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Valuation Framework
Content:
I. Theoretical Drivers of Firm Valuation
This information is intended to be general in nature and should neither be construed as investment advice nor a recommendation of any
specific security or strategy.
Published October 2013. For financial professional use only. Do not distribute to the public.
Executive Summary 3
EXECUTIVE SUMMARY
This paper examines the effectiveness of various valuation drivers in screening for companies that are potentially
pre-disposed to outperform on a relative basis. Of the five drivers put forth by Merton Miller and Franco
Modigliani in their seminal 1961 work on valuation, our analysis narrows to one driver that has proven over
time to be an effective filter: Return on invested capital, or ROIC. This does not mean that Miller-Modiglianis
other drivers are any less important; our conclusion is that ROIC is better deployed in a screening phase of an
investment process and the other drivers, less effective as screens, are better utilized later in the fundamental
research phase of our investment process as validation or rejection of the screen findings. Based on our findings,
we believe:
ROIC is an effective, time-tested screen for finding companies with the potential to outperform
The ROIC Curve, our proprietary screening mechanism, plots the relationship between ROIC and Enterprise
Value/Invested Capital (a proxy for market valuation) and effectively reveals which companies may be mis-
priced by the market and are therefore potentially pre-disposed to outperform
When coupled with rigorous fundamental research, which then includes other Miller-Modigliani measures
and other drivers, this screening mechanism has produced proven investment results over time
Guggenheim Investments Value (GIV) strategy seeks value to invested capital (EV/IC). This relationship
investment opportunities in which a companys long- is described in more detail later, but we begin with a
term fundamental expectations and/or risk profile brief discussion of the academic valuation theory that
implied by the current stock price are materially underpins the ROIC Curve and an explanation as to
different from our internal assessment of the firms why ROIC is a relevant factor for valuation screening.
intrinsic value.
With regard to quantitative measures, although we
Our investment philosophy has the following key utilize many metrics to establish a companys intrinsic
components: value, we believe that return on invested capital
is the most reliable and robust. We also point out
Bottom-up stock selection that intrinsic value is an effective risk-management
framework: Buying business at a discount doesnt just
Concentrated positions with portfolio weightings
offer a large potential upside; it also helps limit losses
based on relative conviction level
by allowing for margin of safety if the investor is
35 year average time horizon wrong.
Preference for companies with stable or In sum, we believe that intrinsic value is a rational
improving competitive positions approach that can help investors avoid being either
paralyzed or whipsawed by the markets irrationality,
Sell discipline based on deteriorating fundamentals,
volatility and often-conflicting messages. We find that
valuation materially exceeding internal estimate,
such dislocations can actually unearth many attractive
portfolio rebalancing (risk control), or better
opportunities for astute investors, but that price charts
investment opportunity elsewhere
and other external indicators can easily lead investors
Valuation and rigorous fundamental analysis astray.
constitute the two core elements of our research
We believe that in order to find viable long-term
A key component of GIVs internal valuation opportunitiescompanies that are currently earning
methodology is the ROIC Curve, a graphical more than their cost of capital, have a record of
representation of the relative valuation of companies protecting capital and are in a strong competitive
across a benchmark universe. The ROIC Curve is position to grow that capital once the current
based on the relationship between a firms return on recession turns aroundinvestors must adopt a
invested capital (ROIC) and the ratio of enterprise bottom-up value framework.
WACC and competitive advantage period suffer from The competitive advantage period is not a directly
measurability and automation difficulties. NOPAT, observable data item; it must be subjectively judged
while measurable, suffers automation difficulties as by the fundamental analyst and therefore suffers from
normalization of earnings is often necessary on an measurability and automation difficulties.
industry-by-industry basis, and industries change over
time. Although academics have proposed several The following chart in Table 1 compares the various
models of WACC estimation, including the Capital Miller-Modigliani drivers and confirms our hypothesis
Asset Pricing Model (CAPM), these models have of ROIC as an effective initial screen.
difficulty measuring the equity risk premium and
therefore result in limited efficacy. The last Miller and Modigliani valuation driver to
ROIC
NOPAT
GROWTH
WACC
CAP
address, the firms growth rate, warrants a more McKinsey & Co. in Exhibit 1 which depicts the impact
detailed discussion. There are two key problems of a 1% change in both ROIC and growth on a firms
with using a firms growth rate as the key valuation valuation (defined as enterprise value). The study
driver. The first problem is efficacy. Using a standard holds that a 1% delta in ROIC, given a baseline
discounted cash flow model based on the Miller and ROIC of 9% for instance, results in a 26% increase
Modigliani valuation drivers, we can demonstrate that in valuation versus no change from a similar delta
unless a firm has a high level of ROIC, changes in the in growth given the same base ROIC. Even though
firms growth rate will not have as big of an impact on the study finds diminishing returns to increasing
valuation as an equally sized change in ROIC. ROIC, the efficacy of ROIC over growth as a driver of
This fact is further illustrated by an analysis from valuation is clearly demonstrated.
Value, Compared
Improving returns on invested capital creates more value than growth (except when ROIC is already high).
Value Created by 1% Faster Growth1 % Value Created by 1% Higher ROIC1 %
26
16
8
6 7
0
Baseline ROIC 9 12 20 Baseline ROIC 9 12 20
The second difficulty with a growth-based valuation of individual companies between 1994 and 2003. For
framework is that growth rates are highly unstable example, 50% of firms with an ROIC of over 20% in
and often very difficult to predict. Alternatively, ROIC 1994 remained above 20% in 2003, while only 13% of
tends to be more stable and more predictable. Exhibit firms with a growth rate of over 20% in 1994 remained
2, also courtesy of McKinsey, demonstrates this fact above 20% in 2003.
by comparing the migration of ROIC and growth levels
ROIC in 2003
<5% 510% 1015% 1520% >20%
ROIC in 1994
<5% 43 28 12 6 11
510% 31 40 17 7 6
1015% 21 25 25 11 18
1520% 18 19 20 17 25
>20% 19 5 13 13 50
510% 64 16 12 3 5
1015% 61 15 11 4 9
1520% 59 11 14 5 11
>20% 56 13 10 8 13
4
EV / IC
0
-10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40%
ROIC
Exhibit 3 shows the ROIC curve. The formulaic based profitability metrics, such as pre-tax margin or
definitions for EV/IC and ROIC are as follows: net income margin, because ROIC accounts for the
capital required to generate profits. Pre-tax margin
EV = market value of equity + book value of debt at best only captures the cost of debt capital (via the
cash & short term investments expensing of interest costs). Second, ROIC captures
the return to all investors in the firm, whether debt or
IC = book value of equity + book value of debt equity. Using an alternative measure such as return on
equity (ROE) to capture profitability does not account
ROIC = pretax earnings / IC (as defined above) for differential use of financial leverage among firms
to achieve common equity profitability.
ROIC is calculated using trailing four quarter data and
excludes nonrecurring or extraordinary items. EV and Exclusion of the Financial Sector from the ROIC Curve
IC are both adjusted to reflect operating leases as debt The two largest subsets of the financial sector
capital. banking and insurancehave unique attributes
relative to industrial sectors that require the exclusion
The use of EV/IC as the metric for market valuation is of the financial sector from the ROIC Curve. In the
important because it adjusts for the firms debt level. banking industry, the high degree of financial leverage
This adjustment is significant because equity investors makes the calculation of ROIC not meaningful.
claim on the firms cash flows is subordinate to In the insurance industry, leverage is primarily
creditors. Using a metric such as P/B or P/E does not operating rather than financial in nature because the
capture differential debt loads among firms and thus key leverage statistic is premiums written to equity.
risks overlooking an important economic difference This type of leverage is impossible to capture in the
in comparing firms. Cash is also excluded from EV in ROIC Curve framework. Additionally, both banks and
order to isolate the valuation of the ongoing operating insurance companies have significant uncertainty in
business of the subject company. profit reporting due to the heavy use of accruals (i.e.
provisioning for credit losses in banking and booking
The use of ROIC to measure profitability is also reserves in insurance). This uncertainty generally
instrumental to this valuation framework for two causes financial services companies to trade at a
reasons. First, ROIC is superior to profit margin- significant discount to the broader market.
For financial professional use only. Do not distribute to the public.
10 Using the ROIC Curve as a Screening Tool
6
y = 15.998x2 + 1.548x + 1.376
R2 = 75.10%
5
4
Positive "delta Y"
potential overvaluation
EV / IC
3 Stock A
1 Stock B
Negative "delta Y"
potential undervaluation
0
-10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40%
ROIC
R1000 Annualized Active Returns vs. Benchmark RMidCap Annualized Active Returns vs. Benchmark
8% 5%
7% 4%
6% 3%
5% 2%
4% 1%
3% 0%
2% -1%
1% -2%
0% -3%
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
R2500 Annualized Active Returns vs. Benchmark R2000 Annualized Active Returns vs. Benchmark
8% 8%
6% 6%
4%
4%
2%
2% 0%
0% -2%
-2% -4%
-6%
-4% -8%
-6% -10%
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
1
Delta Y Deciles from 19862012, 3-Year Holding Period. Decile 1 represents largest negative delta Ys; GICS sectors equal weighted to avoid large sector bias.
4% 8% 16% 24%
4% 6.1x 12.5x 15.7x 16.7x
Earnings Growth
Beyond all of the shortcomings related to earnings Beyond a discrepancy in debt levels, two firms could
and growth-based measures of valuation, there is have identical operating profiles but one firm has
one additional problem related to valuation multiples a significant amount of excess cash. The firm with
that use equity market price and/or book value as a excess cash could justifiably trade at a higher P/E
component of valuation: They do not differentiate multiple, assuming all other fundamental factors
firms by financial leverage (debt), and they do not about the two firms were identical. Thus the existence
account for excess cash held by a firm. For example, of different amounts of debt in the capital structure
two firms with identical operating profiles might trade and excess cash would diminish the reliability of
at far different P/E multiples because one uses far comparative valuation using P/E multiples. This
higher financial leverage. The firm with higher leverage problem is mitigated using the ROIC Curve because
justifiably trades at a lower multiple because it has valuation is measured using Enterprise Value, which
increased bankruptcy risk and equity earnings volatility accounts for debt and cash.
due to the high degree of financial leverage.
CONCLUSION
Given GIVs long-term investment horizon and of inclusion into the investment portfolio. Thus we
concentrated position sizes, it is critical that our avoid wasting resources researching securities with
investment professionals maintain an intimate low-probability of success and utilize that time honing
understanding of each of our investment positions. our research on better opportunities. The ROIC Curve
The rigorous depth of research conducted on each provides that small subset of promising opportunities
investment opportunity is both enabled and focused to our investment professionals and also yields initial
by having a screening mechanism that allows our insights about the fundamental quality of a company
team to narrow their research to opportunities that are that serve as a starting point for our fundamental
pre-disposed to outperform and subject to extensive research.
fundamental research, and have a high probability
REFERENCES
Cao, Bing; Jiang, Bin; and Koller, Timothy, "Balancing
ROIC and Growth to Build Value," McKinsey on
Finance, Spring 2006.
The information provided here is intended to be general in nature and should not be construed as investment advice nor a
recommendation of any specific security or strategy.
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