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Sohail Zafar
Lectures 15
Valuation of Corporations continues
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
marketing capabilities. Share of Micro Soft experienced growth in price in the stock market during those
years of non-dividend payments, and investors earned their ROR in the form of capital gains yield only as
there was no dividend yield. So MicoSoft gave nothing in the form of cash to its shareholders for so
many years and its dividend yield was zero for those years, yet share market rewarded the shareholders
in the form of capital gains yield. DDM is not useful for valuing such non dividend-paying corporations.
DDM is also not usable for valuing portions of a co, such as a division of a corporation, or a product line,
or a plant of a Co, or operations of a company in a foreign country. But in real life we observe companies
selling their portions such as divisions, product lines, etc, to other companies. To estimate value of such
portions of a corporation DDM is not usable, rather free cash flows model is more appropriate and you
will learn about that model shortly.
DDM assumes that Co is expected to experience low constant growth rate every year for ever, because if
the growth rate is higher than Kc then the term (Kc - g) in the denominator of the above equation would
become a negative number resulting in a negative value for its shares; and negative value of a share is not
a meaningful idea.
Also the DDM assumes DPS per year till infinity and a constant percentage growth every year in the DPS.
That means DDM assumes policy constancy year after year, such as, constant dividend payout ratio (d =
DPS / EPS ratio), a constant capital Structure (TA / OE ratio), constant Net Profit Margin (NI / S ratio),
constant TA turnover (S/TA ratio), and fixed number of shares outstanding, which means no share issuing
and no share repurchases by the Co. With these assumptions about constancy of 5 corporate policies ,
the percentage growth rate in OE due to retention of NI translate into the same percentage growth rate in
TA, TL, Sales, NI, EPS, DPS, and finally growth in share price. But in real life companies are rarely managed
with such constant policies.
DDM also assumes that the Co must not be expected to merge with another Co, but should continue
forever as an independent Co.
Please note that Kc is rate of return expected to be earned by shareholders, but in finance returns without
risk considerations are not meaningful therefore a theory called CAPM is used which relates shareholders
expected rate of return with the relevant risk of that share as:
Risk adjusted required Kc = Rf + (Rm Rf) beta
And such Kc is termed risk adjusted required ROR by shareholders.
On the other hand expected rate of return from shares has 2 components, namely the dividend yield and
capital gains yield. Dividend yield is given by the Co by virtue of paying cash dividend to shareholders, but
capital gains yield is not given by the co to its shareholders rather it is solely decided in the stock market
as result of change in share price between the buying and selling times; and the co has no control on such
changes in its share price because such price changes in the market are result of actions of millions of
individuals involved in buying and selling that share. This formulation of expected Kc as sum of dividends
yield and capital gains yield is called expected rate of return for share holders; and it does not have in it
explicit considerations for the risk; it can be written as :
expected Kc =
DPS1/Po +
( P1 - Po) /Po
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
and since ( P1 - Po) /Po is percentage growth in share price in one year( or any other period), therefore it is
replaced by symbol g ; and thus formula for expected rate of return for shareholder becomes:
Expected Kc =
(DPS1/ Po ) + g
If 5 policies are kept constant then , as proven in previous sessions, this growth rate in share price ( called
capital gains yield) is also equal to ROE (1 d).
To understand the Value Drivers let us explode the DDM as follows:
Revision of variables in DDM:
(
1) DPS1= DPSo (1 + g)
2) g =ROE ( 1 - d)
3) ROE=NI/OE = NI/S * S/TA * TA/OE
4 ) d=
)
{
)}]
SEVEN DRIVERS FOR VALUE CREATION ACCORDING TO DDM WITH CONSTANT GROWTH ASSUMPTION
This model says that share value increases if :
1. DPS increases; it makes sense because any asset which is expected to give high cash flows in future is
more valuable in your eyes today, and that is true for shares also
2. Beta decreases; it makes sense because beta is relevant risk of share, and low risk makes the share
attractive
3. interest rates in the economy decline thus causing both Rf and (Rm Rf ) to decline
4. net profit margin increases (NI /S ratio); it makes sense because higher profit margin on sales means
higher profitability
5. turnover of TA increases (S / TA ratio); it makes sense because higher asset productivity means that
more is produced and sold by using given resources called assets
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
6. financial leverage increases (TA / OE ratio); it is believed that higher leverage would result on one hand
in higher financial risk but at the same time it would also contributes toward in magnification of ROE , and
higher ROE would lead to higher growth rate, and higher growth is believed to lead to higher price. But it
is important to note at this stage that though higher ROE translates into higher growth rate, g, but it is not
always necessary that higher growth would translate into higher growth in share price or in other words
in value creation. Let us postpone that discussion for the time being.
7. dividend payout ratio decreases ( d); and that also makes sense because by retaining and reinvesting
a bigger percentage of NI the Cos management is sending a signal that it has promising investment
opportunities of high ROE, and such a signal is viewed positively by the market participants thereby
increasing the demand for such a share and pushing its price higher.
Please notice 4 of the 5 corporate policies (except number of shares outstanding) discussed above are
here as value drivers. These 7 value drivers are hidden in the DDM.
Interestingly by shuffling the terms of expected rate of return formula:
Expected Kc =
(DPS1/ Po ) + g
you can derive DDM with constant growth valuation formula for estimating fair value of a share , as
shown below:
Taking g on the left side you have
Kc - g = DPS1/ Po
and taking P0 on the left side you have
Po (Kc - g) = DPS1
And bringing (kc g) to the right side , you have Po = DPS1 / (Kc - g)
and this is DDM with constant growth valuation formula. Thus based upon the common sense that ROR
for shareholders by investing in shares of any corporation comes from 2 components , namely, expected
dividend yield (DPS1/Po )and expected capital gains yield (( P1 - Po) /Po ), the valuation formula can be
derived.
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
(next year)
Increase in total operating capital = (Operating NWC + Operating Net FA (next year) ) ( Operating NWC +
Operating Net FA (last year) )
Second Method
Increase in total operating capital=increase in operating NWC + increase in operating net FA
Increase in operating NWC = operating NWC (next year - Operating NWC (last year ).
Increase in operating net FA = Operating net FA (next year) - Operating FA (last year)
It is important to clearly understand how these items are calculated from balance sheet
The Concept of Operating NWC
Operating NWC = Operating WC Operating CL.
Operating WC are Operating CA. The Operating WC can be viewed as those CA which are used in normal
business operations to generate sales such as cash, account receivables from sales, and inventory; this
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
means investment in marketable securities, though a CA, do not qualify as operating CA because they
have no such role. Therefore:
Operating WC = Operating CA = CA non operating CA such as investment in marketable securities.
Operating CL= CL ST bank loans
Operating CL are those CL which are generated as part of normal business operations such as accounts
payable to suppliers of raw material inventory, accruals of various operating expenses which have been
recorded as expenses but not paid as yet. It means that short term bank loan is not an operating CL
because it is not created automatically (spontaneously) due to normal business operations , rather it is
created as a deliberate financing decision of management to take short term loan instead of long term
loan or instead of issuing shares or instead of issuing bonds; and therefore ST bank loan should be
counted as part of debt capital in this context along with long term interest bearing loans, long term
bonds payable and long term lease contracts.
Typically operating NWC is composed of only those CA which are financed by long term debt and OE. It
must be clear to you that all CA are not financed by investors ( i.e. shareholders and long term debt such
as long term bank loans) because some CA are financed by CL such as Accounts Payables and Accruals;
and only the remaining CA are financed by long term debt loan and owners equity. Therefore operating
NWC can be written as:
Operating NWC = (Cash + R/A + Inventory) (Acc P/A + Accruals related to operating expenses)
Operating NWC =(non interest or dividend earning CA) (non interest paying CL)
Operating NWC = (CA excluding investment in marketable securities) (CL excluding ST bank loans)
Operating NWC
= CA financed by investors.
The Concept of Operating net FA
Operating net FA = Net FA Non Operating FA . Non operating FA include those long term assets which
are not used in day to day business operations such as investment in land for future use, investment in
bonds and stocks for long term purposes, also investments in Subsidiary Cos shares.
Net FA = FA Accumulated Depreciation.
It is important for you to do a brief exercise at this stage. Following is the balance sheet given in
equation form
Cash + R/As + inventory + marketable securities + FA (net) + Govt Bonds and land = P/As + accruals + ST bank loan + LT Loan + OE
+ 100
+500
+ 200
1,400
= 50 + 150 +
= 1,400
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300
500 + 400
Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
500
= 300
Op capital
= Debt
900
= 800
900
= 1200 - 300
900
= 900
500
+ 400 - 300
+ OE -
non op assets
+ 400 - 300
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
Terminal value at the end of year 5 is PV of all FCFs beyond year 5 till infinity, and it is estimated
assuming a constant growth rate of FCFs after year 5.
Terminal value in year 5 = FCF5(1 + g) / (WACC g).
Please Note that FCF 5 (1 + g) means FCF 6 and dividing it by the term (WACC g) estimates at the end of
year 5 the PV of all FCFs from year 6 onwards till infinity. Also note that since terminal value is estimated
at the end of year 5 so from the viewpoint of time zero,( i.e. now ) it is still a future value and has to be
discounted for 5 years to find its PV therefore the whole term
5
FCF5(1 + g) / (WACC g) has to be divided by (1 + WACC) . Similarly the original FCFs of year 5 also
5
have to be discounted by this term (1 + WACC) . Therefore in the above formula both the FCF of year 5
as well as the terminal value of cash flows at the end of year 5 are jointly shown as being discounted by
5
the factor (1 + WACC) . The following data is from your text book.
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
From the above tables showing projected income statements and balance sheets , we have shown below
the estimation for FCF. Note the Year 2009 is the latest year and its data is actual, years 2010 to 2013 are
projected data.
2009
Actual
+ R/A +
Inventory ) (P/A +
Accruals)
Operating NWC = (CA excluding investment in marketable securities) (CL excluding ST bank loans)
Operating NWC =(17+85+170) (17+43),
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
279
=491
2010 Estimated
Operating NWC =(Cash
+ R/A +
Inventory ) (P/A +
(20
Accruals)
+ 50)
=250
+ 310
=560
Increase in Total Operating Capital2010 = Total Operating Capital 2010 - Total Operating Capital 2009
=
560
491
= 69
NOPAT 2010 = EBIT( 1 - T)
= 85 ( 1 0.4)
= 51 million Rs
Free Cash Flows (FCF) 2010 = NOPAT Increase in Total Operating Capital
=51
69
= - 18 m Rs.
Similarly in the table above the FCFs are estimated for the next 4 years till 2013. Using the data given in
table, and WACC estimate of 10.84% for this Co, and beyond year 4 (year 2013) the FCF constant growth
rate estimate of 5% per year for ever, the following is an estimate of its Value of operations. Note next
year 2010 is year 1; 2011 is year 2 from today that is end of year 2009.
1
Note that Terminal Value at the end of year 4 (that is end of in 2013) of all the FCF beyond 2013 is
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
= 615 million Rs
Value of TA ( Value of Firm) = Value of Operations + Value of non operating assets
= 615
+ 63
= 678
Note : the only non operating assets in this co now (that is end of 2009) are marketable securities of Rs
63
Value of Equity = Value of TA - Debt
= 678
- 247
= 431 million Rs
Note: operating CL (accounts payables and accruals) are not included in debt, because those were already
used in estimating FCF. The remaining liabilities are short term bank loan of 123 and LT Bonds payable of
Rs 124 , adding up these interest paying Debts you get 123 + 124 = 247 million Rs.
Value of Common Equity = Value of Equity - Preferred equity capital
= 431
- 62
= 369 million Rs
(preferred share capital was taken from balance sheet of 2009)
Fair Price per share = Value of common equity / number of shares outstanding
= 369 / 100 million
= 3.69 Rs per share
This is the maximum price you are willing to pay per share based on your forecast and analysis; usually it
is termed fair value or intrinsic value, or justified value , or theoretical value of share.
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
- BV of common equity
= 369
= 124 m Rs
- 245
(BV of OE is from balance sheet of 2009, and it is common share capital + RE)
This increase in wealth of shareholders has occurred over the whole life of the company , not in one year.
678
247
62
678
554
MVA
245
+ MVA
= MVA
Note: There are various ways to decompose value of TA that you have just estimated, some of these
decompositions are shown below:
Value of TA = Debt + BV of preferred stock + MV of common equity
678
= 247 +
62
369
Value of TA =
678
615
Debt
247
63
62
85
245
+ 124
Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
85 ( 1 0.4)
51 -
- [560 * 10.84%]
60 .7
= -9.7
In 2010 EVA was negative, so shareholders wealth was lost in that year, no value creation took place in
that year. EVA of -9.7 is also called Residual Income, that is the income left over after paying the providers
of capital their respective required RORs, which means shareholders get their expected Kc, and Debt
holders get their respective Kd from EBIT, Government gets its tax, after that the left over is called
residual income and it belongs to shareholders. Positive residual income or EVA is likely to reflect itself in
higher share price in the stock market.
EVA concept is usable in compensating the divisional managers : if their respective divisions show
positive EVA they are rewarded. EVA is being increasingly used to reward or punish top management
teams of corporations. Note the relationship of EVA with MVA is not mathematical , that is, the sum of all
past years EVAs do not add up to MVA but a conceptual one, that is, a co would have positive MVA if it
had positive EVAs in the past years of its life.
= 51 /560
-1.73%
= 9.1%
-1.73%
= - 1.73%
- 60.7/560
- 10.84%
Note: ROIC refers to return on invested operating capital and it is EBIT (1 T) / total operating capital.
From the data given in tables above we found the following EVA estimates. Note EBIT ( 1 - T) is also
called NOPAT; and WACC in this example is 10.84%.
EVA = NOPAT
EVA2009 =43.8
EVA2010= 51
- (0.1084*560) = -9.7 m
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
EVA 2011=33
- (0.1084*616) = -33.7 m
- (0.1084*679) =7.4 m
It shows that for the next 2 years ( 2010 and 2011) EVA is going to be negative based upon projected
income statements and balance sheets. Thereafter this Co can hope not to see value creation in next 2
years (2010 and 2011) but can hope to see value creation in year 2012 and year 2013 as estimated EVA is
positive for those years. It implies that share price is likely to fall in next 2 years (2010 and 2011), but in
the following 2 years (2012 and 2013) you expect as analyst that share price would increase.
Please note the logic of value creation by attaining positive EVA is based upon the idea that once the
providers of debt capital and equity capital have their expected rupee of returns = (WACC * total
operating capital) from NOPAT and still some NOPAT is left over then that left-over NOPAT belongs to
shareholders. Thus EVA in rupees is a type of surprise profits, over and above the expected profits, for
shareholders. If this surprise is positive then shareholders are happy and demand for such shares
increases thus causing the share price to go up. But if this surprise is negative (negative EVA) then
shareholders are disappointed and demonstrate their disappointment by getting rid of this share that
causes increase in supply of share due to the disgruntled and disappointed shareholders off loading the
share, resulting in fall in share price. EVA is also termed as residual income, meaning after paying all the
claimant their due share, whatever is left over as residual profits that goes to shareholders.
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
used to reinvest in the business to make-up for the regular wear and tear in its operating capital and also
used to expand its operating capital.
Equity CFs each year = ( NI + Depreciation Expense) Retention.
The retention shows up as annual increase in RE of the co. Such reinvestment of NI in a co is deemed
necessary because such investment is required to replace assets that have depreciated, and to finance
growth of its operating capital ,i.e. , growth in its operating NWC + Operating FA.
Both free cash flows method and equity cash flows method require forecast of next 4 to 5 years Income
Statements and Balance Sheets. Beyond that it is customary for analysts to assume a constant g of cash
th
Terminal Value of equity CFs at the end of year 5 = Equity CF5 (1 + g) / (Kc g )
Fair value for share of a Co Today = Value of Equity of Co / number of shares outstanding
And it is an estimate of fair value of shares of Co today in the eyes of analysts, though in real life all
analysts sitting in different brokerage houses and investment banks may not make the same estimate for
annual equity cash flows or for constant growth rate or for required rate of return of shareholders (Kc),
and therefore may not recommend the same fair value of share of a co, but their estimate of fair value is
usually very close to each other; and for an outsider an average of these estimated fair values estimates
of various analysts is a good working number. The following table gives projected income statements for
the next 5 years along with equity cash flows estimated for each of the next 5 years for a target Co being
evaluated by analysts as a potential target for take-over. Please note that projected next 5 years balance
sheets must also have been made by this analyst but those have been omitted here.
Why making projected balance sheets is also necessary? Is it not sufficient to make projected income
statements? The answer is No! without having some idea of projected assets in balance sheets, you
cannot project annual depreciation expense in income statements; nor without loan amounts in balance
sheets, you can project interest expense in the income statements.
expenses as well as interest expense are increasing in the projected income statements in this example, it
implies that in the projected balance sheets FA were increasing, and long term debt was also increasing
because these 2 expense items in income statement depend on the 2 items of balance sheet.
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
Projected Income Statements for the next 5 years and extraction of Equity Cash Flows
Year
1
Years
2011
2012
2013
2014
2015
Net sales
105
126
151
174
191
CGS
75
89
106
122
132
Selling &
Admin Exp
10
12
13
15
16
Depreciation
10
EBIT
12
17
23
28
33
10
11
11
Interest
EBT
13
17
22
Taxes
1.6
3.2
5.2
6.8
NI
2.4
4.8
7.8
10.2
13.2
Add back:
Depreciation
expense
10
Cash Flow =
NI +
depreciation
expense
10.4
12.8
16.8
19.2
23.2
Less
Retention
12
Equity cash
6.4
8.8
9.8
10.2
11.2
Please note that after doing 5 years forecasting in detail it is customary to assume that the co would
continue as a going concern (a living co) for ever therefore equity cash flows generated by this co after 5
years (after 2015) are also relevant to value its shares today. It is done by finding terminal value of equity
cash flows at the end of 2015. Terminal value of equity cash flows at the end of year 2015 is sum of PVs
of all future equity cash flows growing at constant growth rate of 10% per year for ever. Formula for the
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
PV of growing perpetuity is used to estimate terminal value of equity cash flows at the end of 2015 as
shown below.
Note all equity cash flows , including cash flows separately estimated for each of the next 5 years as well
as cash flows beyond 5 years estimated as terminal value of equity cash flows, are discounted at the Cos
cost of equity ( Kc) to estimate fair value of the Cos equity, and this value of equity is divided by the
number of shares of the Co outstanding to estimate the fair value of its share. Constant growth rate of
cash flows after 2015 is estimated as 10% per year for ever, and Kc (risk adjusted required rate of return
demanded by shareholders) is estimated as 18.2% in this case. Please remember CAPM is one model
which can be used to estimate Kc.
Terminal value of equity cash flows at the end of year 5 (2015) = equity cash flows 2015 ( 1 + g) / ( Kc g),
= 11.2 ( 1 + 0.1) / (0.182 - 0.1),
= 150 .2 million Rs
Fair value of equity now (end of 2010) = equity Cash flows 2011 / (1 + Kc )
+ equity cash flows 2013/ (1 + Kc)
(equity cash flows 2015 + Terminal value of equity cash flows at the end of 2015) / (1 + Kc)
+ 9.8 / ( 1 + 0.182)
= 92.8277 million Rs
You can use FC-100 calculator to get the same answer as follows:
CASH mode; data editor; enter cash flows as :
-0 exe; 6.4 exe ; 8.8 exe ; 9.8 exe ; 10.2 exe ; 161.4 exe ; esc ; i 18.2 exe ; solve NPV ; and you
get 92.8277 as answer.
Since 10 million shares of this co are outstanding so
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
This is another model of valuation of shares that is useful for valuing unlisted and untraded companies
such as private limited companies. Since current share price ( P0 ) is not observable for such companies
and so their PB ratio cannot be calculated, therefore average PB ratio of comparable companies is used as
a proxy:
P0 of a Pvt Ltd Co = Average PB ratio of comparable companies * book value per share of this Pvt Ltd co
This model of valuation can be used for companies which do not pay cash dividends, and also for
companies that are not listed and their shares are not trade thus their share price is not observable. PE
ratio assumes a positive EPS to arrive at a positive PE ratio and therefore can not be used for companies
reporting negative EPS, but PB model can be used for companies whose EPS is negative
RELATIONSHIP OF PE RATIO , PB RATIO, EPS , AND ROE
Use of PE ratio and PB ratio for valuation purpose can be brought together as analyzed below:
PB ratio = P /BV
PB ratio * BV = P (1)
And we know that ROE = NI /OE , you can write it on per share basis as
ROE = (NI /shares) / (OE / shares)
ROE = EPS / BV
BV = EPS / ROE
Inserting this formulation of BV in equation (1) above we get
PB ratio * (EPS / ROE) = P
P = PB ratio * EPS * 1 / ROE ..(2)
We also know that
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
Country
Average PE Ratio
Valuation
Kuwait
40
over
USA
20
over
Pakistan
12
under
Then as a believer in PE ratio, one must conclude that Pakistani market is undervalued, and therefore
international investors should move in herds to invest in Pakistani share market. But objective reality is
exactly the otherwise, not only international investors are not flocking in Pakistani market but also local
Pakistani investors are leaving Pakistani market. Similarly if US market is overvalued compared to
Pakistani market, then why Pakistan investors are buying over valued shares in USA?
Moreover it is not clear whether low PE ratio indicates undervaluation or poor growth prospects?
Similarly whether high PE ratio indicates overvaluation or high growth prospects?
Let us take the case of high PE ratio first. If high PE ratio means share is already over valued relative to its
EPS, then how can we expect its share price to grow more in value in future, that is, how can we expect
growth in price of a share that is already viewed as over valued at its current price. Common sense tells
us that price of overvalued assets fall in future, rather than experiencing an increase in future. So the
growth in their value should be negative.
Let us now take the case of low PE ratio. If low PE means share is already undervalued relative to its EPS
and common sense tells us that undervalued assets are expected to grow in value in future then how can
low PE can be viewed as a signal of low growth prospects for its value in future.
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
perspective, and is based upon EPS reported under their supervision. Though this practice is unfortunate,
and is partially responsible for excessive focus on short term performance probably at the expense of
ignoring the long term survival and growth prospects of a company, yet a relevant question arises as to
which variable is more important for value creation? EPS or ROE?
breakdown of EPS that shows that higher EPS leads to higher ROE , which ultimately leads to higher value
per share, though not always.
ROE = NI / OE
ROE = NI /S * S/TA * TA/OE
Multiplying both sides with OE/shares
ROE * OE/shares = NI /S * S/TA * TA/OE * OE / shares
NI/OE * OE /shares = NI /S * S/TA * TA/OE * OE / shares
As OE/shares is called book value per share or just BV
And as RHS reduces to NI/shares that is EPS
so
ROE * BV = NI /shares
ROE * BV = EPS
This shows that higher EPS is likely to result in higher ROE if BV per share remains constant. Usually BV
per share gets diluted due to issuance of bonus shares, but dilution of EPS due to the same reason also
takes place; so the relationship of high EPS and high ROE remains unchanged. But if co issues new shares,
raises new equity capital , invests in new projects, but investment turns out not that profitable, and thus
EPS does not increase as much, in this case BV increases but EPS does not increases as much and net
result is low or no increase in ROE, and that is still in line with EPS and ROE being related. Thus from value
creation perspective:
Higher EPS leads to higher ROE, which in turn leads to higher share price; and therefore focus on EPS as
value driver is not misplaced; and media reporting EPS as indicator of managerial performance and
investors using EPS as a guide about value creation is not altogether wrong because of direct relationship
of EPS with ROE. But a more important issue is whether high ROE always leads to value creation? The
following paragraphs attempt to analyze that contention.
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
that franchise PE is positive only if franchise factor is positive and franchise factor can be positive only if
ROE is greater than Kc.
But it is important to realize that value creation due to high ROE is subject to certain other conditions as
well. From your corporate finance course you know that for non financial companies:
ROE = ROIC + (ROIC Ki) D/OE
The derivation of this ROE model and its implications for value of share would be discussed in detail in
the later lectures about financing decisions.
ROIC = EBIT (1 - T) / capital invested in a business
capital invested = NWC + FA = LTL + OE
EBIT = S CGS Operating Expenses.
Ki = Kd (1 - T)
Kd = weighted average cost of debt , that is, interest expense / debt capital employed by a company.
EBIT is operating profits of a business, and ROIC shows operating performance of a business regardless of
its financial policy and dividend policy. In other words it does not matter for generating ROIC whether
NWC + FA were financed all by OE or by some combination of LTL + OE. What matters for earning ROIC is
the fact that how much assets are available, and once these assets (NWC + FA) have been put in place
then how productively and efficiently they are managed. So for earning ROIC investing decision or capital
budgeting decision matter; and financing or capital structure decisions are irrelevant.
ROE that is not the case, for ROE depends both on operating performance and financial leverage, that is
on both investing decisions as well as financing decisions, or in other words both on capital budgeting
decisions and capital structure decisions. And that can be seen by the presence of both ROIC and debt to
equity ratio and after tax cost of debt in the above stated formulation of ROE.
So a co can choose to attain higher ROE through better operating performance (higher ROIC); or through
employing higher financial leverage (high Debt to equity ratio). Both paths of attaining higher ROE are
available to the top management of a company. But employing high debt to equity ratio entails higher
financial risk. Since perceived higher risk has a dampening effect on the value, therefore higher ROE
achieved by using higher debt to equity ratio may not translate in higher share price because market
recognizes the fact that the method used to attain higher ROE was risky. The analytical logic of this
common sense is as follows:
If D/OE ratio is high, it leads to higher Beta of shares because, according to Hamda equation,
BL = B BU (1 + ( 1 - T) D/OE
And higher BL results in higher Kc as per CAPM
Kc = Rf + (Rm Rf)BL
And higher Kc results in lower share price as per DDM :
P0 = DPS0 (1 + g) / (Kc - g)
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And though higher ROE should result in higher g because * g = ROE (1 d)], and ultimately higher share
price should result as pricing model given above shows, but that effect of higher growth rate is likely to be
more than neutralized due to higher Kc , and it is possible share price falls though co has shown higher
ROE and resulting higher growth rate. Such situation is termed as growth without value creation,
though such a co is growing but shareholders are not getting wealthier by experiencing increase in share
price. In fact shareholders of such a co may be losing wealth due to fall in share price. In plain words, the
number of factories in a co may be increasing one to two factories, and two to four; but its shareholders
wealth may be shrinking due to persistent fall in share price.
On the other hand higher ROE achieved through higher ROIC has no such negative fallout, and this is the
sure route to value creation. Therefore confused thinking should be avoided, myopic view that higher
ROE must be attained at any cost should be shelved, and more analytical approach of charting the right
course of attaining higher ROE through earning higher ROIC should be adopted for definite value creation.
In summary it is the better operating performance through higher ROIC that is the sure way of value
creation. It is useful to look deeper into operating performance. Better operating performance is
attained either by:
1)
higher EBIT (1 T)
2)
Higher EBIT is result of higher sales revenues, lower CGS, and lower operating expenses. Note CGS +
Operating expenses are termed operating costs. That means improving the Marketing performance
(sales); and cutting production costs (CGS) and cutting the overhead costs ( the operating expenses)
generates value. Higher ROIC also means avoiding overinvestment in the assets of a business so that
capital invested is a smaller number , and since it is in denominator of ROIC, therefore a smaller
denominator means higher ROIC.
Analytically
ROIC = EBIT (1 T) / capital invested. It can be bifurcated as:
RIOC = EBIT (1 - T) / Sales * Sales / capital invested
ROIC = after tax operating profit margin * turnover of capital invested
After tax operating margin on sales depicts ability of a co to extract after tab operating profits from a
rupee of sale; and turnover of total capital shows productivity of 1 rupee of capital employed to generate
sales. For example if after tax operating margin is 20% or 0.2 and turnover of capital is 2, then ROIC = 0.2
* 2= 0.4 or 40%.
Please note that better operating performance can be neutralized if after tax cost of debt ( Ki) is too high.
For value creation through higher ROE, it is imperative that ROIC must be greater than Ki, otherwise ROE
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would be lower than ROIC, growth rate would be low and value would be destroyed. It must be
understood that in most cases after tax cost of debt is too high if a big portion of total capital is raised as
debt capital , therefore companies with too high a debt to equity ratio are more likely to have an
excessively high Ki. In simple language, do not borrow at very high interest rate (kd), because that may
cancel out good effect of high ROIC, and ultimate ROE may turnout low resulting in low growth and
ultimately low share price.
So we may conclude that high ROE creates value for shareholders only if it is attained through achieving
high ROIC, but high ROE may destroy value if attained by using too high a debt to equity ratio. Therefore
it is correct to say that the ultimate driver of value creation is ROIC, not ROE. It is operating performance
( buying, storing, manufacturing, and selling) that creates value for the owners of a business, not the
decisions to take more loans at high interest rates to expand the business and to have 4 factories instead
of one. Management, while doing planning for business expansion, must be watchful of the concept of
value destroying growth or growth without value creation. If a companys management attains high ROE
by employing very high financial risk, the market, instead of rewarding the shareholders of such a
company, may punishes them.
If you are looking for a concrete answer about wealth creation for owners of a business, as depicted by
share value in stock market, then the answer is high ROIC as measured by EBIT (1 T) / (NWC + FA).
The previous discussion about role of ROIC and attendant EBIT, NWC + FA, etc is unfortunately not
applicable to financial Institutions because assets of FIs are not easily classifiable as NWC + FA. Concept of
EBIT is also not applicable to financial institutions( FIs), and therefore it is not realistic to calculate ROIC
and WACC for FIs, though some analysts try to do that.
previous section is valid for FIs as well. That is, operating performance is the source of value creation, too
much financial leverage may hurt value.
In fact the fear of FIs using excessive financial leverage by employing too much debt financing is
recognized with such seriousness that the whole idea of Basel Accord and related capital adequacy
requirements, etc , are aimed at restricting the FIs from using too much borrowed funds (debt capital),
and forcing them to have appropriate levels of equity capital as well.
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