CFROI Cash Flow Return on Investment Valuation : A Total System Approach to Valuing the Firm

385 Pages·1999·23.91 MB·English

by  Bartley Madden

CFROI Valuation
A Total System Approach to Valuing the Firm
To Maricela, Gregory, Jeffrey, Miranda and
Lucinda
CFROI Valuation
A Total System Approach to Valuing
the Firm
Bartley J. Madden
Butterworth-Heinemann
LinacreHouse,JordanHill,OxfordOX28DP
225WildwoodAvenue,Woburn,MA01801-2041
AdivisionofReedEducationalandProfessionalPublishingLtd
AmemberoftheReedElsevierplcgroup
Firstpublished1999
(cid:211) BartleyJ.Madden1999
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Contents
PREFACE xi
AUTHOR BIOGRAPHY xv
ENDORSEMENTS xvii
1. OVERVIEW 1
Valuation foundation 1
The need 1
Process for learning what works 2
Knowledge and action 3
Knowledge as assumptions 3
Critical role of feedback 4
Problem recognition 5
Past experiences influence what we observe 5
Nurturing clearer observations 6
Analyzing the firm as a total system 6
Feedback 6
Accounting statements measure results 7
Benefits of approach 8
CFROI valuation model 9
Rooted in discounted cash flow (DCF) 9
CFROI economic performance metric 9
A new approach to discount rates 10
Portfolio manager perspective 11
2. CFROI LIFE CYCLE 13
Economic performance 14
CFROI as a return measure 15
Managerial skill and the competitive life cycle 18
Life-cycle examples 21
3. CFROI MODEL AND DCF/CFROI ARITHMETIC 64
CFROI valuation model map 65
Pricing equation 66
vi Contents
Net cash receipts (NCRs) 66
Packaging the NCR stream 68
A model firm as a portfolio of projects 69
Two valuation methods 75
Valuing the NCR stream 75
Present value of existing assets 76
Present value of future investments 76
Calculating and interpreting a CFROI 79
4. MARKET-DERIVED DISCOUNT RATES AND COMPANY-
SPECIFIC RISK DIFFERENTIALS 82
Discount rate tied to valuation model 83
Investors’ demanded returns 84
Historical achieved returns 84
Effects of taxes and inflation 86
Valuing future investments 88
The market aggregate of firms 89
The derivation procedure demonstrated 89
Forecasting aggregate net cash receipts 91
Market-derived discount rate 92
CFROIs and market discount rates, 1960–1996 93
Market real debt and real equity rates 93
Real and nominal rates compared 95
Effects of taxes and inflation on demanded real
equity rates 97
Risk differentials 99
Concept illustrated for bonds 99
Risk-differential determinants: leverage and size 100
Empirical test design 101
Empirical test results 102
Example firm-specific risk differentials 102
5. CFROI CALCULATION DETAILS 105
Improved accuracy requires comprehensive calculations 106
A note on calculation methods 108
Units of measurement and inflation adjustments 109
CFROI calculation example 110
Four major inputs to CFROI 110
Asset life 113
Current-dollar depreciating assets 114
Gross plant inflation adjustment 115
Mark-up of plant illustration 115
HOLT’s mark-up procedure for plant 116
Contents vii
Gross plant inflation adjustment to 1993 dollars 117
Revaluations 117
Construction in progress 118
Current-dollar gross leased property 118
Key issues concerning intangibles/goodwill 119
Treatment depends on question explored 119
HOLT’s treatment of goodwill 122
Proposal: use pooling, footnote goodwill 122
Adjusted intangibles 123
Current-dollar non-depreciating assets 124
Financial subsidiaries: a special case 125
Testing proposed fixes 127
Monetary assets 129
Net monetary assets 129
Current-dollar inventory 130
Current-dollar land 130
Other long-term assets 131
Investments & advances 131
Deferred-tax assets (excluded) 131
Current-dollar gross cash flow 133
Depreciation & amortization 133
Adjusted interest expense 133
Rental expense 134
Monetary holding gain (loss) 134
LIFO charge to FIFO inventories 135
Net pension (and other post-retirement benefit)
expense 136
Minority interest 137
Special item after tax 138
Concluding remarks on CFROI 138
Capital structure 139
Conventional debt 140
Operating lease debt 140
Pension debt 141
Other liabilities excluding pension obligation 141
Preferred stock 142
Minority interest (balance sheet) 142
6. HOLT’S DUALGRADE(cid:210) CORPORATE PERFORMANCE
SCORECARD 143
Introduction 144
(cid:210)
Two components to performanceDDualGrade 145
viii Contents
Expected near-term CFROI 145
% Future 145
DualGrade(cid:210) data 146
DualGrade(cid:210) in Appendix C 147
Example dual grades 148
Some general observations about DualGrade(cid:210) 150
Industry data 151
Changing competitive landscape 152
‘Setting the line’ 154
Stock price reveals the market’s ‘line’ for expected
CFROI fade 154
Simple example applications 155
Under-performance expected to continue 155
Effects of implementing lean manufacturing 155
CFROIs, ‘the line’, and growth 157
Comparison with other performance scorecards 159
7. VALUING EXPECTED PERFORMANCE, AN
APPLICATION 161
Growth and fade 162
A review 162
The need: forecasting NCRs 163
Baseline fade patterns 164
Empirical evidence for CFROI fade rates 165
Empirical test design 165
Empirical results 166
Donaldson Company’s CFROI-model track record 168
Sustainable growth calculation challenges 169
Caveats 171
Example valuation calculation: Donaldson Company 172
HOLT’s database and software 172
Forecast life cycle 173
Plausibility benchmarks from historical data 175
Value of existing assets 175
Value of future investments 176
Effect of fade 178
Total-firm warranted value and warranted share price 179
Comparing actual prices with warranted prices 181
Stock price volatility and plausible range of forecast
economic performance 182
Portfolio approach versus firm-specific value approach 183
Evaluating share repurchase programs 184
Contents ix
The magnitude of wealth-creating investment
opportunities 184
Estimating the per share impact 184
Life-cycle perspective on stock price reactions to quarterly
reports 187
8. EVALUATING VALUATION MODELS 189
The mainstream finance method 191
Learning need: feedback, testing of assumptions 191
Origin of the CAPM: mathematics and efficient
portfolios 192
Assumptions become unchallengeable, deductive
logic rules 193
From observations to new/revised theory 194
Residual income 195
A little history 195
Foundation in accounting 196
CAPM equity cost of capital 197
Wide range of historical measures of equity premium 198
Examples of unreasonable CAPM/beta risk premiums 198
Criteria for evaluating valuation models 202
EVA(cid:210) as a type of RI model 202
Our conclusions summarized 203
Criterion 1: insights from analyzing firms’ track records 204
EVA(cid:210) limitations revealed 204
Criterion 2: identification of key valuation issues 206
Criterion 3: accuracy 207
Criterion 4: plausibility judgements 208
Criterion 5: ease of implementation 210
Criterion 6: process for model improvement 211
Postscript: ‘free cash flow’ ambiguity 212
Focus on managerial skill, not free cash flow 212
More FCF is not necessarily favorable 213
9. THINKING ABOUT CRITICAL ISSUES 214
Shareholders, stakeholders, and government policy 216
Valuation models and public policy 216
Efficient resource allocation, trade-offs, and skilled
managements 217
Managerial skill: vision 218
Example of success 219
Managerial skill: total system efficiency 219
Local accounting efficiencies 219