Value-Based Management and
Course Summary
Week 14 – April 20, 2006
J. K. Dietrich - FBE 532 – Spring 2006
Maximize Shareholders’ Wealth
 Management
seeks financial policies and
strategies that increase value of shares
 Policies and strategies that produce returns larger
than investors’ opportunity costs increase value
(economic value added)
 Sustained ability of management to add economic
value increases the value of the firm’s assets
relative to investment costs (market value added)
J. K. Dietrich - FBE 532 – Spring 2006
Market and Economic Value Added
Intrinsic Value
Invested Capital
Market Value Added
$
$
$
0
38,848 $
20,000 $
18,848 $
1
2
3
4
5
5,000 $ 6,000 $ 7,000 $ 8,000 $ 56,250
4,000 $ 4,000 $ 4,000 $ 4,000 $ 24,000
1,000 $ 2,000 $ 3,000 $ 4,000 $ 32,250
$60,000
$50,000
$40,000
$30,000
$20,000
$10,000
Market Value Added
$0
Invested Capital
1
2
Intrinsic Value
J. K. Dietrich - FBE 532 – Spring 2006
3
Invested Capital
Intrinsic Value
4
5
Market Value Added
Positive NPVs, MVA and EVA
 Positive
net present value projects earn
higher than the discount rate
 The discount rate captures the opportunity
cost of capital being tied up
 The dollar amounts of free cash flow earned
above the opportunity rate is EVA
 The present value at the discount rate of
EVA is MVA
J. K. Dietrich - FBE 532 – Spring 2006
Advisors and Service Providers
 Investment
bankers assist management in
adding value
– Advice
– Implementation
 Venture
capitalists create value
– For their investors through excess returns
– For the clients through realization of investment
plans (LBOs and venture capital)
J. K. Dietrich - FBE 532 – Spring 2006
Performance Assessment
 For
public companies, share price performance is
the first step in assessing management’s
performance
 To dig into details, must use accounting data
– Dupont analysis
– Analysis of operations and segments
 Objective
is to identify realized or potential
sources of value
J. K. Dietrich - FBE 532 – Spring 2006
Market Value of the Firm
 Value
of the entire firm = entity value
 Copland et al and PVFIRM calculate
market value of the entity = market value
of D + E
 Entity value is present value of all free cash
flows, available for division among all
investors, whether in form of debt or equity
 Cash flows to entire firm discounted at
weighted average cost of capital
J. K. Dietrich - FBE 532 – Spring 2006
Advantages of Entity Approach
 Focuses
on operations and not financing,
avoiding problem of changing capital structure
through time
 Focuses on free cash flow and pinpoints
impact of alternative strategies
 Free cash flow is net operating profit less an
allowance for taxes (NOPLAT) minus
necessary investments in working capital and
fixed assets
 Can focus on explicit forecast period and
continuing values after explicit forecast period
J. K. Dietrich - FBE 532 – Spring 2006
Free Cash Flow
 Free
cash flow is standard approach
 Net Operating Profit less Adjustment for
Taxes (NOPLAT) - Net Investments
 Free cash flow does not include interest
expenses (or other financing costs)
 Net investments are from working capital
and capital expenditures
 Need sales, operating costs, cash, accounts
receivable, accounts payable, and inventory
assumptions
J. K. Dietrich - FBE 532 – Spring 2006
Financial Analysis
 Required
for assumptions concerning future
performance
 Require historical and comparable firm data but
future may not be like the past
 You can use my handout Financial Statement
Analysis and Assumptions for Valuation
 Always apply plausibility check to both ratios,
assumptions, and projections
 Ratio analysis of projections useful in assessing
plausibility of assumptions
J. K. Dietrich - FBE 532 – Spring 2006
Dupont Analysis of Performance
 Dupont Analysis
focuses on return on equity
(RWJ, p. 39):







EAC
ROE 

BVE 
 Closest
to goal of management
 Ratios can be calculated in different ways
– Year-ending number balance sheet number or
averages of two years
– Before tax or after tax
J. K. Dietrich - FBE 532 – Spring 2006
Abbreviations used in Ratios
 Abbreviations
for accounting values used:
ROE = return on equity
EAC = earnings available to common
BVE = book value of equity
EBT = earnings before tax
EBIT = earnings before tax and interest
SLS = sales
ASSTS = total operating assets
J. K. Dietrich - FBE 532 – Spring 2006
Basic Ratio Approach
 ROE
can be decomposed into elements:





  EBIT  
  EBT   ASSTS 
EAC
SLS





ROE  EAC 




BVE EBT   SLS   ASSTS   EBIT   BVE 
















ROE  (1 T)  M arg in  Turnover  LeverageFactors
 Focus
first on gross return on assets (p. 38)
ROA  MarginTurnover

ROA = “Earning Power” determined by
gross profit margin and asset turnover
J. K. Dietrich - FBE 532 – Spring 2006
Gross Profit Margin (p. 38)
 Sales
 Components
–
–
–
–
of Costs
Materials
Labor
SG&A
Other
 Common
size income statement valuable
 Need assumptions for future on these
J. K. Dietrich - FBE 532 – Spring 2006
Asset Turnover (p. 35)
 Working
Capital
– Inventories
– Accounts Receivable
 Look
at liquidity and activity ratios
– Turnover, days
 Current
liabilities: trade and bank debt
 Fixed Assets
– Net vs. Gross
– Turnover, average age
 Need
assumptions to project these
J. K. Dietrich - FBE 532 – Spring 2006
Valuation is Critical to Finance
 Three
critical factors in valuation
– Cash flows
– Discount rates
– Calculation of net present value
 Where
does value come from?
– Ability to earn excess returns (EVA)
– Sustained ability to invest at excess returns
(results in MVA)
J. K. Dietrich - FBE 532 – Spring 2006
Markets and Firms
 Firms
operate in markets
– Goods and services (products and investments)
– Financial markets
 Efficient
market theory is benchmark for
analysis in finance
– No excess returns possible
– Forces close examination on sources of value
– Inefficiencies or inability to arbitrage are
sources of value
J. K. Dietrich - FBE 532 – Spring 2006
Financial Theory and Practice
 Well-defined
objective function (maximize
shareholders’ wealth)
 Theories of how corporate policies and
strategies influence value
– Investments
– Capital structure
– Dividends
 All
require analysis of cash flows, discount
rate, and present value
J. K. Dietrich - FBE 532 – Spring 2006
Course Summary – Apr. 27, 2006
 Prepare
Vyaderm Pharmaceutical case (no
write-up required) but bring analysis
 Begin review for final examination by
looking over past cases analyses and
reviewing issues raised
J. K. Dietrich - FBE 532 – Spring 2006