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P.V. VISWANATH
FOR A FIRST COURSE IN VALUATION
2
 Earnings and Cashflows
 Showing how ROIC forecasts depend upon the
competitive structure of the industry.
 Discussion of the sources of competitive advantage.
 Showing how forecasts of Net Investment need to be
derived from forecasts of Capital Efficiency ratios.
 Showing how to use forecasts of capital efficiency,
revenue growth and operating margin to come up
with a consistent firm valuation.
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 Earnings are not the same as cashflows.
 Earnings numbers (such as Net Income) are constructed to answer
questions, such as – what was the profitability of the firm this
period?
 Such questions may be important for various purposes – one to
construct incentive-compatible compensation packages; two, to help
in forecasting future profitability, which is preliminary to decisionmaking on whether to continue or discontinue projects or
enterprises.
 Accounting rules help normalize earnings over time by distributing
revenues and expenses fairly over time.
 For this purpose, we need to use various accounting principles, such
as the matching principle, which will assign costs to revenues and
other principles governing revenue recognition that will assign
revenues and costs to specific time periods.
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 Revenues are recognized when the service for which the
firm is getting paid has been performed in full or
substantially, and the firm has received in return either
cash or a receivable that is both observable and
measurable.
 For expenses that are directly linked to the production of
revenues (like labor and materials), expenses are
recognized in the same period in which revenues are
recognized.
 Expenses that are not directly linked to the production of
revenues are recognized in the period in which the firm
consumes the services.
 But still, there is a basic difference between accounting
earnings and cashflows!
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 A dollar of accounting earnings cannot necessarily be paid out as dividends
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or used up otherwise in that period. For example, there might have been
revenue generation, but the money might not have been collected!
This means that we cannot directly use earnings to compute the increase in
the present value of the firm and the increase in the wealth of the firm’s
stakeholders.
If the objective of the firm is taken to be maximization of the firm’s market
value or the wealth of the firm’s equity-holders, we need to take another
tack.
The market for corporate and treasury bonds provide a direct valuation in
today’s dollars of future dollars that are available for consumption in those
future periods.
Hence if we can estimate the cashflows generated by a firm in future
periods, we can compute the present value of those future cashflows. Any
activities that increase that present value is then desirable. Cashflows, thus,
can be used as a direct guide to valuation and indirectly to rational
decision-making.
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 However, as argued before, it is earnings that will allow us to
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determine the profitability of a firm in a given period.
On the other hand, we need cashflows to compute the value of
the firm.
How do we resolve this seeming contradiction?
The answer is that we use both.
We use accounting numbers as a guide to forecasts of future
profitability and future earnings.
We then use rules to take us from earnings numbers to
cashflow numbers.
We then discount future cashflows using appropriate discount
rates.
Thus we use earnings in their place and cashflows in their
place!
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 There are two basic elements that we have to worry about – inflows
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and outflows.
As far as outflows are concerned, accountants distinguish between
operating expenses – outlays that yield benefits only in the
immediate period (such as labor and materials for a manufacturing
firm) and capital expenditures – those that yield benefits over
multiple periods (such as land, buildings, and long-lived assets).
Operating expenses are subtracted from income in the period in
which they are incurred.
Capital expenditures are spared out over multiple periods and
deducted as an expense in each period. These expenses are called
depreciation (for a tangible asset) or amortization (for an intangible
asset).
Since the actual cash outlay occurs at the beginning when the capital
expenditure is incurred, for cashflow purposes, we must recognize
the capital expenditure at the time of incurring; and, at the same
time, add back the depreciation/amortization which is charged to
income over time because there is no cash outflow at that time.
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 As far as inflows are concerned, under the accrual system of
accounting, revenues are recognized when the sale is made rather
than when the customer pays. Obviously, the second date is more
relevant for cashflows than the first date.
 The problem is that if the two dates are different, accrual revenues
differ from cash revenues. There are four possibilities:
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Customers who bought their goods in prior periods may pay in this period – this
will reduce accounts receivable (current asset) and hence decrease Non-Cash
Working Capital. Net Income less change in Non-Cash Working Capital is
positive.
Customers who buy their goods in this period may defer payment to future
periods – this will increase accounts receivable (current asset) and hence
decrease Non-Cash Working Capital. Net Income less change in N0n-Cash
Working Capital is zero.
Customers may pay in advance for products that will not be delivered until future
periods – this will increase unearned income (current liability). This is not
recognized in Net Income at all, and the net effect on Net Income less change in
N0n-Cash Working Capital is positive.
Customers who buy goods and services may never pay – this is treated in the next
slide.
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 Suppose $1000 of sales this period are estimated to be uncollectible. First, accounts
receivable will go up to the tune of all credit sales (including the $1000). Then, the
allowance for uncollectible accounts will be increased by $1000 and Uncollectible
Accounts will be charged $1000. This has several effects. On the income statement,
revenues of $1000 will be offset by the Uncollectible Accounts expense and the effect
will be zero. On the balance sheet, the increase in the allowance for uncollectible
accounts of $1000 will be shown as a deduction from accounts receivable and hence the
net effect will be zero.
 For our purposes, the total amount of cash received for the $1000 sale is zero and this is
reflected in a zero effect on Net Income less change in Non-Cash Working Capital.
 If the customer actually pays, the original decrease (when the account was deemed
uncollectible) in Accounts Receivable is reversed and Allowance for Uncollectible
Accounts is decreased. Then the payment is recognized by a decrease in Accounts
Receivable and an increase in cash. The change in Non-Cash Working Capital is now
negative (because the net effect on A/R is negative) and Net Income less change in NonCash Working Capital is positive. (Ultimately, this happy event flows through directly
to Retained Earnings without affecting the income statement.)
 When the account is actually written off, the allowance for uncollectible accounts is
decreased and Accounts Receivable increased so the net effect on current assets is zero,
which is appropriate since there is no cashflow at all.
Schaum's Outline of Financial Accounting 2 Ed. By Jae K. Shim, Joel G. Siegel, p. 175-6
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 What we see in all these cases is that Net Income less change in Non-
Cash Working Capital moves us from the accrual system to a cash
accounting system, which is what we desire.
 Similarly, other deviations from cashflow due to the accrual system of
accounting (such as operating expenses and other outflows that are
not cash transactions) are taken into account by adjusting earnings by
the change in non-cash working capital.
 We see, thus, that there are three kinds of modifications that need to
be made to earnings:
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One, change in non-cash working capital
Two, capital expenditures (defined broadly as any long-term investment)
Three, adding back non-cash charges such as depreciation; this is often done by
netting it out from capital expenditures.
Since an increase in non-cash working capital (such as an increase in accounts
receivable) can also be thought as resources tied up that could have been used
profitably elsewhere, changes in non-cash working capital represent changes in
invested capital.
The sum of changes in non-cash working capital and capital expenditures gives us
the aggregate change to Invested Capital.
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 In order to value the company, it is necessary to forecast Free
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Cashflow and discount it to the present.
Free Cashflow is defined as NOPLAT - Increases to Invested
Capital = NOPLAT – Capital Expenditures + Depreciation –
Changes in Non-Cash Working Capital
NOPLAT broadly speaking can be defined as Revenues less
Costs less Taxes.
We can proceed to forecast Revenues and Costs separately
and even forecast the components of these two budget
categories.
However we must keep in mind that there are two other issues
with which these forecasts must be kept consistent.
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One, our ROIC forecasts must be consistent with the competitiveness of
the firm within the industry.
Two, our assumptions regarding Net Investments over time must be
consistent with our efficiency in using our assets.
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 It is important to keep in mind in making assumptions
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regarding Operating Income is that Sales and Income cannot
change in a vacuum.
Unless a firm has a monopoly, competitors actions and
reactions have to be taken into account.
As long as an industry is profitable, there will be an incentive
for new competitors to enter the industry and for existing
competitors to intensify their efforts.
Ultimately, this means that in the long run, ROIC will tend to
be equal to WACC. If ROIC is much less than WACC, existing
firms will exit the industry and if ROIC is greater than WACC,
new firms will enter the industry.
However, this does not mean that every firm in the industry
will have to operate with a ROIC figure close to WACC.
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 While there is general pressure for ROIC to be close
Percent
to WACC, the specific situation depends very much
on each firm.
Competitive
Pressure
Peak
ROIC
Sustainability
WACC
Years
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 What is common to all firms striving to maximize value is the ability
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to keep ROIC as high as possible and higher than WACC for as long
as possible.
When competitive pressures get too strong to be able to bear, ROIC
tends back down to WACC.
The way in which ROIC can be kept higher than WACC is by
exploiting competitive advantages.
In the short run, ROIC can be kept high by developing new
strategies that are more innovative in generating customer wants
and/or cheaper production techniques. In this sense, this is not a
zero-sum game.
Alternatively, the firm can increase value by competing head-on
against competitors.
Ultimately, though, in the long-run, this is a zero-sum game,
because the innovative actions of individual firms will themselves
increase expected returns.
What can a firm do to increase its competitive advantage?
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 The availability of economies of scale in production
 Investments that are structured to exploit economies of scale are more likely
to be successful than those that are not.
 Product differentiation
 Investments designed to create a position at the high end of anything,
including the high end of the low end, differentiated by a quality or service
edge, will generally be profitable.
 Cost advantages
 Investments aimed at achieving the lowest delivered cost position in the
industry, coupled with a pricing policy to expand market share, are likely to
succeed, especially if the cost reductions are proprietary.
 Monopolistic access to distribution channels
 Investments devoted to gaining better product distribution often lead to
higher profitability.
 Protective government regulation
 Investments in project protected from competition by government
regulation can lead to extraordinary profitability. However, what the
government gives, the government can take away!
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(Unit Price  Unit Cost) x Quantity
ROIC  (1  T)
Invested Capital
 Another way of recognizing the sources of value is to
consider the above reworking of the Zen Formula.
 This shows that for individual firms to have high
ROICs, year in and year out for many years, there
must be an advantage in one of three areas:
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Price
Cost
Capital Efficiency
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 In commodity markets, companies are price takers.
 There is very little difference between the product offered
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by one company and that offered by another.
The production cost thus directly determines the sales
price.
To enable price setting, a company must find a way to
differentiate its product from its competition.
For example, Coca Cola is a price setter and can charge a
price well in excess of its marginal costs.
This is because customers choose soft drinks based on
taste, preference and brand image.
Coca Cola Customers are loyal and do not switch brands
even when faced with a low-priced alternative.
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ROIC for Coca-Cola
700%
600%
500%
400%
300%
ROIC
200%
100%
0%
Computed from data for Coca-Cola by Prof PV Viswanath
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 Question:
 Why did Coca-Cola’s ROIC drop after 1999-2000 to
such a low level?
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 Another way to obtain a high ROIC is to sell products and
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services at a lower cost than the competition.
Wal-Mart is an example.
It is know for using its substantial purchasing volume to
lower its costs and force better terms from its suppliers.
The company invests heavily in computing power and
technology to improve its cost position; thus, it stands at
the forefront of RFID, a new technology to keep track of
inventory.
Chinese apparel firms also have cost competitiveness.
However, over time, labor costs in China will increase
and erode their competitiveness relative to perhaps other
firms located in Vietnam.
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 Tom Copeland tells of achieving capital efficiency in a firm
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that he consulted for:
The client had constructed poles that were thicker and closer
than required by engineering standards, and with thicker
cable.
When asked the reason for such a strong distribution system,
the reply was that a strong system was better able to resist
wind damage from tree limbs during storms.
It turned out that it was more value effective to use less thick
poles and cables and simply trim the trees more often.
This caused profit to drop, but the drop in required capital
was even lower and resulted in higher ROIC.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=717744&downl
oad=yes
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 Even if profits per transaction are low, a company can
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generate value by selling more products per dollar of
invested capital than its competition.
In the airline industry, an aircraft generates revenue
when it is transporting passengers, not when it sits on
the ground empty.
Thus, the more an airline flies each aircraft in a given
day, the more value it can create.
Southwest Airlines has a single kind of airplane, allowing
for cost savings in maintenance, but also advantages in
flexibility, since all aircraft can be used for all flights.
By spending more on getting aircraft serviced quickly,
the total number of aircraft necessary can also be
reduced, thus increasing capital efficiency.
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 At this point, we have made our ROIC forecasts.
 Now, we make our forecasts regarding NOPLAT (i.e.
Operating Income). We have to ensure that these are
consistent with our assumptions regarding Invested Capital.
 It is not possible to increase operating income without either
increasing the efficiency of use of existing assets or increasing
the amount of invested capital.
 Hence if there are no clear avenues to increasing the efficiency
of existing assets, invested capital must increase to be
consistent with assumptions of increased operating income.
 We have to make sure as well that assumptions regarding
increased sales are consistent with the productivity of the
assets used in the generation of those sales.
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 How do we do this?
 First we forecast ROIC based on assumptions
regarding the competitiveness of the firm within the
industry, as discussed above.
 We also need to make assumptions regarding
revenue growth and after-tax operating profit
margin, using the modified Dupont Analysis already
discussed.
 Finally, we need to make assumptions about the
terminal growth rate and the cost of capital.
 We are now ready to value the firm.
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 Suppose you have made the following forecasts for the
next seven years:
Base
Year
Forecast
Revenue
Growth
After-tax
Op Margin 0.025
Capital
Efficiency 1.053
ROIC
1
2
3
4
5
6
7
15%
14%
13%
12%
11%
10%
9%
3%
6%
8%
20%
16%
12%
8%
1
3%
1
6%
1.1
9%
1.1
22%
1.1
18%
1.2
14%
1.2
10%
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Year
Base Yr
1
2
3
4
5
6
7
Revenues
1000 1150 1311 1481.43 1659.20 1841.71 2025.89 2208.21
Operating Profits
25 34.5 78.66 121.48
331.84
302.04
237.03
183.28
Invested Capital
950 1150 1311 1346.75 1508.37 1674.29 1688.24 1840.18
Free Cashflow
-165.5 -82.34 85.72
170.23
136.12
223.08
31.34
 We first use forecasts of revenue growth to compute revenues
in all years.
 We then use the estimate of Operating Margin to obtain
Operating Profits.
 The Capital Efficiency Estimates are then used to obtain the
required Invested Capital each period.
 Finally, the change in Invested Capital is added to Operating
Profits to yield Free Cashflow.
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 Assuming a cost of capital of 10% and a terminal
growth rate in FCF of 5%, we can compute the
terminal value of the enterprise, as of year 7 as
(31.34)(1.05)/(0.10-0.05) = $658.15
 The present value of this quantity is 658.15/(1.1)7 =
$337.73
 The sum of the present values of the cashflows for
the first 7 years can be computed in a
straightforward way using the 10% discount rate as
$188.69.
 The sum of these two quantities, which is $526.43 is
the enterprise value.