1. Chapter 13 Calculating and Interpreting Results Instructors: Please do not post raw PowerPoint files on public website. Thank you! 1

2. Session Overview Is the Model Technically Robust? Ensure that all checks and balances in your model are in place, such as whether the balance sheet balances. Is the Model Economically Consistent? The next step is to check that your results reflect appropriate value driver economics. For example, does invested- capital turnover increase over time for sound economic reasons? Perform a Sensitivity Analysis. With a robust model in hand, test how the company’s value responds to changes in key inputs. Start with a single input analysis, and then change multiple inputs simultaneously. Use Scenario Analysis to Address Uncertainty. Since the future is never truly knowable, consider making financial projections under multiple scenarios. The scenarios should reflect different assumptions regarding future macroeconomic, industry, or business developments, as well as the corresponding strategic responses by industry players. 2

3. Is the Model Technically Robust? In the unadjusted financial statements, the balance sheet should balance every year, both historically and in forecast years. Check that net income flows correctly into dividends paid and retained earnings. In the rearranged financial statements, check that the sum of invested capital plus nonoperating assets equals the cumulative sources of financing. Is net operating profit less adjusted taxes (NOPLAT) identical when calculated top-down from sales and bottom-up from net income? Does net income correctly link to dividends and retained earnings in adjusted equity? Does the change in excess cash and debt line up with the cash flow statement? 3

4. Is the Model Technically Robust? For example: In the rearranged financial statements, check that the sum of invested capital plus nonoperating assets equals the cumulative sources of financing. 4 PriorCurrent year Inventory200225 Accounts payable(125)(150) Operating working capital75 Net PP&E300350 Invested capital375425 Equity investments1525 Total funds invested390450 Reconciliation of total funds invested Interest-bearing debt225200 Common stock50 Retained earnings115200 Total funds invested390450 Invested capital

5. Is the Model Economically Consistent? Are the patterns intended? For example, does invested-capital turnover increase over time for sound economic reasons (economies of scale) or simply because you modeled future capital expenditures as a fixed percentage of revenues? Are the patterns reasonable? Avoid large step changes in key assumptions from one year to the next, because these will distort key ratios and could lead to false interpretations. For example, a large single-year improvement in capital efficiency could make capital expenditures in that year negative, leading to an unrealistically high cash flow. Are the patterns consistent with industry dynamics? In certain cases, reasonable changes in key inputs can lead to unintended consequences. Is a steady state reached for the company’s economics by the end of the explicit forecasting period (that is, when you apply a continuing-value formula)? A company achieves a steady state only when its free cash flows are growing at a constant rate. 5

6. Is the Model Economically Consistent? For example: Are the patterns consistent with industry dynamics? In certain cases, reasonable changes in key inputs can lead to unintended consequences. 6 ROIC Impact of Small Changes: Sample Price and Cost Trends Minor changes in price growth and cost reduction can lead to unrealistic improvements in ROIC over long periods.

7. Are the Results Plausible? Perform a sound multiples analysis. Calculate the implied forward-looking valuation multiples of the operating value over, for example, EBITA, and compare these with equivalently defined multiples of traded peer-group companies. 7 Specialty Retail: Trading Multiples, December 2009

8. Perform a Sensitivity Analysis With a robust model in hand, test how the company’s value responds to changes in key inputs. –Senior management can use sensitivity analysis to prioritize the actions most likely to affect value materially. –From the investor’s perspective, sensitivity analysis can focus on which inputs to investigate further and monitor more closely. Assessing the Impact of Individual Drivers. Start by testing each input one at a time to see which has the largest impact on the company’s valuation. Analyzing Trade-Offs. Strategic choices typically involve trade-offs between inputs into your valuation model. For instance, raising prices leads to fewer purchases, lowering inventory results in more missed sales, and entering new markets often affects both growth and margin. 8

9. Assessing the Impact of Individual Drivers Start by testing each input one at a time to see which has the largest impact on the company’s valuation. Among the alternatives presented, a permanent one-percentage-point reduction in selling expenses has the greatest effect on the company’s valuation. 9 Sample Sensitivity Analysis

10. Analyzing Trade-Offs Although an input-by-input sensitivity analysis will increase your knowledge about which inputs drive the valuation, its use is limited. –First, inputs rarely change in isolation. For instance, an increase in selling expenses is likely to accompany an increase in revenue growth. –Second, when two inputs are changed simultaneously, interactions can cause the combined effect to differ from the sum of the individual effects. 10 Valuation Isocurves by Growth and Margin

11. Use Scenario Analysis Build a set of scenarios that reflect different assumptions regarding future macroeconomic, industry, or business developments, as well as the corresponding strategic responses by industry players. Each value driver should be consistent with the overall scenario. 11 Key Value Drivers by Scenario

12. Use Scenario Analysis Assess how likely it is that the key assumptions underlying each scenario will change, and assign to each scenario a probability of occurrence. 12 Example of a Scenario Approach to DCF Valuation