Cichello

Copyright © 1990, 1994, 2000, 2005, 2010, 2015, 2021 by McKinsey & Company. All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750–8400, fax (978) 646–8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748–6011, fax (201) 748–6008, or online at www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762–2974, outside the United States at (317) 572–3993, or fax (317) 572–4002. Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com. Library of Congress Cataloging-in-Publication Data: Cloth edition: ISBN 978-1-119-61088-5 Cloth edition with DCF Model Download: ISBN 978-1-119-61246-9 University edition: ISBN 978-1-119-61186-8 Workbook: ISBN 978-1-119-61181-3 DCF Model Download: 978-1-119-61086-1 Cover design: Wiley Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1

Contents

About the Authors Introduction Part One

ix

xi

Questions

1 Why Value Value?

3

2 Finance in a Nutshell

5

3 Fundamental Principles of Value Creation 4 Risk and the Cost of Capital

7

11

5 The Alchemy of Stock Market Performance

15

6 Valuation of ESG and Digital Initiatives

19

7 The Stock Market Is Smarter Than You Think 8 Return on Invested Capital 9 Growth

21

27

31

10 Frameworks for Valuation

35

11 Reorganizing the Financial Statements 12 Analyzing Performance

39

43

13 Forecasting Performance 14 Estimating Continuing Value 15 Estimating the Cost of Capital

47 51 55 v

vi CONTENTS

16 Moving from Enterprise Value to Value per Share 17 Analyzing the Results 18 Using Multiples

63

67

19 Valuation by Parts 20 Taxes

59

71

75

21 Nonoperating Items, Provisions, and Reserves 22 Leases

77

81

23 Retirement Obligations

83

24 Measuring Performance in Capital-Light Businesses

85

25 Alternative Ways to Measure Return on Capital 26 Inflation

89

91

27 Cross-Border Valuation

95

28 Corporate Portfolio Strategy

99

29 Strategic Management: Analytics

103

30 Strategic Management: Mindsets and Behaviors 31 Mergers and Acquisitions 32 Divestitures

107

111

115

33 Capital Structure, Dividends, and Share Repurchases 34 Investor Communications 35 Emerging Markets

127

36 High-Growth Companies 37 Cyclical Companies 38 Banks 39 Flexibility Part Two

123

129

131

135 139

Solutions

1 Why Value Value? 2 Finance in a Nutshell

145 147

3 Fundamental Principles of Value Creation 4 Risk and the Cost of Capital

151

149

119

CONTENTS vii

5 The Alchemy of Stock Market Performance 6 Valuation of ESG and Digital Initiatives

153 155

7 The Stock Market Is Smarter Than You Think 8 Return on Invested Capital 9 Growth

157

159

161

10 Frameworks for Valuation

163

11 Reorganizing the Financial Statements 12 Analyzing Performance

165

167

13 Forecasting Performance

169

14 Estimating Continuing Value

173

15 Estimating the Cost of Capital

175

16 Moving from Enterprise Value to Value per Share 17 Analyzing the Results 18 Using Multiples

179

181

19 Valuation by Parts 20 Taxes

183

185

21 Nonoperating Items, Provisions, and Reserves 22 Leases

177

187

189

23 Retirement Obligations

193

24 Measuring Performance in Capital-Light Businesses 25 Alternative Ways to Measure Return on Capital 26 Inflation

197

199

27 Cross-Border Valuation

203

28 Corporate Portfolio Strategy

207

29 Strategic Management: Analytics

209

30 Strategic Management: Mindsets and Behaviors 31 Mergers and Acquisitions 32 Divestitures

195

211

213

215

33 Capital Structure, Dividends, and Share Repurchases

217

viii CONTENTS

34 Investor Communications 35 Emerging Markets

223

36 High-Growth Companies 37 Cyclical Companies 38 Banks

229

39 Flexibility Index

233

231

219

227

225

About the Authors

The authors, collectively, have more than 100 years of experience in consulting and financial education. Tim Koller is a partner in McKinsey’s Stamford, Connecticut, office, where he is a founder of McKinsey’s Strategy and Corporate Finance Insights team, a global group of corporate-finance expert consultants. In his 35 years in consulting, Tim has served clients globally on corporate strategy and capital markets, mergers and acquisitions transactions, and strategic planning and resource allocation. He leads the firm’s research activities in valuation and capital markets. Before joining McKinsey, he worked with Stern Stewart & Company and with Mobil Corporation. He received his MBA from the University of Chicago. Marc Goedhart is a senior expert in McKinsey’s Amsterdam office and endowed professor of corporate valuation at Rotterdam School of Management, Erasmus University (RSM). Over the past 25 years, Marc has served clients across Europe on portfolio restructuring, M&A transactions, and performance management. He received his PhD in finance from Erasmus University. David Wessels is an adjunct professor of finance at the Wharton School of the University of Pennsylvania. Named by Bloomberg Businessweek as one of America’s top business school instructors, he teaches courses on corporate valuation and private equity at the MBA and executive MBA levels. David is also a director in Wharton’s executive education group, serving on the executive development faculties of several Fortune 500 companies. A former consultant with McKinsey, he received his PhD from the University of California at Los Angeles.

ix

x ABOUT THE AUTHORS

Michael Cichello is a finance professor at the McDonough School of Business at Georgetown University. He teaches corporate valuation to undergraduate, MBA, and Executive MBA students and works with executives of several Fortune 500 companies to implement value-creating opportunities. Michael also helped create Georgetown’s top-ranked Online Master of Science in Finance program. His research explores managerial incentives, corporate governance, and financial contracting schemes. Professor Cichello received a PhD in finance from Michigan State University. McKinsey & Company is a global management consulting firm committed to helping organizations create change that matters. In more than 130 cities and 65 countries, teams help clients across the private, public, and social sectors shape bold strategies and transform the way they work, embed technology where it unlocks value, and build capabilities to sustain the change. Not just any change, but change that matters—for their organizations, their people, and in turn society at large.

Introduction

The purpose of any workbook is to actively engage the reader/learner in the transfer of knowledge from author to reader. Although there are many levels at which knowledge can be transferred, the Valuation Workbook endeavors to provide the following three services: 1. A walk-through accompaniment to Valuation: Measuring and Managing the Value of Companies, seventh edition 2. A summary of each chapter 3. Tests of comprehension and skills of many types Multiple-choice questions pique your memory as you read the text. Lists and table completions force you to actively rearrange concepts, explicitly or implicitly, within the text. Calculation questions allow you to apply the skills deployed by the authors in accomplishing the analysis called valuation. Our aim is to encourage you to question what you read against the background of your own business experience and to think about new ways to analyze and approach valuation issues.

xi

Part One

Questions

1 Why Value Value? The chief measures for judging a company are its ability to create value for its shareholders and the amount of total value it creates. Corporations that create value in the long term tend to increase the welfare of shareholders and employees as well as improve customer satisfaction; furthermore, they tend to behave more responsibly as corporate entities. Ignoring the importance of value creation not only hurts the company but leads to detrimental results such as market bubbles. Value creation occurs when a company generates cash flows at rates of return that exceed the cost of capital. Accomplishing this goal usually requires that the company have a competitive advantage. Activities such as leverage and accounting changes do not create value. Frequently, managers shortsightedly emphasize earnings per share (EPS); in fact, a poll of managers found that most managers would reduce discretionary value-creating activities such as research and development (R&D) in order to meet short-term earnings targets. One method to meet earnings targets is to cut costs, which may have short-term benefits but can have long-run detrimental effects. 1. Data from both Europe and the United States found that companies that created the most shareholder value showed ____________ employment growth. 2. The _______________ in the late 1990s, and the ___________ in 2007–08, arose largely because companies and banks focused on ___________ over ____________. 3. Maximizing current share price is not equivalent to maximizing long-term value because ____________. 4. Discretionary expenses that managers can slash in order to pump up short-term profits include ____________.

3

4 QUESTIONS

5. During the Internet boom of the late 1990s, many firms lost sight of value creation principles by blindly pursuing ____________ without ____________. 6. The empirical evidence shows that the link between the value created by the acquisition of another company and earnings per share (EPS): A. Is strong and positive. B. Does not exist. C. Is weak and negative. D. Is strong and negative. 7. Paying attention to which of the following tends to lead to a company creating long-term value for shareholders? I. Cash flow. II. Earnings per share. III. Growth. IV. Return on invested capital. A. I and II only. B. II and III only. C. II, III, and IV only. D. I, III, and IV only. 8. A firm that grows rapidly will: A. Always create value. B. Create value if the return on invested capital (ROIC) is greater than the cost of obtaining funds. C. Create value if the return on invested capital (ROIC) is less than the cost of obtaining funds. D. Create value if the firm increases market share. 9. In order to create long-term value, companies must: A. Focus on keeping costs at a minimum. B. Find the optimal debt-to-equity ratio. C. Seek and exploit new sources of competitive advantage. D. Monitor and follow macroeconomic trends. 10. Focus on short-term results by banks was a contributing factor to the financial crisis of 2007–08. A. True B. False

2 Finance in a Nutshell Companies create value when they earn a return on invested capital (ROIC) greater than their opportunity cost of capital. If the ROIC is at or below the cost of capital, growth may not create value. Companies should aim to find the combination of growth and ROIC that drives the highest discounted value of their cash flows. In so doing, they should consider that performance in the stock market may differ from intrinsic value creation, generally as a result of changes in investors’ expectations. To illustrate how value creation works, this chapter follows a company from its early years through going public. Throughout the discussion, attention is given to key measures of performance, such as ROIC, growth, and company value based on discounted cash flow (DCF). Five core ideas around value creation and its measurement are illustrated: 1. In the real market, you create value by earning a return on your invested capital greater than the opportunity cost of capital. 2. The more you can invest at returns above the cost of capital, the more value you create. That is, growth creates more value as long as the return on invested capital exceeds the cost of capital. 3. You should select strategies that maximize the present value of future expected cash flows or economic profit (EP). The answer is the same regardless of which approach you choose. 4. The value of a company’s shares in the stock market equals the intrinsic value based on the market’s expectations of future performance, but the market’s expectations of future performance may not be the same as the company’s. 5. The returns that shareholders earn depend on changes in expectations as much as on the actual performance of the company.

5

6 QUESTIONS

1. Lily’s Emporium creates value if it generates a ________ return on its invested capital (ROIC) than what they could earn if they invested their capital elsewhere. 2. Logan’s Stores’ superior growth over Lily’s Dresses was not translating into a ________ ROIC because Logan’s Stores had to invest ________ in order to grow and had a ________ differentiated product than Lily’s Dresses. 3. Lily and Nate can address the trade-off between short-term decline in ROIC and long-term increase in ROIC by estimating whether the expansion is valuable through ________________________. 4. Lily and Nate should keep the ________-performing stores open because even though they have ________ ROICs than the other stores, these ________-performing stores still have ROICs ________ than the cost of capital. Thus, these stores still create additional ___________ by staying open. 5. The intrinsic value of Lily’s Emporium is based on the ________________ ________, while the share price is based on ________________________. Investors would want to buy Lily’s stock when their intrinsic value estimate is ________ than the current stock price. 6. As Lily’s Emporium expands, it needs a planning and control system that incorporates both ________- and ________-looking measures that are ________________. 7. (True/False) Suppose that an investor bought shares in Lily’s Emporium and held them for five years. If the firm generated ROICs above their cost of capital, this means that the investor had returns above the cost of capital. 8. (True/False) Both the DCF and EP methods should yield the same valuations if properly applied.

3 Fundamental Principles of Value Creation Earnings generation and value creation are correlated over the long run, but they are not the same. Value creation is determined by cash flows, which can be disaggregated into revenue growth and return on invested capital (ROIC). For any level of growth, increasing ROIC increases value; however, the reverse is not true. When ROIC is greater than the cost of capital, increasing growth increases the value of the firm; when ROIC is less than the cost of capital, increasing growth decreases the firm’s value. When ROIC equals the cost of capital, growth does not affect a firm’s value. For the years 1995 to 2018, Rockwell Automation provides a good example of the importance of increasing ROIC. Over the period, revenue shrank by 3 percent per year, but ROIC increased from 12 percent to 35 percent, with a resulting annual total return to shareholders of 19 percent per year. The key value driver formula, is: ( ) g NOPATt=1 1 − ROIC Value = WACC − g where NOPAT is the net operating profit after taxes. Because the formula assumes the relationships are static, it has some limitations on its application in practice; however, it does outline the important relationships that determine and drive value. Part Two of the text expands on the formula. 1. Rank the types of growth from highest to lowest, where highest = 1, in terms of the amount of shareholder value each typically creates from the same incremental increase in revenue.

7

8 QUESTIONS

Types of growth

Ranking

A. Increase share in a growing market.

1.

B. Expand an existing market.

2.

C. Acquire businesses.

3.

D. Introduce new products to market.

4.

2. High-ROIC companies typically create more value by _________, while lower-ROIC companies create more value by __________. 3. Most often in mature companies, a low ROIC indicates ________. 4. Complete the following sentence concerning the relationships among earnings, cash flow, and value. Earnings and cash flow are often ____________, but earnings don’t tell the whole story of value creation, and focusing too much on earnings or earnings growth ____________ ____________. 5. When ROIC is greater than the cost of capital, the relationship between growth and value is ____________. When ROIC is less than the cost of capital, the relationship between growth and value is ____________. When ROIC equals the cost of capital, the relationship between growth and value is ____________. 6. With respect to countries, the core valuation principle is ____________, as made evident by the fact that U.S. companies trade ____________ companies in other countries. 7. When comparing the effect of an increase in growth on a high-ROIC company and a low-ROIC company, a 1 percent increase in growth will have ____________. 8. At high levels of ROIC, improving ROIC by increasing margins will create __________ value than an equivalent ROIC increase by improving capital productivity. 9. Economic profit is the spread between __________ and _________ times ______________. 10. If the growth of a company is 2 percent and the ROIC is 10 percent, what is the investment rate? A. 2 percent. B. 5 percent. C. 12 percent. D. 20 percent.

FUNDAMENTAL PRINCIPLES OF VALUE CREATION 9

11. For a given company, next year’s NOPAT is $300. For the foreseeable future, the growth rate will be 5 percent, the ROIC will be 15 percent, and the weighted average cost of capital (WACC) will be 13 percent. Using the key driver formula, calculate the value of the company. A. $1,666. B. $2,222. C. $2,500. D. $2,750. 12. Changing capital structure creates value only if it ____________. 13. An acquisition will create value only if it increases cash flows by ________________. 14. When the likelihood of investing cash at ________ is _____, share repurchases make sense as a tactic for avoiding value destruction. 15. With respect to value creation, define financial engineering. 16. Because interest expense is tax deductible, share repurchases can have the beneficial effect of ____________, but this may not increase share price because ____________. 17. Studies of share repurchases have shown that companies _________ at timing share repurchases, often ______________.

4 Risk and the Cost of Capital A company’s cost of capital is critical for determining value creation and for evaluating strategic decisions. It is the rate at which you discount future cash flows for a company or project. It is also the rate you compare with the return on invested capital to determine if the company is creating value. The cost of capital incorporates both the time value of money and the risk of investment in a company, business unit, or project. The cost of capital is an opportunity cost, based on what investors could earn by investing their money elsewhere at the same level of risk. Only diversifiable risks affect a company’s cost of capital. Other risks, which can be diversified, should only be reflected in the cash flow forecast using multiple cash flow scenarios. Companies should take on all investments that have a positive expected value, regardless of their risk profile, unless the projects are so large that failure would threaten the viability of the entire company. Most executives are reluctant to take on smaller risky projects even if the returns are very high. The ability of investors to diversify their portfolios means that only nondiversifiable risk affects the cost of capital. Companies in the same industry will have similar costs of capital. The risks they cannot diversify away are those that affect all companies—for example, exposure to economic cycles. Certain projects carry what many investors see as high risk. Companies should not bump up the assumed cost of capital to reflect the uncertainty of risky projects. In doing so, they often end up rejecting good investment opportunities as a result. A better approach for determining the expected value of a project is to develop multiple cash flow scenarios, value them at the unadjusted cost of capital, and then apply probabilities for the value of each scenario to estimate the expected value of the project or company.

11

12 QUESTIONS

Using scenarios has several advantages, including (1) providing decision makers with more information; (2) encouraging managers to develop strategies to mitigate specific risks; and (3) acknowledging the full range of possible outcomes. In theory, a company should take on all projects or growth opportunities that have positive expected values even if there is high likelihood of failure, as long as the project is small enough that failure will not put the company in financial distress. In practice, companies tend to overweight the impact of losses from smaller projects, thereby missing value creation opportunities. Executives making decisions for their companies should think about the company’s risk profile, not their own. Corporations are designed to take risks and overcome the natural loss aversion of individuals. To overcome loss aversion and make better investment decisions, individuals and organizations must learn to frame choices in the context of the entire company’s success, not the individual project’s performance. Although hedging may reduce the short-term cash flow volatility, it will have little effect on the company’s valuation based on long-term cash flows. Some risks, like the commodity price risk in this example, can be managed by shareholders themselves. Other risks, such as some forms of currency risk, are harder for shareholders to manage. The general rule is to avoid hedging the first type of risk but hedge the second if possible. 1. A firm’s cost of capital is driven by investors’ ____________, because firm managers have a fiduciary responsibility to the company’s investors. 2. The cost of capital incorporates both the ____________ and the ____________ in a company, business unit, or project. 3. Within a company, individual business units can have different costs of capital if ________________. 4. The ability of investors to diversify their portfolios means that only ____________ risk affects the cost of capital. 5. Because ____________ risk generally affects all companies in the same industry in the same way, a company’s ____________ is what primarily drives its cost of capital. 6. Certain projects carry high risks. Managers should not ignore these risks, but should explicitly include them in ____________, not _______________. 7. Some advantages to using a scenario expected cash flow approach over an ad hoc risk premium approach when evaluating high-risk projects are: A. ________________________ B. ________________________ C. ________________________

RISK AND THE COST OF CAPITAL 13

8. Managers should take on all projects or growth opportunities that have ___________________ even if there is high likelihood of failure, so long as the project is __________________________. 9. Managers should hedge the risks that __________________________.

5 The Alchemy of Stock Market Performance The expectations treadmill is the name for a problem faced by high-performing managers who try to meet the high market expectations that result from the high level of performance in recent periods. It’s the reason that, in the short term, extraordinary managers may deliver only mediocre total shareholder returns (TSR). It’s also the dynamic behind the adage that a good company and a good investment may not be the same. An example of this is a comparison of the company and stock performance of Tyson Foods and J&J Snack Foods from 2013 to 2017. Although J&J outperformed Tyson in both revenue growth and ROIC, the annualized TSRs were 14 and 27 percent, respectively. Investors in J&J had very high expectations relative to investors in Tyson, as illustrated by EV/NOPAT multiples for J&J being 1.4 to 2.2 times those of Tyson. Decomposing TSR can give better insights into a company’s true performance and in setting new targets. There is already the traditional method of decomposing TSR into three parts: (1) percent change in earnings, (2) percent change in P/E, and (3) dividend yield. A clearer picture can be found from breaking TSR into five parts: (1) the value generated from revenue growth, (2) investment required to generate revenue growth, (3) the impact of a change in margin on net income growth, (4) the starting ratio of net income to market value, and (5) the change in the P/E ratio. A more thorough analysis can explain why a small decline in TSR in the short run to adjust expectations may be preferable to desperately trying to maintain TSR through ill-advised acquisitions and ventures.

15

16 QUESTIONS

Use the following financials to answer Questions 1 through 4. $ million

Base year

1 year later

Invested capital

$200

$208

Earnings

$20

$22

P/E

12

12.6

Equity value

240

276

Dividends

$10

$12

1. What is the TSR from performance? A. −2.0 percent. B. −0.5 percent. C. 4.5 percent. D. 6.7 percent. 2. What is the dividend yield? A. 4.2 percent. B. 4.8 percent. C. 5.0 percent. D. 6.0 percent. 3. What is the zero-growth return? A. 8.3 percent. B. 10.5 percent. C. 12.5 percent. D. 15.3 percent. 4. What is the TSR? A. 14.0 percent. B. 15.0 percent. C. 15.5 percent. D. 20.0 percent. 5. Using the traditional approach, an analyst can break down TSR into two or three components. List the components in the two-component breakdown: A. ___________________________________________________________ B. ___________________________________________________________ List the components in the three-component breakdown: A. ___________________________________________________________ B. ___________________________________________________________ C. ___________________________________________________________

THE ALCHEMY OF STOCK MARKET PERFORMANCE 17

6. For periods of ____________ years or more, it is true that if managers focus on ____________, then their interests and the interests of shareholders should be aligned. 7. The detrimental result of the expectations treadmill is that, for firms that have had superior operating and TSR performance, the managers who try to continually meet the higher expectations may engage in detrimental activities such as ____________ or ____________. 8. A company should measure management performance in terms of the company’s performance, not its share price. Three areas of focus should be _______, _______, and _______.

6 Valuation of ESG and Digital Initiatives Two key items requiring executives’ attention are managing the intertwined elements of environmental, social, and governance concerns (ESG) and grappling with the impact of “digital” initiatives. The principles of corporate valuation do not include simple prescriptions for assigning values to various approaches to ESG or individual digital assets or strategies. Work is still in progress on how to identify robust metrics of their success. For ESG initiatives, companies should focus on the few areas that make a difference in their industry—for example, water consumption for beverage makers, supply chain management for apparel companies, or carbon emissions for many industries. ESG initiatives may link to cash flow in five important ways: (1) facilitating revenue growth, (2) reducing costs, (3) minimizing regulatory and legal interventions, (4) increasing employee productivity, and (5) optimizing investment and capital expenditures. For digital initiatives, companies need to pay close attention to the risks of embracing or ignoring technological trends. In either case, basic principles of valuation are recommended to establish a foundation for measuring outcomes, combined with gathering data to improve their application in the future. Digital initiatives may improve a company’s performance in five key areas: (1) new business models, (2) cost reduction, (3) improved customer experience, (4) new revenue sources, and (5) better decision making. Use the following information for Questions 1 and 2: Suppose that you manage SaladCo, a salad chain with thousands of stores globally. You are considering investing in an app that allows customers to preorder salads and other food to pick up at their local stores. 1. You should evaluate this decision by constructing ________________ analysis, comparing ___________ cash flows with a base case. 19

20 QUESTIONS

2. You should be careful to define the base case as a ________________, not ________________, as competitors are likely working on deploying the same technology. 3. (True/False) For ESG concerns, E stands for environmental criteria, which include the energy a company takes in and the waste it discharges, the resources it needs, and the consequences for living beings as a result. 4. (True/False) For ESG concerns, S stands for social criteria, which address the relationships a company has and the reputation it fosters with people and institutions in the communities where it does business. 5. (True/False) For ESG concerns, G stands for governance, which includes the political party or parties that are in power at the time. 6. Current research appears to find that companies that pay attention to ESG concerns ________ experience a negative impact on value creation and ________ experience a reduction in downside risk. 7. In what ways may ESG link to firm cash flows? A. __________________________________________________________ B. __________________________________________________________ C. __________________________________________________________ D. __________________________________________________________ E. __________________________________________________________ 8. In what ways may firms improve their performance using digital initiatives? A. __________________________________________________________ B. __________________________________________________________ 9. Network effects are the idea that some firms may be able to earn higher __________ and _______________ because their product becomes more valuable with each new customer. 10. Digital initiatives might create network effects by allowing a first mover to _____________________ due to _____________________. 11. In addition to potential industry disruption, what are potential ways that digital initiatives may enhance firm value? A. __________________________________________________________ B. __________________________________________________________ C. __________________________________________________________ D. __________________________________________________________

7 The Stock Market Is Smarter Than You Think Return on invested capital (ROIC) and growth are the only drivers of value creation, yet managers often spend time and resources attempting to smooth earnings, meet earnings targets, stay listed in a stock index, and become cross-listed. The evidence shows that the stock market does not reward these efforts, nor do changes in accounting rules and stock splits have lasting effects. These issues do not have an effect on stock returns unless they reflect a change in fundamental value. Listing and delisting from an index do not seem to have long-term effects for any given firm. Although there can be a negative effect initially from delisting, the effect usually reverses in a few months. Furthermore, crosslisting within developed markets does not have an effect; however, firms in emerging markets may benefit from cross-listing in a developed market. Investors apparently see through accounting changes. If investors focused on earnings, for example, a move from FIFO to LIFO would lower the share price, but it generally does the opposite because of the increase in cash flows. As another example, mere changes in goodwill do not affect share price; however, a change in goodwill that is associated with a real change in the firm produces a reaction from sophisticated investors. When there is mispricing, two possible sources of this are: (1) the combinations of overreaction, underreaction, reversal, and momentum, and (2) bubbles and bursts. Unrealistic expectations of continued growth, which led to excessively high P/E ratios, caused the tech bubble in the late 1990s. High earnings that were not sustainable caused the credit bubble a decade later. Thus, in the latter case, it was not that the P/E ratios were too high, but that the earnings in the ratio eventually had to fall. 1. Which of the following are properties that should lead to firms having higher value in the stock market? 21

22 QUESTIONS

I. Higher P/E. II. First-in first-out (FIFO) accounting. III. Higher growth. IV. ROIC greater than the cost of capital. A. I and II only. B. I, II, and III only. C. III and IV only. D. II, III, and IV only. 2. Which two of the following situations will create the most value? I. A high-ROIC company increasing P/E. II. A high-growth company increasing P/E. III. A high-ROIC company increasing growth. IV. A high-growth company increasing ROIC. A. I and II only. B. I and III only. C. II and III only. D. III and IV only. 3. According to Exhibit 7.6 in the text, which is true of the two sectors with the highest and second highest market-value/capital ratio? I. Their market-value/earnings ratios were the highest and second highest, respectively. II. Their ROICs were the second and third highest, respectively. III. Their growth rates were the highest and third highest, respectively. IV. Their P/E ratios were the highest and second highest, respectively. A. I and II only. B. I and IV only. C. II and III only. D. II, III, and IV only. 4. The point of Exhibit 7.13 in the text is to show: A. That even the companies with the lowest earnings volatility do not have smooth earnings. B. The negative relationship between earnings volatility and returns to shareholders. C. The positive relationship between earnings volatility and returns to shareholders. D. The significant change in stock returns that occurs when the managers of a company engage in earnings smoothing.

THE STOCK MARKET IS SMARTER THAN YOU THINK 23

5. Academic research has found that share prices of companies that are removed from a major stock index: A. Trend down until significant news arrives to reverse the trend. B. Do not experience any abnormal returns either in the short term or in the long term. C. Drop immediately and then begin trading normally. D. Drop immediately, but the decline is usually reversed within one or two months. 6. Which of the following are valid reasons that cross-listing might actually improve a company’s stock performance? I. Improved corporate governance. II. Trading in multiple time zones. III. Access to an increased number of investors. IV. Affirmation effect of being listed in more than one developed market. A. I, II, and IV only. B. I and III only. C. II and III only. D. II, III, and IV only. 7. Which of the following are valid reasons that a firm’s stock split can be followed by an increase in the value of the shares of that firm? I. Signaling. II. Liquidity. III. More shares outstanding. IV. Self-selection. A. I and IV only. B. II and III only. C. II, III, and IV only. D. None of these. 8. Voluntary option expensing has been found to have which of the following? A. A negative impact on share price. B. A positive impact on share price. C. No impact on share price. D. A positive impact if LIFO accounting is used and a negative effect if FIFO accounting is used.

24 QUESTIONS

9. An analysis of 50 European companies that began reporting using U.S. GAAP over the period 1997 to 2004 found which of the following? I. Earnings under GAAP were generally lower than earnings under the home country’s rules. II. The differences in earnings under the two regimes were all less than 10 percent. III. The stocks of the 50 companies generally reacted positively when the disclosures were made. IV. Executives had concerns over the impact of reporting under U.S. GAAP. A. I and II only. B. I, II, and III only. C. I, III, and IV only. D. II, III, and IV only. 10. The effect of the announcement of goodwill impairment on share prices has been found to be: A. Positive and significant overall. B. Negative and significant overall. C. Insignificant. 11. (True/False): Random deviations from intrinsic value can occur in stock prices, but managers are best off assuming that the market will correctly reflect the intrinsic value of their decisions. 12. Both the 2000 bubble and the 2007 bubble were valuation bubbles. 13. Market-wide price deviations from fair value are less frequent than individual company share price deviations from the company’s fundamental value. 14. In the 2000 stock bubble, most of the large-capitalization companies with high P/Es were clustered in all of the following sectors except: A. Utilities. B. Technology. C. Media. D. Telecommunications. 15. Which of the following was not one of the faster growing sectors in the period 2000–2006? A. The energy sector. B. The financial sector. C. The transportation sector. D. The utilities sector.

THE STOCK MARKET IS SMARTER THAN YOU THINK 25

16. Which of the following is/are correct concerning how managers should perceive short-term volatility of their stock? I. See it as a sign of market inefficiency. II. Take it into account when driving ROIC. III. Take it into account when driving growth. IV. Investors offer no rewards for predictable earnings or earnings guidance. A. I, II, and III only. B. I and IV only. C. II and III only. D. IV only. 17. Which of the following characterize noise traders? I. They do not care about intrinsic value. II. They are always in the minority. III. They can move price outside the bounds of intrinsic value. IV. They trade on small events. A. I and II only. B. I, III, and IV only. C. II, III, and IV only. D. II and IV only.

8 Return on Invested Capital The basic source of value creation is competitive advantage. The following expression expands the expression of ROIC proposed in Chapter 3: ROIC = (1 − Tax Rate)

Price per Unit − Cost per Unit Invested Capital per Unit

This formula explains how a higher ROIC is the result of a competitive advantage from being able to charge a higher price or being able to produce at a lower cost. The structure-conduct-performance (SCP) framework provides a strategy model for competitive advantage. One of the most widely used approaches in analyzing strategy is Porter’s framework, which focuses on threat of entry, pressure from substitute products, bargaining power of buyers, bargaining power of suppliers, and the degree of rivalry among existing competitors. These forces differ widely by industry. Five pricing advantages and four cost advantages determine overall competitive advantage. The five pricing advantages are innovative products, quality, brand, customer lock-in, and rational price discipline. The four cost advantages are innovative business methods, unique resources, economies of scale, and scalable products/processes. In a competitive economy, the pricing and cost advantages can erode through competition, and the sustainability of the high ROIC from a competitive advantage depends on issues such as the length of the life cycle of the business and the potential for renewing products. The evidence shows that the relative ROIC of a firm to the average of all other firms and to the firms in the industry remains fairly sustainable for periods of 10 years or more; however, there will be some reversion to the median and/or mean. 1. List Michael Porter’s five forces: A. __________________________________________________________ B. __________________________________________________________ 27

28 QUESTIONS

C. __________________________________________________________ D. __________________________________________________________ E. __________________________________________________________ 2. The key driver of ROIC is ____________. 3. According to empirical studies over the past five decades, how successful have firms been in sustaining their rates of ROIC? 4. Explain what quality means in the context of competitive advantage and ROIC. 5. For a pricing advantage, using rational pricing discipline requires either a ____________ or ____________. 6. Explain the difference between economies of scale and scalable products. 7. Between 1963 and 2000, the median ROIC was about ____________ percent, and the interquartile range was from ____________ percent to ____________ percent. 8. Since the early 2000s, the median ROIC was about ____________ percent, and the interquartile range was from ____________ percent to ____________ percent. 9. The increase in median ROIC and the widening of the distribution of ROICs are the result of _________________________. 10. The reason for the increasing difference between ROIC without goodwill and ROIC including goodwill is that __________________. 11. From highest to lowest, rank the following three industries based on ROIC. They have been selected based on branding advantages and barriers to entry. A. Construction

1.____________

B. Pharmaceuticals

2. ____________

C. Branded consumer goods

3. ____________

D. Healthcare equipment, supplies

4. ____________

12. If a firm establishes itself as a high-ROIC firm, within 10 years it is expected that the ROIC will: A. Have fallen to the average or be below the average ROIC. B. Have fallen, but will still be above the average ROIC. C. Not have fallen, and will maintain about the same. D. Have continued to trend up.

RETURN ON INVESTED CAPITAL 29

13. Given that a company charges $3.40 per unit, has a cost per unit of $1.80, has a tax rate of 32 percent, and requires $16 of invested capital per unit, what is the ROIC? A. 6.8 percent. B. 10.2 percent. C. 15.6 percent. D. 30.3 percent. 14. Cereal manufacturers have been successful at branding their products, while meat producers have been unable to do so to a large degree. Based on this fact, which of the following is the most accurate concerning the pricing advantage that cereal manufacturers have over meat producers? A. The ROIC for cereal manufacturers is less than that of meat producers because branding does not create value and branding has a cost. B. The ROIC for cereal manufacturers is equal to that of meat producers because the costs and benefits reach an equilibrium. C. The ROIC for cereal manufacturers is twice as high as that of meat producers. D. The ROIC for cereal manufacturers is three times as high as that of meat producers.

9 Growth Growth can vary greatly across industries and across firms within industries. There are three components of revenue growth: (1) portfolio momentum, (2) market share performance, and (3) mergers and acquisitions. Components (1) and (2) are types of organic growth. Components (1) and (3) have the highest explanatory power. In other words, high growth depends more on choosing the right markets and acquisitions and less on gaining market share. The highest value-creating strategy is entering into fast-growing markets that take revenue from distant companies instead of rivals in the local industry. Other value-creating strategies include developing new products or services, persuading customers to increase the use of the existing products, and attracting new customers. Trying to increase market share in a growing market may have some success, but it will probably fail to create value in a mature market because of the reactions of rivals. Product promotions, pricing promotions, and incremental product changes rarely create lasting value. Since products have natural life cycles, sustaining growth is more difficult than sustaining ROIC. To sustain growth, a firm must consistently develop new products in a timely fashion. A study of publicly traded companies found that over the period 1965 to 2017, the median revenue growth rate was 4.9 percent, and the range of the growth rates was 0 percent to 9 percent. High growth rates decay quickly, and large companies struggle to grow. The median growth of publicly traded companies exceeded that of U.S. gross domestic product (GDP) for four possible reasons: (1) sample selection, (2) the effects of outsourcing, (3) expansion into foreign markets, and (4) the effects of inorganic factors, such as mergers and acquisitions and currency fluctuations. 1. Identify the sources of organic growth and indicate which has the highest explanatory power for growth. 2. Explain the importance of incremental innovation in creating value. 31

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