Connecting Strategy, Business Management & Shareholder Value

1. June 2015 Connecting Strategy, Business Management & Shareholder Value Tutor: David Yates www.financetalking.com info@financetalking.com +44 (0)1572 717000

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3. “Our long-term mission and objectives remain firmly in place — to continue to invest in building world-class franchises with sustainable strategic characteristics that create exceptional shareholder value” Stanley Black & Decker Inc 2014 Annual Report Question… • What does shareholder value actually mean and how do companies create it?

4. Funding Characteristics Assets Debt • Must be repaid • Interest (tax-deductible) • Covenants • Debt leverages returns to shareholders • Less expensive – lower risk, lower return • Approx5% interest after tax Equity • Permanent capital • Dividend yield + capital growth = TSR • Voting • More expensive – high risk, high return • Approx10% expected return

5. Shareholder Value – Investors’ Perspective TSR should be enough to compensate shareholders for the risk (opportunity cost) Total Shareholder ReturnTSR = 12% Dividend 2 (2%) Share Price 110 (+10%) Share Price 100 Beginning of the year End of the year “Shareholder value is an outcome - not a strategy”, Jack Welch 2009

6. Shareholders’ Perspective on Profit Dividends give shareholders a cash return Dividends Profit (Net Income) Dividends Dividends Share Price Appreciation Profit (Net Income) Dividends Retained for reinvestment TSR Share Price appreciation Retained earnings are reinvested to generate growth

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8. Which Company is Doing Best? A B Profit 10m Profit 10m

9. Which Company is Doing Best? A B Assets100m Assets200m Debt50m Debt100m Equity50m Equity100m Profit 10m Profit 10m

10. Is the Business Worth the Effort? A B Assets100m Assets200m Debt50m Debt100m Equity50m Equity100m Return on capital is 5% If cost of capital is 7.5% Not worth the effort! Return on capital is 10% If cost of capital is 7.5% A worthwhile business! Profit 10m Profit 10m

11. Shareholder Value – Company Perspective Assets100m Debt50m Equity50m Return on capital 15% Return on capital 10% Creating 2.5m of value Cost of capital 7.5% Economic Profit Profit 10m 2.5m Cost of capital 7.5m

12. Cost of Capital Assets100m Debt50m Cost of capital: A core concept in business decision-making– all investments must return more than cost of capital to be economically viable i.e. ROCE must beat WACC Equity50m Return on capital 15% Return on capital 10% Creating 2.5m of value Cost of capital 7.5% Economic Profit Profit 10m 2.5m Cost of capital 7.5m

13. Cost of Capital - Calculations Assets (Value of the Enterprise) Debt • Cost of Debt • 4-5% risk free rate • Plus extra required by lender for company risk (1-2%?) • Less tax relief • Approx 4-6% • Cost of Equity • 4-5% risk free rate • Plus extra required for equity risk (3-9%) • Equity risk premium is higher for some than for others (multiply by β) • Approx 7-14% Equity (Market Value)

14. Weighted Average Cost of Capital? Assets Assets Assets Debt @ 5% Debt @ 5% Debt @ 5% Equity @ 10% Equity @ 10% Equity @ 10% Note: Assets, Debt and Equity are all at market values

15. Weighted Average Cost of Capital Assets Assets Assets Debt @ 5% Debt @ 5% Debt @ 5% Equity @ 10% Equity @ 10% Equity @ 10% WACC is (25% x 5) + (75% x 10) = 8.75% WACC is (50% x 5) + (50% x 10) = 7.5% WACC is (75% x 5) + (25% x 10) = 6.25% Note: Assets, Debt and Equity are all at market values

16. Which is the Riskiest for Investors? Assets Assets Assets Debt @ 5% Debt @ 5% Debt @ 5% Equity @ 10% WACC is (25% x 5) + (75% x 10) = 8.75% WACC is (50% x 5) + (50% x 10) = 7.5% WACC is (75% x 5) + (25% x 10) = 6.25% Equity @ 10% Equity @ 10% Note: Assets, Debt and Equity are all at market values

17. Which is Most Efficient for Investors? Assets Assets Assets Debt @ 5% Debt @ 5% Debt @ 5% Equity @ 10% WACC is (25% x 5) + (75% x 10) = 8.75% WACC is (50% x 5) + (50% x 10) = 7.5% WACC is (75% x 5) + (25% x 10) = 6.25% Equity @ 10% Equity @ 10% Note: Assets, Debt and Equity are all at market values

18. Efficient Balance Sheets Stronger, less risky Weaker, more risky Assets Assets Assets Debt @ 5% Debt @ 5% Debt @ 5% Equity @ 10% WACC is (25% x 5) + (75% x 10) = 8.75% WACC is (50% x 5) + (50% x 10) = 7.5% WACC is (75% x 5) + (25% x 10) = 6.25% Equity @ 10% Equity @ 10% Less efficient More efficient Note: Assets, Debt and Equity are all at market values

19. How could a company lower its cost of capital? Question… Share buy-backs Higher leverage Excellent communication around risk Reduce stock price volatility

20. The Optimum Capital Structure? cost of equity Cost of capital WACC 10% - cost of debt 5% - Optimum capital structure? Amount of capital

21. Changing the Capital Structure Stronger, less risky Weaker, more risky Assets Debt @ 5% Debt @ 5% Assets • Invest using debt • Pay more dividends • Buy back shares Equity @ 10% • Issue shares for new investment • Issue shares to reduce debt • Make profits and retain them Equity @ 10% Less efficient More efficient

22. Value Creation – Telling the Story Assets100m Debt50m Allocate capital efficiently Equity50m Manage capital Manage capital Reduce cost of capital Grow profits Economic Profit Profit 10m 2.5m Cost of capital 7.5m

23. Driving Growth at the Required Return Growth + Return on capital > cost of capital Profit Capital Revenue Margins Capital allocation Capital management Costs Volume Price Capex Dividends Share buy-backs Working capital Leverage(gearing)

24. The Link with TSR TOTAL SHAREHOLDER RETURN= Share price growth + dividends Growth + Return on capital > cost of capital OUTCOME Profit Capital Revenue Margins Capital allocation Capital management STRATEGY Costs Volume Price Capex Dividends Share buy-backs Working capital Leverage(gearing)

25. The Whole Story… = + Growth Return on capital > cost of capital More valuable + Deliver on expectations • Key drivers: • Quality • Growth • Risk Investor Relations = Higher share price?

26. Which of the following describes the creation of shareholder value? Question… Market capitalization exceeds book value Dividends are higher than the peer group Return on capital is higher than cost of capital TSR exceeds the interest rate on bonds

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28. Valuation Methodologies Summary Relative Valuation Absolute Valuation Discounted Cash Flow Valuation (DCF) • Today’s value of all the future cash the business is expected to generate • Very sensitive to assumptions • Need to use multiples as a sense-check • Key drivers are quality, growth and risk • Using ratios to compare similar companies • Very simple • Problematic for companies that don’t fit neatly into their sector and for loss-making companies • Key drivers are quality, growth and risk • Influences • Sentiment • Fundamentals • Liquidity • Influences • Sentiment • Fundamentals • Liquidity

29. Valuing a Company Using Multiples • Forecast thevalue driver • Identify the sector & sector forward multiple • Apply multiple Choose a suitable peer group Discount or premium according to quality, growth and risk Choose appropriate value driver (e.g. net income, net asset value) Know how you stack up against your peers

30. Valuing Walmart • Forecast thevalue driver • Identify the sector & sector forward multiple • Apply multiple Walmart’s forecast EBITDA is $38.7bn Company is typical of its sector Sector EV/EBITDAis 7.6x Company is worth 7.6 x $38.7bn = $294.1bn (EV)

31. What Might Change the Multiple? Better/worse GROWTH prospects than peers Forecast the value driver Identify the sector and sector multiple Apply multiple • Higher/lower forecast (i.e. earnings upgrade/downgrade) • More/less certainty on forecast (i.e. QUALITY & RISK)

32. Using IR to Influence Multiples Clear explanation of what drives value (linking to KPIs and management compensation) Forecast the value driver Identify the sector and sector multiple Apply multiple Articulate how your company’s growth rate and/or returns differ from peers

33. Valuing a Company Using DCF • Forecast cash flows for next few years • Forecast long term growth rate • Discount all cash flows and add up Ideally forecast 5-10 years Assume close to rate of growth in economy Divide by number of shares to find price

34. Discounted Cash Flow Valuation Continuing period cash flows Forecast period cash flows Yr5 + growth….. Yr1 Yr2 Yr3 Yr4 Yr5 x x x Discount rate x x xx xx = Present value

35. Approximately what % of a valuation (using a 5-year forecast period) would you expect the terminal value to comprise? Question… Less than 30% 30-50% 50-70% Over 70%

36. Walmart DCF Model (WACC 7.9%, LTGR 2%) continuing period cash flows forecast period cash flows $m Now 19,763 19,037 17,012 17,662 18,337 20,158… 20,1580.079 – 0.02 = 341,661 17,012 1.079 15,767 17,6621.0792 15,171 18,3371.0793 14,597 19,0371.0794 19,763 1.0795 14,044 13,512 341,661 1.0795 233,608 Enterprise Value (present value) 306,699 Deduct debt of $41,246m = equity value of $265,453m = $82.44 per share

37. Influencing Discounted Cash Flow Valuation Continuing period cash flows Forecast period cash flows Yr5 + growth….. Yr1 Yr2 Yr3 Yr4 Yr5 • Predictability demonstrates QUALITY of earnings (guidance and targets) • Profits convert to cash • Returns > cost of capital x x • A convincing GROWTH story x Discount rate Discount rate x • Effective communication of RISK is key • Lower volatility will reduce cost of capital x xx xx = Present value

38. The Role of Guidance Strategic Plan Capex plan Budget 1 year financial plan Actual Results Forecast • Aim to bring market closer to management’s view of the business • Use a range rather than a precise number • Set out economic assumptions • Give sensitivity to exchange rates, commodity prices, interest rates etc • Consider using medium-term KPI targets Guidance(IR) Sell-side analysts

39. Walmart Sensitivity Analysis Lower WACC and higher growth substantially increases value Higher WACC and lower growth substantially reduces value Understand the assumptions that are built into your stock price

40. Checking Assumptions in Stock Price Email miranda@financetalking.com if you would like a copy of our simple model

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42. The Link to Financial Planning & Reporting Strategic Plan Capex plan Budget 1 year financial plan Actual Results Earnings Releases Forecast Guidance(IR) The Street

43. Investment Appraisal Strategic Plan Investment appraisal process must ensure growth without compromising returns Capex plan Budget 1 year financial plan Actual Results Forecast Earnings Releases Guidance(IR) • Communicate your capital allocation process • Justify investment (including acquisitions and R&D) on the basis of returns The Street

44. Budgeting & Forecasting Strategic Plan Capex plan Budget 1 year financial plan Actual Results Forecast Earnings Releases • Accurate budgeting/forecasting process is absolutely crucial to successful expectations management • Consider pre-warning on earnings misses • Missing guidance destroys trust and is VERY negative for the stock price Guidance(IR) The Street

45. Investors value cash flows. Which of the following actions would increase a company’s cash flows? Question… Reducing working capital Increasing capex Making more profit Reducing depreciation

46. How do Cash Flows Fit In? Growth + Return on capital > cost of capital • Communicate around cash conversion • Capex and working capital are important elements in calculating operating free cash flow Income Statement Balance Sheet Profit Capital Revenue Margins Capital allocation Capital management Costs Volume Price Capex Dividends Share buy-backs Working capital Leverage(gearing)

47. Telling the Story ROCE/ROIC/ROE target? Efficient capital structure Growth + Return on capital > cost of capital Profit Capital Capital allocation policy Margin development Growth targetsNew products/markets Revenue Margins Capital allocation Capital management Dividend/buy-back policy Dividend/buy-back policy Capex & acquisition returns must meet or beat WACC Leverage cost base Operational leverage Capex & acquisition returns must meet or beat WACC Costs Volume Price Capex Dividends Share buy-backs Working capital Leverage(gearing) Efficient cost management Appropriate leverage now and in future? Efficient working capital management

48. Explain How You Create Value Walmart 2015 10-K

49. Show How Your Performance Metrics Stack Up “Over the past several years, we have maintained a consistent strategic framework comprised of three key initiatives – Customer Service; Product Authority; and Disciplined Capital Allocation, Productivity and Efficiency” The Home Depot 2014 10-K

50. Explain Your Capital Policy & Allocation