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INTERPRETING RESULTS

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 companys 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.

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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?

Is the Model Technically Robust?

Invested capital Prior year 200 (125) 75 300 375 15 390 Current year 225 (150) 75 350 425 25 450

For example:

In the rearranged financial statements, check that the sum of invested capital plus nonoperating assets equals the cumulative sources of financing.

Inventory Accounts payable Operating working capital Net PP&E Invested capital Equity investments Total funds invested

Reconciliation of total funds invested Interest-bearing debt 225 Common stock 50 Retained earnings 115 Total funds invested 390

200 50 200 450

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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 companys 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.

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.
ROIC Impact of Small Changes: Sample Price and Cost Trends
dollars Year Price Number of units Revenue Cost per unit Number of units Cost Profit Invested capital ROIC (percent) 1 2 3 4 5 ... 10 50.0 51.5 53.0 54.6 56.3 65.2 100.0 103.0 106.1 109.3 112.6 130.5 5,000.0 5,304.5 5,627.5 5,970.3 6,333.9 8,512.2 43.0 100.0 4,300.0 700.0 7,500.0 9.3 42.1 103.0 4,340.4 964.1 7,725.0 12.5 41.3 106.1 4,381.2 1,246.3 7,956.8 15.7 40.5 109.3 4,422.4 1,547.9 8,195.5 18.9 39.7 112.6 4,464.0 1,869.9 8,441.3 22.2 35.9 130.5 4,677.8 3,834.4 9,785.8 39.2 Growth (percent) 3.0

2.0

Minor changes in price growth and cost reduction can lead to unrealistic improvements in ROIC over long periods.

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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.

Specialty Retail: Trading Multiples, December 2009

$ million Ticker AZO BBBY BBY HD LOW PETM SHW SPLS Company AutoZone Bed Bath & Beyond Best Buy Home Depot Lowe's Petsmart Sherwin-Williams Staples Market capitalization 7,915 10,368 16,953 49,601 34,814 3,386 7,029 18,054 Debt and debt equivalents 2,783 2,476 11,434 6,060 634 1,099 3,518 Gross enterprise value 10,698 10,368 19,429 61,035 40,874 4,019 8,128 21,572 Net enterprise value 10,535 9,477 18,525 60,510 39,960 3,867 8,044 20,938 1-year forward multiples (times) Revenue 1.5 1.3 0.4 0.9 0.8 0.7 1.1 0.9 EBITDA 7.5 9.5 6.0 9.2 8.3 6.5 9.5 10.1 EBITA 8.5 11.3 7.4 13.0 12.2 10.4 11.4 13.2

Perform a Sensitivity Analysis

With a robust model in hand, test how the companys 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 investors 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 companys valuation. Analyzing Trade-Offs. Strategic choices typically involve tradeoffs 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.

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Assessing the Impact of Individual Drivers

Start by testing each input one at a time to see which has the largest impact on the companys valuation. Among the alternatives presented, a permanent one-percentage-point reduction in selling expenses has the greatest effect on the companys valuation.

Sample Sensitivity Analysis

Analyzing Trade-Offs

Although an input-by-input sensitivity analysis will increase your knowledge about which inputs Valuation Isocurves by Growth and Margin 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.

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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.

Key Value Drivers by Scenario

percent 2009A Scenario 1 Revenue growth 5.0 2010 12.0 2011 15.0 Financial forecasts 2012 14.0 2013 12.0 2014 10.0 2015 5.0 Continuing value 3.5 Scenario assessment New product introduction leads to spike in revenue growth. Margins improve to best in class, as consumers pay a price premium for product. Capital turnover drops slightly during product launch as company builds inventory to meet expected demand.

After-tax operating margin Times: Capital turnover () Return on invested capital

7.5 1.5 11.3

9.0 1.4 12.6

11.0 1.3 14.3

14.0 1.4 19.6

14.0 1.5 21.0

12.0 1.6 19.2

10.0 1.6 16.0

8.0 1.6 12.8

Scenario 2 Revenue growth

5.0

3.0

(1.0)

(1.0)

1.5

1.5

1.5

1.5

Revenue growth drops as competitors steal share.

Operating margins Times: Capital turnover () Return on invested capital

7.5 1.5 11.3

7.0 1.4 9.8

6.5 1.4 9.1

6.0 1.4 8.4

5.5 1.3 7.2

5.5 1.3 7.2

6.5 1.3 8.5

6.5 1.3 8.5

Lower prices put pressure on margins; cost reductions cannot keep pace. Capital efficiency falls as price pressure reduces revenue; inventory reductions mitigate fall.

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Techniques in Excel
The

Data Table commands Tornado Charts

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Output

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.
Example of a Scenario Approach to DCF Valuation
$ million

67% Probability

Scenario 1 Value of operations Nonoperating assets Enterprise value Interest-bearing debt Equity value

5,044 672 5,716 (2,800) 2,916

Probability-weighted equity value 1,954

Description Company's new-product launch reinvigorates revenue growth. Higher average selling prices lead to increased operating margins and consequently higher ROICs. ROICs decay as new product matures, but future offerings keep ROIC above cost of capital.

33% Probability

Scenario 2 Value of operations Nonoperating assets Enterprise value Interest-bearing debt Equity value

1,993 276 2,269 (2,269)

Company launches new product, but product is seen as inferior to other offerings. Revenue growth remains stagnant and even declines as prices erode and company loses share. ROICs eventually rise to cost of capital as management refocuses on cost reduction.

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Conclusions
Technically

robust? Economically consistent? Sensitivity analysis

- a powerful tool that offers insights into the key valuation drivers