Book Review: Evaluation | CFA Institute Enterprise Investor

Evaluation: Measuring and managing the value of a company, 7th edition. 2020. McKinsey & Company, Tim Koeler, Mark Goyedhart and David Wessels. Willie.

What is “value”? This is an important question for investors: turning investment theory into a successful value-based equity strategy has proved challenging over the past decade.

Tim Koeler, Mark Goyedhart, and David Wessels set out the basic principles of valuation and provide step-by-step guidelines for measuring a company’s value. This is the seventh edition Evaluation (The first was published in 190) Many today challenge three pricing strategies to address three issues: the growing proportion of investment in indomitable resources, the network impact enjoyed by influential technology companies, and the assessment of the inclusion of an environmental, social, and governance (ESG) lens.

The key principles of business valuation are the general economic rules that apply to all market situations. The guiding principle is simple: “Companies that grow and earn returns on capital that exceed their capital costs.”

The authors argue that many investors are using the wrong criteria by focusing on earnings per share. In practice, “expected cash flows, discounts on capital costs, drive costs,” the authors explain. What’s more, the stock market is not easily fooled when companies take steps to increase reported accounting profits without increasing cash flow. ” In fact, rising earnings generally indicate that the company will post lower earnings in the future.

The book, originally written as a handbook for McKinsey & Company consultants, provides a guide on how to evaluate. At the heart of the book is a series of step-by-step methods for calculating prices using Enterprise Discounted Cash Flow (DCF) and discounted economic profit method. The authors claim that “a good analyst will focus on the key drivers of value: return on invested capital, revenue growth and free cash flow.” Analysts need to be prepared to dig into the footnotes so that “each financial statement can be restructured into three categories: operating items, operating items and sources of money.” Where can this ideal analyst be found? Detailed work on the described scale requires time and judgment. The authors cite the example of Maverick Capital as practitioners: they hold only five positions per investment professional, many of whom have covered the same industry for more than a decade.

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I should make it clear: that’s not me. My decade as an equity fund manager ended 20 years ago. Instead, I have come up with the perspective of a multi-asset investor in this book for practical lessons, of which there are plenty.

First, companies that find strategies to achieve attractive returns on invested capital (ROIC) have a better chance of sustaining higher market returns. In a study of U.S. companies between 1963 and 2017, the top quintile of companies ranked by ROIC Did See returns declining on average, but they remain about 5% higher than the average after 15 years.

According to the authors, this “high ROIC companies should focus on growth, while low-ROIC companies should focus on improving returns.” Growth is rarely a solution for low return businesses. “In mature companies, a low ROIC indicates a flawed business model or attractive industrial structure.”

ROICs across the industry are generally stable, so industry rankings do not change much over time.

Over the past 35 years, high market valuations have been driven by increasing margins and return on capital. For asset allocators, higher valuations of U.S. companies than other countries reflect higher ROICs.

Financial Analyst Journal Current Issue Tile

The highest return businesses weave together a number of competitive advantages. The authors have identified five sources of premium pricing: innovative products; Value (real or perceived); Brand; Customer lock-in, such as replacement razor blades; And reasonable price discipline (avoidance of manufactured goods). And they identify four sources of competitive advantage over cost: innovative business methods (e.g., IKEA stores); Unique resources (in mining, North American gold is closer to the surface than South Africa and thus cheaper to extract); The dimensions of the economy; And network economy.

The second lesson is that maintaining high-average growth is much less common than maintaining high-average growth. The authors note that “high growth rates have eroded very rapidly. In fact, companies that grow faster than 20 percent typically grow only 8 percent in five years and 5 percent in ten years. However, some sectors continue to grow rapidly, including There are life sciences and technologies, others, such as chemicals, matured well before 1990.

Third, analysts who value fast-growing Internet and technology stocks say, “It should start with the future. Think about the situation, and compare the economics of business models with your peers. An estimate is needed. DCF remains an essential tool, providing a value in each of the many possible situations. The greatest increase in value is seen in the industries where the winner takes all. The authors say, Competition is kept off. ”To properly evaluate a fast-growing company, investors need to take a 10- or 15-year approach, which often involves more than just increasing the amount of losses at an early stage.

Digital applications can give a clear advantage to the performance of all companies. McKinsey & Company has identified at least 33 opportunities ranging from digital marketing to robotic process automation.

The future of investment management

Fourth, the best owner of a business changes frequently over his life cycle. The authors explain, “A company … will probably begin to own its founders and end its days in the portfolio of a company that specializes in withdrawing cash from businesses in a declining sector.” Provides good structure.

Fifth, however, “one-third or more of the acquiring companies destroy the value for their shareholders, as they transfer all the benefits of the acquisition to the shareholders of the selling company,” the author says. Acquisitions typically pay about 30% more than the previously announced price. Nevertheless, acquisitions can create value and this book provides six archetypes for successful deals.

In contrast, partitions usually add value, a sixth lesson. The authors note that “the stock market continues to respond positively to both sell-offs and spin-offs. The study also found that their profits tend to increase by one-third within three years after the transaction is completed.”

Finally, corporate strategies that address ESG issues can increase cash flow in five ways:

  1. Facilitate revenue growth
  2. Reduce costs
  3. Reduce regulatory and legal interference
  4. Increase employee productivity
  5. Optimize investment and capital expenditure

For example, a study found that gold miners avoid planning or operation delays with social engagement activities. Or a way to do nothing is free. Good performance in the ESG issue reduces the negative risk. For example, it can help avoid stuck assets. A strong ESG proposal could create more sustainable opportunities, raising the standard of DCF.

ESG reporting, however, is not featured in the Investors Communication chapter. I would urge the authors to resolve this issue in their next edition. Property owners need to understand the impact of their investment.

Advertising Tiles for ESG and Responsible Institutional Investment Around the World: A Critical Review

In conclusion, the growing focus on Internet or ESG issues does not obscure the rules of economics, competition and value creation. As the authors say, “The faster companies can increase their revenue and raise more capital at attractive rates, the more value they create.”

This well-written book gives CEOs, business managers and financial managers insights into creating strategies they can use to build value and provide investors with the tools to measure their success.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

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Robert N. Farago, ASIP

Robert N. Farago, ASIP, an Edinburgh-based investment professional and has previously served as thought leader at Aberdeen Standard Investments and head of asset allocation at Schroeders Private Bank.

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