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NYO-ZWB887-20050927-SN1

Valuation: Measuring and Managing the Value of Companies


Tim Koller

October 11, 2005

This report is solely for the use of client personnel. No part of it may be circulated, quoted, or reproduced for distribution outside the client organization without prior written approval from McKinsey & Company. This material was used by McKinsey & Company during an oral presentation; it is not a complete record of the discussion.

TODAYS DISCUSSION

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Understanding value creation

Balancing performance and health

SIMILAR P/E

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PE Ratio

21

19

* Excluding acquisition, divestiture and foreign exchange impact Source: Compustat; Zacks; McKinsey Corporate Performance Center

SIMILAR P/E, DIFFERENT GROWTH

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PE Ratio

Organic growth* 2002-04 Percent

21

19

12

* Excluding acquisition, divestiture and foreign exchange impact Source: Compustat; Zacks; McKinsey Corporate Performance Center

SIMILAR P/E, DIFFERENT GROWTH

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PE Ratio

Return on invested Organic growth* capital 2002-04 2002-04 Percent Percent

21

60

19

20

12

* Excluding acquisition, divestiture and foreign exchange impact Source: Compustat; Zacks; McKinsey Corporate Performance Center

WHY ROIC MATTERS


Year 1 Company A g = 5% ROIC = 10% Earnings Investment Cash flow 100 (50) 50

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Year 2 105 (52) 53

Company B g = 5% ROIC = 20%

Earnings Investment Cash flow

100 (25) 75

105 (26) 79

CORE DRIVERS OF VALUE

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Return on invested capital Cash flow Value

Revenue growth Cost of capital

VALUE OF GROWTH AND ROIC


Implied PE ratios

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Return on Invested Capital 7% 3% 8 9% 11 13% 14 25% 16

Growth 6%

11

16

21

9%

11

19

27

VALUE OF GROWTH

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Increase in value due to 1% faster growth Percent 9 7 4 0 ROIC Percent 9 11 15 25

IMPACT OF IMPROVING ROIC


Impact of 1% higher ROIC Percent

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25

15 7

Current ROIC Percent

12

20
9

VALUE CREATION FROM GROWTH DEPENDS ON TYPE OF GROWTH


Shareholder value created for incremental $1 of revenue
New-product Expanding an existing market Growing share in a growing market Competing for share in a stable market Acquisition 0.30-0.75 1.75-2.00

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0.10-0.50 -0.25-0.40

-0.05-0.20

Source: McKinsey analysis

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U.S. EARNS HIGHER VALUATIONS DUE TO HIGHER ROIC


Median Market-to-Book Ratio 2002-04 Median Return on Equity 2002-04

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2.6 2.3

13

12 9

1.0

U.S.

Europe

Asia

U.S.

Europe

Asia

11

PREDICTED P/E TRACKS ACTUAL P/E


25

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20

15

Median P/E* Modeled P/E

10

0 1963

1967

1971

1975

1979

1983

1987

1991

1995

1999

2003

* Average of beginning and end of year S&P 500 median P/E Source: McKinsey analysis

12

MEDIAN ROIC HAS BEEN STABLE


14% 12% 10%

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Median ROIC
8% 6% 4% 2% 0% 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998
13

CORPORATE PROFITS CONSTANT PERCENTAGE OF GDP


11% 9%

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Corp. profits/GDP
7% 5% 3% 1% -1% -3% 1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995

Average = 5.5%

14

INFLATION RATE DRIVES A MEDIAN P/E


25

NYO-ZWB887-20050927-SN1

20

Median P/E*
15

10

Inflation
0 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003

* Average of beginning and end of year S&P 500 median P/E Source: McKinsey analysis

15

TODAYS DISCUSSION

NYO-ZWB887-20050927-SN1

Understanding value creation Balancing performance and health

16

CFOs DEFER INVESTMENT TO MEET EARNINGS TARGETS


Decrease discretionary spending Delay new project even if value sacrificed Book revenues now rather than next quarter Incentivize customers to buy this quarter Draw down on reserves Postpone accounting charge Sell asset to recognize gain this quarter Repurchase common shares Alter accounting assumptions
* Footnote Source: Source

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80 55 40 39 28 21 20 12 8
17

NOT ALL EARNINGS ARE EQUAL


Consumer goods company Percent growth

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Volume Pricing/mix Cost reduction Share repurchase EPS growth target


Source: Academic paper

3-4

1-2

1-2

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MODEST GROWTH EXPECTATIONS FOR MAJOR COMPANIES


Company

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Forward P/E Ratio

Estimated Growth 2005 2019 CAGR


5.2

A B C
D

20 19 18 20 21 16 18
4.0 4.1

5.5

5.7

E
F G

4.7

5.4

Source:Company reports, Analyst reports, McKinsey Corporate Performance Center analysis

19

ANALYST EPS FORECAST CONSISTENTLY OVER-OPTIMISTIC


80.00 70.00 60.00

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2003 2002 2000 2001

EPS (US cents)

50.00 40.00 1995 30.00 20.00 10.00 Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 Date of Forecast 1985 1986 1988 1989 1990 1987 1991 1993 1992 1994 1999 1997 1998 1996

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HIGH-TECH COMPANY NAIVE VALUATION


$ per share
$120

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DISGUISED

$61

$70

Naive multiples valuation

Multiples valuation adjusted for performance and peers

Actual market value

21

GROWTH DECAYS VERY QUICKLY


Median real growth of cohorts Percent

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35 30 25 20 15 10 5 0 -5

>20

1520

1015 510

<5

10

12

14
22

Years

LONG-TERM PERFORMANCE EXPECTATIONS DRIVE SHARE PRICE


Abnormal return on 137 announcements of fiscal year earnings for 2002 by U.S. companies Percent

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Positive Change in expected EPS for 2004 change in long-term expectations

2.3

3.6

Negative

-4.1

1.0

Lower

Higher

Actual EPS 2002 relative to expected EPS for 2002 short-term surprise
Source: Datastream; IBES; McKinsey analysis 23

PERFORMANCE AND HEALTH


Performance Health Short-term metrics Sales Productivity Operating cost productivity ROIC Capital productivity Asset health Medium-term metrics Commercial health

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Long-term metrics

Growth

Intrinsic Value

Cost structure health

Strategic health Core business Growth opportunities

Organizational health Cost of capital


24

MANAGING PERFORMANCE AND HEALTH

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Strategic initiatives across multiple time horizons Organizational processes focused on health New dialogue with investors and the Board

25

MANY DIRECTORS DONT UNDERSTAND COMPANYS STRATEGY AND INITIATIVES


1,016 respondents, percent
How would you describe your board's understanding of the company's current strategy?

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How would you describe your board's understanding of 5-10 key initiatives needed to achieve long-term objectives?

None Limited
27 1

None
4

42

Good

Complete 11

62

Limited Good

51 4

Complete

26

DIRECTORS WANT TO KNOW MORE


1,016 respondents, percent
As a director, I would like to know more about: Market health Organizational health Network health Financial performance Operational health Do not need more information

NYO-ZWB887-20050927-SN1

70 55 40 31 28 14
27

PERFORMANCE AND HEALTH


Performance Health Short-term metrics Sales Productivity Operating cost productivity ROIC Capital productivity Asset health Medium-term metrics Commercial health

NYO-ZWB887-20050927-SN1

Long-term metrics

Growth

Intrinsic Value

Cost structure health

Strategic health Core business Growth opportunities

Organizational health Cost of capital


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