Valuation: Measuring and Managing the Value of Companies, Seventh Edition
By Tim Koller, Marc Goedhart and David Wessels
About the Authors ix
Part One Foundations of Value
1 Why Value Value? 3
2 Finance in a Nutshell 17
3 Fundamental Principles of Value Creation 27
4 Risk and the Cost of Capital 55
5 The Alchemy of Stock Market Performance 69
6 Valuation of ESG and Digital Initiatives 83
7 The Stock Market Is Smarter Than You Think 99
8 Return on Invested Capital 127
9 Growth 155
Part Two Core Valuation Techniques
10 Frameworks for Valuation 177
11 Reorganizing the Financial Statements 205
12 Analyzing Performance 239
13 Forecasting Performance 259
14 Estimating Continuing Value 285
15 Estimating the Cost of Capital 305
16 Moving from Enterprise Value to Value per Share 335
17 Analyzing the Results 357
18 Using Multiples 367
19 Valuation by Parts 391
Part Three Advanced Valuation Techniques
20 Taxes 413
21 Nonoperating Items, Provisions, and Reserves 427
22 Leases 443
23 Retirement Obligations 457
24 Measuring Performance in Capital-Light Businesses 467
25 Alternative Ways to Measure Return on Capital 483
26 Inflation 493
27 Cross-Border Valuation 507
Part Four Managing for Value
28 Corporate Portfolio Strategy 527
29 Strategic Management: Analytics 547
30 Strategic Management: Mindsets and Behaviors 571
31 Mergers and Acquisitions 585
32 Divestitures 613
33 Capital Structure, Dividends, and Share Repurchases 633
34 Investor Communications 667
Part Five Special Situations
35 Emerging Markets 691
36 High-Growth Companies 709
37 Cyclical Companies 725
38 Banks 733
39 Flexibility 759
Appendix A Discounted Economic Profit Equals Discounted Free Cash Flow 793
Appendix B Derivation of Free Cash Flow, Weighted Average Cost of Capital, and Adjusted Present Value 799
Appendix C Levering and Unlevering the Cost of Equity 805
Appendix D Leverage and the Price-to-Earnings Multiple 813
Appendix E Other Capital Structure Issues 817
Appendix F Technical Issues in Estimating the Market Risk Premium 823
Appendix G Global, International, and Local CAPM 827
Appendix H A Valuation of Costco Wholesale 835
Appendix I Two-Stage Formula for Continuing Value 859
The first edition of this book appeared in 1990, and we are encouraged that it continues to attract readers around the world. We believe the book appeals to readers everywhere because the approach it advocates is grounded in universal economic principles. While we continue to improve, update, and expand the text as our experience grows and as business and finance continue to evolve, those universal principles do not change.
The 30 years since that first edition have been a remarkable period in business history, and managers and investors continue to face opportunities and challenges emerging from it. The events of the economic crisis that began in 2007, as well as the Internet boom and its fallout almost a decade earlier, have strengthened our conviction that the core principles of value creation are general economic rules that continue to apply in all market circumstances. Thus, the extraordinarily high anticipated profits represented by stock prices during the Internet bubble never materialized, because there was no “new economy.”
Similarly, the extraordinarily high profits seen in the financial sector for the two years preceding the start of the 2007–2009 financial crisis were overstated, as subsequent losses demonstrated. The laws of competition should have alerted investors that those extraordinary profits couldn’t last and might not be real.
Over time, we have also seen confirmed that for some companies, some of the time, the stock market may not be a reliable indicator of value. Knowing that value signals from the stock market may occasionally be unreliable makes us even more certain that managers need at all times to understand the underlying, intrinsic value of their company and how it can create more value. In our view, clear thinking about valuation and skill in using valuation to guide business decisions are prerequisites for company success.
Today, calls mount for changes in the nature of shareholder capitalism. As we explain in Chapter 1, we believe this criticism derives largely from a misguided focus by corporate leaders on short-term performance that is inconsistent with the value-creation principles we describe in this book.
Creating value for shareholders does not mean pumping up today’s share price. It means creating value for the collective of current and future shareholders by applying the techniques explained in this book.
Why This Book
Not all CEOs, business managers, and financial managers possess a deep understanding of value, although they need to understand it fully if they are to do their jobs well and fulfill their responsibilities. This book offers them the necessary understanding, and its practical intent reflects its origin as a handbook for McKinsey consultants. We publish it for the benefit of current and future managers who want their companies to create value, and also for their investors. It aims to demystify the field of valuation and to clarify the linkages between strategy and finance. So while it draws on leading-edge academic thinking, it is primarily a how-to book and one we hope you will use again and again. This is no coffee-table tome: if we have done our job well, it will soon be full of underlining, margin notations, and highlighting.
The book’s messages are simple: Companies thrive when they create real economic value for their shareholders. Companies create value by investing capital at rates of return that exceed their cost of capital. These two truths apply across time and geography. The book explains why these core principles of value creation are genuine and how companies can increase value by applying them.
The technical chapters of the book aim to explain, step-by-step, how to do valuation well. We spell out valuation frameworks that we use in our consulting work, and we illustrate them with detailed case studies that highlight the practical judgments involved in developing and using valuations. Just as important, the management chapters discuss how to use valuation to make good decisions about courses of action for a company. Specifically, they will help business managers understand how to:
- Decide among alternative business strategies by estimating the value of each strategic choice.
- Develop a corporate portfolio strategy, based on understanding which business units a corporate parent is best positioned to own and which might perform better under someone else’s ownership.
- Assess major transactions, including acquisitions, divestitures, and restructurings.
- Improve a company’s strategic planning and performance management systems to align the organization’s various parts behind improved execution of strategic priorities and create value.
- Communicate effectively with investors, including whom to talk with and how.
- Design an effective capital structure to support the corporation’s strategy and minimize the risk of financial distress.
Structure of the Book
In this seventh edition, we continue to expand the practical application of finance to real business problems, reflecting the economic events of the past decade, new developments in academic finance, and the authors’ own experiences.
The edition is organized into five parts, each with a distinct focus. Part One, “Foundations of Value,” provides an overview of value creation. We make the case that managers should focus on long-term value creation for current and future shareholders, not just some of today’s shareholders looking for an immediate pop in the share price. We explain the two core principles of value creation: (1) the idea that return on invested capital and growth drive cash flow, which in turn drives value, and (2) the conservation of value principle, which says that anything that doesn’t increase cash flow doesn’t create value (unless it reduces risk). We devote a chapter each to return on invested capital and to growth, including strategic principles and empirical insights.
Part Two, “Core Valuation Techniques,” is a self-contained handbook for using discounted cash flow (DCF) to value a company. The reader will learn how to analyze historical performance, forecast free cash flows, estimate the appropriate opportunity cost of capital, identify sources of value, and interpret results. We also show how to use multiples of comparable companies to supplement DCF valuations.
Part Three, “Advanced Valuation Techniques,” explains how to analyze and incorporate in your valuation such complex issues as taxes, pensions, reserves, capital-light business models, inflation, and foreign currency. It alsodiscusses alternative return-on-capital measures and applications.
Part Four, “Managing for Value,” applies the value-creation principles to practical decisions that managers face. It explains how to design a portfolio of businesses; how to run effective strategic-planning and performance management processes; how to create value through mergers, acquisitions, and divestitures; how to construct an appropriate capital structure and payout policy; and how companies can improve their communications with the financial markets.
Part Five, “Special Situations,” is devoted to valuation in more complex contexts. It explores the challenges of valuing high-growth companies, companies in emerging markets, cyclical companies, and banks. In addition, it shows how uncertainty and flexibility affect value and how to apply optionpricing theory and decision trees in valuations.
Finally, our nine appendixes provide a full accounting of our methodology in this book. They provide theoretical proofs, mathematical formulas, and underlying calculations for chapters where additional detail might be helpful in the practical application of our approach. Appendix H, in particular, pulls into one place the spreadsheets for the comprehensive valuation case study of Costco featured in this edition.
An Excel spreadsheet valuation model is available via Web download. This valuation model is similar to the model we use in practice. Practitioners will find the model easy to use in a variety of situations: mergers and acquisitions, valuing business units for restructuring or value-based management, or testing the implications of major strategic decisions on the value of your company. We accept no responsibility for any decisions based on your inputs to the model. If you would like to purchase the model (ISBN 978-1-118- 61090-8 or ISBN 978-1-118-61246-9), please call (800) 225-5945, or visit www .wileyvaluation.com.