BUSINESS: The Ultimate Resource

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MANAGEMENT LIBRARY
Valuation
by Tom Copeland, Jack Murrin, and Tom Koller

Why Read It?

Prompted by more intensive competition, the restructuring of industries, and ever more sophisticated stockholders, managers are checking over their company portfolios more critically than ever before in order to find out precisely where value is being created or destroyed. At a time when stakeholder value is gaining ground and stock options play an ever more important role in the remuneration of leading employees, value-oriented portfolio structuring and resource allocation are becoming central factors in strategic thinking.

Getting Started
The authors provide management with the necessary equipment to help them identify the sources and extent of value appreciation and depreciation within the company. In a series of theoretical analyses based on capital market research, they present the discounted cash flow (DCF) method and supplement their explanatory material with numerous case studies drawn from business practice.

Contribution
1. Company Value and Company Strategy Companies, say the authors, need competitive strategies not only for the familiar goods and services markets, but also for the market in the disposal rights of companies. This is where the success of efforts to increase company value, which derives from cash flows, will be felt. Managers must pursue active value-management policies. There are two stages in the development of a value-oriented policy:

a restructuring that frees up the values locked into the company; establishing priorities for enhancing value.

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BUSINESS: The Ultimate Resource

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Managers should regularly create and make use of opportunities to increase value, according to Copeland and his colleagues. In this way they can avoid having to react under pressure later. 2. Company Value on a Cash Flow Basis: A Guide for Practitioners The procedure that combines best with the objective of long-term value enhancement, the authors suggest, is the discounted cash flow (DCF) method. The DCF method has the following advantages:

The bases for valuation are free cash flows, as only these are available for servicing invested capital. Future expectations are systematically taken into account. Capital structure, financing costs, and risk are fully covered, so that the whole debit side of the company balance sheet is taken into consideration. An objective yardstick for comparing strategic options is created. Almost all the information needed to calculate the value of the company can be derived from existing and projected figures given in the company accounts.

In accordance with the DCF component model, the value of a companys equity capital is equivalent to the value of various cash flows that lead ultimately to the cash flow to stockholders (dividends, stock repurchases, stock issues). This, say the authors, has four advantages. 1. Evaluating the relevant components of the company helps to identify and understand the individual sources of investment and finance that influence the value of the company. 2. It enables operating drivers with the greatest prospects for enhancing value to be identified. 3. It can be applied at various levels and combined with investment accounting. 4. It is sufficiently differentiated to cope with the complex situations and can be conducted using simple data-processing technology. 3. Using the DCF Component Model to Value a Company The authors split this process into five stages:

Stage one: analysis of historical performance. First the relevant components of free cash flows are determined. Then a comprehensive profile of past performance is drawn up. It provides important clues to forecasting future performance. Stage two: determining capital costs. The first step is to establish the capital structure of the company. From this the weighting factors for the weighted average cost of capital (WACC) formula can be derived. Next, external capital

Bloomsbury Publishing Plc 2003

BUSINESS: The Ultimate Resource

October 2003 Upgrade 13

costs are determined. Finally, equity capital costs are assessed, a process best conducted using the capital asset pricing model (CAPM) or the arbitrage pricing model (APM).

Stage three: prognosis of future performance. Here the assumptions and scenarios relevant to a prognosis of the companys economic situation and competitive position in its industry are worked out. Forecasts also need to be made for the decisive drivers of value: growth and return on capital. Stage four: estimating continuance value. First the most suitable DCF method to apply must be decided on. The choice is between the long-term detailed prognosis, the continuing-value formula taking account of growing cash flows, and the value factor formula. The time frame for a detailed prognosis is established. The parameters are then assessed: these are the operating result after tax, free cash flow, the return on new investment, the growth rate, and the WACC. Finally, the continuing value is discounted to the present. Stage five: calculation and interpretation of results. The final phase comprises the calculation and checking of the value of the company, together with the interpretation of the results in the light of the circumstances surrounding the decision.

This method of calculation, the authors say, is also suitable for valuing companies under more complex framework conditions. It allows the options price theory to be applied to both their assets and their liabilities.

Context
Insufficient attention to value has meant that the value of companies worldwide has been reduced without this becoming apparent in their published accounts. This development prompted the consultancy firm McKinsey to conduct extensive research that ultimately resulted in the DCF method. This book, whose three authors are partners at McKinsey, supplements accounting disciplines with a comprehensive plan for company evaluation. It was hailed on its appearance by finance experts worldwide as a must-read for managers, security analysts, and investors alike. The new edition shows how the system can be applied in the valuation of companies from the New Economy.

For More Information

McKinsey & Co. Inc, Tom Copeland, Jack Murrin, and Tim Koller. Valuation: Measuring and Managing the Value of Companies. 3rd ed. New York: John Wiley and Sons, 2000.

Bloomsbury Publishing Plc 2003