CREDIT SUISSE FIRST BOSTON CORPORATION

Equity ResearchAmericas
Industry: PC Hardware and Peripherals December 29, 1997 PC3495 Charles R. Wolf Bob Hiler 212/325-3077 charles.wolf@csfb.com 212/325-4341 bob.hiler@csfb.com

Wolf Bytes 20
Earnings Are an Opinion. Cash Is A Fact.

The P/E-to-growth investment rule says an investor should buy a companys shares if its earnings growth rate exceeds its P/E ratio. However, empirical evidence dramatically refutes the notion that earnings growth determines valuation. The downfall of P/E-to-growth lies in its exclusion of return on capital from the valuation equation. The classic discounted cash flow modelwhich captures both growth and returnsrepresents a far more compelling paradigm.

Wolf Bytes 20
They say you cant value these companies like regular stocks, because they have no earnings, argues one trader, But what happens when one of these companies earn a few cents? Then all of a sudden they have P/Es of 600, and theyre incredibly overvalued, right? Its tough to value a company. Its even more difficult when the company has no earnings. So, its not surprising that investors rely on simple rules of thumb. One of the currently popular rules is that a companys shares are attractive if its earnings growth rate exceeds its price/earnings ratio. Many analysts find this appealing because it connects valuation and growth in a simple, intuitive manner. Unfortunately, as we demonstrate in Wolf Bytes 20, the P/E-to-growth decision rule is seriously flawed. Its flawed conceptually because it ignores the return a company earns on its invested capitala crucial component of the valuation exercise. Its also flawed empirically, with virtually zero power to explain companies actual price/earnings ratios. We show that the only conceptually accurate valuation tool is the classic discounted cash flow model, the foundation of Miller and Modiglianis Nobel Prizewinning research in financial economics. This model says that a companys value equals the discounted value of the cash that can be taken out of a business during its remaining life. Just as a bondholder discounts fixed cash flows to value a bond, a value-based investor discounts his best estimates of expected future cash flows to value a stock.


Introduction

We show in Wolf Bytes 20 that the discounted cash flow model not only captures both growth and returns in a consistent manner, but also possesses exceptional powers in explaining companies actual share price performance.
Simple but Wrong: The P/E-to-Growth Investment Selection Criterion

The P/E-to-growth investment criterion represents a seductive approach to stock selection. It rests on a conceptual foundation that appears eminently sensible: The value of any asset is the present value of future returns. Shareholders receive returns in the form of future earnings. It follows that the amount an investor is willing to pay for a dollar of earnings in the immediate future should be directly related to the rate at which he expects the earnings stream to grow.
!

This speciously correct valuation logic links a companys growth rate to its price/ earnings ratio. Numerous First Call reports, for example, document that sell-side analysts regularly use higher earnings growth rates to justify higher P/Es and target prices. Its something of a mystery, however, how the logic evolved into a simple one-to-one link between a companys earnings growth rate and its P/E, with an anticipated growth rate greater than the P/E automatically translating to a Buy. If the market agreed with this investment decision rule, we would expect companies price/earnings ratios to be related directly to their growth rates. Nothing could be further from the empirical truth. In a regression analysis, the P/E ratios of

Fortune, Hey, Whats Your Search Engine? October 27, 1997, p. 306. Berkshire Hathaway Owners Manual (http://www.berkshirehathaway.com/owners.html) Frank K. Reilly, Investment Analysis and Portfolio Management. 4th Edition, Dryden Press, 1994, p. 392.

Wolf Bytes 20
32 technology generated a nominal 6% correlation with their actual five-year earnings growth rates.
"

Chart 1 Earning Growth Rates Do Not Determine P/E Multiples

45

40

35 R = 6%

le pi tl u M s g in nr a /Ee icr P

30

25

20

15

10

0 - 10% 0% 10 % 20 % 30 % 40 % 50 % 60 % 70 % 80 %

5 - y e a r E a r n in g s G r o w t h R a t e

Source: First Call, CSFBC analysis

The weak statistical results highlight a crucial flaw in the P/E-to-growth valuation modelthe use of earnings to measure returns. As any small business person knows, its cash that counts, not earnings. And there are many reasons that cause earnings and cash flows to diverge. To cite one, amortization of goodwill lowers earnings but has absolutely no effect on cash flows. These accounting vagaries distort economic realities, making earnings growth an imperfect proxy for cash generation. Even if, by chance, earnings correlate perfectly with cash, the P/E-to-growth model is still hopelessly flawed. Thats because it ignores the amount of earnings that must be reinvested in a business to generate future earnings. To take an extreme example, if it takes $1,000 to generate a perpetuity of $1 of earnings, the value of

We used actual earnings datainstead of analysts consensus estimates of forward five-year earningsto calculate five-year forward earning growth rates of each company. We also used actual earnings datainstead of analysts consensus estimates of forward 12-month earningsto calculate 12-month forward P/Es. Since our regression gives investors the benefits of foreknowledge of a companys future earnings potential, we would expect to observe a high correlation between P/E and growth in this regression. We did not observe this. Of course, it could be countered that the investment rule is premised on anticipated growth rates and our regression analysis uses actual growth as the independent variable. However, the observation that there is virtually no correlation between price/earnings multiples and actual growth rates is proof of the weakness of the decision rule. Blind reliance on this rule undoubtedly has translated to subpar investment performance. See Appendix A for further explanation of the methodology used for this regression, as well as a list of technology companies that were included in this regression.
"

Wolf Bytes 20
a company will be lowered unequivocally. But the P/E-to-growth model would ignore this, looking only at the $1 increase in earnings.
#

Finally, we often do not have the appropriate data to value a company using the earnings growth/multiple framework. In fact, in our sample of 271 actual company years, less than half have both positive earnings as well as reasonable (defined as less than 100%) one-year earnings growth rates.
$

Table 1 We Often Lack the Data Needed to Do a Traditional P/E Analysis

Earnings Positive? Earnings Growth Positive?

Earnings and Growth Positive?

Earnings Positive and Earnings Growth Positive and Earnings Growth less than 100%?

93.7%

61.3%

60.5%

49.1%

Source: First Call, CSFBC analysis

So, the P/E-to-growth model is not the silver bullet that proponents have claimed. Investors who focus on higher earnings at any cost are making a mistake. The silver bullet lies elsewhere, as we demonstrate below.
Cash-In, Cash-Out: Cash Is the Heart of Value-Based Analysis

If shareholders demand cash, a framework is required that has cash at its core. To value a company, we must assess the timing and magnitude of cash inflows and outflows. Only then can we determine how much cash an investor should spend to buy a piece of that company. We must first determine [1] how much cash a business needs to invest in the business , and [2] how much cash the business generates each year. From these two numbers, we can calculate the cash-on-cash return or return on capital. If this return is higher than the firms opportunity cost of capitalthe blended average of its cost of debt and equitythe business is creating positive economic profits.
% &

The next step in the analysis is to project the companys cash flows going forward to quantify the amount of cash the business will generate or consume. We then

To be precise, we must compare the present value of cash outflowsan investment of $1,000 in this example with the present value of cash inflowsand in this example, if we assume this companys cost of capital is 10%, this perpetual cash stream of $1 is worth $10. If the value of the cash inflow is greater than the value of the cash outflow, the companys valuation will improve. However, in this case, the company pays out $1,000 and gets an earnings stream worth $10. Thus, the company is now worth $990 less, and its valuation will fall. This example also demonstrates that a companys cost of capitalwhich reflects its business and financial risk can affect the present value of future earnings. Since these future earnings from risky ventures will be discounted to present value using a higher cost of capital, they will be less valuable than future earnings from a less risky alternative. Thus, another major shortcoming of using earnings growth is that this does not take into account the important effects of risk.

We have seen some imaginative methods to circumvent this problem. For example, when an analyst predicts that next years earnings will be negative, he or she will not be able to value the company using a multiple on next years earnings. However, the analyst can project earnings out until they become positive, apply a multiple to that number, and then discount this dollar amount to present value using the companys cost of equity. We typically see this valuation technique used on emerging high-tech and biotech stocks. In the jargon of value investors, we call this cash amount invested capital. In laymans terms, we call this cash invested and define it as net cash invested in the business that the owners have put at risk and upon which they expect to earn a return. For details, see the EVA Primer, by Al Jackson, Michael Mauboussin, and Charles Wolf. In the jargon of value investors, we call this cash amount net operating profit after taxes or NOPAT. In laymans terms, we call this cash earnings and define it as the cash pool available to either pay the owners of the company who have provided capital to the firm or reinvest in the business.

&

Wolf Bytes 20
discount these future cash flows at the companys cost of capital to arrive at a fair market or intrinsic value of the company.
' 

To illustrate this approach, we performed a cash-based valuation for an array of hypothetical companies with different cash growth rates and returns on capital. In our calculations, we assumed the following.


The company will grow its cash earnings at a constant rate for five years,

whereupon growth stops and the company reaps the fifth-year cash inflow for infinity.


The company has to invest a certain amount of cash during this period of initial growth. After that, the company does not have to invest further since it has stopped growing.
!

The company will earn a constant cash-on-cash return based on its industry and competitive position. Chart 2 portrays our results for companies with selected growth rates and returns on capital. What they unambiguously demonstrates is that a companys cash-oncash returns drive valuation. Earnings growth only improves valuations when a company earns a return higher than its cost of capital. When a company returns just its cost of capital, earnings growth has no effect on valuation. And when a company returns less than its cost of capital, earnings growth actually lowers its valuation. Earnings growth is relevant only through its effect on the all-important direction of valuation. The difference between a companys return and its cost of capital determines whether its valuation increases or falls as a function of its earnings growth.

'

In the jargon of value investors, we call the cost of capital the weighted average cost of capital or WACC. In laymans terms, its the blended average of the interest rate on debtan explicit cost of financingand the minimum percentage that shareholders expect to earn on their equity investmentan implicit cost of financing. Value investors use the companys cost of capital to discount free cash flows to calculate a firms intrinsic value. Free cash flow (FCF) is cash available for distribution to investors. It is the difference between cash earningstechnically termed NOPATminus the cash the company plows back into the businesstechnically called net investment. Details of this calculationfor a company with a 25% return on capital and a 10% cash earnings growth rate are in Appendix B. Value investors call the number of years that this company can invest and grow its businessfive years in this examplea companys competitive advantage period or CAP. For more detail on CAP, see Competitive Advantage Period CAPthe Neglected Value Driver by Michael Mauboussin and Paul Johnson, or the EVA Primer by Al Jackson, Michael Mauboussin, and Charles Wolf. To be precise, the company can invest more cash in its core business but after this forecast period, we assume that these additional investments simply return the cost of capital, so they will be value-neutral and not affect the stock price. Also, after this forecast period, the company will have to invest a certain amount annually to maintain the productive asset base even after the five years of growth. However, it will have to invest only the amount needed to cover that years depreciation of assets, so it will maintain a constant level of cash invested in the business.





!

Wolf Bytes 20

Chart 2 Cash-on-Cash Returns Determine Whether Valuation Improves as Cash Earnings Grow

15. 0

14. 0

13. 0

12. 0

el iplt u M E/ P

11. 0

AAAAAAAAAAA AAAAAAAAAAA AAAA AAAAAAAA AAAAAAA AAA AAAAAAAAAAAA AAAAAAAAAAA AAAAAAAAAAAA AAAA AAAA AAAA AAAAAAAAAAAA AAAAAAAAAAA AAAAAAAAAAAA AAAAAAAAAAA AAAA AAAAAAAA AAAAAAA AAA AAAAAAAAAAA AAAAAAAAAAA AAAA AAAAAAAA AAAAAAA AAA AAAAAAAAAAA AAAAAAAAAAA AAAAAAAA AAAAAAA AAA AAAAAAAAAAA AAAA AAAAAAAAAAA AAAAAAAAAAA AAAA AAAAAAAA AAAAAAA AAA AAAAAAAAAAA

R e t ur n o n C a pi t al

10. 0 8% 10% 8. 0 15%

9. 0

7. 0

AAAA AAAAAAAA AAAAAA AA25%

C o s t of 5% 10% 15% 20% C a pi t al = 10%

6. 0

C a sh Ea r n i n g s G r o w t h R a t e

Source: CSFBC analysis.

To test this model, we examined data from our 45-technology-company universe over the past eight years using CSFBCs value-based database. In particular, we quantified: How much the market valued each dollar of cash invested in the companys business.
"

How much cash the company returned to investorsbeyond the minimum cash that investors demanded for risking their cashper dollar of invested capital.

"

We calculate this by dividing core enterprise valuethe present value of cash flows generated by operating assets of the companiesby invested capitalnet cash invested in operating assets. For details on why we use core enterprise value instead of total enterprise value or net enterprise value, see Appendix C.

Wolf Bytes 20

Chart 3 The Market Values a Companys Ability to Produce Cash

60

50

iot a lRa it pa C de ts ev In ot e lua V es ir rpe t n E

-5 0 % -

40

R 30

= 66 %

y = 27.3
20

Excess

Returns + 2.57

10 Intercept Slope

t Stat 7.80 22.79

P-value 0% 0%

0%

5 0%

1 00 %

1 50 %

2 00 %

(1 0 ) R e tu r n o n C a p i ta l - C o st o f C a p i ta l (%)

Source: CSFBC Value Dynamic Framework Database, CSFBC analysis

Chart 3 shows that the market does assign a positive value to a companys ability to produce cash. The positively-sloped line and surprisingly high correlation coefficient unambiguously demonstrate that higher cash-on-cash returns increase valuations. Additional regressions that we performed indicate that this relationship holds within industries and for companies over time.
#

Check Your Assumptions: What to Do When Your Forecast Period Is Infinite

Although the cash-based valuation model is the clear winner over the P/E-togrowth model, as strikingly demonstrated in Charts 1, 2 and 3, we are not finished. Most important, we must examine the assumptions underlying our estimates of intrinsic value to insure that these are consistent with economic realities. In our opinion, the most important but overlooked assumption that analysts make is the duration of the period in which a company generates positive cash flows. Analysts frequently assume that a company will continue to generate steady cash flows even after its explicit forecast periods. This can be a mistake; a ten-year old calculating the present value of his weekly allowance probably would be wrong to assume that his parents largesse would continue into the infinite future. Many analysts measure the value of a business by using Miller and Modiglianis valuation equation. This equation determines value by summing the capitalized value of a companys current operations and the present value of growth

#

This regression demonstrates an extremely strong relationship between our two variables. For example, the high R2 associated with this regression means that the majority (66%) of the fluctuations in the markets valuation can be explained by the cash returns a company earns over its cost of capital. This contrasts favorably with the 6% R2 we observed in the regression testing P/E to growth. Of even more statistical significance, we want t-stats to be over 2 and p-values of less than 5%but both statistics clear that hurdle by a country mile. To elaborate, a p-value measures the probability that we just got lucky and happened to pick a favorable sample of companies. In fact, our regression statistics tell us that theres less than a 1 in 100 chance that our results were a fluke. See Appendix D for details.

Wolf Bytes 20
opportunities. This method performs admirably when one can assume that the economics of the core business will stay steady or even improve in the future. Analysts can usually assume this for companies in mature industries, such as foods and consumer products. Indeed, the high valuation of companies such as Microsoft implies that the stock market also makes this assumption for some successful hightech companies.
$

This assumption quickly becomes inappropriate, however, when valuing companies in emerging or volatile industries. After all, investors must be fairly confident before they assume a company will generate value to eternity. For one thing, competitive forces can erode the long-term profitability of an industry. Even in lucrative industries, not every company has a Bill Gates who can create a defensible business franchise. This helps to explain the debacles in share prices that typically occur when a highflying technology company misses the consensus earnings estimate by even a nominal amount. To illustrate, in our valuation analysis above, with a 25% return on capital and a 10% cash growth rate, 75% of a companys valuation is attributable to the free cash flow generated after our five-year forecast period. If expectations of these cash flows implode after an earnings shortfall, the market could instantly destroy a substantial portion of a companys market value. Such sharp selloffs happen whenever the market begins to doubt the longer-term prospects of a technology company.
% &

$

Market Value =

(ROIC WACC) NOPAT 0 + Investmentt t +1 WACC WACC (1 + WACC) t=0 This equation is the key equation in Merton Miller and Franco Modiglianis Dividend Policy, Growth, and the Valuation of Shares, The Journal of Business (University of Chicago, October 1961), pp 411-433.

%

Another caveat: If an investor currently doubts the ability of a company to generate future cash flows, he should more than assume that the company has a CAP of 0 years. In fact, as we discuss in detail in Appendix E, even with a CAP of 0 years, we are still implicitly assuming that the company will at least earn enough cash to cover future capital chargesdefined as the invested capital base times weighted average cost of capital. This may not be the case. Caveat emptor. This may help explain the fat tails that we see in charts of frequency distributions of price changes seen in the stock market. When a companys operating performance disappoints, investors may sell off the stock and sharply lower its price. If this happened frequently enough, we would observe large price changes much more often than if price changes followed a normal distribution.

&

Wolf Bytes 20
Our analysis demonstrates that the P/E-to-growth model provides a conceptually flawed portrayal of the valuation process. Nor does the market adhere to it, as shown by our empirical results. Cash-based valuation is the clear winner, both conceptually and empirically. This is not to suggest that P/E ratios have no role to play in the valuation process. They do provide a rough indication of investors expectations. And analysts frequently rely on changes in price/earnings ratios, such as multiple expansion or contractionas a proxy for a value-based model. A P/E ratio is not an end in itself, however, but rather the byproduct of a discounted cash flow analysis.
N.B.: CREDIT SUISSE FIRST BOSTON CORPORATION may have, within the last three years, served as a manager or co-manager of a public offering of securities for or makes a primary market in issues of any or all of the companies mentioned. Closing prices are as of December 22, 1997:

Conclusion

Acxiom (ACXM, 16 /&, Not Rated) Adtran Inc. (ADTN, 27

#

/$, Not Rated)

Advanced Micro Devices (AMD, 18

!

/$, Hold) *

Altera Corporation (ALTR, 36 /$, Buy) * AMP Incorporated (AMP, 40 /&, Buy) * Apple Computer (AAPL, 13



/$, Hold)

Applied Materials (AMAT, 30, Hold) * Avnet (AVT, 66 /&, Buy) * Berg Electronics (BEI, 20 /", Buy) * Cisco (CSCO, 53 /$, Buy) * Compaq Computer (CPQ, 53 / , Buy) Creative Technologies (CREAF, 19 /", Strong Buy) * Dell (DELL, 78 /$, Hold) DSC Communications (DIGI, 21 /$, Buy) * Gateway 2000 (GTW, 33, Hold) Hewlett Packard (HWP, 61 /$, Hold) IBM (IBM, 102 /&, Buy) * Intel Corporation (INTC, 70, Buy) * Itron Inc. (ITRI, 16 /$, Buy) * LSI Logic (LSI, 20 / , Hold) * LTX Corporation (LTXX, 4 /$, Buy) * Lucent (LU, 76, Buy) * MEMC Electronic Materials (WFR, 15 /&, Hold) * Micron Electronics (MUEI, 9 /$, Hold) Micron Technology (MU, 27 /$, Hold) * Microsoft (MSFT, 128



/$, Buy) *

Molex (MOLX, 29 /&, Hold) * Motorola (MOT, 58 /", Not Rated) National Semiconductor (NSM, 26 /$, Buy) * Newbridge Networks (NN, 35



/$, Not Rated)

Nortel (Northern Telecom) (NT, 85 /", Buy) * Oracle (ORCL, 21 /&, Hold) * Pairgain (PAIR, 18 /&, Buy) * Tektronix (TEK, 37, Buy) * Tellabs (TLAB, 49 / , Strong Buy) * Teradyne (TER, 32

#

/$, Hold) *

Texas Instruments (TXN, 45 /$, Buy) * Varian (VAR, 48 /&, Hold) * Western Digital (WDC, 15 /$, Hold) * Xylinx (XLNX, 36 / , Buy) *

*Followed by a different Credit Suisse First Boston analyst.

Wolf Bytes 20

Appendix A Methodology Used in Regression of Earnings Growth Rates on P/E Multiples

We tested the hypothesis that companies price/earnings ratios would be directly related to their anticipated growth rates. In Appendix A, we detail the methodology and data sources used in this regression. We obtained historical earnings information from First Call, a data service of Thomson Financial Services. We used First Call because it has become the de facto source of actual earnings numbers and estimates. We obtained at least five years of actual fiscal year earnings for the following 34 companies in the technology sector.
Table 2 Technology Companies Used in Regression of Earnings Growth Rates on P/E Multiples

Ticker 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 AAPL ACXM ALTR AMAT AMD AMP AVT BAY CPQ CSCO CS DG DELL DIGI HWP IBM IFMXE INTC LSI MOLX MOT MSFT MU NN NSM NT ORCL SUNW SYBS TEK TER TLAB VAR XLNX

Dates 1990-1997 1993-1997 1990-1996 1990-1996 1990-1996 1990-1996 1990-1997 1993-1997 1990-1996 1990-1997 1990-1997 1990-1996 1990-1997 1990-1996 1990-1996 1990-1996 1990-1996 1990-1996 1990-1996 1990-1997 1990-1996 1990-1997 1990-1997 1990-1997 1990-1997 1990-1996 1990-1997 1990-1997 1991-1996 1990-1997 1990-1996 1990-1996 1990-1997 1991-1997

Company Name Apple Computer Acxiom Altera Applied Materials Advanced Micro Devices AMP Avnet Bay Networks Compaq Cisco Cabletron Systems Data General Dell Computer DSC Communications Hewlett Packard IBM Informix Intel Corporation LSI Logic Molex Motorola Microsoft Micron Technology Newbridge Networks National Semiconductor Northern Telecom Oracle Sun Microsystems Sybase Tektronix Teradyne Tellabs Varian Xylinx

CSFBC Analyst Charles Wolf

Industry PC Hardware Telecom Equipment

Jack Geraghty Jack Geraghty Jack Geraghty Todd Raker Jack Geraghty Peter Rubicam Charles Wolf Peter Rubicam Peter Rubicam Amit Chopra Charles Wolf Michael Schmidt Charles Wolf Amit Chopra Esther Schreiber Jack Geraghty Jack Geraghty Todd Raker Jack Geraghty Esther Schreiber Jack Geraghty NA Jack Geraghty Michael Schmidt Esther Schreiber Amit Chopra Esther Schreiber Jack Geraghty Jack Geraghty Michael Schmidt Jack Geraghty Jack Geraghty

Semiconductors Semiconductors Semiconductors Connectors Semiconductors Data Networking PC Hardware Data Networking Data Networking Enterprise Hardware PC Hardware Telecom Equipment PC Hardware Enterprise Hardware Enterprise Software Semiconductors Semiconductors Connectors Semiconductors Enterprise Software Semiconductors Data Networking Semiconductors Telecom Equipment Enterprise Software Enterprise Hardware Enterprise Software Semiconductors Semiconductors Telecom Equipment Semiconductors Semiconductors

10

Wolf Bytes 20
We obtained historical price data from FactSet, an online financial and market data vendor. We also used FactSet to determine the actual date on which these 34 companies reported their earnings. We used price data from the day after a companys reporting dateinstead of fiscal year-end price datato ensure that the market reflected financial performance data in the share price. We chose to use the day after a companys report to give the market time to absorb the new information. Finally, we also independently corroborated the FactSet data using PR Newswire and company Web pages. We used actual earnings datainstead of analysts consensus estimates of forward five-year earningsto calculate five-year forward earning growth rates of each company. Since our regression gives investors the benefits of foreknowledge of a companys future earnings potential, we would expect to see a high correlation between P/E and growth in this regression. We also used actual earnings datainstead of analysts consensus estimates of forward 12-month earningsto calculate 12-month forward P/E multiples. Again, our regression gives investors advance knowledge of future results, which should raise the correlation. Despite our giving investors a crystal ball to predict earnings, our results did not prove a strong relationship between a companys long-term earnings growth and its P/E. Indeed, only 6% of the fluctuation in a companys P/E could be explained by examining changes in earnings growth. More significant, the negative slope of the line does not agree with the underlying theory of the P/E-to-growth framework, which predicts a highly positive slope.

11

Wolf Bytes 20

Appendix B Valuation Using the Economic Profit and Free Cash Flow Valuation Methodologies

In Appendix B, we value a hypothetical company using both the economic profit and free cash flow valuation methodologies. Both methods provide the same results, although each has its benefits and drawbacks. The economic profit method, shown below, has the benefit of showing the analyst the return on capital for every year. This ties together an intuitive measure of performancereturn on capitalwith valuation. However, this approach does not highlight the fact that a company creates value by generating cash inflows and minimizing cash outflows. The economic profit method values the company by summing three variables: The present value of economic profits that we explicitly forecast during the next five years. The present value of economic profits that occur after our explicit forecast period. The level of invested capital. This presents an apparent paradox. Specifically, if invested capital is simply an accumulation of sunk costsand every economist tells us that sunk costs are irrelevant in determining the value of an assetwe should not add invested capital to calculate enterprise value. However, as we prove in Appendix E, we include invested capital in the value equation because it is a proxy for the present value of future capital charges minus the present value of future investments. We applied the economic profit valuation model to a hypothetical company. In this exercise, we assumed that the company earned a constant return on capital of 25% and had a constant cost of capital of 10%. This company also invested a certain amount every yearat its constant 25% return levelto grow its earnings by 10%. We assumed that the company would grow its sales and cash earnings for only five years, after which it would earn the same cash earnings in perpetuity. Finally, we assumed that the company starts with $500 invested in the business, has no debt and one share outstanding.

12

Wolf Bytes 20

Table 3 Valuation of a Company Using the Economic Profit Method

Year Cash Invested (t) Cash Earnings (t)

1 500 125

2 550 138

3 605 151

4 666 166

5 732 183

6 732 183

Return on Capital (%) Cost of Capital (%) Excess Return (%)

25.0% 10% 15%

25.0% 10% 15%

25.0% 10% 15%

25.0% 10% 15%

25.0% 10% 15%

Economic profit ($) PV of Economic Profit (t) Perpetuity of Economic Profit

75 68 700

83 68 770

91 68 847

100 68 932

110 68 1,098

PV of Economic Profit (0 ... t)

PV of perpetuity Beginning Invested Capital Enterprise Value

68 636 500 1,205

136 636 500 1,273

205 636 500 1,341

273 636 500 1,409

341 682 500 1,523

Shareholder Value Price per share Price to cash earnings multiple

$ $

1,523 1,523 12.2

Using these assumptions, the company is worth $1,523. And with cash earnings of $125, the companys P/E is 12.2 times. Alternatively, we can use the free cash flow method to value this company. This method has the advantage that it explicitly measures the cash inflows and cash outflows for every year. However, it is not as intuitive as the economic profit method, because it does not provide the analyst with guideposts such as a companys return on capital. The free cash flow valuation method values a firm as the present value of future cash inflows (cash earnings, or NOPAT) minus the present value of future cash outflows (cash investment). An important link between the two models is that cash investment in the FCF model is the same as annual change in the invested capital level in the economic profit model.
Table 4 Valuation of a Company Using the Free Cash Flow Method

Year

Cash Earnings (t) Annual Cash Invested (t) FCF (t)

125 50 75

138 55 83

151 61 91

166 67 100

183 183

183 183

PV of FCF (t)

68 68

68 136

68 205

68 273

114 386

PV of FCF (0 ... t)
Perpetuity of Cash Earnings (t) PV of perpetuity (t)

1,250 1,136

1,375 1,136

1,513 1,136

1,664 1,136

1,830 1,136

Enterprise Value

1,205

1,273

1,341

1,409

1,523

13

Wolf Bytes 20
Both methods value the company at exactly the same dollar amount. This is reassuring, since both models are theoretically equivalent. In addition, the FCF method provides us with additional insight by placing emphasis on cash flow generation. For example, it highlights that our company will generate substantial cash flows following our five-year forecast period. Specifically, Table 4 shows that the company will generate $183 a year for infinity. This is equivalent to a perpetuity with a present value of $1,136. This is 75% of the firms total enterprise value.

14

Wolf Bytes 20

Appendix C Core Enterprise Value and Excess Cash

We use core enterprise valuethe present value of cash flows generated by the operating assets of a companyto calculate enterprise value-to-invested capital ratios. In this calculation, we start with total enterprise valuethe sum of the markets valuation of a companys debt and equity. In an efficient market, total enterprise value will equal the present value of all cash flows generated by a firm. This lumps together cash generated by operating assets (the core business), as well as cash generated by nonoperating assets (such as excess cash not invested in a firms core business). In this calculation, though, we want to isolate the value of operating assets. With the help of a few assumptions, we can make this distinction. First, we assume that excess cash is distributed to investors via dividends or share repurchases. We can then calculate the present value of this amount. The remaindertotal enterprise value minus present value of excess cashcomprises what we call core enterprise value, the present value of cash flows generated by the operating assets of the company.
 ' 

We can use this concept to refine our use of value-based analysis. Most notably, we should use core enterprise valueinstead of total enterprise valuewhen we calculate enterprise value-to-invested capital ratios. Both the numerator and denominator should be consistent. Invested capital excludes excess cash, and so should enterprise value. Finally, we note that most analysts use net enterprise valueor total enterprise value minus balance sheet cashwhen calculating ratios involving enterprise value. This does approximate core enterprise value, but systematically overstates it by the amount of required cash. In our experience, this can systematically bias the results of analysis.

'

We can define excess cash as actual balance sheet cash minus required cash. Required cash is usually calculated as a percent of sales, or as a fixed amount. This will be equal to the amount of excess cash if we assume that the company will immediately return this cash to shareholders. However, it may be less than the amount of excess cash if the analyst expects the company to delay the return of excess cash. As a practical matter, however, analysts may wish to just assume that the cash is immediately returned.

15

Wolf Bytes 20

Appendix D Methodology of Regression on the Extent to Which the Market Values a Companys Ability to Produce Cash

We tested the hypothesis that the market values a companys ability to produce cash. To test this, we regressed the companys enterprise value-to-invested capital ratiohow much the market values each dollar of cash invested in the companys businessagainst the companys return on capital less its cost of capital. As with our other regression, we obtained historical price data from FactSet, an online financial and market data vendor. As before, we used price data from the day after a companys reporting dateinstead of fiscal year-end price datato ensure that the market reflected financial performance data in the share price. We obtained data on a companys return on capital, cost of capital, excess cash levels, invested capital base, and long-term debt from CSFBCs proprietary Value Dynamic Framework (VDF) database. We obtained information from the period 1990 to the present for 45 technology companies, as listed below:
Table 5 Technology Companies Used in Cash-Based Regression

Ticker 1 AAPL 2 ACXM 3 ADTN 4 ALTR 5 AMAT 6 AMD 7 AMP 8 AVT 9 BAY 10 BEI 11 CPQ 12 CREAF 13 CS 14 CSCO 15 DELL 16 DGN 17 DIGI 18 GTW 19 HWP 20 IBM 21 IFMXE 22 INTC 23 ITRI 24 LSI 25 LTXX 26 LU 27 MOLX 28 MOT 29 MSFT 30 MU

Company Apple Computer Acxiom Adtran Inc. Altera Corporation Applied Materials Advanced Micro Devices AMP Incorporated Avnet Bay Networks Berg Electronics Compaq Computer Creative Technologies Cabletron Systems Cisco Dell Data General DSC Communications Gateway 2000 Hewlett Packard IBM Informix Intel Corporation Itron Inc. LSI Logic LTX Corporation Lucent Molex Motorola Microsoft Micron Technology

Analyst Charles Wolf

Michael Schmidt Jack Geraghty Jack Geraghty Jack Geraghty Todd Raker Jack Geraghty Peter Rubicam Todd Raker Charles Wolf Jack Geraghty Peter Rubicam Peter Rubicam Charles Wolf Amit Chopra Michael Schmidt Charles Wolf Charles Wolf Amit Chopra Esther Schreiber Jack Geraghty Michael Schmidt Jack Geraghty Jack Geraghty Michael Schmidt Todd Raker Jack Geraghty Esther Schreiber Jack Geraghty

16

Wolf Bytes 20

Table 5 Technology Companies Used in Cash-Based Regression

continued

31 MUEI 32 NN 33 NSM 34 NT 35 ORCL 36 PAIR 37 SUNW 38 TEK 39 TER 40 TLAB 41 TXN 42 VAR 43 WDC 44 WFR 45 XLNX

Micron Electronics Newbridge Networks National Semiconductor Nortel (Northern Telecom) Oracle Pairgain Sun Microsystems Tektronix Teradyne Tellabs Texas Instruments Varian Western Digital MEMC Electronic Materials Xylinx

Charles Wolf Michael Schmidt Jack Geraghty Michael Schmidt Esther Schreiber Michael Schmidt Amit Chopra Jack Geraghty Jack Geraghty Michael Schmidt Jack Geraghty Jack Geraghty Jack Geraghty Jack Geraghty Jack Geraghty

17

Wolf Bytes 20

Appendix E Derivation of Invested Capital Formula

We can value an enterprise using the standard economic profit valuation formula (1):

Enterprise Value = Invested Capital + PV(Economic Profit )

t =0

(1)

where, by definition: PV = Present Value,

Economic Profit t ($) = NOPATt ($) - Capital Charge t ($) , and Capital Charge ($) = Weighted Average Cost of Capital (%) Invested Capital ($)
Expanding Equation 1 using Definitions 2 and 3, we arrive at Equation 4:

(2) (3)

Enterprise Value = Invested Capital + PV(NOPATt ) PV(Capital Charge t ) (4)

t =0 t =0

Equivalently, we can also value the same enterprise by using the free cash flow (FCF) valuation formula (5):

Enterprise Value = PV(Free Cash Flow t )

t =0

(5)

where, by definition:

PV(Free Cash Flow t ) =

t =0

PV(NOPATt ) PV(Investment t )
t =0 t =0

(6)

Since Both Equation 1 and 5 are equal to enterprise value, we can set them equal to one another. We thus get Equation 7:

Invested Capital + PV(Economic Profit t ) = PV(Free Cash Flow t )

t =0 t =0

(7)

Substituting Equation 5 and 6 into Equation 7, we arrive at Equation 8:

Invested Capital + PV(NOPATt ) PV(Capital Charges t ) =

t =0 t =0

PV(NOPAT ) PV(Investment )
t =0 t t =0 t

(8)

We can cancel out the PV(NOPAT) on both sides of the equation to obtain Equation 9:

Invested Capital - Capital Charge t = PV(Investment t )

t =0 t =0

(9)

Finally, bringing the Capital Charget over to the right side of the equation, we arrive at Equation 10, a definition of invested capital as the present value of future cash flows:

18

Wolf Bytes 20 Invested Capital = PV(Capital Charget ) PV(Investment t )

t =0 t =0

(10)

In words, a companys beginning capital is equal to the present value of the capital charges minus the present value of its investments. Thus, we have shown that in the economic profit valuation formula, invested capital can be viewed as a present value formula, rather than as an accumulation of sunk costs. Accordingly, the economic profit valuation formula can also be represented as a sum of present values. Specifically:

Value = PV(Economic Profit t ) + PV(Capital Charget ) PV(Investment t )

t =0 t =0 t =0

(11)

19

Wolf Bytes 20
The VDF database is part of CSFBCs value-based research effort, led by Michael Mauboussin, the Equity Product Manager. Patrick McCarthy is the VDF analyst responsible for coordinating value-based research in the technology sector. Mr. McCarthy and individual CSFBC analysts did the detailed analyses that provided the data for our analysis. We thank Mr. Mauboussin, Mr. McCarthy, and the CSFBC technology team for their assistance with this project.

Acknowledgments

This memorandum is for informative purposes only. Under no circumstances is it to be used or considered as an offer to sell, or a solicitation of any offer to buy, any security. While the information contained herein has been obtained from sources believed to be reliable, we do not represent that it is accurate or complete and it should not be relied upon as such. We may from time to time have long or short positions in and buy and sell securities referred to herein. This firm may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any company mentioned in this report. 1997, CREDIT SUISSE FIRST BOSTON CORPORATION