1. Fin 4201/8001 1 The project Note: Since there is basically no reading, time to get organized. Report and Presentation Sources – usual suspects + value line Analyze with Buffett tenets, spread sheet w/ forecasts, ratios…. Conclude – Would WB buy? If not, what would have to change?

2. Fin 4201/8001 2 The project (applies to presentation AND report) Abstract Introduce company & environment Operations Industry

3. Fin 4201/8001 3 The project (applies to presentation AND report) Ratio analysis Buffett’s tenets Equity Valuation Recommendation References, Tables, Charts,…

4. Fin 4201/8001 4 Objective: Investment decision. Price < Estimated value = Buy Three step approach (Top-down) Analysis of economies and markets Analysis of Industry Analysis of individual firms Introduction to Security Valuation

5. Fin 4201/8001 5 Valuation (the softer side) Governance and the market for corporate control Buffett = cost < value But how do you know? Valuation. Our focus ≈ ROIC and DCF

6. Fin 4201/8001 6 Return On Invested Capital = Profit/capital ROIC is after tax profit divided by (working capital + PPE) Scorecard vs. some benchmark Goal ≠ maximize But can’t just look at $ either – Capital costs money (growth for growths sake) ROIC > Opportunity cost of capital Ultimate = stock performance or value creation

7. Fin 4201/8001 7 How ROIC drives value (starting profit = 100 cost of capital = 10%) Op Profit /Growth ROIC = 7.5% ROIC = 10% ROIC = 12.5% ROIC = 15% ROIC = 20% 3%8871,0001,0581,1131,170 6%7081,0001,1171,2951,442 9%4101,0001,3541,5911,886

8. Fin 4201/8001 8 DCF – Discounted Cash Flow Returns depend on market expectations The great equalizer Maximize PV of cash or economic profit Ultimate measure is stock performance Problems Predict future (Buffett KISS and stable) Earnings can be manipulated

9. Fin 4201/8001 9 Cash is King WSJ 1974 – EPS doesn’t matter A lot of executives apparently believe that if they can figure out a way to boost reported earnings, their stock prices will go up even if the higher earnings do not represent any underlying economic change. In other words, the executives think they are smart and the market is dumb….The market is smart. Apparently, the dumb one is the corporate executive caught up in the EPS mystique.

10. Fin 4201/8001 10 Cash flow can be difficult to interpret HeinekenHistorical FCFProjected FCF 19942381999446 19956182000754 1996(1,035)2001800 19975602002526 19983642003910 No context for above numbers = means little Actual 94-98 Projected 99-03 Revenue Growth8.55.6 EBITA Growth12.96.6 ROIC After goodwill12.3

11. Fin 4201/8001 11 What does matter and how? Empirical evidence Total return Changes in value linked more closely to expectations than absolute performance. M/B (Market to Book) ROIC and Sales Growth Market is smart Sees through cosmetics Market puts some faith in Long Term D/P, capital spending, write-offs, leverage

12. Fin 4201/8001 12 Making value happen (soft but indicative) Announce program to enhance value Could be just window dressing – six actions to reinforce 1.Inspiring w/ targets linked to value creation a)Calibrate against financial market (share price, EPS) b)Industry context c)Industry leader or role model?

13. Fin 4201/8001 13 Six areas to reinforce value commitment 2.Manage portfolio of businesses for value creation a)Investors can diversify on their own b)At least a couple: c)Industry shaper – spots discontinuities & preempts to shape d)Deal Maker – superior insight into intrinsic value e)Asset allocator – efficient capital, cash, time, talent allocation f)Skill replicator – transfers skills across business units g)Performance Manager – uses tech and resources efficiently h)Talent agent – attracts, retains and develops innovative talent i)Growth asset allocator – proven and sustained leading of innovation

14. Fin 4201/8001 14 3.Org design and culture – 1.Clear divisions and individual accountability 2.Culture matters – not touchy-feely, but has to match 4.Identify key value drivers – understand components of EBIT and where ROIC is coming from 5.Target setting and performance reviews – Is economic profit really there? 6.Motivate managers and employees – facilitate reaching targets (higher pay has been shown to work) Six areas to reinforce value commitment

15. Fin 4201/8001 15 Where does the future come from? Art Look at trends and ability to change them Value drivers Market share R&D ROIC→Growth →FCF →Value Cash is king Value those cash flows

16. Fin 4201/8001 16 Cash Flow Valuation (the numbers) Future projections Invested Capital A measure of the how much capital is invested NOPLAT – Net operating profit less adj. taxes A measure of profits ROIC – Return on Invested Capital Profitability ratio Free Cash Flow Valuation

17. Fin 4201/8001 17 Invested Capital Operating working capital Operating CA – Operating CL (non-interest bearing) + Net PPE + Other assets - other liabilities + Goodwill + Non-operating investments

18. Fin 4201/8001 18 Invested Capital - financing Adjusted equity Shareholders equity plus, Amortized goodwill plus, deferred taxes All interest bearing debt

19. Fin 4201/8001 19 NOPLAT Revenues -- COGS -- Selling, general and other expenses -- Depreciation ----------------------------------------------------------------------------------- = EBITA -- Taxes on EBITA + Increase in deferred taxes ------------------------------------------------------------------------------------ = NOPLAT

20. Fin 4201/8001 20 Tax on EBITA Tax provision + Tax shield on net interest expense -- Tax on non-operating income ------------------------------------------------------------------------- = Tax on EBITA

21. Fin 4201/8001 21 NOPLAT Net income + Increase in deferred taxes + Goodwill amortization ----------------------------------------------------------------------------------- = Adjusted net income + Interest expense after tax, net -- Non-operating income ------------------------------------------------------------------------------------ = NOPLAT

22. Fin 4201/8001 22 ROIC NOPLAT --------------------- Invested Capital

23. Fin 4201/8001 23 FREE CASH FLOWS NOPLAT + Depreciation -- Increase in WC, capital expenditure, discontinued operations, other assets net of other liabilities. -- Increase in Goodwill + After-tax Non-operating income ---------------------------------------------------------------------- = FREE CASH FLOWS

24. Fin 4201/8001 24 Coming Attractions Spread sheet to incorporate numbers Ratio analysis Some way to quantify Buffett tenets