Session 10: Value Enhancement

Ingredients of Business Value

In this section, the speaker discusses the four ingredients that drive the value of a business: cash flows from existing assets, expected growth in those cash flows, risk captured in a discount rate, and the point in time in the future when closure is applied to those cash flows.

Four Ingredients of Business Value

• The four ingredients that drive the value of a business are:

• Cash flows from existing assets

• Expected growth in those cash flows

• Risk captured in a discount rate

• The point in time in the future when closure is applied to those cash flows

Enhancing Business Value

In this section, the speaker talks about how to enhance the value of a business by focusing on one of the four pathways: increasing cash flows from existing assets, pushing up growth rates for future cash flows, reducing risk and discount rates applied to those cash flows or delaying closure.

Value Enhancement vs Price Enhancement

• Everything you do to enhance business value has to flow through one of these four pathways.

• When companies talk about enhancing value they often mean price enhancement which is different than value enhancement.

• To illustrate this difference two graphs are shown:

• Companies that added ".com" to their names saw their prices jump significantly during dot com boom even though intrinsic values did not change.

• Companies that removed ".com" from their names after dot com bust saw market react positively.

• If you focus on enhancing prices you will be dancing to tune called by market which may not be best for your company.

Four Ways to Increase Business Value

• There are four ways to increase business value:

• Increase cash flows from existing assets

• Push up growth rates for future cash flows

• Reduce risk and discount rates applied to those cash flows

• Delay closure

Ways to Increase Company Value

In this section, the speaker discusses four ways to increase company value.

Increasing Cash Flows from Existing Assets

• To increase cash flows from existing assets, companies can run their assets more efficiently and cut costs that are not creating any value.

• Companies can minimize taxes paid on operating income to increase cash flows and value.

• Reinvesting less to maintain existing assets can also increase value.

Changing Growth Rate

• Companies can reinvest more or reinvest better to grow faster.

• Finding more projects internally or doing a big acquisition are two ways to reinvest more.

• Improving operating margin and capital efficiency are two ways to improve return on capital in existing investments.

Most Effective Growth Strategies

• The most effective growth strategy is coming up with new products that break through into new markets.

• Expanding into new markets geographically or within the same geography is the second-best strategy.

• Fighting for market share in a growing market is not a bad strategy, but fighting for market share in a stable market may not be value-enhancing.

• Growing through acquisitions has historically been the worst growth strategy.

Growth Strategies for a Company

In this section, the speaker discusses growth strategies for a company and how to increase its value.

Increasing Value

• Look for growth strategies that deliver both growth and value.

• Push for a longer growth period by coming up with new competitive advantages or sustaining existing ones.

Potential Competitive Advantages

• Brand name is a great competitive advantage. Take care of it if you have one.

• Legal barriers to entry can protect from competition, but be careful about giving up pricing power.

• Switching costs can create significant competitive advantages. Make the cost of switching into your product low and out as high as possible.

• Cost advantage over competition can be used to charge lower prices or deliver higher margins.

Reducing Cost to Capital

• Change the mix of debt and equity to reduce cost to capital, but be aware of consequences.

• Make your product less discretionary to customers or bring down fixed costs through outsourcing or flexible wage contracts with employees.

• Get rid of mismatches between debt and assets to reduce default risk and lower cost to capital.

Example Valuation of SAP

• The speaker values SAP with its existing management in place, which has two blind spots - aversion towards borrowing money and reluctance towards investing in emerging markets.

• New CEO could try increasing debt ratio, but must estimate cost to capital at different debt ratios.

Optimal Mix of Debt and Equity for SAP

In this section, the speaker discusses the optimal mix of debt and equity for SAP.

The Impact of Debt Ratio on Cost to Capital

• The cost to capital keeps dropping as the debt ratio goes from 0% to 10% to 20% all the way up to 30%.

• Beyond 30%, the cost to capital starts to increase.

• The optimal mix of debt and equity for SAP is 30%.

Changes Made at SAP

• Two changes were made at SAP:

• Increase in debt ratio

• Assumption of a higher reinvestment rate that they could reinvest more in emerging markets

• These changes resulted in a value per share of €126.

Enhancing Value

• To enhance value, start with the basics.

• The basics are:

• Change value by increasing cash flows

• Find a way to get more value from growth to reduce your cost to capital or push out that stable growth period.

Changing Company Value

In this section, the speaker talks about how changing company value can be challenging and how those changes ultimately show up in your value and price.

Challenges Faced When Changing Company Value

• With real businesses, changing company value can be challenging.

• It's often difficult to make those changes on the ground.

How Changes Show Up in Your Value and Price

• Making changes on the ground will ultimately show up in your value and price.