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NYO-ZWB887-20050927-SN1
Valua t ion : Measur ing and
Manag ing t he Va lue of Compan ies
Tim Koller
October 11, 2005
This report is solely for the use of client personnel. No part of it may be circulated, quoted, or reproducedfor distribution outside the client organization without prior written approval from McKinsey & Company.This material was used by McKinsey & Company during an oral presentation; it is not a complete record ofthe discussion.
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TODAY S DISCUSSION
Understanding value creation
Balancing performance and health
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SIMILAR P/E
PE Ratio
21
19
* Excluding acquisition, divestiture and foreign exchange impactSource: Com ustat Zacks McKinse Cor orate Performance Center
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SIMILAR P/E, DIFFERENT GROWTH
Organic growth*2002-04
PercentPE Ratio
21
19
3
12
* Excluding acquisition, divestiture and foreign exchange impactSource: Com ustat Zacks McKinse Cor orate Performance Center
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SIMILAR P/E, DIFFERENT GROWTH
Return on investedcapital 2002-04
Percent
Organic growth*2002-04
PercentPE Ratio
21
19
60
20
3
12
* Excluding acquisition, divestiture and foreign exchange impactSource: Com ustat Zacks McKinse Cor orate Performance Center
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WHY ROIC MATT ERS
Year 1 Year 2
100 105Company Ag = 5%
ROIC = 10%
Company Bg = 5%
ROIC = 20%
(50)
50
100
(25)
75
(52)
53
105
(26)
79
Earnings
Investment
Cash flow
Earnings
Investment
Cash flow
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CORE DRIVERS OF VA LUE
Return oninvested capital
Revenuegrowth
Cash flow Value
Cost of capital
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VALUE OF GROWTH AND ROIC
Implied PE ratios
8 11 14
6 11 16
4 11 19
16
21
27
3%
6%
9%
7% 9% 13% 25%
Return on Invested Capital
Growth
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VALUE OF GROWTH
Increase in value due to 1% faster growthPercent
9 11 15 25ROICPercent
7
4
0
9
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IMPACT OF IMPROVING ROIC
Impact of 1% higher ROICPercent
25
15
7
9 12 20Current ROICPercent
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VALUE CREATION FROM GROWTH DEPENDSON TYPE OF GROWTH
Shareholder value created for incremental $1 ofrevenue
1.75-2.00New-product
Expanding an existing
marketGrowing share in agrowing market
Competing for share ina stable market
Acquisition
0.30-0.75
0.10-0.50
-0.25-0.40
-0.05-0.20
Source: McKinse anal sis
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U.S. EARNS HIGHER VALUATIONS DUETO HIGHER ROIC
Median Return on Equity2002-04
U.S.
13 12
9
Europe Asia
Median Market-to-Book Ratio2002-04
U.S.
2.62.3
1.0
Europe Asia
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PREDICTED P/E TRACK S ACTUAL P/E
0
5
10
15
20
25
1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003
Modeled P/EMedian P/E*
* Average of beginning and end of year S&P 500 median P/ESource: McKinse anal sis
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MEDIAN ROIC HAS BEEN STA BLE
0%
2%
4%
6%
8%
10%
12%
14%
1962 1966 1970 1974 1978 1982 1986 1990 1994 1998
Median ROIC
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-3%
-1%
1%
3%
5%
7%
9%
11%
1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995
CORPORAT E PROFITS CONSTANTPERCENTAGE OF GDP
Corp. profits/GDP
Average = 5.5%
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INFLA TI ON RAT E DRIVES A MEDIAN P/E
0
5
10
15
20
25
1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003
Median P/E*
Inflation
* Average of beginning and end of year S&P 500 median P/ESource: McKinse anal sis
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TODAY S DISCUSSION
Understanding value creation
Balancing performance and health
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80
55
40
39
28
21
20
12
8
Decrease discretionary spending
Delay new project even if value sacrificed
Book revenues now rather than next quarter
Incentivize customers to buy this quarter
Draw down on reserves
Postpone accounting charge
Sell asset to recognize gain thisquarterRepurchase common shares
Alter accounting assumptions* Footnote
Source: Source
CFOs DEFER INVESTMENT TO MEETEARNINGS TARGETS
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NOT A LL EARNI NGS ARE EQUA LConsumer goods companyPercent growth
2
1-2
1-2
8
3-4Volume
Pricing/mix
Cost reduction
Share repurchase
EPS growth target
Source: Academic paper
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MODEST GROWTH EXPECTAT IONS FOR MAJ ORCOMPANIES
B
C
E
A
Forward P/ERatio
Estimated Growth2005 2019CAGR
19
18
20
16
18
21
20
5.4
4.0
4.7
4.1
5.7
5.5
5.2
Company
D
F
G
Source:Company reports, Analyst reports, McKinsey Corporate Performance Center analysis
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ANALYST EPS FORECASTCONSISTENTLY OVER-OPTIMISTIC
1986
1992
1991
19901988 1989
1985
1997
1987
1995 1996
1994
1993
2002
20012000
19991998
2003
-
10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00
Jan-
85
Jan-
86
Jan-
87
Jan-
88
Jan-
89
Jan-
90
Jan-
91
Jan-
92
Jan-
93
Jan-
94
Jan-
95
Jan-
96
Jan-
97
Jan-
98
Jan-
99
Jan-
00
Jan-
01
Date of Forecast
E P S
( U S
c e n
t s )
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HI GH-TECH COMPANY NA IVE VAL UA TION$ per share DISGUISED
$120
$61$70
Naivemultiplesvaluation
Multiplesvaluationadjusted for
performanceand peers
Actualmarketvalue
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GROWTH DECAYS VERY QUICK LYMedian real growth of cohortsPercent
-505
1015202530
35
0 2 4 6 8 10 12 14
20
Years
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LONG TERM PERFORMA NCE EXPECTA TIONS
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LONG-TERM PERFORMA NCE EXPECTA TIONSDRIVE SHA RE PRICE
Abnormal return on 137 announcements of fiscalyear earnings for 2002 by U.S. companiesPercent
-4.1
2.3
1.0
3.6PositiveChange inexpected EPSfor 2004 change inlong-termexpectations
Negative
Lower Higher
Actual EPS 2002 relative to expectedEPS for 2002 short-term surprise
Source: Datastream; IBES; McKinsey analysis
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PERFORMANCE AN D HEAL TH
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PERFORMANCE AN D HEAL TH
HealthPerformance
Short-termmetrics
Medium-termmetrics
Long-termmetrics
IntrinsicValue
Growth
Cost ofcapital
SalesProduc-tivity
ROIC
Operatingcostproductivity
Capitalproductivity
Commercialhealth
Coststructurehealth
Assethealth
Organizational health
Strategic health
Core business Growthopportunities
NYO-ZWB887-20050927-SN1
MANAGING PERFORMANCE AND
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MANAGING PERFORMANCE ANDHEALTH
Strategic initiatives across multipletime horizons
Organizational processes focused onhealth
New dialogue with investors and theBoard
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MANY DIRECTORS DONT UNDERSTAND
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MANY DIRECTORS DONT UNDERSTANDCOMPANY S STRATEGY AN D INI TI AT IVES
1,016 respondents, percent
How would you describe your board'sunderstanding of 5-10 key initiativesneeded to achieve long-term objectives?
How would you describe your board'sunderstanding of the company's currentstrategy?
1
27
1162
GoodComplete
Limited
None
Good
Complete
Limited
None
4
51
4
42
NYO-ZWB887-20050927-SN1
DIRECTORS WANT TO K NOW MORE
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DIRECTORS WANT TO K NOW MORE1,016 respondents, percent
As a director, I would like to know more about:
70
55
40
31
28
14
Market health
Organizational health
Network health
Financial performance
Operational health
Do not need more information
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PERFORMANCE AN D HEAL TH
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PERFORMANCE AN D HEAL TH
HealthPerformance
Short-termmetrics
Medium-termmetrics
Long-termmetrics
IntrinsicValue
Growth
Cost ofcapital
SalesProduc-tivity
ROIC
Operatingcostproductivity
Capitalproductivity
Commercialhealth
Coststructurehealth
Assethealth
Organizational health
Strategic health
Core business Growthopportunities
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