BCGS VALUE MANAGEMENT FRAMEWORK AN OVERVIEW FOR MBA STUDENTS,By Rawley Thomas Director of Research,The Boston Consulting Group 200 South Wacker Drive Chicago, Illinois 60606 312-627-2618 Thomas.RawleyBCG.com,WHAT GETS MEASURED GETS DONE,Traditional Valuation Techniques Versus BCGs Valuation Framework,Traditional Valuation Techniques Forecast nominal cash flows by estimating P&L line items and changes to the balance sheet Estimate terminal value with a perpetuity of the forecasted last years net cash flow Determine cost of capital by weighting equity CAPM cost with debt cost Discount the cash flows and terminal value to present value with the weighted average cost of capitalObservations on Missing Elements No performance measure to determine if the business is achieving returns above or below the cost of capital or if the trend in those returns is up or down No fade in performance to determine likely cash flows in a competitive environment Discount rates determined by past price changes, not future likely cash flows No extensive empirical testing,BCGs Valuation Framework Translate accounting statements to gross cash flows and gross cash investments in constant dollars to produce cash on cash returns Translate cash on cash returns to economic performance measures (CFROIs) by adjusting for asset life and mix of depreciating versus non-depreciating assets Determine sustainable asset growth rates Fade CFROIs and asset growth rates toward corporate averages consistent with life cycle theory and empirical evidence to estimate future cash flows (replaces terminal valuation) Estimate market derived real discount rate by equating the present value of the cash flows for a large aggregate to the sum of the prices of debt and equity Apply the market derived discount rate to the cash flows derived from fading economic performance to determine market valuation; subtract debt to determine equity valuation Test model values against actual stock prices for thousands of firms for 10-40 years across many countries; refine, refine, refine,MANY ASSETS FOLLOW THE SAME USEFUL OUTPUT PATTERN AS A CAR .,Constant Dollar Level Annuity,Economic Life,Likely Actual Output,Output Decline with Straight Line Depreciation,ISSUES WITH TRADITIONAL RETURN MEASURES,(*) Economic depreciation = amount of annual sinking-fund payment earning COC required to replace assets ($357 = 0.1/1.114 - 1)(12,000 - 2,000),Investment profile of a new plant,Subsequent annual measurement,Yr 1 Yr 6 Yr 12 Income 843 843 843 Depreciation 714 714 714 Cash flow 1,557 1,557 1,557 Cash invested 12,000 12,000 12,000 Book capital 11,286 7,716 3,432ROCE (%) 7.5 10.9 24.6 ROGI (%) 13 13 13 CFROI (%) 10 10 10,ROCE = Income/book capital ROGI = Cash flow/cash invested CFROI = (Cash flow - economicdepreciation(*)/cashinvested,Yr 1 Yr 6 Yr 12 NOPAT(1) 843 843 843 Book capital(2) 11,286 7,716 3,432 Cost of capital(3) x10% x10% x10% Capital charge(4) 1,129 772 343 EVA(1-4) (286) 71 500Cash flow(6) 1,557 1,557 1,557 Cash invested(7) 12,000 12,000 12,000 Cost of capital(8) x10% x10% x10% Capital charge(9) 1,200 1,200 1,200 Economic dep.(*)(10) 357 357 357 CVA(6-9-10) 0 0 0,VALUE-ADDED MEASURES REFLECT RETURN, COST OF CAPITAL AND SIZE Return on New PlantMeasured Over Time,(*) Economic depreciation = amount of annual sinking fund payment earning COC required to replace assets ($357 = 0.1/(1.114 - 1)(12,000 - 2,000),Investment profile of a new plant,Tracking the Sample of 1970 Companies through time,Tracking the Sample of 1980 Companies through time,Tracking the Sample of 1987 Companies through time,Note the averages & dispersions have risen between 1970-1987, hypothesized to be related to supply-side policy changes,THE MARKET EXPECTS THE PERFORMANCE OF MERCK TO FADE . (REGRESS TOWARD MEAN PERFORMANCE),Fade = 0%,Fade = 10%,Illustrates Perpetuity Trap: Overvalues High Return Firms Dramatically,R2=0.13 N=750,R2=0.40 N=750,R2=0.25 N=750,R2=0.25 N=750,On the 24 groups of 25 firms, Stewart claims a 44% R2. This higher correlation relates to the elimination of 300 companies instead of 31 extreme outliers and the grouping of companies that serves to eliminate the intra-group variance.,N=861 R2=0.27,R2 = 0.21,R2 = 0.67,R2 = 0.10,APPROACH TO IMPLEMENTATION What Full Effort Might Look Like,Module 1,Analytical diagnostic: “value audit”,Module 2,Measure selection and tailoring,Module 3,Value Driver analysis of BUs,Module 4,Install in planning, budgeting & reporting,Module 5,Install in compensation,Module 6,Apply to portfolio management,Value analysis of company and business units Identify priorities and issues,Review options against applica-tions Tailor as required,Transfer approach to BUs Link to operating decisions,Re-examine processes and linkages Provide training and document-ation,Structure Measures Targeting,Resourceallocation Portfolio balancing External reporting,COMPARISON OF COST OF CAPITAL MEASUREMENT METHODS,CAPM,Market Derived,Assumes investor discount rate risk premiums did not change during the past measurement period. Therefore, future risk premiums equal past risk premiums.,