HOLT

November 2012

HOLT NOTES
bryant.matthews@credit-suisse.com 312.345.6187
Valuation raymond.stokes@credit-suisse.com 44.20.7883.6143

Definition Cash flows are forecast over a horizon equal to

Example: Apple Inc. as of April 2012
Estimating the value or worth of a business. Stage 1
100+N years, where N is a firms Asset Project
Life, and discounted at the weighted average FY1 and FY2 CFROI are derived from
Overview cost of capital (WACC). The present value sumI/B/E/S consensus eps estimates combined
A firms worth equals the market value of its equals Total Operating Enterprise Value (OEV). with HOLTs normalized asset growth estimate.
invested capital (IC) plus the present value of HOLTs Warranted Equity Price equals OEV plus Last years achieved CFROI of 30.3% is
future economic profit (EP): Investments less Debt and Minority Interest. forecast to climb to 32.6% in 2012 and fall to
25.2% in 2013. CFROI used in valuation (t+1)
N
EPi Fade-to Levels is a blend of FY1 and FY2 CFROI, in this case
Firm Value = IC 0 + Industrials: CFROI and WACC fade to 6.0%; equaling 30.4%. This level is forecast to shed
i=1 (1 + WACC i ) i Financials: CFROE and re fade to 7.5%; 32% of excess return over the next 4 years,
Regulated Utils: CFROI and WACC fade to resulting in a CFROI at t+5 of 22.5%. Growth
WACC = Weighted Average Cost of Capital 3.5%. is also forecast to fade, albeit more sharply,
from 43.5% to 18.9%, over the same interval.
Firm value is a function of product or service HOLT uses a 3-stage discounted cash flow Fade is a function of CFROI Level, Trend,
offering, management skill, brand value and (DCF) model, where: Volatility and Reinvestment Rate.
other intangible assets, barriers to entry, ease
N
of replication, and a host of other factors that FCFFi Apple, Inc.
enhance or diminish value. Ultimately, the price WEV = 9/11 9/12 9/13

paid for a firm is a product of investor i=1 (1 + WACC i ) i CFROI

LFY
30.3
FY+1
32.6
FY+2
25.2
FY+3 FY+4 FY+5

perception. Still, basic principles of corporate WEV = Warranted Enterprise Value

valuation are helpful in estimating firm value. WACCi = cost of capital at time t=i, {i|1,...N}
Used in Valuation t+1 t+2 t+3 t+4 t+5
N = Terminal period (N) CFROI 30.4 28.4 26.4 24.5 22.5
Accounting Treatment Growth 43.5 36.4 30.1 24.2 18.9
Most assets are valued at historical cost, HOLTs Valuation Stages
Discount Rate 4.3 4.3 4.3 4.3 4.3
except assets using mark-to-market Stage 1: an explicit forecast fades near-term
accounting (MMA). MMA requires corporations CFROI and Growth estimates to likely levels
Stage 2
to value specific assets at estimated current based on empirical outcomes for firms with
Apples t+5 CFROI fades from 22.5% to 6%
market price whereas historical cost reflects similar starting CFROI and asset growth features.
over 95 years. Growth fades toward 2.5%.
the price of an asset at some prior point in The discount rate fades from 4.3% to 6%.
time. Financial instruments are typical assets Stage 2: CFROI and growth mean-revert at an
using MMA. IASB ruled that all Pensions will exponential decay rate over 95 years, eliminating
Stage 3
be mark-to-market after January 1, 2013. excess profits and converging toward the cost of
Assets are wound off the balance sheet.
Historical cost accounting does not reflect capital and long-term growth rate. Economic
Terminal value equals the Inflation Adjusted
current replacement cost or expected value. profit equals the required capital charge at t=N.
Net Assets at T=100. Terminal value can also
CFROIWACC6%; Growth2.5%.
be modeled as a constant growth, cost of
HOLT Treatment
capital business: TV = FCFFN(1+gn)/(rN-gN).
HOLT estimates a companys worth by Stage 3: Assets are wound off the balance
forecasting likely CFROI and real growth rates sheet. Since firm CFROI=WACC, this is
over an extended period. CFROI and Growth equivalent to a constant growth perpetuity.
determine enterprise free cash flows (FCFF)
which are discounted to present value. All Apple Inc
three factors (CFROI, Real Growth, and
WACC) are mean-reverting, such that zero Stage 1 Stage 2 Stage 3
economic profits are generated in distant
years. 30 2. CFROI, Growth and WACC 3. Since Assets are wound off the
1a. Consensus gravitate toward balance sheet, Terminal Value equals
the Inflation Adjusted Net Assets at
Method eps result in FY1 long-term averages
T=100. This is equivalent to a constant
(6%, 2.5%, 6%)
Near-term CFROI are derived from consensus and FY2 CFROI 20 growth cost of capital perpetuity.
eps estimates and then faded over 4 years to 1b. Near-term FCFFN (1 + gN )
likely levels based on empirical outcomes for CFROI fades to ( WACC N gN )
firms with similar starting CFROI and growth likely t+5 10
outcome
features. From this, cash flows are produced
for periods 1 to 5. Thereafter, cash flows are
generated as CFROI fades toward the cost of 0
0 10 20 30 40 100
capital and growth toward its long-term mean
CFROI WACC LT CFROI=6.0%
of 2.5%. Fade (yrs 1-5) Fade (yrs 6-100) Terminal value
Advanced Concepts Total System Approach HOLT provides both multiples and a forecast
Key points: HOLT employs a total system approach to of free cash flow for estimating firm value. In
1. Mean reversion offers objective reference measuring and forecasting corporate returns, both cases, HOLTs approach is unique and
2. Resolves terminal value issue growth rates, risk and valuation. Within this Percent to Best offers a superior screening
3. Total system calibration system, CFROI is measured as a real rate of factor to traditional alternatives.
4. Superior to alternatives return, adjusted for inflation and other distortive
effects. This increases comparability across time, Multiples Versus DCF
Objective countries, industries, and peers and makes Multiples offer insight into the relative value, or
HOLTs system of mean-reversion results in CFROI a more useful quality factor in stock attractiveness, of a firm. In a typical multiples
forecasted cash flows that, on average, reflect screens. Historical CFROI serve as a benchmark approach to valuation, a stock is compared to
the economic reality of a corporate lifecycle. against which current and expected returns can a set of similar peers, and a premium or
Empirical observation shows that corporate be compared. discount is applied to the stock based on the
rates of return converge toward a long-term analysts expectations of future profitability
average of 6% as industries mature and Since CFROI is a real rate of return, it is directly and/or growth.
consolidate. Moreover, growth declines as comparable to a real cost of capital.
industries mature, eventually tracking a long- HOLT provides two especially useful valuation
term average population and industrial HOLTs total system approach is objective: near- multiples, including:
production real growth rate of 2.5%. Percent term earnings estimates are converted to CFROI
to Best offers investors an objective reference and linked to probable medium and long-term Economic PE Ratio
stripped of subjectivity and bias against which outcomes. An extensive history of HOLT- Value-Cost Ratio
other valuation signals can be compared. adjusted data offers an unsurpassed source for
measuring the long-term required yield and HOLTs Economic PE is equal to Enterprise
growth rate and for providing meaningful Value divided by Gross Cash Flow minus
Median CFROI Through Time empirical benchmarks. economic depreciation, analogous to the
based on starting CFROI
traditional P/E ratio. Firms with low Economic
highest high average low lowest Within this comprehensive system, the discount PE tend to out-perform firms with high
15 rate acts as the final calibrating mechanism, Economic PE. The average firm displays an
10 tuning current aggregate price levels to empirical Economic PE multiple of 16.7. This multiple is
tendencies and the prevailing risk appetite. This highly effective in selecting stocks most likely
5
results in a relative valuation framework that to out/under perform.
0 displays monotonic properties in rank Percent to
-5 Best across all sectors. HOLTs Value-Cost Ratio (VCR) is a measure
0 5 10
Years after formation
15 of a firms market enterprise value relative to
Source: Credit Suisse, HOLT Valuation Alternatives its inflation adjusted net assets, in concept,
Global Industrials, 1950-2011
Estimating firm value is a challenging task. At its similar to Price-to-Book or, even better,
simplest, firm value would equal total net assets, Tobins Q. Cost of capital businesses trade at
Median WACC Through Time which would define the total value of the VCR close to 1.0. When VCR exceeds 1.0,
based on starting WACC enterprise for all capital providers. Equity value expected future economic profit exceeds zero.
highest high average low lowest would then equal residual Shareholder Equity. The average firm has a VCR close to 1.4.
10 However, assets, when utilized by skilled VCR is highly effective in selecting stocks
8 management, often exceed book value. Thus, most likely to out/under perform.
determining firm value becomes an exercise in
6
pricing expectations, that is: valuing expected HOLT Percent to Best, Economic Yield, and
4 future cash flow. Value-Cost Ratio all display consistent and
2
exceptional strength, compared to other
0 5 10 15 There are three primary techniques used to multiples, in identifying firms most likely to
Years after formation
Source: Credit Suisse, HOLT estimate firm value: outperform.
Global Industrials, 1950-2011 Multiples
Forecast free cash flow Probability Based
Terminal Valuation Issue Options (not discussed) Most DCF models are based on an explicit
A significant benefit of HOLTs mean-reverting cash flow forecast that may incorporate
valuation framework is that it eliminates excess Multiples offer a simple, fast, and often effective anywhere from 2 to 20 years. These forecasts
profits in distant years, thereby forcing firms to method for gauging relative value. Multiples can can be quite valuable, often produced by
become cost of capital enterprises, as suffer from several drawbacks, including: experts with a deep understanding of the firm,
evidenced by mature industries. Unless the its competitive position, and the industry within
rate of return converges toward the discount Weaknesses of Multiples which the firm competes. The HOLT Valuation
rate, the terminal value will embed excess Comparable only for similar peers model produces an estimate of firm value
profit or loss indefinitely. This facet of DCF Distorted by negative earnings or cash flow based on probabilities, that is, the best likely
modeling is easily overlooked, but has a Easily distorted by growth estimated outcome given a firms starting
significant impact on estimated firm value. Easily distorted by firm accounting methods CFROI and growth characteristics. HOLTs
HOLT research shows that seemingly sticky Easily distorted by capital structure changes Warranted Price is a com pelling and
profits or losses are generally eliminated over Can become unsynchronized for cyclical objective counter-point to subjective
time as capital is reallocated toward the most firms analyst-based m odels.
profitable opportunities.
 HOLT
November 2012

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