Session 10: Value Enhancement

Summary

This script discusses the four key drivers of business value: cash flows, growth rate, risk, and terminal value. It emphasizes the difference between value enhancement and price enhancement, advocating for strategies that increase intrinsic value rather than just market price. The speaker outlines four pathways to enhance value: increasing cash flows from existing assets, boosting growth rate, reducing the discount rate, and extending the period of growth. Examples and strategies are provided, including running assets more efficiently, reinvesting better, and building competitive advantages.

Takeaways

• 💹 The value of a business is driven by four key ingredients: cash flows from existing assets, expected growth in those cash flows, the risk associated with those cash flows (captured in the discount rate), and the terminal value which represents the future cash flows beyond the forecast period.
• 📈 Value enhancement focuses on improving one or more of these ingredients, rather than merely increasing the price of a business, which is a different concept.
• 🔍 To increase the value of a business, one must either boost cash flows from existing assets, increase future growth rates, reduce the risk (and thus the discount rate), or extend the period of growth before reaching a stable state.
• 🏦 Restructuring and other value enhancement strategies must align with one of the four value drivers mentioned above.
• 📊 Two studies showed that changing a company's name can temporarily affect its stock price, but such changes do not necessarily reflect an increase in intrinsic value.
• 💼 To enhance value, a company can run its assets more efficiently, cut costs that do not add value, minimize taxes legally, and reduce the amount of reinvestment needed to maintain those assets.
• 🌱 Growth can be achieved by reinvesting more or reinvesting more effectively, but only if the return on capital exceeds the cost of capital.
• 🚀 The best growth strategies are creating new products, entering new markets, and gaining market share in growing markets, while the riskiest are fighting for market share in stable markets and growing through acquisitions.
• 🛡 Competitive advantages such as strong brand names, legal barriers to entry, high switching costs, and cost advantages can help extend a company's growth period and increase value.
• 💼 Reducing the cost of capital can be achieved by altering the debt-to-equity ratio, making products less discretionary, reducing fixed costs, and eliminating debt-asset mismatches.
• 📈 A real-world example of increasing a company's value is provided by revaluing SAP with a higher debt ratio and a higher reinvestment rate in emerging markets, which significantly increased the estimated value per share.

Q & A

What are the four ingredients that drive the value of a business?

The four ingredients that drive the value of a business are cash flows from existing assets, expected growth in those cash flows, the risk in those cash flows captured in a discount rate, and the point in time in the future where you apply closure on those cash flows, known as the terminal value.

How does enhancing the value of a business differ from enhancing its price?

Enhancing the value of a business involves improving one or more of the four ingredients that drive business value, such as increasing cash flows, growing at a sustainable rate, reducing risk, or extending the period of growth. Enhancing the price is more about market perception and might not reflect the intrinsic value, as seen in the example of companies changing their names during different market conditions.

What are the four pathways to enhance the value of a business?

The four pathways to enhance the value of a business are: 1) increasing cash flows from existing assets, 2) increasing the growth rate, 3) reducing the discount rate applied to cash flows, and 4) pushing off the day of closure or maturity of the company.

How can a company increase cash flows from existing assets?

A company can increase cash flows from existing assets by running them more efficiently, cutting costs that do not create value, minimizing taxes paid within legal limits, and reducing the amount of reinvestment needed to maintain those assets.

What does it mean to get more value from growth?

Getting more value from growth means finding ways to either increase the return on capital invested or to reinvest capital more efficiently. It's not just about higher growth rates but about ensuring that the growth is profitable and sustainable.

How can a company lower its discount rate?

A company can lower its discount rate by changing the mix of debt and equity, making its product or service less discretionary to customers, reducing fixed costs, or eliminating mismatches between debt and assets.

Why is growing through acquisitions considered a difficult strategy?

Growing through acquisitions is considered difficult because to create value, the acquirer must pay less than the market price for the acquired company. Overpaying can lead to lower value creation for the acquiring company.

What are some ways a company can extend its growth period?

A company can extend its growth period by developing new competitive advantages, such as a strong brand name, legal barriers to entry, high switching costs, or cost advantages over competitors.

How does the script illustrate the difference between value enhancement and price enhancement?

The script illustrates the difference by showing how companies that added '.com' to their names during the dot-com boom saw their stock prices increase significantly without changing their business operations, which would not affect intrinsic value. Conversely, after the market bust, companies that removed '.com' from their names also saw positive reactions, showing that price changes can be fleeting and not indicative of true value.

What is the role of taxes in value enhancement?

While it may seem unpatriotic, the script suggests that companies should aim to minimize taxes within the bounds of the law to increase cash flows and, consequently, value, as long as it doesn't negatively impact the company's operations or reputation.

Can you provide an example from the script on how changing financial strategy can enhance a company's value?

Yes, the script uses the example of SAP, where changing the debt ratio to be more aggressive about borrowing money and assuming a higher reinvestment rate in emerging markets led to an increase in the company's value per share from €16 to €26.