12

The corporate valuation model

This chapter reviews:

• Financial leverage
• Internal return versus required return
• The importance of ROE
• The corporate valuation model

Introduction

This chapter is a natural conclusion to all the previous chapters. It integrates the material and illustrates the relationships between many of the ratios. It does this through a single model of corporate value.

Specifically we will:

• establish the financial leverage links between ROTA and ROE
• examine further the great importance of ROE
• tie together:
  • operating efficiency measures
  • leverage ratios
  • valuation factors.

The overall aim of this chapter is to identify and quantify the drivers of corporate value.

To accomplish this we will make much use of the V chart (valuation chart).

Financial leverage

The popular term ‘financial engineering’ refers to schemes that aim to increase shareholders’ return from a given return earned by a company.

The material that follows will give some appreciation of financial engineering.

The concept of leverage, or gearing, was covered briefly in Chapter 9 on financial strength. We demonstrated that high leverage could substantially increase the return to shareholders. This chapter will explore further the impact of leverage and the specific elements that link ROTA and ROE.

In Chapter 5 we calculated the following values for the Example Co. plc:

• ROTA 14.0%
• ROE 16.7%

Financial engineering has been used to transform a pre-tax (EBIT) return of 14.0% (ROTA) on the company’s total assets into a post-tax (EAT) return of 16.7% (ROE) to shareholders. This is leverage in action.

Three financial variables link ROTA and ROE:

• debt to equity ratio
• average interest cost
• tax rate.

An explanation of each variable follows:

1. Debt to equity ratio

We looked at three methods of calculating the debt to equity ratio in Chapter 9 on financial strength. To demonstrate financial leverage we will use a hybrid approach which takes all debt (or non-equity funds) in the balance sheet (whether interest-bearing or not) and compares it to equity (owners’ funds) expressed as a traditional ratio.

For Example Co. plc:

• Total debt (LTL + CL) = $440m
• Equity (OF) = $360m
• So the debt to equity ratio used here is: 1.2 times (440: 360).

2. Average interest cost

For this calculation we take the interest charge from the profit and loss account and divide it by total debt to give an ‘average’ interest charge on non-equity funds.

As this includes a number of ‘free’ funds in the balance sheet, e.g. accounts payable, the actual interest cost will inevitably be higher. However, the ‘average’ cost is specific to our demonstration.

For Example Co. plc:

• Interest = $20m
• Total debt (LTL + CL) = $440m
• So the average interest cost used here is 4.5%.

3. Tax rate

For this calculation we take the tax charge from the profit and loss account and divide it by pre-tax profit (EBT) to give an average tax rate for the year under consideration.

For Example Co. plc:

• Tax = $32m
• EBT = $92m
• So the average tax rate used here is 35%.

These three variables are laid out diagrammatically in Figure 12.1.

V chart

In Figure 12.2, a V chart (valuation chart) displays in geometric form the relationships between different performance measures for the Example Co. plc.

The V chart integrates in one diagram the financial variables that determine a company’s valuation in the stock market.

The V chart looks formidable at first sight because there appear to be so many parts to it. However, we will work carefully through it. There are approximately six separate steps. Each step is simple in itself. The result of the exercise will be comprehension of quite a difficult subject. Once this is achieved the remaining material will be very easy to follow.

Step 1 The chart is constructed on a base that represents the total funds in the business divided between total equity ($360m) and total non-equity ($440m).

Step 2 Where equity and non-equity meet we draw to scale a vertical line representing ROTA (14%).

Step 3 At the extreme left of the base we place a vertical line representing the average cost of all non-equity funds – 4.5%.

Step 4 At the extreme right of the base we erect a vertical line to represent ROE (pre-tax) – 25.6%.

 

 

Step 5 We join the upper limit of the ‘Interest’ line (Step 3) to the upper limit of the ‘ROTA’ line in the middle of the diagram (Step 2) and extend this diagonal to meet the ROE line on the right of the diagram (Step 4).

Step 6 The point where the diagonal line meets the right-hand vertical line represents ROE value (pre-tax).

ROE (pre-tax and post-tax)

ROE is normally calculated post-tax based on EAT. This is because the tax authorities must be paid before the shareholder.

In a V chart, however, we use ROE (pre-tax). This is simply to demonstrate the link between ROTA and ROE and the effects of the following three variables:

• debt to equity ratio
• average interest cost
• tax rate.

For Example Co. plc the calculations are as follows:

ROE (post-tax):

ROE (pre-tax):

We can move between ROE (pre-tax) and ROE (post-tax) with simple multiplication as follows:

(In the above calculation of ROE there is a small rounding difference with the figure of 16.7% as the tax rate is an average.)

V chart dynamics

To understand the dynamics of financial leverage, it is useful to imagine the V chart’s diagonal line as a cantilevered beam which is anchored on the left vertical line.

The aim of the diagram is to demonstrate changes which impact on the ROE (pre-tax). The ROE (pre-tax) is represented by the height of the right-hand side of the V chart. This height is affected by the angle of the diagonal line.

The angle of the diagonal line and hence the size of the ROE (pre-tax) is determined by three factors:

1. The height of the left vertical line, or ‘anchor’, i.e. the average interest cost
2. The height of the centre vertical line, i.e. the ROTA value
3. The position of the centre vertical line, i.e. the relative values for ‘equity’ and ‘non-equity’.

We can write this in an equation:

(In the above calculation of ROE there is a small difference due to rounding.) We can use either the chart or the formula to track a change in any of the input values to its effect on ROE (pre-tax).

Three examples are shown in Figure 12.3.

Example A: Increase ROTA by 1%

Example A demonstrates that a 1% increase in ROTA has a 2% positive impact on ROE (pre-tax).

Example B: Increase non-equity/equity to 1.5 times

Example B demonstrates that an increase in the debt to equity ratio from 1.2 to 1.5 has an almost a 3% positive impact on ROE (pre-tax).

This shows that using leverage, or financial engineering, can substantially increase the return to shareholders.

Example C: Increase interest cost by 0.5%

Example C demonstrates that a 0.5% increase in interest costs has an almost a 1% negative impact on ROE (pre-tax).

One of the risks of leverage is exposure to changes in interest rates. This shows that leverage is not without its risks. There is both upside potential and downside risk to consider.

The V chart approach has identified and quantified the variables that link the ROTA to ROE. The ones with the biggest impact and therefore the most important are ROTA and leverage (the debt/equity ratio).

Out next step is to link ROE to company value. When this is complete we will be able to trace a path from shop-floor variables right through to stock-market value. This is addressed in the next section.

Internal return versus required return

We looked at the market to book ratio in the previous chapter on investor ratios. We calculated this ratio using total company values as follows:

With the market/book ratio we express the relationship that exists between a company’s value on the stock market and the underlying asset/book value as shown in the balance sheet. This ratio can be calculated for the company in total or for one share in the company.

As an alternative we can also perform the same calculation on a single-share basis.

First we need to calculate the book value per share:

We then divide the share price by the book value per share:

Naturally the answer is also 2 times.

However neither the total or per share calculation of market to book identify the factors that drive the market/book ratio. To see these drivers we must look to another set of relationships.

The ROE figure tells us the rate of return that the company is delivering to the shareholders (internal return). The earnings yield figure is the rate of return investors require to hold the share (required return). As a recap these two ratios are calculated as follows:

The market/book ratio falls out of the relationship between ROE (internal return) and earnings yield (required return):

The market to book ratio is driven by ROE. It is determined by the relationship between what the market demands (earnings yield/required return) and what the company delivers (ROE/ internal return).

This concept is of crucial importance. It illustrates the fact that investors decide on a rate of return necessary for a particular business. Then they value that business at a premium or a discount, depending on whether the return delivered by the business is greater or less than their required rate.

The importance of ROE

ROE drives company value. There are those who will dispute this statement. With good logic they will argue this is too simple an explanation because ROE is a short-term accounting measure. It does not take into account any future changes to the business or growth prospects. Nevertheless we can say that, other things being equal, the most important driver of value is ROE.

The V chart, covered earlier, demonstrated the key drivers of ROE. The most important are:

• ROTA
• leverage (the debt/equity ratio).

In turn, as covered in Chapter 6 on performance drivers, the factors that drive ROTA are:

• profit margin
• asset turnover.

Driving profit margin asset turnover are all the operating ratios.

So it is ROE that brings together all the operating and financing characteristics of the business.

We therefore can trace a path from the shop floor to stock-market value.

However we need to examine a little more the factors that help the stock market decide on the earnings yield it will demand from a particular company.

Investors will weigh up the prospects for:

• the particular company
• the industrial sector
• the economy overall.

The main influencing factors under each heading are shown in Figure 12.4.

Investors are buying the expected future returns of the company. If growth prospects are good this will promise high returns. However they trade off risk against return. For a high perceived risk they will look for a high return.

Note: An increase in leverage (the debt/equity ratio) has a double effect: it increases ROE but it also increases risk and therefore normally results in a higher ‘earnings yield’ value. The increase in ROE (the numerator) should increase corporate value but if debt/equity is pushed beyond a prudent level the resulting increase in the earnings yield (the denominator) will actually reduce overall value.

The corporate valuation model

In Figure 12.5 we are now able to pull together the various sections of the overall corporate valuation model.

Section A illustrates the drivers of operating performance covered in Part Two of this book (Chapters 5 and 6).

Section B shows the financial leverage model given earlier in this chapter.

Section C brings in the investor ratios covered in Chapter 11.

This completes the chain linking shop-floor value drivers to stock-market value.

Figures from the Example Co. plc accounts are used for the various nodes in the model. There is an arithmetical link between each node in the chain that produces the final corporate value of $720m.

The independent variables in the model that can be influenced by management can now be identified:

• the cost percentages in the profit and loss account:
  • material
  • labour
  • overheads.
• the main asset groups in the balance sheet::
  • fixed assets
  • inventories
  • accounts receivable.
• the level of financial leverage (debt to equity ratio)
• the interest rate as well as free versus paid borrowings
• the tax rate.

One can work back from a desired end result to determine what the value of any single input variable must be, if the other inputs remain constant. This uses the equation established with the V chart.

For example, if the management of Example Co. plc set a target of 20% for ROE (post-tax), they could work back to determine that the value of ROTA needed to deliver that is 16.5%. They can subsequently set targets for each of the supporting drivers to work back to a ROTA of 16.5%.