Valuation Fundamentals and Analysis

1Copyright © 2021 Accountant-Lawyer Alliance

Prepared and Presented by:William Kline, Ph.D., CFA

Valuation Fundamentals and Analysis


• The information included in this webinar is for educationalpurposes only and is not intended to be a substitute forfinancial advice by a financial professional (i.e., financialadvisor, CPA, attorney, or insurance agent).

• Views, thoughts, and opinions during this presentation,conveyed by slides or verbally, belong solely to the author,not any other organization, group, or individual.

Disclaimer

2


1. Introductions

2. Purpose of Valuations

3. Standards of Value

4. Valuation Methodologies

5. Cash Flow Models

Agenda

6. Pricing Multiples7. Private valuation (DLOM, DLOC)8. Valuation Exercise9. Hansson Private Label Observations10. Refining Your Model Inputs With

Business Analysis3


• William Kline, Ph.D., CFA is an Associate Professor of Management at PennsylvaniaState University - Harrisburg. He received his Ph.D. in Strategic Management fromthe Fox School of Business at Temple University. He has received four awards forteaching excellence including the Beta Gamma Sigma Professor of the Year Award(PSU – Harrisburg), the Dean’s Award for Faculty Excellence and Stanley FuchsAward (Fordham University), and the Award for Excellence in Teaching by a DoctoralCandidate (Temple University).

• Dr. Kline’s primary research interests include strategic decision-making and executivecompensation. He has been published in 12 peer-reviewed journals including theAcademy of Management Perspectives, the Journal of International Management, andthe Journal of Strategy & Management.

• Prior to entering academia, Mr. Kline was a manager at PricewaterhouseCooperswhere he completed valuations for mergers and acquisitions, business planning, aswell as tax and financial reporting. Mr. Kline also spent time consulting at CBIZValuation Group, Inc. and Curtis Financial Group, a regional investment bank.

Speaker Bio

4


Discuss some of the more common standards of value used in valuation exercises.

Learning Outcomes


Standards of Value Value –“The monetary worth of something; relative worth, utility, or importance; something intrinsically valuable or desirable.” Merriam-Webster Dictionary

• Intrinsic Value: Value by someone with perfect information about the assets or security. CFA Institute• Fair Market Value –“The price at which the property under consideration would change hands between a

willing buyer and a willing seller, neither being under compulsion to buy or sell and each having reasonable knowledge of all pertinent facts.” IRS Revenue Ruling 59-60

• Strategic / Investment Value –“The value to a particular investor based on individual investment requirements and expectations. Importantly, Investment Value may differ from Fair Market Value due to differences in estimates of future earnings power, perception of risk, and synergies available to a particular buyer. ” International Glossary of Business Valuation Terms

• Liquidation Value – Value if one sold all assets separately (net of liabilities). CFA Institute• Note, values generally assume that the entity/project is a going concern. 6


List and describe the types of engagements where valuation principles are applied.

Learning Outcomes


• Buy/sell agreements

• Family limited partnerships (FLPs)

• Business planning

• Project selection

• Stock selection

• Bond selection

• Tangible/intangibles assets

• Business planning/consulting

• Mergers and acquisitions

• Litigation and ownership disputes

• Estate, gift, and income taxes

• Marital dissolution

• Employee Stock Ownership Plans (ESOPs)

• Financial reporting

• Allocation of purchase price

• Goodwill impairment

Valuation Applications

8


List the five steps in the valuation process.

Learning Outcomes

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10

1. Understand the business, industry, and the economy• Business (SWOT, Capabilities, Value Chain, Business Model, Competitive

Advantage, Business/Corporate Strategy)• Industry (Strategic Groups, Industry Structure, Porter’s Analysis)• Economy (Business Cycles, PEST, Economic Indicators, Trade Patterns)

2. Forecast company performance

• Top down or bottom up forecast (Financial Statement Analysis)

3. Select appropriate approach (Income Approach, Market Approach, Cost Approach)

4. Estimate value

5. Make investment decision

Valuation Process


Describe what factors drive the valuation of an asset/project/security.

Learning Outcomes

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Basic Valuation Concepts

Risk-Adjusted Future Benefits

Value today

Cash Flow

2

Cash Flow

3

Cash Flow

4

Cash Flow

1=

Risk Adjustment (Dependent on the type of cash flow)

t = 0

CF1 = CF2 = CF3 = CF4 =

12Future Cash Flow /( 1 + r ) n


13

• Dividends (Dividend Discount Models DDMs)

• Free Cash Flow to the Firm (FCFF)

• Free Cash Flow to Equity Holders (FCFE)

• Bond coupon and principal payments

• Rental income, net of expenses

• Project cash flows from new initiatives

Cash Flow Examples


Estimating Risk• Total risk captures various types of risk like inflation and firm/project

specific risk

• Risk is quantified with mathematical formulas and is commonly called a discount rate

• Cost of equity = Rf + β ( Rm – Rf )

- Capital Asset Pricing Model (CAPM)

- Build Up Method

• WACC = (% Capitalization Equity)(Cost of Equity) + (% Capitalization Debt)(Cost of Debt)(1 – tax rate)

• Projects = Firm risk + project specific risk14


• Company specific factors require evidence as to why the factor was not included in market-based data used for the cost of capital estimates. An expert must justify why the subject firm has more/less risk than the typical market participant.

• Potential differences include:• Available slack: Liquid assets as a % of total assets vs. peers• Human resource slack: Management depth vs. peers• Potential slack: Borrowing capability vs. peers• Supplier power: Supplier concentration vs. peers• Buyer power: Buyer concentration vs. peers• Investment portfolio: R&D as % of sales vs. peers • Sales diversification: Sales concentration by region vs. peers

Company-Specific Factors

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The Impact of Time

@10% At End of Year 1 At End of Year 2 At End of Year 3

100 110 121 133.1Present Value Future Value

Formula 100 X (1+.10)1 100 X (1+.10)2 100 X (1+.10)3

@10% At End of Year 1 At End of Year 2 At End of Year 3

100 110 121 133.1Present Value Future Value

Formula 110 121 133(1+.10)1 (1+.10)2 (1+.10)3

DiscountingWhat is the value of $133 dollars three years from today?

What is the value of $100 grown at 10% for 3 years?Compounding

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How much is $133 3 years from now worth to you today (if in general, you can earn 10% per year)?

$100 $133$121$110

Year 1 Year 2 Year 3

=110/(1+0.10)1 =121/(1+0.10)1 =133/(1+0.10)1

OR

=133/(1+0.10)3

Present Value of Sum Certain = FV /( 1 + i ) n

FV InterestTime or N


Impact of Time: Present Value of an Ordinary Annuity (Winning Lottery Ticket)

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A General Model and A Simple Bond Example• Coupon Rate – 5%

• Maturity – 3 yrs

• Yield on similar bonds – 6%

• $1,000 par

• What should this bond be trading for?

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Describe the three primary valuation approaches.

Learning Outcomes

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Overview of Valuation Approaches1. The Asset Based Approach, also referred to as the Cost Approach, measures the value of an asset by the cost to

reconstruct or replace it with another of like utility.• The technique entails a restatement of the balance sheet to reflect the market value of its assets and liabilities.

• This approach is frequently used in valuing real estate or investment companies, or for liquidation scenarios. It is not an appropriate valuation approach for companies having significant intangible value, or cash flow from the use of its assets.

2. The Income Approach measures the value of an asset by the present value of its future earnings. (Absolute Valuation)• Value indications are developed by discounting expected cash flows to their present value at an appropriate rate of return (the

discount rate). The discount rate selected is generally based on rates of return available from alternative investments of similar type and quality.

3. The Market Approach measures value through an analysis of reasonably comparable guideline companies for which valuations are known. (Relative Valuation)

• Values may be known because these companies are publicly traded or because they were recently sold and the terms of the transaction were disclosed.

• Key differences between the subject and the comps are incorporated into the analysis through adjustments.

21


Compare/contrast direct capitalization and discounted cash flow models in the Income Approach.

Learning Outcomes

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Discounting Annuities

Source: Investopedia.com

Discounted Cash Flow vs. Direct Capitalization

vs.$1,000 (1+g)

-----------------------WACC-g

(Capitalization Rate)

Where WACC = 5%, g = 3%

= $1,030----------------------

5% - 3%

= $51,500

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Describe when a dividend discount model is the appropriate valuation model.

Learning Outcomes

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Dividend Discount ModelsDividend discount models are most appropriate when:

• The company pays a dividend.

• Expected FCFs are negative within forecast horizon.

• Understandable and consistent relationship between dividend policy and earnings.

• Investor takes a non-control perspective.

Concept: The value of a stock today is equal to the present value of all future cash flows, where cash flows are represented as dividends. 25


($4.00)

($3.00)

($2.00)

($1.00)

$0.00

$1.00

$2.00

$3.00

$4.00

2000 2001 2002 2003 2004 2005

EPSDPS

Ford Motor CompanyDividend Discount Models

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0%

50%

100%

150%

200%

250%

300%

2000 2001 2002 2003 2004 2005

Payout %

Ford Motor Co. Payout Ratio

Dividend Discount Models

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$0.00

$0.20$0.40$0.60$0.80$1.00

$1.20$1.40$1.60$1.80$2.00

2000 2001 2002 2003 2004 2005

EPSDPS

Hormel Foods Corp.


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24%

25%

26%

27%

28%

29%

30%

31%

32%

2000 2001 2002 2003 2004 2005

Payout %

Hormel Foods Corp. Payout Ratio


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Example of present value concept:An asset will generate cash flows (or dividends) of $100 in year 1, $150 in year 2, and $200 in year 3. The discount rate is 10%. The value of the asset in year three is projected to be $50.

100 150 200 + 50

V0 = ------- + ------- + -------------

1 + .10 (1 + .10)2 (1 + .10)3

V0 = $90.91 + $123.97 + $187.83

V0 = $402.71


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The Gordon Growth Model requires three inputs and two estimates (g and k):

D0 ( 1 + g ) D1

V0 = ---------------- or -------------

k – g k – g

D0 = Dividend per share at time 0.

g = Long-term growth rate in dividends.

k = Discount rate (cost of equity/required return).


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Note, the Gordon Growth Model is commonly used to estimate the terminal value in FCF projections.


The present value of growth opportunities (PVGO) :

E

V0 = --------- + PVGO

k


32


Use the dividend discount model to infer expected growth rates.

Learning Outcomes

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Inferring market expectations.Example: S & P 500 Index.

D1

V0 = ----------k - g

We know V0, and can reliably estimate D1 and k, so…..


34


Index Value (11/4/21): 4,600

D0: $ 60 (1.3% dividend yield)

K: 10.%

Solve for g:

60 (1+g)

4,600 = --------------

.10 - g

g = 8.8%


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Describe when a free cash flow models are the appropriate valuation model.

Learning Outcomes

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Free cash flow models (FCF)• Dividends represent cash actually paid to shareholders.

• Free cash flow models estimate total cash flows available for distribution to shareholders.

• Unlike dividends, free cash flow to equity (FCFE) and free cash flow to the firm (FCFF) are not published numbers.

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Free Cash Flow Models Free Cash Flow models are most appropriate when:

• The company does not pay a dividend

• Actual dividends differ significantly from capacity to pay dividends

• There is a relationship between free cash flows and profitability

38


Define free cash flows to the firm and free cash flows to equity holders.

Learning Outcomes

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FCFF = Cash flows available to equity holders and debt holders after all operating expenses have been paid and necessary investments in working capital and capital expenditures have been made.

FCFE = Cash flows available to the company’s common equity holders after all operating expenses, interest, and principal payments have been paid and necessary investments in working and fixed capital have been made.

Analysis of Equity Investments: Valuation. Stowe, Robinson, Pinto, and McLeavey. 2002. Association for Investment Management and Research.

Free Cash Flow Models

40

A15

Slide 40

A15 Visually, I like this little flow chart which highlites the two terms.

Handout of flow chart. Author, 4/18/2007


Business Enterprise Value

CF Bondholders

CF Equityholders

Total CF to

Business

41


Business Enterprise Value

•CF to Bondholders•CF to EquityholdersFCFF•CF to EquityholdersFCFE

BusinessEnterprise

Value

EquityValue

42


Business Enterprise Value to Equity Value

BEV Cash IBD Equity Value

43


Free Cash Flow to the Firm (FCFF) Calculation

Net Income

+ Noncash Charges

+ Interest Expense ( 1 – t )

- CAPX

- Working Capital Investment

= FCFF

44


Free Cash Flow To Equity (FCFE) Calculation

Net Income

+ Noncash Charges

- CAPX

- Working Capital

+ Net Borrowing

= FCFE

45


Single-Stage FCFF and FCFE Growth Models:

FCFF 0 ( 1 + g )

Firm Value = ------------------------

WACC – g

FCFE 0 ( 1 + g )

Equity Value = ------------------------

r – g46


Compare/contrast the methods found in the Market Approach.

Learning Outcomes

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1. Guideline Public Company Method (GPCM) – uses trading multiples from comparable public companies as a basis for focal firm valuation.

2. Guideline Transactions Method (GTM) – uses transactions multiples from public/private acquisitions as a basis for focal firm valuation.

3. Prior Transaction Method (PTM) – uses information from previous focal firm transactions.

Market Approach Methods


Market Approach BasicsMajor concept: Law of one price (i.e., similar assets should trade for the same price)

Two methods:

1. Method of comparables (our focus today)

2. Method based on forecasted fundamentals (See Appendix B)

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50

• 5 similar houses (same builder, 4 bedrooms, no pool, 2-car garage, same school district, same development) in a target area sell for an average of $500,000 in the last 6 months. What is a similar house worth?

• Which method is this?

• What is the implied value of each bedroom? In other words, what is a buyer willing to pay per bedroom in this market?

Housing Market Example


• Price / Revenue

• Price / Earnings

• Price / Book Value of Equity

• EV / Revenue

• EV / EBITDA

• EV / EBIT

• EV / Debt-free Net Income

• EV / Debt-free Cash Flow

• EV / Total Assets

Some Common Multiples

51


Describe the concepts of discounts for lack of marketability and discounts for lack of control.

Learning Outcomes


Discount for Lack of Marketability (DLOM)

• A marketability discount is applied to compensate an investor for the limited ability to readily convert an illiquid asset to cash.

• Restricted Stock Studies – Restricted stock are securities issued by the company that are not registered with the SEC (1990 Rule 144). These securities had to be held for 2 years. Studies indicate discounts of 25 – 45%. After 1997, when the SEC changed the holding period to 1 year, the discounts decreased to an average of 13%.

• Research of Private Transactions Prior to Public Offering – Consisted of examining private stock transactions prior to the company going public.

• What is a reasonable DLOM?

• Studies generally exhibit a wide range of anywhere from 10 – 60%, but discounts tend to cluster from 25 – 45%. Thus, it is industry practice to start with 35% and adjust accordingly.


Discount for Lack of MarketabilitySome Common DLOM Factors to Consider:

• Restrictions of resale of shares

• Nature and history of the company

• Capital structure

• Management

• Distribution policy and dividend paying capacity

• Costs associated with a public offering

• Holding period 54


DOLM Discount Example

Concluded PE multiple 10x

Subject Company earnings $50,000,000

Equity Value (Marketable Value) 500,000,000$

Discount for Lack of Marketability of 35% 175,000,000$

Equity Value (non-marketable) 325,000,000$

55


Discount for Lack of Control• A control discount is applied because the investor has an inability to do

the following:• Select directors, officers, and management• Declare and distribute cash or other property• Buy and sell assets• Determine compensation• Negotiate and consummate mergers and acquisitions • Block any of the above stated actions

56


DLOC• When a publicly traded firm is acquired by another company or is taken private, the

purchaser often pays a premium above the freely traded, minority (non-controlling) interest share price. This premium is referred to as a control premium. From this control premium, the implied lack of control discount can be calculated.

• Lack of control discount = 1 - (1 / (1 + control premium))

Using a control premium of 17 percent, the control discount is calculated as follows:

100% - 100% = 14.5%

100% + 17% 57


DLOC

Source: Houlihan Lokey Howard & Zukin’s Mergerstat Review, 2008 – All Industries.

Year Median Average1998 30.1% 40.7%1999 34.6% 43.3%2000 41.1% 49.2%2001 40.5% 57.2%2002 34.4% 59.7%2003 31.6% 62.3%2004 23.4% 30.7%2005 24.1% 34.5%2006 23.1% 31.5%2007 24.7% 31.5%

High 41.1% 62.3%Low 23.1% 30.7%

58


Select Private Valuation ConsiderationsCertain circumstances may add to the complexity of private entity valuations.

Availability and/or reliability of financial statements and other critical data Access to management Relevance of available market data Ownership of non-operating assets Determination of “normalizing adjustments”

Excess compensation Discretionary and non-operating expenses (e.g. country club dues, sports tickets, family

members on payroll) Non-recurring items Impact of related-party transactions

Overcoming owner/management preconceptions of value59


Nature and history of the company and its business

General economic outlook Industry outlook Financial condition of the company Results of operations of the Company Company forecasts Earnings capacity of the company Liquidation value.

Goodwill and other intangible value of the company

Precedent transactions involving the company Market price of the publicly traded stocks of

companies in a similar line of business Acquisitions of companies in a similar line of

business Reliance on key personnel Risk factors specific to the company

60

Select Private Valuation Considerations


61

Let’s Do An Exercise:Open Your Valuation

Exhibits File


62

Refine Our Logic WithHansson Private

Label Observations


63

Refine Our Inputs With Industry Specific

and Firm Specific Observations


64

External Factors


List and describe the phases of the business cycle.

Learning Outcomes

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66


Early cycle: a sharp recovery from recession, as economic indicators such as GDP and industrial production move from negative to positive and growth accelerates. Easy monetary policy, rapid profit growth, low inventory.

Mid cycle: Typically the longest phase with moderate growth. Economic activity gathers momentum, credit growth is strong, and profitability is healthy as monetary policy turns increasingly neutral.

Late cycle: Economic activity often reaches its peak, implying that growth remains positive but slowing. Rising inflation pressures and a tight labor market may crimp profits and lead to tighter monetary policy.

Recession: Economic activity contracts, profits decline, and credit is scarce for businesses and consumers. Monetary policy eases and inventories gradually fall despite low sales, setting the stage for recovery.

67


Describe industry classification (Industry life cycle, business cycle reactions, competition/oligopoly/monopoly) and explain why classifying an industry is important.

Learning Outcomes


Industry Analysis: Classification by Industry Life Cycle• Pioneer - high risk and many failures.

• Growth - growth accelerates.

• Mature - mirrors overall economy.

• Decline - demand steadily decreases.69


Describe industry classification based on business cycle reactions and explain why classifying an industry is important.

Learning Outcomes


Industry Analysis: Classification by Business Cycle Reaction

Business Cycle Reaction

Growth Defensive Cyclical

71


Early cycle: financials (JPM,GS, MS), real estate (AMT, CCI), consumer discretionary (NKE, MCD), IT (AAPL, MSFT), industrials (MMM, HON) materials (DD, ECL)

Mid cycle: IT and communications (FB, TMUS)

Late cycle: Energy (VLO, CXV), materials (NEM, SMG)

Recession: Consumer staples (PG, KO), utilities (DUK, XEL), health care (CVS, BIIB)

Investopedia.com/top-stocks-4581225

72


Note: The typical business cycle shown above is a hypothetical illustration. There is not always a chronological progression in this order, and in past cycles the economy has skipped a phase or retraced an earlier one. Source for sector performance during business cycle: Fidelity Investments (AART). Unshaded (white) portions above suggest no clear pattern of over-or underperformance vs. broader market. Double+/– signs indicate that the sector is showing a consistent signal across all three metrics: full-phase average performance, median monthly difference, and cycle hit rate. A single +/– indicates a mixed or less consistent signal. Returns data from 1962 to 2016. Annualized returns are represented by the performance of the largest 3,000 US stocks measured by market capitalization, and sectors are defined by the Global Industry Classification Standard (GICS®). Past performance is no guarantee of future results. See below for important information.

https://www.fidelity.com/viewpoints/investing-ideas/sector-investing-business-cycle

73


Describe why we use the Porter’s framework. Explain the key components in each of the 5 forces.

Learning Outcomes

74


Average Return on Invested Capital in U.S. Industries, 1992–2006


Profitability of Selected U.S. Industries


Industry Analysis: Porter’s Five Forces1. Threat of new entrants

2. Threat of substitute products or services

3. Bargaining power of buyers

4. Bargaining power of suppliers

5. Rivalry amongst existing firms

Source: Competitive Advantage: Creating & Sustaining Superior Performance. Michael E. Porter. The Free Press. 1998.

77


Threat of Entry What influences the likelihood of a new competitor entering the market?

1. Economies of scale (supply side)2. Network effects (demand side)3. Switching costs4. Capital requirements5. Incumbent advantages6. Distribution networks7. Protectionist policies 78


Power of Suppliers1. What is the industry’s supplier concentration?

2. How easy is it to switch to other suppliers? (Microsoft operating systems..)

3. Is the product or service standardized or customized?

4. Any substitutes available?

5. Can suppliers enter the market and compete? (forward integration)

6. At the industry level, do suppliers have customer concentration (is there mutual dependence or do the suppliers sell to many industries)? 79


The Power of Customers1. What is the customer concentration? (i.e., what % of sales come from

the industry’s largest customer?)

2. How standardized is the product or service being supplied to the customer?

3. Can the customer easily find a new vendors?

4. What is the probability of backward integration?

5. How important is the component that the customer buys?

80


The Threat of Substitutes1. Is it easy to find a substitute (closeness in function) for this

industry’s product or service?

2. Can I do things in my firm instead?

81


Rivalry Among Existing Competitors1. Can firms effectively differentiate?

2. Again, what are the switching costs?

3. Does the industry have high fixed costs?

4. How is industry capacity expanded? (In large chucks or in small amounts?)

5. Are product or services perishable?

6. What is the industry growth rate?

7. Are there high exit barriers? 82


83

• Score each force on a scale from 1 – 5 (1 being weak, 5 being strong)

• Calculate a total industry score (will range from 5 min – 25 max)

• Conclude on industry attractiveness to:• Existing firms (do they want to stay?)• Firms who could potentially enter (is it worth it to try and get in?)

Industry Methodology for Projects


84

Internal Factors


Who Needs to Understand Business Models?

Learning Outcomes


1. Entrepreneurs (building from scratch)

2. Managers/Executives

3. Equity Analysts/Valuation Specialists

4. Investors/Portfolio Managers

5. Loan officers/Lenders

6. Advisors/Consultants

7. Auditors

Who Needs to Understand Business Models?

86


Define a business model and strategy.

Learning Outcomes


• Strategy is a long-term plan to differentiate the enterprise in an effort tocreate competitive advantage.

• A business model is the summation of the core business decisions and tradeoffs employed by a company to earn a profit. • Example – Dell Computer created a made-to-order model while other

competitors held excess inventory.

Business Model and Strategy

88


Differentiate between corporate-level strategies, business-level strategies and function-level strategies.

Learning Outcomes


Levels and Types of Strategy• Corporate-Level Strategy

• A plan that indicates in which industries and national markets an organization intends to compete.

• Business-Level Strategy• Outlines the specific methods a division, business unit, or organization will

use to compete effectively against its rivals in an industry

• Functional-level strategy • A plan of action to improve the ability of each of an organization’s functions

to perform its task-specific activities in ways that add value to an organization’s goods and services.

90


Compare/contrast differentiation and low-cost strategies. Also, compare/contrast broad and focused strategies. (Hint: draw the 2x2 chart discussed in class to guide your explanation)

Describe the concepts of differentiation parity and low-cost parity.

Learning Outcomes

91


Differentiation Low-Cost

Bro

adF

oc

us

DB LB

DF

Strategy Matrix

LF92


Generic Strategies• Low-cost providers (Example: McDonalds)

• Efficient facilities• Being selective with new customers (profiling)• Minimizing costs in areas like R&D, service, sales force, advertising, etc.• Cheaper sources of inputs (vertical integration?)• Must have differentiation parity

93


Generic Strategies

• Differentiation (Example: Mercedes, Apple)• Design or brand image• Features• Customer service• Dealer network• Extensive research and development

94


Explain how scholars/practitioners should go about performing segmentation analysis.

Learning Outcomes

95


Customer Segmentation• Age

• Gender

• Location

• Types of users

• Income

• Behavior

96


Generic Strategies

• Broad or Focus? Focused would be:• One buyer group• One segment of a product line• Geographic market

97


Discuss the key components in a business model.

Learning Outcomes


Customer Segments

Customer Relationships

Channels

Revenue StreamsCost Structure

Key Resources

Key ActivitiesValue

Propositions Key Partners

Business Model Canvas (Osterwalder and Pigneur)

Business Model Canvas


100

DEMAND SIDESUPPLY SIDE

SUCCESS

Customer Segmentation

What segments are you serving?

101


102


What are the 3 main trigger question areas in determining a customer segment?

Learning Outcomes

103


1. What is the one thing that your customer couldn’t live without accomplishing? What are the stepping stones that could help your customer achieve this key job?

2. What are the different contexts that your customers might be in? How do their activities and goals change depending on these different contexts?

3. What does your customer need to accomplish that involves interaction with others? 4. What tasks are your customers trying to perform in their work or personal life? What

functional problems are your customers trying to solve? 5. Are there problems that you think customers have that they may not even be aware of? 6. What emotional needs are your customers trying to satisfy? What jobs, if completed, would

give the user a sense of self-satisfaction? 7. How does your customer want to be perceived by others? What can your customer do to help

themselves be perceived this way?8. How does your customer want to feel? What does your customer need to do to feel this way?9. Track your customer’s interaction with a product or service throughout its lifespan. What

supporting jobs surface throughout this life cycle? Does the user switch roles throughout this process?

Customer Jobs Trigger Questions (Page 4)


Explain what is meant by customer gains and customer pains.

Learning Outcomes

106


• Customer Gains: Gains describe the outcomes and benefits your customers want. Some gains are required, expected, or desired by customers, and some would surprise them. Gains include functional utility, social gains, positive emotions, and cost savings. (Customers want to experience)

• Customer Pains: Pains describe anything that annoys your customers before, during, and after trying to get a job done or simply prevents them from getting a job done. Pains also describe risks, that is, potential bad outcomes, related to getting a job done badly or not at all. (Customers want to avoid)

Customer Gains and Pains

107

Value Proposition

Why does a customer buy your product or service?

108


109


Describe how to use/evaluate gain creators and pain relievers

Learning Outcomes


111

• Specific investments that create a gain or relieve a pain.

• This is all about asset allocation (i.e., cash, working capital borrowing capacity, talent, physical plant, etc.) to the optimal features that provide gains or relieve pains.

• Each creator/reliever must be tied to a gain/pain and related to the value proposition.

• Managers must be able to describe how they work.

Using gain creators and pain relievers

Commute to work (11)

Help environment (16)

Latest tech (13)

Long trips (5)

Image of success (17)

Performance like sports car (6)

Always up to date features (4)

High safety ratings (3)

Long range (12)

Lack of space (15)

Fear of dead battery (8)Geeky perception of EV (16)

Long recharging time (9)

Frequent charging (10)

Tesla Convertible Upper middle class male of

higher income

High speed charging system and solar wall (9)

Physical structure, lots of storage (10)

High capacity battery (5)

Components to deliver top performance 4 seconds to 60 (4)

R&D infrastructure for highest safety ratings (2) System to Upgrade via

remote access (6)Free supercharger network (8)

Luxury image (7)

High performance luxury electrical car (3)

Value Map (1)


Explain the “elements of value” concept and note how firms use this concept to increase revenue.

Learning Outcomes


• Companies must consider all elements of value (things consumers will pay for) and develop the optimal combination (this is a managerial capability isn’t it?).

• Firms that score highly on 4 or more elements have more customer loyalty and grow faster than their peers.

• Note: Apple only score highly on 11 of the 30 elements discussed in the article. Pick and choose.

• Adding more elements can move a firm from being viewed as a commodity.

Elements of Value

114


List and describe the 4 element of value categories.

The Elements of Value, Harvard Business Review, September 2016

Learning Outcomes


116


Functional Elements of Value

117


Emotional Elements of Value


Life Changing Elements of Value

119


Social Elements of Value

Self-transcendence is a personality trait associated with experiencing spiritual ideas[1] such as considering oneself an integral part of the universe.[2] https://en.wikipedia.org/wiki/Self-transcendence

120


121

Air Jordan Example

Customer Relationships

How are you interacting with your customers?

122


123


Discuss the types of relationships a company can establish.

Learning Outcomes

124


1. Personal assistance (Merrill Lynch - Tiers) – Call or support centers

2. Dedicated personal assistance (Merrill Lynch - Tiers) – One-on-one

3. Self-service – Consumer is on their own

4. Automated services (Google) – System makes recommendations based on algorithm

5. Communities (Glaxo) – User communities help each other solve problems

6. Co-creation (Amazon) – Customers create value by giving reviews/feedback

Customer Relationship Types

125

Distribution Channels

How are you distributing your product/service to

your customers?

126


127


Discuss the distribution options that companies have.

Learning Outcomes

128


Channels

129

1 2 3 4 5Awareness Evaluation Purchase Delivery After Sales

1. Own or Partner?2. Direct or Indirect?3. Sales force, Web Sales, Own Stores, Partner Stores, Wholesaler?

What are the three factors driving channel decisions?

Cost, fit, advantage

Revenue

What are customers willing to pay/how do they pay?

130


131


1. Asset sale (clothing) – Selling ownership rights to a product

2. Service payment (consulting engagement) – Fee in return for analysis or implementation

3. Usage fee (data usage) – Paying for what a customer uses

4. Subscription (gym membership) – Access to services

5. Lending/renting/leasing (Zipcar or rental property) – Right to use temporarily

6. Licensing (IP) – Permission to use IP in return for fee

Revenue

132


133


Male of higher income with preferences for high-tech and a certain image of success (6)

B-to-B battery sales (8)

Service of cars (9)

Sale of cars (4)

Charging wall installation sale (13) Charging fees (11)

Tesla Online Store (5)

Dealer ownership (10)

High connectivity & upgrade via remote access (7)

Retail outlets at malls (12)

Personal assistance at dealership (3)

Tesla Convertible


134

• Reflection: • What is most unique about the revenue portion of the model? • What is most unique about the distribution portion of the model? What

factors drive the need for control of awareness and evaluation in the distribution module?

• What is most unique about the customer relationship portion of the model?• Which of the above potentially give a competitive advantage?

Tesla Demand Side Reflection

Key Resources

What resources are needed to deliver your value

proposition?

135


136


Discuss the Resource-Based View (RBV)

Learning Outcomes

137

Define resources.


Key Definitions• Resources – tangible and intangible assets

138


The Resource-based View• What is the resource-based view?

• This view perceives the firm as a portfolio of assets where the development of idiosyncratic resources and capabilities is the primary task of management. Managers aim to maximize value through the optimal deployment of existing resources and capabilities, while developing the firm’s resource base for the future. (Grant, 1996)

• It is a theory about why some firms have a competitive advantage

• Internal resources are what make some competitors better than others.

139


Resource-based View• Control of rare commodities would be a simple example of a resource

that could drive a competitive advantage. However, it is more likely that a knowledge-based asset or a set of capabilities will drive advantage.

140


Resource-based View – 4 Factors1. Valuable – Does a resource create value? A resource must enable a firm to

employ a value-creating strategy, by either outperforming its competitors or reduce its own weaknesses (Barney, 1991, p99; Amit and Shoemaker, 1993, p36).

2. Inimitable – Can someone copy the resource? An important underlying factor of inimitability is causal ambiguity, which occurs if the source from which a firm’s competitive advantage stems is unknown (Peteraf, 1993, p182; Lippmanand Rumelt, 1982, p420). If the resource in question is knowledge-based or socially complex, causal ambiguity is more likely to occur as these types of resources are more likely to be idiosyncratic to the firm in which it resides (Peteraf, 1993, p183; Mahoney and Pandian, 1992, p365; Barney, 1991, p110).

3. Nonsubstitutable – Can a competitor use another resource in place of yours?

4. Rare – Is it a scarce resource? 141

Key Activities

What are your firm’s key capabilities?

142


143


Resource-based view• A subsequent distinction made by Amit & Schoemaker

(1993, p35) is that the encompassing construct previously called resources can be split up into resources and capabilities. In this respect resources are tradable and non-specific to the firm, while capabilities are firm-specific and used to utilize the resources within the firm, such as implicit processes to transfer knowledge within the firm (Makadok, 2001, p388-389; Hoopes, Madsen and Walker, 2003, p890). This distinction has been widely adopted throughout the resource-based view literature (Conner and Prahalad, 1996, p477; Makadok, 2001, p338; Barney, Wright and Ketchen, 2001, p630-31).

http://en.wikipedia.org/wiki/Resource-based_view

144


Assets

Tangible

PP&E Hardware Cash

Intangible

Brand Trademarks Customer Relationships

145

1. Each asset has an ROI or NPV

Project 1 Project 2 Project 3

3. Assets get integrated to perform activities for projects in each business module square.

2. Assets get integrated to activities.


Resource to Capabilities Example

Training Hiring

SoftwareWorkforce

Customization

Better Trained/More Productive Workforce 146


Describe the Knowledge-Based View (KBV).

Learning Outcomes

147

What is the difference between things that are codified and things that are tacit?


Knowledge-based view• As presented earlier, knowledge-based resources may be the driver of

value. Scholars have since developed a knowledge-based view of the firm. Basically, firms are created in order to integrate the specialist knowledge of its employees.

• Codified vs. Tacit

148

Key Partners

What partners can help overcome firm weaknesses?

149


150


Describe partnership options.

Learning Outcomes

151


Partnership Options• Exporting

• Contract Manufacturing

• Licensing

• Franchising

• Strategic alliances

• Equity-based joint ventures

• Wholly owned subsidiaries

152


Explain the differences between partner options as they pertain to: degree of control, dissemination risk, and resource commitment.

Learning Outcomes

153


Characteristics of Partner Types (1 of 2)

Partner Types

Degree of Control

Dissemination Risk

Resource Commitment

Export Low Low Low

Contract Manufacturing

Medium Low to Medium Low

Licensing Low High Low

Franchising Low to Medium Medium Low


Partner Types Degree of Control

Dissemination Risk

Resource Commitment

Equity-based Entry: Joint

Venture

Medium-High Medium-High Medium-High

Equity-based Entry: Wholly-

owned Subsidiary

High Low High

Characteristics of Partner Types (2 of 2)

Cost

What does it cost to deliver this value proposition?

156


157


158

1. Pharma – R&D

2. Manufacturing – Heavy Tangible Assets (Fixed vs. Variable)

3. Economies of scale and scope

4. Ultimately drives margins

Cost Structure


159


Male of higher income with preferences for high-tech and a certain image of success (6)

B-to-B battery sales (8)

Service of cars (9)

Sale of cars (4)

Charging wall installation sale (13) Charging fees (11)

Tesla Online Store (5)

Dealer ownership (10)

High connectivity & upgrade via remote access (7)

Retail outlets at malls (12)

Personal assistance at dealership (3)

Tesla Convertible

Land and dealership buildings (2)

Design and engineering (3)

Elon Musk (4)

R&D cost (5)

Component suppliers (6)

Manufacturing know-how (7)Parking location owners (8)

Panasonic batteries (9)Engineers, technicians, service (10)

Manufacturing and assembly plant costs (11)

Retail lessors (12) Charging stations (13)

Marketing expense (14)


160

Apple I-Phone

Iphonedevice

Iphoneaudience

App developers

App developers

Iphonerevenue

Transaction cut on App sales

Design skills

Marketing expertise

Apps control approval

Telecom operators

Phone hardware

Apps catalog

Appstore

Apps

Automated on Apple platform

Retail stores and online

IT infrastructure

IT costsMarketing costs

Software

Apple Brand

R&D

Apps submission portal

Iphoneaudience


161

ALA

CPE/CLE pricingCPAs, Attorneys, Professionals

Corporate Sponsors

Corporate Sponsors

Memberships Sponsorships

Network development

Teaching expertise

Content control approval

Presenters

Outsourced admin partners

www.alacommunity.org

Course catalog

Automated online order

IT infrastructure

IT costs Marketing costs

Software

ALA Brand

CPAs, Attorneys, Professionals

Call center

Face-to-face seminars

Networking


162

1. Value is based on future benefits (cash flows in some form) adjusted for risk.

2. Valuation approaches are straight-forward.

3. Good decisions are based on the quality of your analysis and your ability to determine the appropriate inputs for valuation models.

4. The best managers/investors are the best at estimating inputs.

Summary and Recap


163

Thank You!


Appendix A: Cost of Capital Support


Prepared and Presented by:

William Kline, Ph.D., CFA,

Cost of Capital Support Slides


1. Introductions

2. Cost of Capital Overview

3. WACC Calculation

4. WACC Weightings

5. Cost of Debt

6. Cost of Common Equity

Agenda

7. Cost of preferred Equity

8. Firm Specific Adjustments

9. Conclusion

166


Describe the cost of capital concept.

Learning Outcomes


Cost of Capital Basics• Firms raise money from a variety of sources, each with a different cost.

• Capital comes from common and preferred equity holders and creditors.

• The cost of capital becomes a benchmark for project selection.

• The cost of capital is a marginal cost: the cost of raising additional capital.

168


Common Applications• Bond valuation

• Equity valuation

• Corporate finance (project feasibility and profitability)

• Real estate investments

169


Explain how discount rates influence asset values.

Learning Outcomes


The Risk Adjustment

Current Costs VersusRisk-Adjusted

Future Benefits

Building or investing in

something today

Cash Flow

2

Cash Flow

3

Cash Flow

4

Cash Flow

1Versus

Risk Adjustment

t = 0 CF1 = CF2 = CF3 = CF4 =

r =Future Cash Flow /( 1 + r ) n 171




Risk Adjustment Example

172


Define a capitalization rate.

Learning Outcomes




Risk Adjustment Example vs. Direct Capitalization

vs.$1,000 (1+g)

----------------------- WACC-g

(Capitalization Rate)Where WACC = 5%, g = 3%

= $1,030----------------------- 5% - 3%

= $51,500

174


Estimate a discount rate with the weighted average cost of capital (WACC) formula.

Learning Outcomes


WACC Example

WACC = MV(Debt)

MV(Equity)+MV(Debt)

æ

èç

ö

ø÷´ rd ´ (1-Tax rate)

é

ëêê

ù

ûúú+ MV(Equity)

MV(Equity)+MV(Debt)

æ

èç

ö

ø÷´ re

é

ëêê

ù

ûúú

WACC = 0.50´5%´ (1-0.30)éë ùû+ 0.50´10%éë ùû= 6.75%

wd is the proportion of debt that the company uses when it raises new funds = 50%we is the proportion of equity that the company uses when it raises new funds = 50%rd is the before-tax marginal cost of debt = 5%t is the company’s marginal tax rate = 30%re is the marginal cost of equity = 10%wp is the proportion of preferred stock the company uses when it raises new funds = NArp is the marginal cost of preferred stock = NA

176


And Preferred Shares?

WACC = wd ´ rd ´ (1-Tax rate)éë ùû+ wpe ´ rpeéë

ùû+ we ´ re éë ùû

Just add weighting and cost for preferred stock

177


Explain how cost of capital component (debt, common/preferred equity) weightings are estimated. Discuss the pros and cons of each approach.

Learning Outcomes


• The problem: We cannot directly observe the optimal capital structure.

• Do we incorporate trends or just examine weighting at a point in time?

• Do we simply ask management?

Weightings Discussion

179


1) Market value of each component in the capital structure (debt and equity) of pure-play publicly-traded guideline firms, which gives % for each component, as of the valuation date

2) Book value of debt and market value of equity in the capital structure (debt and equity) of pure-play publicly-traded guideline firms, which gives % for each component, as of the valuation date

3) Trend of the market value of each component in the capital structure (debt and equity) of pure-play publicly-traded guideline firms, which gives % for each component

4) Trend of the book value of debt and market value of equity in the capital structure (debt and equity) of pure-play publicly-traded guideline firms, which gives % for each component, as of the valuation date

5) Market value of each component in the target-firm’s capital structure (debt and equity), which gives % for each component

6) Book value of debt and market value of equity in the target firm’s capital structure (debt and equity), which gives % for each component

7) Ask management and use that estimate for the %

Cost of Capital Weightings

180


Potential Weighting IssuesWhat do you do in practice? Book value or market value?

What questions would you ask if you were cross-examining an expert witness?

181


Calculate the cost of capital for debt. Provide sources of data for each component.

Learning Outcomes


The Cost of Debt

1. Yield-to-maturity approach: Estimate the yield to maturity on the company’s current portfolio of debt.

2. Debt-rating approach: Benchmark the bond yields of firms with a similar risk profile.

183


At ParYears 10.00YTM 5.00%

Current Price (1,000.00) Coupon $50.00

Par $1,000.00

DiscountYears 10.00YTM 6.38%

Current Price (900.00) Coupon $50.00

Par $1,000.00

PremiumYears 10.00YTM 3.78%

Current Price (1,100.00) Coupon $50.00

Par $1,000.00

The Cost of Debt: Yield-to-Maturity Approach

Then Incorporate Taxes rd = 0.05 (1 – 0.3) = 3.50% 184


The Cost of Debt: Debt Rating Approach

Then Incorporate Taxes rd = 0.05 (1 – 0.3) = 3.50%

Ratings agencies research the financial health of each bond issuer (including issuers of municipal bonds) and assign ratings to the bonds being offered. Each agency has a similar hierarchy to help investors assess that bond's credit quality compared to other bonds. Bonds with a rating of BBB- (on the Standard & Poor's and Fitch scale) or Baa3 (on Moody's) or better are considered "investment-grade." Bonds with lower ratings are considered "speculative" and often referred to as "high-yield" or "junk" bonds.

185


Investment grade Moody's Standard & Poor's FitchStrongest Aaa AAA AAA

Aa1 AA+ AA+Aa2 AA AAAa3 AA- AA-A1 A+ A+A2 A AA3 A- A-Baa1 BBB+ BBB+Baa2 BBB BBBBaa3 BBB- BBB-

Non-investment-grade Moody's Standard & Poor's FitchBa1 BB+ BB+Ba2 BB BBBa3 BB- BB-B1 B+ B+B2 B BB3 B- B-Caa1 CCC+ CCC+ Caa2 CCC CCCCaa3 CCC- CCC-Ca CC CC

Weakest Moody's Standard & Poor's FitchC C C

D Dhttps://www.fidelity.com/learning-center/investment-products/fixed-income-bonds/bond-ratings

Ratings agencies research the financial health of each bond issuer (including issuers of municipal bonds) and assign ratings to the bonds being offered. Each agency has a similar hierarchy to help investors assess that bond's credit quality compared to other bonds. Bonds with a rating of BBB- (on the Standard & Poor's and Fitch scale) or Baa3 (on Moody's) or better are considered "investment-grade." Bonds with lower ratings are considered "speculative" and often referred to as "high-yield" or "junk" bonds. 186


April 2021, 2.91%

187


May 3rd 2021, 3.59%188


Discuss the cost of debt calculation in practice.

Learning Outcomes


Cost of Debt In PracticeWhat do you do in practice?


190


Calculate the cost of capital for common equity. Provide sources of data for each component.

Learning Outcomes


The Cost of Common Equity 1. Capital Asset Pricing Model (CAPM): Use the single

factor model.2. Bond Yield Plus Risk Premium (Build Up Method): Use

yields on similar bonds and add an equity risk premium.3. Dividend Discount Model: Solve for the cost of equity by

using the dividend discount model.

192


Cost of Common Equity: Capital Asset Pricing Model

• E(Ri) = Required return on equity for security i• RF = Current expected risk-free return (Source: https://www.federalreserve.gov/releases/h15/)• i = Beta of security I (Sources: Yahoo Finance, Bloomberg, etc.)• E(RM) = Expected return on the market portfolio• E(RM) – RF = Equity risk premium

E(Ri) = R

F+

iE(R

M)- R

Féë ùû

193


Cost of Common Equity: Bond Yield + Equity Premium1. Estimate bond yield for a security with similar risk

(discussed in the previous segment)

2. Add an equity risk premium.• Historical average of the premium of stocks over bonds

since 1926• Subjective estimate based on various sources including

Duff & Phelps stock analysis, academic research, and surveys.

194


Cost of Common Equity: Dividend Discount Model1. Gather inputs for the DDM (Current price, expected

dividends, expected growth)

2. Solve for the cost of equity (Ke)

KeDividends

Current Price

= ----------------------- + Expected Growth

195


Cost of Common Equity In PracticeWhat do you do in practice?


196


The Cost of Preferred Equity

1. Preferred stock dividend yield: Simply divide the preferred dividend by preferred share price.

2. Average cost of common and debt: If market-based data is difficult to obtain, split the difference between the cost of common equity and the cost of debt.

197


Cost of Preferred Equity In PracticeWhat do you do in practice?


198


Discuss other potential issues in estimating the cost of capital (options, warrants, convertible preferred/bonds)

Learning Outcomes


1. Outstanding options/warrants

2. Convertible preferred/bonds

Other Potential Issues?

200


Discuss firm-specific factors that could be incorporated in the discount rate.

Learning Outcomes


• Company specific factors require evidence as to why the factor was not included in market-based data used for the cost of capital estimates. An expert must justify why the subject firm has more/less risk than the typical market participant.

• Potential differences include:• Available slack: Liquid assets as a % of total assets vs. peers• Human resource slack: Management depth vs. peers• Potential slack: Borrowing capability vs. peers• Supplier power: Supplier concentration vs. peers• Buyer power: Buyer concentration vs. peers• Investment portfolio: R&D as % of sales vs. peers • Sales diversification: Sales concentration by region vs. peers

Company-Specific Factors

202


Appendix B: Pricing Multiple

Support


Valuation Using Method of Comparables

Step 1: Calculate the price multiple of your subject company.

Step 2: Select comparison assets.

Step 3: Calculate a mean or median value of the multiple for the assets. Result is the benchmark value of the multiple.

Step 4: Compare subject’s actual multiple with the benchmark value.

Step 5: Assess whether differences between the subject and benchmark values are explained by differences in fundamentals.


Justified Trailing P/E Ratio

D1 D0 ( 1 + g )

P0 = --------------- or P0 = -----------------

k - g k - g

Dividing both sides by current (trailing) earnings, or E0, yields:

D0 ( 1 + g) / E0 ( D0 / E0 )( 1 + g ) ( 1 – b )( 1 + g )

P0 / E0 = --------------------- or P0 / E0 = ------------------------ or P0 / E0 = --------------------

k - g k - g k - g


Justified Price/Book Ratio

P 0 ROE – g

----- = --------------

B 0 k - g

A61

Slide 206

A61 Equation states that the justified P/B is an increasing function of ROE, all else equal.

The larger ROE is in relation to k, the higher the justified P/B based on fundamentals. Author, 4/13/2007


Justified Price/Sales Ratio

P 0 (E 0 / S 0) (1 – b) (1 + g)

----- = --------------------------------

S 0 k – g

A64

Slide 207

A64 Where E/S is the business' profit margin

Author, 4/14/2007


Appendix c: Additional

Internal Analysis


KBV Exercise• Step 1 – http://www.kalvan.net/howtojug/howtojug.htm

• Step 2 - http://www.wikihow.com/Juggle

• Step 3 - http://www.youtube.com/watch?v=kCt1bmSASCI

209


Describe support activities and primary activities in a firm’s value chain. How do firms use the value chain to make outsourcing decisions? Provide an example.

Learning Outcomes

210


The Value Chain“The value chain groups a firm’s activities into several categories, distinguishing between those directly involved in producing, marketing, delivering and supporting a product or service; those that create, source, and improve inputs and technology; and those performingoverarching functions such as raising capital, or overall decision making”

- Michael Porter 211


Upstream, Support, and Downstream Activities and Competitive Advantage

Firm Infrastructure(e.g., financing, planning, investor relations)

Human Resource Management(e.g., recruiting, training, compensation system)

Procurement(e.g., components, machinery, advertising, services)

Inbound Logistics

Operations Outbound Logistics

Marketing and Sales

After-Sales Service

Support Activities

Primary Activities

Value: What buyers are

willing to pay?

Technology Development(e.g., product design, testing, process design, R&D

212

Valuation Fundamentals and Analysis

Documents