Matching Returns and Capital – Operating, Financing and Non-core Items

As discussed above, returns and capital are used in various valuation approaches to produce either an equity or enterprise valuation. Depending on the approach used and the valuation produced, there will be a number of adjustments to be made to the valuation to arrive at the estimated value of the share price of a company. Assuming that an operating enterprise value is produced, this would have to be adjusted as follows:

In calculating an operating enterprise value, only the operating returns and capital would be used.The value for non-equity finance would be calculated using the financing returns and capital and the value of the non-core assets would be derived from the non-core returns and capital. What is crucially important is that the correct returns and capital items are used in each part of a valuation, e.g. returns from non-core assets should not be used to calculate the value of operating assets, etc.

When producing a valuation therefore, the elements of a company’s returns and capital must be broken down into three key areas:

A calculation of enterprise and equity values will start by analysing the operating and financial items in a set of accounts. Operating items relate to enterprise value, the value of the entirety of the operations of the business, while financing items are deducted from enterprise value to get to equity value. Non-core items are extracted from the accounts and valued separately. As discussed, an example of non-core items would be Nestlé’s investment in L’Oréal, which is a non-core investment (food vs. cosmetics).

Operating Items

Within a set of accounts, operating items in the income statement include EBIT (earnings before interest and tax) and any items above EBIT (profit before interest, which is paid away to non-equity financiers). In the cash flow statement, the operating items are detailed in cash flow from operations (again before financing payments/receipts) and in the balance sheet, operating items are the net operating assets of the company.

Looking in a bit more detail, this means the return items that are operating items include revenue, EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) and EBIT, and the capital items include operating assets such as fixed and intangible assets and working capital (current assets less current liabilities).

Financing Items

In a set of accounts, financing items in the income statement include items such as interest in the income statement (to get to profit after interest, which is available to equity holders), cash flow from financing and investment in the cash flow statement and non-equity finance in the balance sheet.

This means financing items will include interest payable and receivable and other financial

income/expense from the income statement. These would be deducted from operating returns to get to equity returns. In the balance sheet, financing items include net financial debt, provisions and minority interests.

Financing items in total make up non-equity finance (as detailed above) and in each area would be defined as follows:

It is worth commenting at this point on the definition of net financial debt. The simplifying

assumption made above is that any cash (or marketable securities) held by a company is not required to finance the operations of the company. However, there will be occasions when a company does require cash to finance its operations, e.g. a retailer that requires a cash float for its tills or a travel company that is required to post a bond as part of its ABTA membership. If cash is identified that is not surplus but an integral part of the operations of the company, then it should not be deducted from financial debt but instead included in working capital as part of the operational assets of the company.

Non-core Assets and Liabilities

Non-operating or non-core items relate to unusual items or investments that the company has made that are not part of the underlying operations of the business. They include assets that are no longer part of the business (discontinued operations, disposed assets) or investments that do not relate to the company’s ongoing operations, e.g. Nestlé’s investment in L’Oréal.

In the accounts of a company, non-core assets relate to anything that is not part of the underlying returns or capital of the company. In the income statement, this would generally include restructuring charges (unless recurring), impairments and profits/losses on disposal of assets/businesses. Disposal profits or losses may be operational for some types of company, e.g. for a car rental business (constantly turning over its vehicle fleet). Under IFRS, assets and liabilities held for sale are separated out in the balance sheet, so these are specifically identified as being non-core. For the purpose of this manual, it is assumed that associates (or any investment that is not consolidated) are non-core. Investments in unrelated businesses are always non-core and joint ventures are generally treated as non core, unless the joint venture is proportionately consolidated. 

The main problem with non-operating or non-core items is the amount of judgement that has to be applied to decide what is non-core, which can be difficult to determine. The key issue is consistency. If, for example, associates are treated as core, then any associate income would be included in operating returns and the value of the associate would be included in operating capital.

Key learning points:

1. Returns and capital can be broken down into operating, financing and noncore items.
2. Operating items relate to enterprise value and include returns such as EBITDA and capital.
3. Financing items relate to non-equity finance and if deducted from operating items, produce equity returns or capital.
4. Non-core items do not relate to the core activities of the business and should be extracted.

Capital – Analysis or Valuation?

When determining the capital of a company, the objective is either to analyse the underlying
performance of the company or produce a value of the underlying operations of the company. If the objective is to produce a valuation, then the calculation will use the most up-to-date (market-based) values for capital. If the objective is to calculate capital to analyse the historic operational performance of the business (using ratio analysis such as DuPont analysis), then the accounting version of enterprise value, which is called capital employed, needs to be calculated. Capital employed is based purely on the accounts of the business being valued and is also known as book value.

When looking at a company, an analyst will often find that the company has set of core activities (and associated capital) that generate what would be termed operating returns. These are the underlying, ongoing and sustainable returns of the company. These activities will be detailed in the historic accounts of the company and will usually be split out into some form of divisional analysis. For example, in Nestlé’s financial statements, the activities of the business are split between the three core geographic regions of its food business (Europe, America and Asia), the Nestlé Waters business and the Nestlé Nutrition business. However, companies will often have made investments in areas outside of their core activities (“non-core assets”) that must also be reported in their financial statements. In Nestlé’s case, it has a 29.4% investment in L’Oréal SA, which is not part of the core activities of the company and would be stripped out of any valuation of the core operating activities.

Calculating Capital for Ratio Analysis – Capital Employed

Total capital employed of the company can be calculated in two different ways:

These two ways of calculating total capital employed must balance (as they are derived from the two sides of a balance sheet). However, as a set of accounts has been used to calculate capital employed, this may also include non-core assets and liabilities and, as we mentioned above, should not be included in our calculation of operating capital. Therefore, to calculate operating capital employed, net non-core assets must be deducted from the calculations above as follows:

Again, the two approaches to calculating capital employed in this way, being accounting based, will balance, providing a useful cross-check.

Calculating Capital to Value a Company

The accounting-based method of calculating capital is used to analyse performance, but it is a historic measure. It cannot be used to calculate the current market value of a company’s capital, which will be required for a market-based valuation. The calculation of capital for valuation purposes therefore uses market values for the equity and non-equity financing (fair value of debt, pensions, etc. and market value of equity) to come up with a value for equity or enterprise capital used by the company. However, this approach can only calculate the liability side of the balance sheet, as there is not enough information in a set of accounts to calculate the market value of operational assets, even with the greater fair value disclosure for assets and liabilities under IFRS.

The calculation of enterprise and equity capital can be summarised as follows:

If it is assumed that the market is valuing the business correctly, then the share price of the company will include a value for any non-core assets of the business. To arrive at the underlying value of the operating assets of the company (operating enterprise and equity value), the net non-core assets must be deducted as follows:

Unfortunately, as the valuations above can only be determined from the liability side of the balance sheet, this means it is impossible to cross-check an enterprise value from an asset and liability approach. If it was possible to value each of the operating assets separately, then the difference between book value of assets and enterprise value from a liability perspective would be the market’s view of the fair value of the operating assets. This would reflect things like intangible assets that are not reflected in the accounts, views on the recoverability of receivables, etc.

BG Bridge

Going back to the BG Bridge, this shows how the non-core assets are incorporated into a valuation if market values are used. If market values are used in a valuation, then (assuming the market correctly values the company and all its assets and liabilities) the enterprise value and equity value calculated are total enterprise and equity values. Deducting non-core assets produces a valuation for operating enterprise and equity values. Operating enterprise and equity values are sometimes called “clean” values. They represent only the core operations of the company being valued and are often a better source for comparison across industry sectors. The reason why the distinction between total and operating values is important is that certain valuation approaches will produce an operating enterprise or equity value (for example a discounted cash flow or dividend discount valuation). As discussed above, if the valuation approach produces an operating enterprise or equity value, then the non-core assets must be added to the operating valuation to arrive at a total enterprise or total equity value. A total equity value should, if the market is valuing the company correctly, be equal to the current share price and any difference would be an arbitrage opportunity. These two approaches to valuation are called a relative valuation if the approach starts with a market (total) value, or an absolute valuation approach if an operating enterprise/equity value is produced (subsequently adjusted for any non-core assets). The two approaches are discussed in more detail later.

Key learning points:

1. Different calculations of capital are required for analysis and valuation purposes.
2. Capital employed is required for analysis purposes and enterprise value and equity value for valuation purposes.
3. Depending on the valuation approach used, the capital value calculated will either be a total (including non-core assets) or an operating (excluding noncore assets) value.

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Returns and Capital

Returns and Capital

In practice, investment horizons used in equity markets by market participants can be very different and therefore, there are numerous approaches used to value companies. Some are grounded in fundamental corporate finance theory, some are the result of a fad or fashion that is the “flavour of the month”. However, whichever valuation approach is being used, the underlying question that the approach is trying to answer is the same: what return is being generated and how much capital is being used to generate the return? If a cash flow based valuation is used, the return (the company’s cash flows) and the company’s cost of capital (the discount rate calculated using a value of the company’s capital) will be used to calculate an absolute valuation. If a multiple-based valuation is used, return and capital multiples (P/E, EV/EBITDA) will be compared with those of similar companies to arrive at a relative valuation. 

Returns take many forms, commonly used market-based returns include metrics such as earnings, cash flow and returns based on other profitability measures. Capital can also take various forms, from the accounting-based capital employed (used in ratio analysis) to market-based equity and enterprise value capital. The key thing to remember is that the return that is used must be consistent with the capital that is being used. 

The most common forms of returns and capital used in valuation and analysis are as follows:

When looking at returns and capital, there are two basic valuation approaches: to value the whole of a company (the enterprise value or total firm value approach) or to value just the equity of the company (the shareholders’ share of value). The enterprise value approach will use returns (cash flow, profits, etc.) available to all the providers of capital, and the equity approach will just use the returns available to the equity shareholders. The enterprise value approach values all the capital provided to the company, whereas the equity value approach focuses on the value of the company’s shares.

In practice, the end objective is usually to calculate the equity value of a company to determine how much a company’s shares are worth. This could, for example, either be for a valuation being performed by an equity analyst on the buy or sell side or, if the valuation is being produced for a potential M&A transaction, to determine how much would be paid to acquire a 100% stake in the company.

An equity value produces the value of the shares directly and there is no more work required, but an enterprise value needs a bit more effort. The difference between the enterprise value and the equity value is called non-equity finance (or the “BG bridge”). This represents the proportion of the enterprise value owned by providers of capital other than the shareholders of the company. Determining the value of the non-equity finance allows the translation of an enterprise value into an equity value, so calculating the BG bridge correctly is a key element of determining the value of a company’s shares. The interaction between equity and enterprise valuations can be represented as follows:

BG Bridge

The valuation approach taken determines how the BG Bridge is used. For example, if an absolute valuation approach [e.g. a Discounted Cash Flow (DCF)] is used to calculate an enterprise valuation, the valuation starts at the left-hand side of the bridge with an enterprise valuation of operations, adds in non-core assets (which are not generally included in an absolute valuation) and deducts the elements of the bridge (net debt, provisions – including pensions – and minority interest) to arrive at an equity value. If a relative valuation approach is used to produce a valuation (i.e. the approach uses the company’s share price to calculate equity value and the market value of debt, etc.), then noncore assets do not have to be considered (they are assumed to be correctly valued by the market and included in the share price of the company). Exactly how this affects the approach to calculating returns and capital will be dealt with at a later stage as well as how non-core assets are incorporated into a valuation.

Key learning points:

1. There are various valuation approaches used in markets depending on the time horizon being used.
2. A pragmatic approach to valuation would use both fundamentally based and short-term valuation approaches.
3. Returns and capital are the core elements of valuation.
4. The BG bridge describes how an enterprise valuation is translated into an equity value depending on the valuation approach (absolute or relative) used.

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Principles of Valuation and Analysis - Fundamental Framework

Introduction

Valuation is an area that produces more debate and controversy in financial markets than almost any other subject. Calculating the “correct” value for a company’s shares is the holy grail of the investment and investment banking community, the rewards for getting a valuation right (or penalties for getting it wrong) can be enormous. Academic theory suggests that valuation matters, but probably only in the long run. Research shows that for an investment horizon over 12-24 years, valuation is the key driver of value, accounting for up to 50%+ of returns1. Over shorter periods, liquidity, technical factors and even fear/greed can drive markets and valuation becomes almost irrelevant; the TMT bubble at the end of the 1990s was a prime example of greed driving share price movements. In addition, different valuation metrics can have varying importance at different stages of an economic or market cycle and creative analysts or companies can always find new valuation metrics to explain share price movements. As a result, the approach that is taken throughout this manual is a pragmatic one, although a fundamental approach to valuing a company using corporate finance theory is the cornerstone of the approach. A fundamental approach assumes that the value of a company is the discounted present value of the cash flows generated by the company. However, a pragmatic approach also recognises that other  aluation methodologies can be equally important, price/earnings and dividend yield in particular have been proved to have strong correlations with share price returns2. Two of the greatest ever investors, Benjamin Graham and his famous pupil, Warren Buffett, have commented up the subject of valuation as follows:

 

A summary of these comments might be that it should be recognised that valuing a company is both a science and an art. Anyone attempting to value a company should be prepared to adopt a pragmatic approach, realising that whatever valuation is produced will depend on the assumptions used and will be at best only partially accurate. The comments by Warren Buffett above are very apposite. In particular the fact that over the short term, issues such as sentiment are important (“the market is a voting machine”), but in the long term, fundamental valuation will drive share prices  (“the market is a weighing machine”). Buffett’s investment style mirrors this fact; he takes large stakes in undervalued businesses that he holds for a time period he describes as “forever”. Over such a time period, valuation will drive the returns generated from an investment.

1 Standard Life Investments

2 Basu (1977), Basu (1983)

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Passive vs. Active Management

This has nothing to do with conjugating verbs in Latin! Rather, it reflects a critical difference in investment philosophy. Passive management reflects the belief that markets are efficient and therefore it is not possible to beat the market. Hence, there is no point in hiring an active manager to produce a tailored portfolio, as he/she is unlikely to outperform in the long term and will charge higher fees.

There are two strands of passive management. Immunisation (typically used by pension funds) is a duration-based strategy to ensure greater certainty of cash flows by matching assets and liabilities more closely. Indexation replicates a benchmark index performance.

There are several arguments that can be advanced against indexation:

• An index fund will not match the performance of the index precisely. For example, the fund will have operating expenses whereas the index itself does not. The issue of how accurately the index is to be replicated compared with the costs of doing so also needs to be considered
• The performance of an index may not be optimal
• Restrictions may stop a manager from taking positions (or, put more starkly, using his/her brain)
• Replication may be difficult, particularly if some index constituents are illiquid
• You have to own whatever is in the index

Set against these arguments, one can say that the risk with an active strategy is that the fund manager performs poorly (sub-optimal asset selection) and charges you more for doing so!

Active investment strategies are designed to enable the portfolio to outperform the market by taking positions (overweight, underweight or no position) that are different to the constituents of the index. The magnitude of risk relative to the benchmark that the fund manager can take is determined by the tracking error.

A top-down strategy is one which sits within a macro-view that decides how to allocate assets by country, asset class, sector and their individual stocks.

A bottom-up strategy is essentially “stock picking”. One of the most successful stock pickers is Anthony Bolton, whose Fidelity Special Situations Fund was a fairly consistent market outperformer for 25 years. 

Benchmarking

In order to quantify the success or otherwise of a fund manager, a metric in the form of a benchmark is usually stipulated. Examples of equity benchmarks would be broadly based equity indices. In fixed income, the construction of a benchmark portfolio is more complex, as individual securities need to be selected.

The characteristics of the chosen benchmark should be:

•  Specified in advance to the fund manager
• Unambiguous and appropriate to the type of fund being run. For example, the Dow Jones index in the US is far less representative of the US larger capitalisation stocks compared with the S&P 500 index
•  Liquid and easily measurable
•  Reflective of current investment opinions

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