Beyond Earnings E-Book

David A. Holland

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch
• Veröffentlichungsjahr: 2017

Seitenzahl: 531

Beschreibung

Beyond Earnings is targeted at investors, financial professionals, and students who want to improve their ability to analyze financial statements, forecast cash flows, and ultimately value a company. The authors demonstrate that reported earnings are easily gamed by accounting shenanigans and reveal how commonly used profitability measures such as return on equity can be misleading. Because earnings and P/E ratios are too unreliable for valuation, this book takes you beyond earnings and shows you how to apply the HOLT CFROI and Economic Profit framework in a step-by-step manner. A better measure of profitability results in improved capital allocation decisions and fundamental valuations. This ground-breaking book offers the first practical in-depth discussion of how profitability and growth fade, and shows how to put this information to work right away. The authors introduce their trailblazing Fundamental Pricing Model which includes fade as an adjustable value driver and can be used to value the impact of business model disruption. As the authors explain, the key to superior stock picking is understanding the expectations embedded in a stock's price and having a clear view of whether the company can beat those expectations. The HOLT framework has been rigorously field tested for over 40 years by global investment professionals to help them make better stock picks and by corporate managers to understand the expectations embedded in their stock price. Beyond Earnings is an indispensable guide for investors who want to improve their odds of outperforming the competition.

Leseprobe

Table of Contents

COVER

TITLE PAGE

INTRODUCTION

THE PRICING PUZZLE: FOUNDATIONAL HOLT CONCEPT AND A KEY TO BETTER VALUATION

OVERVIEW OF BOOK CHAPTERS

WHO ARE WE AND WHAT DO WE HOPE TO ACHIEVE

NOTES

Section I: Financial Performance Assessment

1 NEVER FORGET THE GOLDEN RULE: PURSUE STRATEGIES WITH POSITIVE NPV

KEY LEARNING POINTS

INTRODUCTION

WHAT DO CORPORATE FINANCIAL MANAGERS DO DURING THE DAY?

WHAT IS VALUE?

THE GOLDEN RULE OF FINANCIAL DECISION MAKING

BACK‐OF‐THE‐ENVELOPE BASICS

IS THE NPV RULE FOOLPROOF?

THE PRICE OF SHORT‐TERMISM

THINKING CLEARLY ABOUT ACTIONS, REACTIONS, AND VALUE

NOTES

2 THE FLYING TRAPEZE OF PERFORMANCE METRICS

KEY LEARNING POINTS

MEASURES OF CORPORATE PERFORMANCE

RETURN ON EQUITY

WHAT ABOUT DEBT AND LEVERAGE?

RETURN ON ASSETS

RETURN ON INVESTED CAPITAL

P/E AS A VALUATION METRIC AND DISCOUNTED CASH FLOW VALUATION APPROACH

HALLMARKS OF A SOUND ECONOMIC PERFORMANCE AND VALUATION MODEL

CHAPTER APPENDIX

NOTES

3 ACCOUNTING TO CASH FLOW RETURN ON INVESTMENT

KEY LEARNING POINTS

IS CFROI A BETTER MEASURE OF PERFORMANCE?

CFROI ADJUSTMENTS USING AMAZON’S 2013 ANNUAL REPORT

UNDERSTANDING THE RELATIVE WEALTH CHART

A COMMENT ON GOODWILL

CHAPTER APPENDIX: GROSS PLANT RECAPTURED

NOTES

Section II: Discounted Cash Flow and Economic Profit Valuation

4 WHAT’S IT WORTH? VALUING THE FIRM

KEY LEARNING POINTS

A REVIEW OF CONVENTIONAL VALUATION APPROACHES

HOLT APPROACH TO FCFF VALUATION

NOTES

5 QUANTIFYING THE VALUE AND RISK OF A COMPANY’S CAP

KEY LEARNING POINTS

INTRODUCTION

THE WORST INVESTMENT I EVER MADE

QUANTIFYING THE MAGNITUDE AND SUSTAINABILITY OF CAP

THOUGHT EXPERIMENT: THE VALUATION OF CORE UNLIMITED

THE PROBABILITY OF PERMANENT DISRUPTION

THE CHARACTERISTICS OF COMPETITIVE ADVANTAGE

FADE IS A VALUE DRIVER

THE FUNDAMENTAL PRICING MODEL

THE VALUE DRIVER TREE

INVESTMENT GROWTH IS A VALUE DRIVER

APPLYING THE FUNDAMENTAL PRICING MODEL

FINAL THOUGHTS FOR THE MOMENT

CHAPTER APPENDIX

NOTES

6 HOLT ECONOMIC PROFIT

KEY LEARNING POINTS

INTRODUCTION

CALCULATING CFROI AS A RATIO

HOLT ECONOMIC PROFIT

THE POWER OF SIMPLICITY: SPREAD, FADE, AND GROWTH IN AN EP FRAMEWORK

USING ECONOMIC PROFIT TO MEASURE THE VALUE OF ACQUISITIONS

DECOMPOSING VALUE CREATION INTO DELTA EP COMPONENTS

WHAT ABOUT GOODWILL?

NOTES

7 RISK, REWARD, AND THE HOLT DISCOUNT RATE

KEY LEARNING POINTS

RISK, RETURN, AND DIVERSIFICATION

HOW LARGE IS THE EQUITY RISK PREMIUM (ERP)?

SHOULD I USE THE ARITHMETIC OR GEOMETRIC AVERAGE?

OTHER RISK FACTORS TO CONSIDER

INTRODUCTION TO THE HOLT APPROACH OF ESTIMATING A FIRM’S DISCOUNT RATE

RELATING THE HOLT DISCOUNT RATE AND FRAMEWORK TO CAPM AND APV

CHAPTER APPENDIX: DO EQUITY DISCOUNT RATES MEAN REVERT?

NOTES

Section III: Value Driver Forecasting

8 THE COMPETITIVE LIFE‐CYCLE OF CORPORATE EVOLUTION

KEY LEARNING POINTS

INTRODUCTION

WHAT IS FADE?

THE COMPETITIVE LIFE‐CYCLE

QUESTION MARKS (EARLY LIFE‐CYCLE)

ESSENTIAL FACTS ABOUT THE COMPETITIVE LIFE‐CYCLE

NOTES

9 THE PERSISTENCE OF CORPORATE PROFITABILITY

KEY LEARNING POINTS

LONG‐TERM REAL RETURN ON INVESTMENT

THE LONG‐TERM REAL REQUIRED RATE OF RETURN

MEASURING PERSISTENCE

PUTTING IT ALL TOGETHER: DEVELOPING A MEAN‐REVERTING FORECAST MODEL

CONCLUSION

NOTES

10 FORECASTING GROWTH

KEY LEARNING POINTS

MEDIAN REAL ASSET GROWTH RATE

THE AVERAGE GROWTH RATE AS COMPANIES MATURE

IS CORPORATE GROWTH MEAN‐REVERTING?

THE SUSTAINABILITY OF GROWTH

FORECASTING GROWTH

CONCLUSIONS

NOTES

11 EVALUATING MARKET EXPECTATIONS

KEY LEARNING POINTS

THE RELATIVE WEALTH CHART AS A DECISION AID FOR EFFICIENTLY ASSESSING STOCK OPPORTUNITIES

DISTILLING EXPECTATIONS FROM A STOCK PRICE

CAN IT BEAT THE FADE?

THE GREEN DOT

THINKING ABOUT EXPECTATIONS AT DIFFERENT LIFE‐CYCLE STATES

WHY THE GREEN DOT IS SO HELPFUL

PICKING STOCKS ACROSS THE LIFE‐CYCLE

FINAL REMARKS

CHAPTER APPENDIX: GAUGING EXPECTATIONS USING PVGO

NOTES

12 CLOSING THOUGHTS

NOTE

INDEX

END USER LICENSE AGREEMENT

List of Exhibits

Introduction

EXHIBIT I.1 The Pricing Puzzle and chapter that corresponds to each driver.

EXHIBIT I.2 Perspectives for application of the Fundamental Pricing Model.

EXHIBIT I.3 The Pricing Puzzle using Economic Profit and the chapter that corresponds to each driver.

Chapter 1

EXHIBIT 1.1 The accountant’s balance sheet equation is Total Assets equals Total Liabilities plus Shareholders’ Equity. The latter is what remains in book terms.

EXHIBIT 1.2 The financial economist’s balance sheet equation is Market Value of Assets equals Market Value of Total Liabilities plus Market Value of Shareholders’ Equity. The latter is better known as market capitalization, or market cap.

EXHIBIT 1.3 DivCo has an opportunity to save $2bn per year and increase its dividend. It issues shares to fund a $5bn investment to generate the savings.

EXHIBIT 1.4 Bad Karma Pharma NPV Tree. Squares represent decision points, and circles represent uncertainties and their probabilities. The path with the greatest expected value should be chosen.

EXHIBIT 1.5 Woody Rock’s NPV. Real options have value. All values shown are net present values.

EXHIBIT 1.6 A simple example connecting time and value with the culinary delights of Cape Town’s Foodbarn.

Chapter 2

EXHIBIT 2.1 Amazon increased the amount it spent on marketing and technology during this period.

EXHIBIT 2.2 Amazon’s return on equity (ROE) and price‐to‐book ratio (P/B). Market capitalization is based on the December year‐end value.

EXHIBIT 2.3 Amazon’s ROE if it cut its technology and content spending to zero.

EXHIBIT 2.4 Flying high or low the Safe, Daedalus, and Icarus Way.

EXHIBIT 2.5 The effect of gearing on ROE for the high and low scenarios for each airline.

EXHIBIT 2.6 Return on asset calculation for Amazon in 2012 and 2013.

EXHIBIT 2.7 Return on invested capital calculation for Amazon in 2012 and 2013.

EXHIBIT 2.8 The P/E ratio for different combinations of constant growth and ROE assuming a 10% cost of equity. It decreases as growth increases for the value destroyer; equals the inverse of the cost of equity for value‐neutral corks; and increases with growth for value creators.

EXHIBIT 2.9 The P/B ratio for different combinations of perpetual growth and ROE assuming a 10% cost of equity. It decreases as growth increases for the value destroyer; equals unity when ROE equals the cost of equity; and increases with growth for value creators.

EXHIBIT 2.10 Forward P/E versus forward earnings growth for U.S. firms with a market cap exceeding $5bn on September 24, 2015.

EXHIBIT 2.11 Earnings growth is comprised of two components: investment and efficiency growth. The former is only value additive when investments are made in positive NPV projects. Efficiency growth can be accomplished by increasing margins and/or turns.

EXHIBIT 2.12 HOLT price‐to‐book ratio versus forward CFROI for U.S. industrial and service firms with a market cap exceeding $5bn on September 24, 2015. The HOLT price‐to‐book ratio is the market enterprise value divided by the inflation‐adjusted net assets. A stock’s premium is a function of the quality of its earnings (CFROI).

EXHIBIT 2.13 Should Impress Industries buy Superstar or Superdud?.

Chapter 3

EXHIBIT 3.1 The evolution of CFROI and other financial performance metrics for Greg’s Braai Design & Build business. Each return calculation is based on its beginning‐of‐year asset base.

EXHIBIT 3.2 CFROI / IRR equivalence for Greg’s Braai Design & Build business.

EXHIBIT 3.3 Inputs for calculating Amazon’s 2013 CFROI.

EXHIBIT 3.4 Amazon’s reported gross property and equipment in 2013.

EXHIBIT 3.5 Adjusted gross plant for Amazon in 2013.

EXHIBIT 3.6 Asset de‐layering example.

EXHIBIT 3.7 Estimated capital expenditure and the corresponding inflation adjustments to restate cumulative investment in current dollars.

EXHIBIT 3.8 Impact of inflation on the oldest asset layer.

EXHIBIT 3.9 Amazon’s inflation‐adjusted gross plant in 2013.

EXHIBIT 3.10 Asset type as a percentage of total inflation‐adjusted corporate assets for U.S. industrial/service firms.

EXHIBIT 3.11 Capitalizing operating leases using the Excel PV function.

EXHIBIT 3.12 Amazon’s capitalized operating leases in 2013.

EXHIBIT 3.13 Capitalized R&D calculation.

EXHIBIT 3.14 Amazon’s capitalized R&D in 2013.

EXHIBIT 3.15 Amazon’s inflation‐adjusted depreciating assets in 2013.

EXHIBIT 3.16 Amazon’s CFROI calculation template: depreciating assets.

EXHIBIT 3.17 Amazon’s adjusted current liabilities in 2013.

EXHIBIT 3.18 Amazon’s adjusted net working capital in 2013.

EXHIBIT 3.19 Amazon’s non‐depreciating assets in 2013.

EXHIBIT 3.20 CFROI calculation template: non‐depreciating assets.

EXHIBIT 3.21 Amazon’s gross investment in 2013.

EXHIBIT 3.22 CFROI calculation template: inflation‐adjusted gross investment.

EXHIBIT 3.23 Estimated R&D life by Industry used by HOLT to capitalize R&D expenses.

EXHIBIT 3.24 Calculating asset life.

EXHIBIT 3.25 Amazon’s asset life in 2013 based on the implied depreciation method.

EXHIBIT 3.26 CFROI calculation template: project life.

EXHIBIT 3.27 Amazon’s net monetary holding gain in 2013.

EXHIBIT 3.28 Amazon’s FIFO profits in 2013.

EXHIBIT 3.29 Amazon’s gross cash flow in 2013.

EXHIBIT 3.30 Amazon’s gross cash flow in 2013 based on a top‐down approach.

EXHIBIT 3.31 Amazon’s CFROI inputs and calculation.

EXHIBIT 3.32 Amazon’s Relative Wealth Chart as of April 30, 2014, indicates a prolonged period of value creation and growth. Shareholders have been handsomely rewarded.

EXHIBIT 3.33 Amazon’s 2013 CFROI calculation.

EXHIBIT 3.34 Roper Technologies Relative Wealth Chart as of June 16, 2015, indicates that it grows by acquisition. Although goodwill dilutes Roper’s performance, its transaction CFROI has remained above its cost of capital. Shareholders have been handsomely rewarded.

EXHIBIT 3.35 Estimating gross plant recaptured.

Chapter 4

EXHIBIT 4.1 Invested capital is the sum of operating working capital and net fixed assets.

EXHIBIT 4.2 Flowchart to determine how long an explicit forecast period should last and how best to estimate the terminal value. ROIIC is the return on incremental invested capital.

EXHIBIT 4.3 Relationship between FCFF, NOPAT, and investment.

EXHIBIT 4.4 Financial forecast and FCFF valuation of Air Liquide. The market enterprise value was circa €44bn as of December 31, 2014, and December 31, 2015.

EXHIBIT 4.5 Flowchart showing the calculation of economic profit and how its value drivers feed into it. Invested capital turns equal sales divided by invested capital. The DuPont relationship is

ROIC = EBIT% × (1 – T

c

) × Invested capital turns

.

EXHIBIT 4.6 Financial forecast and EP valuation of Air Liquide. The market enterprise value was circa €44bn as of December 31, 2014, and December 31, 2015.

EXHIBIT 4.7 Forecast scenarios and their valuations for Air Liquide. The market enterprise value was circa €44bn as of December 31, 2014, and December 31, 2015.

EXHIBIT 4.8 Air Liquide’s enterprise value (€m) for different combinations of terminal growth and fade. The market enterprise value was circa €44bn as of December 31, 2014, and December 31, 2015.

EXHIBIT 4.9 Air Liquide’s enterprise value to book value for different combinations of terminal growth and fade.

EXHIBIT 4.10 Flowchart for the EP and FCFF valuation approaches: EP is on the left‐hand side and FCFF is on the right‐hand side. The valuations should be equivalent for a given forecast.

EXHIBIT 4.11 Change in working capital calculation for Amazon in 2013.

EXHIBIT 4.12 Change in long‐term assets calculation for Amazon in 2013.

EXHIBIT 4.13 Total investment tally for Amazon in 2013.

EXHIBIT 4.14 Amazon has a long history of investing more cash than it generates from its operations.

EXHIBIT 4.15 Calculation of Amazon’s 2013 net value of capitalized operating leases and its corresponding debt‐equivalent. All values are in $m.

EXHIBIT 4.16 Illustration of how CFROI and asset growth drive the estimation of future free cash flows for Amazon.com.

EXHIBIT 4.17 This forecast assumes Amazon’s CFROI fades from 12% to 10% while growth fades from 40% to 5%. The warranted share price of $228 is 25% below the April 30, 2014 share price of $304.

EXHIBIT 4.18 This forecast assumes Amazon’s CFROI fades from 7.6% to 6% while growth fades from 40% to 5%. The warranted share price drops to $155 for this pessimistic scenario.

EXHIBIT 4.19 This forecast assumes Amazon’s CFROI fades from 12% to 10% while growth fades from 20% to 5%. The warranted share price of $169 is 45% lower than the April 30, 2014, share price of $304.

EXHIBIT 4.20 This forecast assumes Amazon’s CFROI fades from 10% to 6% while growth fades from 20% to 5%. The warranted share price drops to $122 for this pessimistic scenario.

EXHIBIT 4.21 The explicit forecast for Air Liquide was loaded into the HOLT model to calculate its future CFROI, asset growth, and warranted value. A real of discount rate of 4.8% was assumed to be consistent with the earlier analysis. The warranted share price is €80 versus the June 2, 2015 share price of €116.

EXHIBIT 4.22 Valuation of Air Liquide based on a five‐year forecast run through the HOLT model. The real discount rate was set to 4.8%.

EXHIBIT 4.23 Valuation of Air Liquide based on a five‐year forecast run through the HOLT model. The discount rate was set to the June 2015 market‐implied discount rate of 3.3%.

EXHIBIT 4.24 The historical default valuation for Air Liquide versus its actual price is shown in the top panel. The economic PE and VCR time series are in the second and third panel, respectively.

Chapter 5

EXHIBIT 5.1 Blockbuster’s timeline:

8

The figures for 1994 are as of December 31, 1993, and those for 2010 are as of December 31, 2009.

EXHIBIT 5.2 The relationship between excess profits and CAP. Firms that earn a return above the cost of capital possess a competitive advantage. Colgate‐Palmolive’s excess profitability (CFROI above the cost of capital, shown in light filler) is large. For how long might this magnitude of profitability persist?

EXHIBIT 5.3 Price/Book versus forward spread for different CAPs (in years). A spread of 0% results in a P/B of 1 no matter what the CAP or growth in book equity is. The impact of CAP on P/B increases significantly as the spread increases, e.g., for a forward spread of 20%, P/B increases 67% from 1.8 to 3.0 if CAP is extended from 5 to 20 years. In this example, the cost of equity is 10%, constant growth in book equity is 5%, and forward spread equals (

ROE

1

– r

e

).

EXHIBIT 5.4 Strategic Resources and Consequences Report proposed by Professors Lev and Gu. The information in squares is quantitative ($ denotes monetary value), and in circles is qualitative (narrative). Used with permission by the authors.

EXHIBIT 5.5 A forward spread of 15% decays at different rates. A fade rate of 0% signifies no fade and a constant spread that lasts forever. A fade rate of 100% means instantaneous fade like a light being switched off.

EXHIBIT 5.6 A forward spread of 15% fades toward 0% at a decay rate of 5%, that is, 5% of the spread is whittled away each year. This is equivalent to a constant spread of 15% collapsing to 0% in 20 years, that is, 1/

f

years.

EXHIBIT 5.7 There are various profitability metrics which feature similar traits. Three popular measures of profitability are return on equity (ROE), return on invested capital (ROIC), and cash flow return on investment (CFROI). All measures of profitability can be split into two drivers whereby Profitability = Profit Margin x Asset Turns. Net profit margin is net income divided by sales. CFROI can also be expressed as a ratio, which we demonstrate in Chapter 6. The profitability margin for CFROI is net cash flow margin (NCF%) which equals gross cash flow (GCF) minus an economic depreciation divided by sales. Gross investment and gross cash flow are adjusted for inflation in the HOLT CFROI framework, which makes CFROI and its drivers comparable over time and across borders.

EXHIBIT 5.8 Profitability drivers and types of competitive advantage. Best‐in‐class firms possess a rare mix of above‐average margins and asset efficiency. These firms enjoy both a consumer and production advantage.

EXHIBIT 5.9 CFROI can be expressed as net cash margin multiplied by asset turns. In this example, we show the margins and turns for companies in the global auto parts industry along with CFROI isocurves of 3%, 6%, and 12%.

27

One of the star performers is Continental AG (CONG).

EXHIBIT 5.10 Discounting future economic profits or free cash flows to the firm will yield equivalent valuations for a given forecast. The amount of future value creation is easier to track and discuss using the EP method. The key to value creation is a relentless focus on generating a positive change in EP. Growth in operating profit is destructive if it leads to a decline in EP. Many firms don’t understand this crucial point and focus on earnings growth at all cost.

EXHIBIT 5.11 Value driver tree showing the key variables in our Fundamental Pricing Model.

EXHIBIT 5.12 Investment growth is the control variable and input while revenue and earnings are outputs.

EXHIBIT 5.13 Earnings growth, whether net income, NOPAT, or net cash flow, results from two sources: investment growth and efficiency growth. The latter results from improvements to operating margin and asset turns and is not sustainable growth. Investment growth in the terminal period should not exceed the risk‐free rate. As the return on capital fades, the retention ratio will have to increase to fund sustainable steady‐state growth.

EXHIBIT 5.14 The HOLT relative wealth and economic profit charts for Macy’s, a U.S. department store. Real asset growth has been less than zero for the past decade. The change in economic profit has been negative for the past two years due to a fall in CFROI. The stock has underperformed the S&P 500 since 2014.

EXHIBIT 5.15 Share price sensitivity matrices on two different dates for Macy’s. The fundamental pricing model was used to generate warranted (intrinsic) share prices for different combinations of the fade rate and the real asset growth rate. On June 26, 2017, Macy’s stock price was $22.47, and on July 1, 2015, it was $63.48.

EXHIBIT 5.16 Percentage of firms with starting CFROI of 6% or higher that maintain or improve CFROI over time. Note that less than 5% of firms can sustain a level CFROI for more than 20 years.

EXHIBIT 5.17 Flowchart to help determine how long the explicit forecast period should be for valuing a company. The flowchart also helps establish assumptions for estimating the terminal value. The Fundamental Pricing Model can be used to value relatively stable ex‐growth firms on the back‐of‐an‐envelope.

EXHIBIT 5.18 The HOLT inputs for the back‐of‐the‐envelope valuation of Macy’s as of June 2015 (left‐hand side) and June 2017 (right‐hand side).

EXHIBIT 5.19 The unbearable lightness and absurdity of P/E ratios. This example illustrates how confusing and unhelpful P/E ratios can be.

Chapter 6

EXHIBIT 6.1 Assessing growth options.

EXHIBIT 6.2 The value drivers for change in economic profit are diagrammed in the flowchart. Investment growth comes from investing in positive NPV projects, and efficiency growth comes from improving operating margins and asset turns. Key performance indicators and incentives should be aligned with increasing economic profit.

EXHIBIT 6.3 Comparison of two mutually exclusive projects with the same IRR but different asset compositions. Which would you choose?

EXHIBIT 6.4 Calculation of the NPV for the two mutually exclusive projects. Project A is the clear winner when NPV is considered. Never forget the golden rule.

EXHIBIT 6.5 EROI and CFROI are compared as a function of non‐depreciating asset intensity.

EXHIBIT 6.6 The equivalence of NPV and the present value of EP is demonstrated for two projects.

EXHIBIT 6.7 Diagram outlining the calculation of HOLT EP.

EXHIBIT 6.8 Diagram outlining the calculation of HOLT EP and FCFF.

EXHIBIT 6.9 The HOLT price‐to‐book ratio for different combinations of fade and EROI.

EXHIBIT 6.10 A table and chart showing Amazon’s operating EP and transaction EP from 2004 to 2013.

EXHIBIT 6.11 Amazon’s economic profit and change in economic profit components.

EXHIBIT 6.12 Danaher’s EROI and value driver performance from 2003 to 2013.

EXHIBIT 6.13 Danaher’s EROI and transaction EROI from 2003 to 2013.

EXHIBIT 6.14 Danaher’s economic profit from 2003 to 2013.

EXHIBIT 6.15 Danaher’s economic profit from operations and after acquisition goodwill has been accounted for from 2003 to 2013.

EXHIBIT 6.16 Danaher’s annual change in EP split into its components.

Chapter 7

EXHIBIT 7.1 Annual returns to Treasuries, Bonds, and Equities, 1900–2016.

EXHIBIT 7.2 The benefit of diversifying risk by adding stocks to a portfolio.

EXHIBIT 7.3 The worldwide geometric and arithmetic premiums relative to bonds since 1900. Dimson, Marsh, and Staunton.

EXHIBIT 7.4 The HOLT Pricing Puzzle. Solving for the discount rate that equates future free cash flows to current enterprise value results in a firm‐specific clearing rate, or a market‐implied cost of capital.

EXHIBIT 7.5 The global standard firm (GSF) discount rate for U.S. Industrial and Service companies.

EXHIBIT 7.6 Market leverage differential for U.S. Industrial/Service firms.

EXHIBIT 7.7 Size differential for U.S. Industrial/Service firms.

EXHIBIT 7.8 The equivalence of valuation for different cost of capital perspectives is demonstrated.

EXHIBIT 7.9 The relationship between the various costs of capital. The asset or unlevered cost of capital is constant and equals the expected cost of debt when leverage approaches 100%. WACC is the after‐tax cost of capital and equals the after‐tax expected cost of debt when leverage approaches 100%.

EXHIBIT 7.10 Monthly time‐series of the weighted‐average real discount rate for U.S. Industrial and Service companies (1976 to present).

EXHIBIT 7.11 Market‐implied discount rates for Industrial and Service firms in key equity markets.

EXHIBIT 7.12 Behavior of U.S. discount rate and 12‐month changes in DR since 1976.

EXHIBIT 7.13 Distribution of one‐month changes in the U.S. discount rate since 1976.

EXHIBIT 7.14 A plot of the U.S. discount rate versus its value in the preceding month since 1976.

EXHIBIT 7.15 Probabilistic evolution of the April 21, 2014, U.S. discount rate of 4.3% as a function of months forward.

EXHIBIT 7.16 Time series of the market‐implied ERP for U.S. Industrial and Service companies.

Chapter 8

EXHIBIT 8.1 Sears’s ROE and prevailing cost of equity, 1912–1920.

EXHIBIT 8.2 A stylized view of the competitive life‐cycle.

EXHIBIT 8.3 An adaptation of the Boston Consulting Group product matrix to identify firms by their position in the competitive life‐cycle.

EXHIBIT 8.4 Asset efficiency.

EXHIBIT 8.5 Stock price performance.

EXHIBIT 8.6 CFROI drivers and competitive advantage. Image shows that best‐in‐class firms possess a rare mix of above‐average margins and asset efficiency. These firms enjoy both a consumer and production advantage.

EXHIBIT 8.7 Honeywell International and its different life‐cycle states.

EXHIBIT 8.8 Life‐cycle transition probabilities. The y‐axis is a firm’s starting position; the x‐axis is its ending position five years later

EXHIBIT 8.9 Life‐cycle transition annualized shareholder return. The y‐axis is the firm’s starting position, the x‐axis is its ending position five years later

EXHIBIT 8.10 General features of competitive life‐cycle states.

EXHIBIT 8.11 Percent of publicly traded firms by life‐cycle state.

Chapter 9

EXHIBIT 9.1 Size‐weighted CFROI for Global & USA Industrial / Service Firms, $250 million minimum market cap 1950–2015.

EXHIBIT 9.2 Median CFROI of High and Low CFROI portfolios over time.

EXHIBIT 9.3 Transition Probability % Global Industrial/Service Firms, 1985–2013

EXHIBIT 9.4 Time‐series of CFROI for global Food, Beverage, and Tobacco, $250 million minimum market capitalization, 1985–2015.

EXHIBIT 9.5 Time‐series of CFROI for global Energy, $250 million minimum market capitalization, 1985–2015.

EXHIBIT 9.6 CFROI transition matrix for Food, Beverage, and Tobacco

EXHIBIT 9.7 CFROI transition matrix for energy

EXHIBIT 9.8 Scatter plot of CFROI persistence for U.S. Industrial and Service Firms.

EXHIBIT 9.9 Stylized example of excess return half‐life.

EXHIBIT 9.10 Empirical fade in CFROI.

EXHIBIT 9.11 Median annual CFROI persistence by U.S. Industry Groups. Global Industrial/Service firms, $250 million minimum market capitalization, 1985–2015.

EXHIBIT 9.12 Annual CFROI correlation for Food, Beverage, & Tobacco versus Energy, $250 million minimum market capitalization, 1985–2015.

EXHIBIT 9.13 Annual CFROI persistence and the long‐term CFROI by Industry Group. Global industrial/service firms, $250 million minimum market capitalization, 1985–2015

EXHIBIT 9.14 Example of fading CFROI using industry inputs.

Chapter 10

EXHIBIT 10.1 Apple‘s Relative Wealth Chart from 2006 through 2015. Assuming investors accurately anticipated Apple’s CFROI would improve to 24% over the next five years (forecast date December 2007), then growth was clearly under estimated. Sustained hyper‐growth is highly unusual and hugely rewarding for positive spread businesses. Attributing the rise in share price over this period to unexpected growth, then growth multiplied Apple’s value by 2.5×.

EXHIBIT 10.2 Median real asset growth rate (RAGR). Global non‐financials, no size restriction.

EXHIBIT 10.3 Five‐Year Median Forward Real Growth Rate by Firm Age.

EXHIBIT 10.4 Inflation‐adjusted asset growth and sales growth transition matrices.

EXHIBIT 10.5 One‐year correlation in Real Asset Growth.

EXHIBIT 10.6 Global Industrial/Service firms, $250 million minimum market cap, 1980–2015.

EXHIBIT 10.7 Amazon’s sustainable growth rate.

EXHIBIT 10.8 The calculation of Amazon’s normalized growth rate.

EXHIBIT 10.9 2015 automobile manufacturer sales as a percentage of total. 2025 assumes 2% annual sales growth versus 50% for Tesla. 2048 shows the effect of 8% compound annual growth for Tesla in the terminal period: Tesla has grown to become 33% of global auto manufacturer sales.

Chapter 11

EXHIBIT 11.1 Macy’s Relative Wealth Chart.

EXHIBIT 11.2 Amazon’s Relative Wealth Chart as of April 30, 2014, indicates a prolonged period of value creation and growth. Shareholders have been handsomely rewarded.

EXHIBIT 11.3 Factoring probability into Amazon’s Relative Wealth Chart.

EXHIBIT 11.4 Tesla’s Relative Wealth Chart in HOLT Lens as of June 30, 2010.

EXHIBIT 11.5 Tesla’s Relative Wealth Chart in HOLT Lens as of June 30, 2010, adjusted for CFROI fading to 6% from 0% and growth fading from 75% to 25%.

EXHIBIT 11.6 Annualized excess shareholder return by CFROI relative achievement. Largest 1,000 stocks by market capitalization, U.S. equities. January 1976–March 2013.

EXHIBIT 11.7 Screening for stocks with high growth expectations.

EXHIBIT 11.8 Key phases of the competitive life‐cycle.

EXHIBIT 11.9 Tesla Flex Valuation and Relative Wealth Chart as of May 22, 2017.

EXHIBIT 11.10 Amazon‘s Flex Valuation and Relative Wealth Chart as of May 30, 2017.

EXHIBIT 11.11 Nestlé’s Flex Valuation and Relative Wealth Chart as of May 22, 2017.

EXHIBIT 11.12 DuPont’s Flex Valuation and Relative Wealth Chart as of May 22, 2017.

EXHIBIT 11.13 BP’s Flex Valuation and Relative Wealth Chart as of May 22, 2017.

EXHIBIT 11.14 McDonald‘s Flex Valuation and Relative Wealth Chart as of January 31, 2003.

EXHIBIT 11.15 McDonald‘s Flex Valuation and Relative Wealth Chart as of May 22, 2017.

EXHIBIT 11.16 PVGO = Market Enterprise Value less the present value of the existing business (wind‐down + replacement value).

Chapter 12

EXHIBIT 12.1 We believe that the purpose of a firm is to build and maintain a sustainable competitive advantage. These are the elements that will help it succeed.

Guide

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E1

“This is a must‐read for any serious student of equity market valuations. Holland and Matthews systematically debunk the widely held view that EPS and other flawed accounting metrics are what drive stock markets. Cash flow is king and this book provides a step‐by‐step guide to calculating a vastly superior measure of corporate performance, the Cash Flow Return on Investment metric.”

John Birkhold, Partner, Origin Asset Management

“This fascinating book is a must‐read for all serious investors and business leaders who want to understand how companies really create value for shareholders.”

Nigel Bolton, Chief Investment Officer Fundamental Active Equity, BlackRock

“HOLT CFROI is a useful framework through which we can compare a stock’s market valuation versus what the economic enterprise’s cash flow prospects are ultimately likely to support, and this book does a great job explaining it in a plain‐English fashion.”

Gunnar Miller, Global Director of Research, Allianz Global Investors

“The HOLT CFROI framework focuses on what really matters in company valuation. A must‐read for every serious fundamental investor!”

Michael Schmidt, Deka Investment, Managing Director Asset Servicing and Alternative Investments, Member of Board

“This is by far the best book I have read on corporate valuation. Every board member should read this book.”

Aled Smith, Director of Global Equities, M&G Investments

“This book makes a significant contribution to performance evaluation and valuation methodology. The authors explain the use of the HOLT framework and CFROI to measure corporate performance and value creation.”

Emeritus Professor Carlos Correia, University of Cape Town

“This book is indispensable to anyone wanting to use HOLT for valuation; for those not familiar with HOLT, however, the book may more appropriately be seen as a form of reference book, to warn the reader about potential problems in valuation and to suggest possible solutions.”

Professor Dr. Michel Habib, University of Zurich

“I would argue that every Director of any public company should spend about a week going through this material very carefully. If they cannot pass an examination on this text they are not fit to be custodians of shareholder capital.”

Emeritus Professor Brian Kantor, University of Cape Town; Chief Economist & Investment Strategist, Investec Wealth & Investment

“Beyond Earnings introduces the concepts of Cash Flow Return on Investment (CFROI) and Economic Profit. Holland and Matthews bring these abstract concepts to life, as they apply them to real world examples of publicly‐listed companies. They show that, as well as helping to judge the effectiveness of corporate management teams, CFROI and Economic Profit can be invaluable in helping to identify mispriced securities. I have no hesitation in recommending this book to anyone interested in investment or corporate finance.”

Tom Mann, Senior Portfolio Manager, Schroder Investment Management

“Using a time‐tested, total systems, CFROI approach to valuation, Holland and Matthews offer theoretical and implementation insights about valuation that are missing from mainstream finance. The HOLT valuation technology is now an integral part of the investment process at a large number of worldwide money management organizations.”

Bartley J. Madden, Author, Value Creation Thinking

“A must‐read for anyone with a mindset of improving their long term investing skills.”

Jacob Gemmel, Senior Portfolio Manager, Swedbank Robur Asset Management

“In our age of alternative truths in politics as well as finance, HOLT has proven to be one of very few truthful voices in analyzing corporate performance.”

Henrik Andersson, Fund Manager, Didner & Gerge

BEYOND EARNINGS

Applying the HOLT CFROI® and Economic Profit Framework

David A. Holland

Bryant A. Matthews

Copyright © 2018 by Credit Suisse Securities (USA) LLC. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per‐copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750‐8400, fax (978) 646‐8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748‐6011, fax (201) 748‐6008, or online at www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

CFROI is a trademark of CSFB HOLT LLC.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762‐2974, outside the United States at (317) 572‐3993, or fax (317) 572‐4002.

Wiley publishes in a variety of print and electronic formats and by print‐on‐demand. Some material included with standard print versions of this book may not be included in e‐books or in print‐on‐demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

Library of Congress Cataloging‐in‐Publication Data is Available:

ISBN 9781119440482 (Hardcover)

ISBN 9781119440505 (ePDF)

ISBN 9781119440529 (ePub)

Cover Design: Wiley

Cover Image: © De Space Studio/Shutterstock

This book is dedicated to the memory of Bob Hendricks who passed away on May 28, 2017. The global success of the HOLT CFROI framework never would have been realized without Bob’s vision, persistence, and uncanny marketing skills. Bob brought the CFROI framework to life for countless fund managers, corporate clients and HOLT employees. He distilled the art of stock selection to its essence in his famous 2‐minute drills. He reminded us that investing was fun but required many hours of attention.

Bob was an amazing presenter – one of the best we’ve seen. To be on the same presentation bill with him was daunting. We recall having to precede him at a seminar in Germany after he had retired. Bob was the keynote speaker. After a full day of lectures on the mechanics of financial performance analysis and equity valuation, when listeners were surely mentally exhausted, he held the audience of fund managers spellbound. Bob de‐mystified stock analysis, breezed through 2‐minute drills, and told tales from his forty years in the financial industry. At the end of his speech, the audience jumped out of their seats and enthusiastically applauded. The Director of Research at a distinguished fund manager told us that he leapt up wondering why Bob Hendricks hadn’t been awarded a Nobel prize only to realize after calm reflection that the presentation simply described the skilled application of a discounted cash flow model. Bob brought the subject of investing to life!

INTRODUCTION

THE PRICING PUZZLE: FOUNDATIONAL HOLT CONCEPT AND A KEY TO BETTER VALUATION

On May 13, 2017, the Financial Times reported that “investors wiped $4.6bn from the market value of the U.S. department store sector in the space of two days, as concern mounted about sliding sales and the effects of online competition.” U.S. department stores suffered an astonishing fall in market value of over 16% in two days.1 Who is responsible for this vaporization of shareholder value? All fingers were pointed at Amazon, the biggest online retailer, which accounts for 5% of retail spending in the United States, and is presently the world’s fifth most valuable company.2

In 1994, Amazon was just a fledgling start‐up. The Internet was beginning to take off as a vehicle for commerce, and growth rates were forecast to be into the hundreds of percent. Seeing an opportunity, Jeff Bezos launched Amazon as an online retail bookstore from his garage. Over the last decade, Amazon has grown its revenue to almost 13 times from where it started for a compound annual growth of 29%.3 To say it is disrupting traditional retailers and ways of doing business is an understatement.

Amazon’s share price has increased 63,990% since its IPO on May 15, 1997, versus 300% in total return for the S&P 500 over the same period.4 Amazon surpassed the mighty Wal‐Mart in 2015 as the most valuable retailer in America. Despite this stellar performance, Amazon regularly posts poor earnings numbers and a subpar return on equity (ROE) yet consistently trades at a price‐to‐book (P/B) ratio in the neighborhood of 20. Is there something missing in the accounting figures?

Jeff Bezos, CEO and founder of Amazon, gives us a clue in his 1997 Letter to Shareholders: “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.” Treating Amazon’s research and development (R&D) cost as a long‐term investment instead of an accounting expense provides a completely different perspective on the company’s economic profitability and value. The capitalization of R&D is explored in the Asset Life section of Chapter 3. Accounting data does not convey a clear picture of a firm’s economic performance, and is becoming less relevant as intangible assets become more important than physical assets in generating economic value.5 A framework that focuses on economic returns and ties them to intrinsic value is crucial for equity investors and corporate managers when pricing assets and strategies. We show how cash flow return on investment (CFROI) improves upon accounting measures of profitability in Chapter 3, using Amazon’s 2013 annual report. We explore discounted cash flow (DCF) and discounted economic profit (EP) valuation methods in Chapters 4 and 6. The tools and techniques are the same for fund and corporate managers, and we welcome both groups to apply this book’s lessons in valuing companies and assessing their profitability.

A thread that runs throughout the book from its opening is the importance of capital allocation and investing in positive net present value (NPV) strategies. We demonstrate the connection between project economics and corporate valuation. Company managers who focus on making positive NPV investments will increase the economic profit and intrinsic value of their firms. Beware when acquisitions and investments are made for “strategic” reasons. This excuse often means that financial reasons are lacking. Capital allocation, NPV, EP, and intrinsic value are intimately linked.

Successful equity investing requires an ability to gauge the expectations of others (what’s priced into the stock) and to skillfully weigh this expectation against the likelihood of success. Accurately predicting a company’s future profitability doesn’t necessarily lead to outperformance. Instead, large gains accrue to investors who identify stocks that will beat expectations. It doesn’t matter if the expectations are for failure or enormous success: If a company can better those expectations, shareholders will reward the company by pushing its share price higher.

The professional employer services firm Automatic Data Processing (ADP) makes this point clear. Since 1991, ADP has earned impressive operating margins that rank it in the top twentieth percentile of profitability in the world. ADP ranks as one of the 50 most profitable firms over the past 25 years.

Despite ADP’s impressive track record of performance, price expectations as of April 2004 showed investors were anticipating even greater success. And investors got it right! Over the next 10 years, ADP outpunched rivals and steadily earned increasing profits. What an impressive achievement: Investors anticipated this success and embedded it into the stock price as early as 2004. But here’s the key point: ADP’s shareholder returns over this ten‐year period were lackluster, and investors earned no more than benchmark performance despite ADP’s stunning record of profitability. How could this happen? It’s simple, really: If you bought ADP in April of 2004, you paid for stellar future operating performance. ADP met this expectation; it did not exceed it. Instead of reaping huge gains as profits rose, shareholders earned exactly what they paid for in the form of benchmark returns. Upon reflection, this should be viewed as an entirely reasonable outcome: If stocks are priced efficiently, then companies that meet expectations should return only their cost of equity.

Starbucks, the purveyor of fine coffee, had similarly high expectations in January 2009. Its cash flow return on investment (CFROI) was expected to rise from 8.5% to 9.3% over the ensuing five years. This seemingly small upward improvement was empirically a 20% probability event, meaning that 80% of firms with similar profitability throughout history were unable to lift CFROI above 9.3%. This placed the odds of success at 1‐in‐4 (0.2/0.8). But, instead of just meeting expectations, Starbucks brewed profits well above this level, pushing CFROI over the brim toward 12%. This success was unanticipated, and Starbucks share price leapt ahead of its benchmark, nearly quadrupling it by 2013. Finding stocks that can beat expectations is the key to earning large returns. We explore how to evaluate market expectations in Chapter 11.

The ultimate aim of equity analysts and portfolio managers is to select future winners and avoid tomorrow’s losers. This requires a considerable measure of predictive skill (or luck). Like a garden, forecasting skill can be cultivated to yield greater output. We provide empirical results for the behavior of corporate growth and profitability in Chapters 8, 9, and 10, and show how you can improve your forecasts of growth and profitability. Growth and profitability both exhibit reversion to the mean, which we describe and model as “fade.”

A key to superior stock picking is utilizing a framework that facilitates consistent and rigorous evaluation of an investment’s positive and negative merits. The HOLT framework is designed to help investors do a better job at grading stock ideas. At the heart of this objective is an effort to de‐bias the investor by exposing a stock’s embedded price expectations. HOLT’s framework is a proven and reliable system that has been rigorously field tested by investment professionals for over 40 years.

This book relies on the Pricing Puzzle as a useful aid for thinking critically about the intrinsic value of a firm (Exhibit I.1). The Pricing Puzzle contains all of the key elements that influence a stock’s price, including fundamental and behavioral drivers. Familiarity with this tool can help you quickly and effectively think through how changes in fundamental drivers are likely to influence the value of a company.

EXHIBIT I.1The Pricing Puzzle and chapter that corresponds to each driver.

HOLT’s valuation model is predicated on a life‐cycle perspective of corporate evolution. From start‐up to mature veteran or restructuring candidate, empirical evidence shows that companies share similar traits at each state of development and that these traits can be helpful in predicting future profitability and growth. Few firms can sustain high profitability for decades. Most companies become cost‐of‐capital operations within five to ten years.

HOLT’s valuation model embeds competitive fade (reversion to the mean) into forecasts of future profitability and growth. Beginning with a firm’s asset base, stated in current dollars, the principle drivers of corporate value are the firm’s economic rate of return (CFROI), asset growth rate, and its likely fade rate in profitability. These three drivers are used to estimate a firm’s free cash flows. Over time, profitability converges toward the cost of capital and growth converges toward a long‐term sustainable level.

The Pricing Puzzle can be elegantly stated as a simple but powerful formula that estimates a mature firm’s value. We call this the Fundamental Pricing Model:

where B is book value, ROC is the forward return on capital, g is the asset growth rate, and f is the rate at which profitability fades to the cost of capital r.6Exhibit I.2 shows the corresponding variables for different perspectives.7 Consistency is paramount!

EXHIBIT I.2Perspectives for application of the Fundamental Pricing Model.

Perspective:

Equity Holders

Capital Providers (Conventional)

Capital Providers (HOLT)

P:

Equity value

Enterprise value

Enterprise value

B:

Book equity value

Invested capital

Inflation‐adjusted gross investment (IAGI)

ROC:

ROE

ROIC

CFROI

g:

Growth in book equity

Growth in invested capital

Real growth in IAGI

r:

Cost of equity,

r

e

Weighted‐average cost of capital (WACC)

Real cost of capital, HOLT DR

f:

ROE fades to

r

e

ROIC fades to WACC

CFROI fades to HOLT DR

This equation introduces a vital component missing from traditional valuation models, such as the Gordon Growth Model: fade (f) is the rate at which profitability reverts toward the mean. The slower the fade, the longer the competitive advantage period (CAP) of a firm with attractive profitability and the greater its intrinsic value. Shifting B to the left‐hand side of the equation restates the formula as price‐to‐book, P/B, which can be calculated on the back of an envelope for stable, mature firms.

Note that when the return on capital equals the cost of capital, growth and fade create no value since no excess rents are earned and P/B equals 1. When CFROI is greater than the cost of capital, P/B is greater than 1. When fade is high, profitability changes quickly. Fade drives down or reduces the intrinsic value of a profitable firm, but drives up or enhances the value of an unprofitable one. The strong statistical relationship between HOLT P/B and CFROI supports the utility of this pricing equation.8 The Fundamental Pricing Model is worth remembering; every student and practitioner of finance should commit it to memory. We explore the use of this equation in Chapter 5 to quickly and effectively estimate a firm’s value, understand its competitive advantage period, and gauge expectations embedded in a stock’s price.

We praise the virtue of cash flow over earnings throughout the book, which begs the question: Is negative free cash flow a bad thing in the short to medium term if a company has a host of positive NPV strategies to invest in? The answer is a resounding “No!” Capital providers will excitedly queue to invest in positive NPV projects, each of which increases the company’s intrinsic value by the expected value of its NPV. For this reason, it is generally easier for company managers to think in terms of economic profit, where a capital charge is subtracted from operating profit. Firms investing in positive NPV projects will create positive economic profit regardless of whether the short to medium term free cash flow is negative. We cover this topic in detail in Chapter 6. The Prizing Puzzle can also be written in terms of economic profit (Exhibit I.3).

EXHIBIT I.3The Pricing Puzzle using Economic Profit and the chapter that corresponds to each driver.

OVERVIEW OF BOOK CHAPTERS

This book is divided into three sections and 11 chapters, with each focusing on a particular aspect of the Pricing Puzzle.

Section I: Financial Performance Assessment

In Chapter 1, we emphasize a core principle for corporate managers and investors: Always pursue positive NPV strategies. The NPV Rule states that any project that delivers returns in excess of its opportunity cost has merit. Managers should continually strive to create value by maximizing NPV. They can accomplish this by focusing their talents and efforts on building a sustainable competitive advantage for their firm. To be clear, short‐term pursuit of profits should not dominate long‐term value creation. Any tension that might arise between short‐term and long‐term objectives is resolvable when managers align their core responsibilities with the purpose of the firm. This logical and useful connection between the two is summarized by Bart Madden: “Maximizing shareholder value is best positioned not as the purpose of the firm, but as the result of achieving the firm’s purpose.”9 Peter Drucker said, “The purpose of business is to create and keep a customer.” He concluded that a firm retains customers, creates its competitive advantage and generates excess profits through innovation and marketing.

Chapter 2 reviews popular profitability metrics and discusses how these measures can be gamed by managers and how investors can sidestep some of these weaknesses. We show the relationship between P/E and a DCF valuation. We introduce the principles of value creation.

In Chapter 3, we describe how CFROI, HOLT’s measure of a firm’s economic return on investment, is determined from accounting information. We use Amazon as a case study and show how CFROI can be calculated from standard financial reporting statements and the notes from annual filings. We explain the adjustments and their economic reasons.

Section II: Discounted Cash Flow and Economic Profit Valuation

Chapter 4 shows how to value a firm. The present value of free cash flows, not earnings, is the ultimate measure of a firm’s intrinsic worth. Companies that earn returns on investment in excess of their opportunity cost will trade at a premium to book because they are generating economic value from their assets that exceeds the cost of their use. Companies that earn returns on investment below their opportunity cost waste investor capital and destroy shareholder value.

Chapter 5 explains the connection between a firm’s competitive advantage period (CAP) and its fade in profitability. We show how the fade rate can be easily incorporated into a DCF model. The impact of changes in CAP on intrinsic value can be assessed. The fade rate is a critical value driver when valuing successful companies whose return on capital exceeds their cost of capital.

Chapter 6 describes HOLT’s measure of economic profit. Economic profit is the earnings that a firm generates in excess of its opportunity cost. Firms that earn positive economic profits generate significant economic value for investors. Valuations from the free cash flow and economic profit methods are equal for a given forecast. We demonstrate the equivalence. The goal for a company is not to increase earnings but rather to increase economic profit. Management bonuses should be tied to increases in economic profit.

In Chapter 7, we focus on investors’ required rate of return. This chapter examines popular measures of the cost of capital. We demonstrate how HOLT’s market‐implied approach is related to these measures. This is a must‐read chapter for HOLT veterans and newcomers who desire a better understanding of risk.

Section III: Value Driver Forecasting

In Chapter 8, we examine the importance of the competitive life‐cycle as a framework for thinking about a firm’s likely future evolution. Instead of classifying firms as value or growth, we split them into four groups based on profitability and expected economic growth: Question Marks, Stars, Cash Cows, and Dogs. We share our research on the probabilities of transitioning from one group to another.

Chapter 9 introduces the concept of fade, or what academics call persistence. This is a ground‐breaking chapter that explores the notion of reversion to the mean in corporate profitability. We offer detailed evidence of mean‐reversion in corporate profitability and show how investors can distinguish between random profitability, sustained profitability, and reversion to the mean. This is an essential chapter for directors of research, portfolio managers, and analysts who wish to improve the plausibility of their forecasts.

In Chapter 10 we investigate the persistence of revenue, earnings, and asset growth. We find overwhelming evidence that growth rates are volatile and quickly revert to the mean. Earnings growth is like white noise and reveals little of predictive value. Forecasts of sustained earnings growth are typically worthless. Few firms maintain high growth rates for long periods.

Finally, in Chapter 11 we wrap it up by focusing on how investors can effectively gauge the expectations embedded in a firm’s stock price. HOLT provides several valuable tools to aid in this effort. This is an essential chapter for investors who seek to hone their skills at picking winning stocks using HOLT Lens.

WHO ARE WE AND WHAT DO WE HOPE TO ACHIEVE

We are valuation practitioners. We have worked with corporate and fund managers to value decisions, divisions, stocks, and strategies. Both sides can use the same metrics and valuation approaches to perform fundamental company analysis. Because we work closely with fund managers and equity analysts, we have focused much of our Credit Suisse HOLT research on refining fundamental valuations by improving forecasts of value drivers. Better probabilistic forecasts result in more accurate valuations.

Our purpose in writing this book is to improve:

Financial performance analysis for corporate and fund managers when assessing a company’s historical and forecast profitability

The pricing model and its assumptions when performing discounted cash flow and economic profit valuations

Value driver forecasting to improve fundamental valuation and stock picking

Return on equity (ROE) is a poor measure of a firm’s profitability since it focuses only on equity investors and not the quality of the firm’s operations. Earnings can be gamed by accounting shenanigans and are also dependent on a firm’s leverage. In short, ROE is not to be trusted. Return on invested capital (ROIC) is a better measure of profitability but liable to accounting distortions. Although it takes more effort to calculate cash flow return on investment (CFROI), it is a comprehensive measure of a company’s profitability. Because CFROI reverses accounting distortions and adjusts for inflation, it is comparable across borders and industries and over time. This is highly advantageous to corporate and fund managers when assessing profitability and the plausibility of forecast profitability. What’s the upside? A better measure of profitability results in improved capital allocation decisions and fundamental valuation.

Earnings and P/E ratios are too unreliable for valuation, so we take you beyond earnings in this book. Although we prefer CFROI as a measure of profitability, the valuation methods we derive are general and can also utilize ROE, ROIC, or other metrics. Asset light businesses might not require the rigor of the CFROI inflation adjustments but will probably necessitate the capitalization of intangible assets such as R&D. It is essential that consistency reigns when measuring financial performance and valuing companies. Amazon provides an excellent case study, and is used throughout the book. We prefer the economic profit approach when discussing valuations since the present value of future economic profits equals the total NPV of all present and future investments. The relationship is one‐to‐one and connects project economics to corporate valuation. A relentless focus on this connection will lead to improvements in capital allocation for corporate executives and their boards. We explore the nuances of using net assets (invested capital) versus inflation‐adjusted gross investment in the assessment of economic profit.

The final section of the book is targeted at fundamental stock pickers but should be of interest to corporate managers and strategists trying to assess the plausibility of a forecast or determine a company’s market‐implied expectations. Knowing what’s in the price of suppliers, competitors, customers, and entire industries is valuable information. Better forecasts of the value drivers, CFROI, asset growth, and fade, should result in more accurate valuations and improved performance for stock pickers. We share our latest thinking and empirical findings from many years of observations.

When deciding which metrics and valuation approach to use for a specific company or investment decision process, it is best to recall the words of Albert Einstein: “Everything should be as simple as it can be but not simpler.”

NOTES

1

Adam Samson, Mamta Badkar, and Nicole Bullock, “US Retail Sector’s Misery—In Charts,”

Financial Times

, May 13, 2017.

2

Reported in “Primed,”

The Economist

, March 25, 2017, pp. 24–26.

3

Even as late as 2014 when we began writing this book, we would have been skeptical of Amazon increasing its sales from $74bn in 2013 to $136bn in 2016. According to our study of sales growth in

Chapter 10

, Amazon only had a 13% probability of growing sales at this rate or higher over three years.

4

Nicole Bullock, and Mamta Badkar, “Amazon’s 20 Years as ‘Pre‐Eminent Disrupter of Retail,’”

Financial Times

, May 16, 2017.

5