Sources of Value: A Practical Guide to the Art and Science of Valuation

Cover......Page 1
Half-title......Page 3
Title......Page 5
Copyright......Page 6
Contents......Page 7
Figures......Page 9
Why should you read this book?......Page 11
Who should read this book?......Page 12
The five financial building blocks......Page 14
The three pillars of financial analysis......Page 16
How should you approach reading this book?......Page 17
Ready to learn!......Page 18
Acknowledgements......Page 19
Section I The five financial building blocks......Page 21
Part 1: The basic question......Page 23
The time value of money......Page 24
Quantifying the time value of money......Page 25
Using value to take decisions......Page 27
Taking stock and defining some terms......Page 28
Part 2: Calculating present values......Page 30
Introducing the idea of discount factors......Page 31
Introducing annuity factors......Page 32
NPV and project evaluation......Page 34
Real life project evaluation......Page 36
Example 1: Uncle Normans birthday treat......Page 38
Example 2: A grand design......Page 42
Example 3: Paving the way to the future......Page 44
Part 4: Individual work assignments......Page 46
Summary......Page 48
Part 1: Debt an initial overview......Page 49
How to value debt......Page 50
Fixed or floating rate......Page 51
Long term or short term......Page 52
Interest rates and inflation......Page 53
Interest rates and exchange rates......Page 54
How lenders minimise risk......Page 55
Credit rating agencies......Page 56
Two advantages of debt over equity......Page 58
Part 2: Equity an initial overview......Page 59
The value of equity......Page 61
The relationship between dividends and funds flow......Page 63
Do dividends matter......Page 65
Issuing new shares......Page 66
Conclusion......Page 67
Part 3: Introducing the cost of capital......Page 68
The capital asset pricing model......Page 69
Risk is carried on equity......Page 70
The Modigliani Miller proposition......Page 73
The indivisible finance pool......Page 74
Precondition 1: What if money is limited......Page 75
Precondition 2: What if risks are too great......Page 76
Estimating the cost of capital......Page 77
Conclusions......Page 78
Part 4: Individual work assignments......Page 79
Summary......Page 82
Part 1: The purpose of accounting......Page 83
How 'well' is a business doing......Page 84
What does a business own and what does it owe?......Page 85
How much cash is being generated......Page 89
Dealing with assets that are not wholly owned......Page 91
Dealing with forex effects......Page 93
Distinguish between investing and financing......Page 94
Introducing the abbreviated financial summary......Page 96
Adding more detail to the income statement......Page 97
Why do it this way......Page 98
How the accounting numbers interact......Page 100
Accounts payable......Page 102
Effect of inflation on working capital......Page 103
Scaffolding example......Page 104
Real life example Corus PLC......Page 108
Part 4: Individual work assignments......Page 117
Summary......Page 119
Strategy......Page 120
Long-term plan......Page 123
Performance reports......Page 125
Controls......Page 126
Nomenclature......Page 127
The planning cycle......Page 128
WYMIWYG......Page 130
Setting appropriate targets......Page 132
Stage gate processes......Page 133
Cost control and risk management......Page 134
Part 3: Key planning techniques......Page 135
Primary activities......Page 136
The five forces model......Page 137
Competitive advantage......Page 141
The McKinsey/GE matrix......Page 143
Introduction......Page 145
The company as a series of projects......Page 146
Overheads and sunk costs......Page 151
The ROCE bridge......Page 153
Valuing a plan......Page 154
Present value and value through time......Page 157
In a plan value growth does not really matter. What matters is present value......Page 158
Part 5: Individual work assignments......Page 159
Summary......Page 162
What sets market price?......Page 163
Probability distributions......Page 167
Cumulative probability curves......Page 169
Doing calculations with expected values......Page 170
Decision trees......Page 171
Success values......Page 173
Making appropriate assumptions......Page 174
Sensitivities......Page 176
Spreading your bets......Page 180
The effect of correlations......Page 182
The ability to take risk......Page 184
The risk/reward trade off......Page 185
'Risk is impact times probability'......Page 188
Managing risks......Page 190
The U-shaped valley......Page 191
Part 4: Categorising risk......Page 192
Internal and external risks......Page 193
Company checklists......Page 194
Three types of risks......Page 195
Part 5: Individual work assignments......Page 197
Section II The three pillars of financial analysis......Page 201
Where have we got to so far?......Page 203
Where next?......Page 204
The three pillars......Page 206
Summary......Page 208
Initial analysis: what sort of model is needed?......Page 209
Incremental and absolute NPVs......Page 211
What is the purpose of an economic model?......Page 213
Three spreadsheets or one?......Page 214
Spreadsheet layout......Page 215
Model audit......Page 217
The aim of evaluation......Page 218
The danger of excess optimisation......Page 219
Managing the optimisation effort......Page 220
Case study: Selecting optimisation studies......Page 221
What is sustaining investment?......Page 223
Justifying sustaining investment......Page 224
The need to control sustaining investment......Page 225
Dealing with changes in legislation......Page 226
Introduction Defining full-cycle economics......Page 227
Why consider full-cycle economics?......Page 228
Defining sunk costs......Page 230
Defining future fixed but non-incremental costs......Page 231
Calculating full-cycle economics......Page 233
Interpreting full-cycle economics......Page 235
Summary: How important are full-cycle economics......Page 236
Inflation and the cost of capital......Page 238
Modelling when inflation is high......Page 239
How tax and working capital make inflation 'hurt'......Page 244
Inflation and 'stock profits'......Page 246
Inflation and forex effects......Page 249
Project life......Page 252
Residual and terminal values......Page 254
Additional complications with joint ventures......Page 257
Monte Carlo analysis......Page 259
Introduction......Page 261
Putting finance into a model......Page 262
Case study: Yellow Moon Chemical Company Inc......Page 264
Why a standard methodology is required......Page 272
2. Incremental analysis......Page 273
3. The stated assumptions......Page 274
4. Cash flow model......Page 275
6. The four economic indicators......Page 276
8. Sources of Value analysis......Page 277
Introduction......Page 278
Part 1: What is the Sources of Value technique?......Page 279
Part 2: Why the Sources of Value technique works......Page 285
Supporting link 1: The principle of additivity of value......Page 286
Supporting link 2: Economic value underpins the share price......Page 288
Supporting link 3: The ROCE bridge and actual returns......Page 289
Supporting link 4: Sector attractiveness and competitive position......Page 291
Supporting link 5: Cost curves and what sets prices......Page 292
Supporting link 6: How markets evolve over time......Page 299
Supporting link 7: Pointforward and fullcycle economics......Page 301
Supporting link 8: Governments and regulators......Page 303
Initial case study: Sources of Value and the scaffolding project......Page 308
Sources of Value: Implementation map......Page 312
Strategy stage analysis sector attractiveness......Page 314
Strategy stage analysis: competitive position......Page 319
Strategy stage analysis: strategic options identification......Page 321
Strategy stage analysis: strategy selection......Page 322
Implementing Sources of Value at the options identification stage......Page 323
Option 1......Page 325
Option 2......Page 326
Option 3......Page 327
Option 4......Page 328
Implementing Sources of Value at the detailed design stage......Page 329
Implementing Sources of Value at the implementation stage......Page 333
Implementing Sources of Value at the operation stage......Page 334
Getting started with Sources of Value......Page 335
The Sources of Value philosophy......Page 337
Strategic implication 1: How to win......Page 338
Strategic implication 2: Look downwards......Page 341
Strategic implication 3: Can you buy success?......Page 344
Strategic implication 4: Having 'quality' investment decision debates......Page 349
Strategic implication 5: How to understand governments......Page 351
Strategic implication 6: Don't go out alone!......Page 355
Strategic implication 7: Don't be 'me too'......Page 356
A final look at Sources of Value......Page 359
Summary......Page 361
The basic principle value = present value of future dividends......Page 362
Problem number 1: The relationship between cash flow and dividends......Page 364
Problem number 2: Prices are set in the market......Page 366
Problem number 3: Uncertainty......Page 368
Problem number 4: I know a professor with a better idea!......Page 370
Overview......Page 372
Step 1: Calculating plan period asset value......Page 373
Step 2: Calculating the present value of the terminal value......Page 377
Step 3: Assess the value of any liabilities......Page 386
Step 4: Divide the net value by the number of shares......Page 388
Short cut approaches......Page 389
ABCDE valuation......Page 392
Understanding performance......Page 396
Continuous good surprises......Page 398
Focus on value......Page 402
CHAPTER 10 Conclusion......Page 407
Where next?......Page 411
Section III Three views of deeper and broader skills......Page 413
Introduction......Page 415
The economic value model......Page 416
Estimating the components of the cost of capital......Page 419
Estimating the cost of capital......Page 432
The cost of capital for a project......Page 435
Alternative approaches to setting the cost of capital......Page 438
Conclusions: The choices to be made concerning the cost of capital......Page 441
Overview......Page 442
Topic 1: An overall approach to risk and reward......Page 443
Topic 2: Treating financing separately......Page 453
Topic 3: Understanding competitors costs of capital......Page 459
Topic 4: Buying and selling......Page 462
Topic 5: Optimisation......Page 464
Topic 6: Risk archetypes and risk sensitivities......Page 468
Topic 7: Fudge factors......Page 469
Topic 8: Pre- or post-tax?......Page 474
Topic 9: Country risk......Page 476
Topic 10: A cottage industry......Page 479
Conclusions: What the cost of capital can tell us about risk and reward......Page 480
Introduction......Page 482
Initial example: The value of flexibility......Page 484
Where flexibility may affect value......Page 487
Introduction: The characteristics and terminology of options......Page 491
Valuing financial options......Page 493
Can financial option valuation methods be used to value flexibility in projects?......Page 496
Introduction: So what should be done about flexibility?......Page 499
Step 1: Life is not a single path into the future......Page 500
Step 2: Recognise when flexibility matters......Page 502
Step 3: Understand the types of flexibility......Page 503
Step 4: Clarify objectives and boundaries......Page 505
Step 6: Identify the important uncertainties and decisions and map them onto the path......Page 507
Step 7: Decide whether flexibilities need to be valued......Page 510
Step 8A: More sophisticated assumptions......Page 511
Step 8B: Risk monetisation......Page 518
Step 8C: Growth value......Page 520
Step 8D: Valuing the tail......Page 522
Step 8E: Monte Carlo simulation......Page 527
Step 8F: Simple decision trees......Page 529
Step 8G: Reverse engineering......Page 534
Step 8H: Black-Scholes......Page 536
Step 8J: Include any additional costs......Page 538
Step 9: Ensure that organisation is equipped to capture flexibility value in the future......Page 539
Step 10: Monitor results to facilitate Plan Do, Measure Learn approach......Page 540
Conclusions: Flexibility is important but flexibility valuation is less so......Page 541
Introduction: Why study this question and how it will be covered......Page 543
Part 1: The nonvalue sector......Page 546
Part 2: Similarities - the planning infrastructure......Page 547
Part 3: Objectives......Page 554
Part 4: Availability of finance......Page 564
Part 5: Attitude to risk......Page 568
Part 6: The acceptability of continuous improvement......Page 570
Part 7: Valuing non-financial items......Page 573
Part 8: The overall scorecard......Page 579
Appendices Individual work assignments: Suggested answers......Page 581
APPENDIX I Building block 1: Economic value......Page 591
APPENDIX II Building block 2: Financial markets......Page 594
APPENDIX III Building block 3: Understanding accounts......Page 602
APPENDIX IV Building block 4: Planning and control......Page 607
APPENDIX V Building block 5: Risk......Page 614
Glossary......Page 623
Bibliography......Page 633
Index......Page 635