Tuesday, April 09, 2013

The Key Value Driver Formula and the Zen of Corporate Finance

This post is a part of my series on valuation. Today, I look at the fundamental drivers of value in a business.


When valuing a company, there are two main factors to consider. The Return on Invested Capital (ROIC) and the growth in cash flows (g)


  • Growth rate = return on new invested capital * investment rate
  • ROIC = capital invested in the business = PPE + net working capital (typically)



If the growth remains constant in perpetuity, we can use the following formula to calculate the value of a company:


  • Value = Free Cash Flow,t=1/(Cost of Capital - Growth)
The cost of capital can be substituted for the Weighted Average Cost of Capital (WACC)

Example: 
Earnings = 100
Net investment = 25
Cash Flow,t=1 = 75
Cost of Capital = 10%
Growth = 5%
Value = 75/(10%-5%) = 75/0.05 = 1500 

Based on this valuation, we can also calculate an implied earnings multiple:

  • Earnings multiple = Valuation/Earnings = 1500/100 = 15X
The free cash flow is calculated as NOPLAT minus net investment. NOPLAT is Net Operating Profit Less Adjusted Taxes and represents the cash generated by the business in a given year. From this we can create what is called the key value driver formula:

  • Value = (NOPLAT,t=1 * (1 - g / WACC)) / (WACC - g)
This article is based on the book Valuation by Koller, Goedhart & Wessel. They call the key value driver formula the Zen of Corporate Finance "because it relates a company's value to the fundamental drivers of economic value: growth , ROIC and the cost of capital".






7 comments:

Vada said...

This is cool!

Anonymous said...

they actually refer to it as the "tao" of corporate finance.

ErikJJ said...

Not in my edition :)

Dan said...

So, this does not seem entirely right:
the KVD should be:

value = NOPLAT (1 - g / ROIC)/(WACC - g )

or

value = NOPLAT(t+1)(1 - g / RONIC)/(WACC - g )

ROIC = return on invested capital
RONIC = return on newly invested capital (future)

ROIC, which is NOPLAT / invested capital, should be used instead of WACC. If you put ROIC or RONIC equal to WACC you are actually assuming you cannot create value in the future.

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