AN06 Exec Koller

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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



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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



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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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14

-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

NYO-ZWB887-20050927-SN1

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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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

NYO-ZWB887-20050927-SN1

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

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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


Network health

Financial performance

Operational health

Do not need more information

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HealthPerformance

Short-termmetrics

Medium-termmetrics

Long-termmetrics

IntrinsicValue

Growth

Cost ofcapital

SalesProduc-tivity

ROIC

Operatingcostproductivity

Capitalproductivity

Commercialhealth

Coststructurehealth

Assethealth


Strategic health

Core business Growthopportunities

Documents

AN06 Exec Koller