Strategic Budgeting, Forecasting & Value Measures
This is the heaviest objective and the one the XP manual says takes several passes. It has two halves. Implement and monitor strategy (strategy map/BSC, CPM, ZBB, forecasting, FP&A), and measure value (Koller value creation, EV→equity, multiples, divestitures, banks; Damodaran control and synergy; Hitchner discounts). The math is light but the distinctions get tested hard. The single idea under all of it: value = cash flow, and ROIC vs cost of capital decides whether growth helps.
- Critique a case company's balanced scorecard / strategy map / comp plan against its strategy, then recommend fixes.
- Run a ZBB ranking or explain decision packages and minimum levels.
- Calculate a value driver / economic profit / EV→equity / multiple, then interpret it (is growth good here?).
- Value control (voting vs non-voting shares), synergy (3 steps), and divestitures. Critique the bad reasons people give (EPS accretion, diversification).
- Apply discounts and premiums (DLOC, DLOM, multiplicative) and contrast Hitchner's "evidence is mixed" with Damodaran's precise view.
Strategic Balanced Scorecard–Based Budgeting & Performance MgmtHandbook of Budgeting (Lalli, 6th ed.) Ch. 2
Why strategies fail: the 4 barriers
Vision barrier
Only about 5% of employees understand the strategy.
Management barrier
Very little executive time is spent discussing strategy.
Resource barrier
Most companies do not link the budget to strategy.
People barrier
Management incentives are rarely linked to strategy.
Strategy map: a cause-and-effect diagram, read BOTTOM → TOP
This is the Pareto Inc. example (Exhibit 2.3). The vision: "delight our enterprise customers as the preferred provider of integrated network solutions and services."
What do shareholders expect?
Who are they; what do they value?
What must we excel at?
People, skills, culture, tech
The three internal "operations strategies" are customer service excellence, technology leadership, and operational excellence. Learning and growth is the foundation: a motivated, prepared workforce.
Balanced scorecard: 5 components per line (Exhibit 2.4, Pareto internal perspective)
| Objective | Measure | Target | Sponsor | Initiative |
|---|---|---|---|---|
| I1 Proactively manage renewal process | Renewal % | 80%+ | VP Sales | Contract renewal IT project |
| I2 Expand service offerings | $ revenue from new offerings | $50M | VP Sales | — |
| I3 Implement new sales model | % revenue from channel partners | 15% | VP Sales | Sales training project |
| I4 Understand customer requirements | # user group members | 20 sessions | VP Sales | — |
| I5 Invest in strategic sales channels | # new partners | Grow 20% | VP Sales | — |
The causal arrows run I4 and I5 → I2 and I3 → I1. Understanding customers and investing in channels drives new offerings and the new sales model, which drives renewals.
Measures
Lead vs lag
- Leading = early warning. Example: a rising order backlog means production is falling behind.
- Lagging = rear-view mirror. Example: accounting results reported months after quarter-end.
Efficiency vs effectiveness
- Efficiency (process): how well the process works. Examples: turnaround time, cost per unit.
- Effectiveness (output): the result. Example: product quality levels.
Measure types
Percentages and growth rates, survey ratings, rankings vs competitors (e.g. a safety ranking), and time (wait time, problem-resolution time).
Targets = budgets
Once objectives and measures exist, set targets. In this chapter targets and budgets are synonymous. Break annual targets into quarterly, monthly, and weekly numbers.
From BSC to budget to pay
- A scorecard that is all financial or all lagging is not "balanced."
- Measures that don't connect to the strategy (e.g. a low-cost carrier measuring premium-lounge satisfaction).
- Saying "read top-down." The map is built and read from the bottom up (learning → internal → customer → financial).
Self-test: What are the four perspectives, and what question does each answer?
Financial: what do shareholders value? Customer: which segments, and what do they want from us? Internal processes: which processes must we excel at to deliver for customers and shareholders? Learning & growth: what people, skills, culture, and technology do we need?Self-test: Classify "% of calls answered in 30 sec" and "customer retention rate."
Calls answered in 30 sec is an efficiency/process measure and leading. Retention rate is an effectiveness/output measure and lagging.Budgeting: Key to Corporate Performance ManagementHandbook of Budgeting Ch. 29 (pp. 659–666 only)
Where it fits: Porter = develop the product-market strategy → strategy map/BSC = details to implement and measure → CPM = regular monitoring and managing.
Exhibit 29.3 example: strategy "Improve sales productivity"
| Tactics & goals | Measures | Dimensions / frequency |
|---|---|---|
| $250,000 sales per rep | Sales revenue | By person, monthly |
| Grow cellular line 25% | Volume | By product |
| Sales costs ≤ 15% of revenue | COGS, salaries, commission, other sales expense | |
| External assumptions to monitor: average sales per head at peer organizations; cellular market share. Internal threats: not enough reps; production can't meet demand. Leading indicators: number of reps and their experience; cellular production levels. | ||
- Which tactics do we want to fund?
- Which tactics cannot be implemented within the set limits?
- What do budget-holders say about those tactics?
- If we must cut costs, which tactics do we eliminate, and how does that affect strategy?
Self-test: What 4 items does Step 1 require for each tactic/goal?
(1) Base measures (by time, region, product), (2) assumptions (economic and competitive climate), (3) KPIs, including leading measures, (4) the person responsible for achieving the goal.Zero-Based Budgeting (ZBB)Handbook of Budgeting Ch. 30
Problems with traditional (incremental) budgeting
- Focus is on changes from last year's spend.
- Requests exceed available funding.
- Hard to translate long-term objectives into action plans.
- Key problems and alternatives are not identified.
- Hard to adjust to changing situations.
- Trade-offs among long-term goals, operating needs, and profits are not clearly identified.
The 5 key elements
The 4 procedural steps
Decision units
Apply to all discretionary activities with an identifiable cost-benefit relationship. Examples: Darwin's underwriting dept, Blue Jay Tire's HR, an ad campaign, a capital project.
NOT applied to direct labor, direct material, and fixed overhead. Those are managed by other methods, e.g. standard costing.
Decision package contents
- Purpose / objective
- Description of actions
- Costs and benefits
- Workload and performance measures
- Alternative methods of accomplishing the objective
- Various levels of effort: elimination, reduced (minimum), current, increased
Why define a minimum level?
- Forces managers to evaluate their operations in depth.
- Gives management the option to reallocate funds to other programs.
5 considerations for the minimum level
- It may not fully achieve the objective.
- It should address the most critical population or most serious problem areas.
- It may just reduce the amount or number of services.
- It may reflect operating improvements, organizational changes, or efficiencies.
- Any combination of the above.
Ranking (Exhibit 30.3)
Each function ranks its own packages (A1 = most important minimum level). Management then merges them into one company-wide ranking by decreasing benefit. The budget line shows what gets funded, and what is lost if lower packages are cut.
Ranking can be done by function, for the whole company, or somewhere in between. It answers two questions: which objectives should we attempt? and how much should we spend? It doesn't make budgeting easier, but it gives good company-wide cost-benefit decisions.
Traditional vs zero-based flow (Exhibit 30.7)
| Stage | Usual approach (numbers-oriented) | Zero-based approach (management-oriented) |
|---|---|---|
| 1. Long-term plan (3–5 yr) | Establish objectives and goals | Establish objectives and goals |
| 2. Operating plan (1 yr) | Estimate costs of current activities → estimate costs of new activities → detail budgets | Evaluate current activities and alternatives → identify and evaluate new activities and alternatives → establish priorities |
| 3. Evaluate & review | Test against dollars/goals | Test against plan → establish trade-offs |
| 4. Final budget | Budget established | Budget and operating plan established → detailed budgets |
Two additional benefits
1 · Reacting to changing situations
There's a built-in contingency plan. If sales or assumptions change:
- Adjust the direct labor, material, and fixed overhead budgets
- Identify the decision packages directly affected
- Modify the rankings
- Add or delete packages in priority order
2 · Strategic development
Translates long-term plans into action plans via packages and ranking. Marketing, engineering, and R&D can be ranked by major program or objective rather than by division.
- Applying ZBB to direct labor, materials, or fixed overhead. It covers discretionary spend only.
- Forgetting "alternative methods". Packages need different ways of doing the job, not just different dollar levels.
- Making arbitrary cuts without understanding the consequences (e.g. production problems, starving R&D and marketing growth).
Self-test: Budget = 9 packages. A new competitor forces a 2-package cut. What happens under ZBB?
Drop the lowest-ranked funded packages (B3, then B2 in the exhibit) in priority order. Management already knows the consequences because each package documents its benefits and the impact of not funding it. That is the built-in contingency plan.Self-test: List the 4 levels of effort.
Elimination; reduced (minimum) level; current level; increased level(s).Forecasting PerformanceValuation (Koller et al., 8th ed.) Ch. 13, excluding "Mechanics of Forecasting"
Steady state (required before continuing value)
- The company grows at a constant rate by reinvesting a constant proportion of operating profit each year.
- It earns a constant return on existing and new capital.
FCF then grows at a constant rate, so you can use a growth perpetuity. The company's growth should be ≤ the economy's.
How long?
- Explicit forecast of 10–15 years (longer for cyclical or very fast-growing firms).
- A short horizon (5 yr) usually undervalues the company or needs heroic continuing-value growth.
- Split it in two: a detailed 5–7 yr forecast (full statements, linked to real drivers like units and cost per unit), then a simplified forecast (revenue growth, margins, capital turnover) to avoid false precision.
7 worksheets of a good model
3 advanced issues
Non-financial operating drivers
When prices or technology change, separate price from volume. Airlines in the early 2000s: forecast costs per seat-mile, not as % of revenue. Labor: units per employee × salary per employee.
Fixed vs variable costs
At public-company scale, nearly every cost is variable in the long run (cell towers must be added as subscribers grow; 10% growth doubles size in about 7 years). Treat truly scalable assets (software, apps) as fixed, but watch for obsolescence that needs repeated spending.
Inflation
Forecast in nominal terms, with the same expected inflation embedded in both the cash flows and the cost of capital. Derive it from government bond rates and inflation-linked bonds (TIPS).
Example: 10-yr Treasury 2.57%, TIPS 0.66% → 1.0257 / 1.0066 − 1 = 1.90% expected inflation for 10 years.
Calculator · Expected inflation
Self-test: Why does a short explicit forecast period usually undervalue a growing company?
The company hasn't reached steady state, so the continuing value (which assumes steady state) misses the remaining high-ROIC growth. You need heroic long-term growth assumptions to compensate.Advanced FP&A Practices for a Volatile EnvironmentCP311-109-26 (McKinsey)
Clear probabilities
Put a clear probability on every major assumption and on the model overall. Probability-weighted, scenario-based forecasts are the most reliable. One owner of the model, ideally the head of FP&A.
True momentum case first
Start with a do-nothing base case on current trends, with management initiatives stripped out. Then layer initiatives on top. This avoids double counting, false optimism, and non-recurring gains, gives accountability (and credit), and supports realistic stretch goals.
Spell out the bear case
A 1-in-3 or 1-in-4 downside. Not an extreme left tail (<5%), but probable. Show its drivers, cash-flow consequences, and effect on investment and capital structure, so you can act early.
Consistent macro assumptions
Sourced and consistent within each country. Take the median of several credible independent sources, or weight them by historical accuracy.
Disaggregate inflation
A single CPI (a basket of about 94,000 items) is wildly inapplicable. Companies buy a few specific inputs whose inflation rates vary a lot.
Relentlessly back-test
Not "set and forget." Compare projections with actuals (weekly or more often), re-weight macro sources, reduce variances. This can be automated with AI and gen AI.
Self-test: The CFO's base case shows 6% growth "including our new pricing initiative." Critique it.
It's not a true momentum case, because the initiative is embedded. Strip the initiative out to see the do-nothing trend, then layer it on separately with its own probability. That gives accountability and avoids double counting or optimistic bias in later investment decisions.Fundamental Principles of Value CreationValuation (Koller, 8th ed.) Ch. 3
Value Inc. vs Volume Inc.
| Company | NOPAT yr 1 | Growth | ROIC | Investment rate | FCF yr 1 | WACC | Value | P/E |
|---|---|---|---|---|---|---|---|---|
| Value Inc. | 100 | 5% | 20% | 25% | 75 | 10% | 1,500 | 15 |
| Volume Inc. | 100 | 5% | 10% | 50% | 50 | 10% | 1,000 | 10 |
Same earnings and the same growth, but different value, because Value Inc. needs to reinvest only half as much to grow. Earnings ≠ value.
Definitions: NOPAT = profit from core operations after the taxes on those operations. Invested capital = cumulative investment in core ops (mainly PP&E and working capital). Net investment = ΔIC. FCF = NOPAT − net investment. ROIC = NOPAT / IC. IR = net investment / NOPAT. In the formula, g and ROIC are strictly the return on new capital (RONIC).
Growth × ROIC value matrix (WACC 9%, NOPAT1 = 100)
Computed with the value driver formula. Exhibit 3.6 shows the same pattern.
| Growth ↓ / ROIC → | 7% | 9% (= WACC) | 13% | 20% | 25% |
|---|---|---|---|---|---|
| 3% | 952 | 1,111 | 1,282 | 1,417 | 1,467 |
| 4.5% | 794 | 1,111 | 1,453 | 1,722 | 1,822 |
| 6% | 476 | 1,111 | 1,795 | 2,333 | 2,533 |
Read across a row (raise ROIC)
Value always rises. Higher ROIC means less investment is needed for the same growth.
Read down a column (raise growth)
ROIC > WACC: value rises. ROIC = WACC: no change (1,111 = 100/0.09). ROIC < WACC: growth destroys value.
- High-ROIC companies create more value by growing. Low-ROIC companies create more by raising ROIC.
- "Grow and ROIC will follow from scale" is true only for young start-ups. In mature firms a low ROIC signals a flawed business model or a bad industry structure.
- Organic new-product growth usually has the highest returns: little new capital, staged and cancellable investment. Acquisitions pay everything upfront plus a premium, so the return is usually only slightly above the cost of capital, though with lower downside risk. Counting the risk of failure doesn't change that pecking order.
Economic profit
EP combines ROIC and size into a currency amount. It encourages investments that earn more than WACC even if they are below the current average ROIC, and it is useful for comparing business units.
Conservation of value: "anything that doesn't increase cash flows doesn't create value"
Debt for equity / leverage
Just re-slicing claims doesn't change value. It matters only via the interest tax shield, or through behavior (debt discipline makes managers more diligent; too much debt makes raising capital for good projects harder).
Share repurchases
Raise EPS but create no value by themselves, since total cash flow is unchanged. If the cash could earn more than WACC, investing it likely gives higher long-term EPS. Buying "undervalued" shares only transfers value from sellers to remaining holders, and companies time buybacks poorly.
Acquisitions
Create value only if combined cash flows rise: cost reductions, faster revenue growth, or better use of fixed and working capital.
Financial engineering
Derivatives, structured debt, securitization, off-balance-sheet financing: mostly no real value, just a short-term illusion. A sale-leaseback makes assets and debt look smaller, but rent replaces depreciation and interest (and is usually higher), so there is rarely any value for investment-grade firms.
Accounting changes
Non-cash charges or a change in accounting method don't change cash, so they don't change value.
Calculator · Value driver formula
Calculator · Economic profit
- "EPS goes up, so value is created" (buybacks, accretive deals). Check the cash flow instead.
- Recommending growth for a company whose ROIC is below WACC.
- Forgetting g < WACC in the formula.
Self-test: NOPAT 200, g 4%, ROIC 8%, WACC 8%. Value? What happens if g rises to 6%?
IR = 4/8 = 50%, so FCF = 100 and value = 100/(0.08 − 0.04) = 2,500. At g = 6%: IR = 75%, FCF = 50, value = 50/0.02 = 2,500. No change, because ROIC = WACC. Value = NOPAT/WACC either way.Self-test: A company with ROIC 30% and WACC 8% asks whether to prioritize margin improvement or growth.
With a high ROIC, Koller says extra growth usually adds more value: each new dollar of capital earns far above WACC, and FCF falls only slightly as reinvestment rises. Low-ROIC firms should fix ROIC first.Moving from Enterprise Value to Value per ShareValuation (Koller, 8th ed.) Ch. 16, pp. 333–341 (stop before "Valuing Interest-Bearing Debt")
| Non-operating asset | How to value |
|---|---|
| Excess cash & marketable securities | Book value (it is fair value), unless volatile equity holdings have changed a lot |
| Nonconsolidated investments: publicly traded | Market value, after checking that the market value reflects intrinsic value (thin float or low liquidity can distort it) |
| Nonconsolidated investments: unlisted, with financials | Separate DCF of the equity stake at the sub's own cost of capital. Include only the parent's stake |
| Nonconsolidated, only parent's accounts available | 20–50% (equity method): simplified cash-flow-to-equity (NI growth and ROE drivers, discounted at the sub's cost of equity) or multiples (P/E, market-to-book) on reported income. <20% (cost method): a tracking portfolio (apply the price change of comparable stocks since acquisition). Triangulate |
| Loans to other companies | Book value if issued on fair terms and credit and rates haven't changed. Otherwise DCF at a similar-risk YTM |
| Finance subsidiaries | Separate them from operations (otherwise they distort ROIC and FCF), value them as a financial institution, and add. Subtract only general debt, since the sub's debt is already inside its value |
| Discontinued operations | Exclude from FCF; add the disclosed net asset value |
| Excess real estate / unutilized assets | Excluded from FCF; add market value |
| Excess pension assets | Market value less tax: liquidation tax (higher) if the plan will be dissolved soon, otherwise the statutory rate (reflecting lower future contributions) |
| Tax loss carry-forwards | DCF of the future tax savings. Start from the deferred-tax asset |
Self-test: Ops DCF 900, excess cash 50, 30% stake in an unlisted JV worth 200 (100%), debt 300, unfunded pension 40, 10 shares. Value per share?
EV = 900 + 50 + 0.3×200 = 1,010. Equity = 1,010 − 300 − 40 = 670. Per share = 67.Using MultiplesValuation (Koller, 8th ed.) Ch. 18
Why not P/E?
It mixes capital structure and non-operating items with operating performance. In the textbook exhibit, a heavily levered company shows a very different P/E while EV/EBITA is similar across peers.
Why EBITA, not EBIT?
Amortization of acquired intangibles is an accounting artifact. Company A buys B for 1,000 (750 over book); amortized over 10 yrs that's 75/yr. EV/EBITA stays at 10× like organic peer C, but EV/EBIT jumps to 16×. That is not a premium, just accounting.
EBITA vs EBITDA
Depreciation usually stands in for the capex needed to replace assets, so subtract it. Use EBITDA only when current depreciation is a poor predictor of future capex. EBITDA multiples are distorted between firms that buy vs lease assets.
EBITA vs NOPAT
EBITA is common and fine when all peers share one operating tax rate (same jurisdiction). Use NOPAT when tax rates differ. Reported taxes include non-operating items.
Alternative multiples
| Multiple | When useful | Caveat |
|---|---|---|
| EV / Revenue | Last resort: start-ups with negative profits, very volatile margins, temporarily depressed earnings (heavy R&D or marketing), or a quick "what if it matched peer margins" | Assumes margins converge to peers' |
| PEG (P/E ÷ growth) | Roughly controls for growth differences | No mathematical basis, no standard horizon for growth (1, 5, or 10 yr?), and it ignores ROIC: in the textbook exhibit, companies with PEGs of 3.4 vs 1.7 are valued the same by DCF |
| Multiples of invested capital | Banks (wealth management vs investment banking), regulated utilities (RAB multiples) | |
| Operating metrics (per subscriber or user) | Young, fast-growing firms (Spotify, Sirius XM) | The metric must tie to ROIC and growth. Business models differ, so only very similar firms are comparable |
Self-test: A conglomerate trades below a "sum of parts" built on industry-average multiples. Is the market missing value?
Not necessarily. Industry averages may come from peers with higher ROIC and growth, or from different sectors. Use a narrow peer group with similar ROIC and growth for each unit, and forward normalized EBITA. (Koller Ch32 makes the same point about misleading sum-of-parts analyses.)DivestituresValuation (Koller, 8th ed.) Ch. 32
= Price − Stand-alone value − Lost synergies − Disentanglement costs − Stranded costs
Lost synergies
Operating synergies with the rest of the portfolio (plus small tax and financing synergies), even if you aren't the best owner.
Disentanglement costs
Legal and advisory fees, IT replacement or reconfiguration, relocation, retention bonuses, and taxes triggered by the deal structure.
Stranded costs
Corporate costs that don't transfer: shared services, IT, shared plants, board, legal, compliance. Real but easily overestimated, and mitigated by restructuring shared services. Divestments often expose excess overhead.
Legal/regulatory and pricing
Contracts (procurement, customer, loan) may need transitional service agreements; these slow the deal more than they hurt value. If the market prices the unit above intrinsic value, sell now. In weak markets (Siemens/OSRAM IPO delays), weigh lower proceeds against the costs of holding on.
The costs of holding on
- Underperformers: waiting leads to a fire sale after the value is already destroyed.
- Good, mature units: corporate inertia. They dampen innovation, absorb scarce management time, and create conflicts. A stand-alone unit gets tailored financing, investment, incentives, and focus.
- Capability mismatch: start-ups need innovation skills; mature units need cost management. Parents excel at only a few, fairly static, capabilities.
- Divestment is not an easy fix for stock undervaluation. Positive announcement returns don't prove a hidden sum-of-parts value (those analyses often use the wrong peer multiples).
EPS and P/E are irrelevant (Exhibit 32.2)
Sell a mature, high-ROIC, low-growth unit worth 450 to the company for 550: +100 created. Mature units carry low multiples, so divesting them usually raises P/E and lowers EPS, even at a value-destroying price below 450. How the proceeds are used changes EPS:
| Use of proceeds | EPS effect | Why |
|---|---|---|
| Hold cash | Most dilution (equity value and P/E rise) | Interest on cash < earnings yield of the unit sold |
| Repay debt | Less dilution | Debt rate > cash rate, but still < the unit's earnings yield |
| Buy back shares | Least dilution; P/E up, but lower than in the other cases | Earnings yield of the remaining business < the divested unit's (6.8%) |
| Invest for growth / acquire | Smaller company, lower EPS, but shareholders still win | Shareholders care about value, not size |
Transaction types
| Type | What happens | Cash to parent? |
|---|---|---|
| Private sale (or JV) to a strategic or financial buyer | Usually the most value if the buyer is a better owner; premium captured now. Downside: may trigger taxable gains | Yes |
| IPO | Sell all shares of the sub to new shareholders | Yes |
| Carve-out | IPO of a minority stake, so the parent keeps control in the first phase | Yes |
| Spin-off (demerger) | Distribute all sub shares to existing parent shareholders | No |
| Split-off | Existing shareholders exchange parent shares for sub shares | No |
| Tracking stock | A separate class of parent shares tracking the unit, spun off or carved out | Only if carved out |
The choice depends on: whether strategic or financial buyers exist, the need for cash, the benefit of keeping some control during the first phase, and the tax implications for the company and its shareholders.
Calculator · Divestiture value created
BanksValuation (Koller, 8th ed.) Ch. 43 (heavily updated in the 8th ed.)
Net interest income
Interest earned on loans minus interest paid on deposits and debt. Not all of it creates value: part is earned by a maturity mismatch (short deposits funding long loans, i.e. riding the yield curve).
Fee & commission income
Advisory, underwriting, asset management, brokerage. Easier to understand and independent of financing, but some fees are highly cyclical.
Trading income
Equities, bonds, FX, CDS, ABS. Highly volatile: years of gains can be wiped out in one year.
Other income
Real estate, minority stakes, distributing third-party products. Small and unrelated to core banking.
Balance sheet
- Assets: cash, loans (the core; consumer rates > commercial; loan-loss reserves required), securities, property, central bank reserves
- Liabilities: deposits (primary, low-cost, predictable, withdrawable anytime, hence the mismatch; SVB 2023), wholesale funding (quick to raise but about 300–400 bp above deposits)
- ALM manages the asset-liability mismatch
Capital (Basel III, Dec 2010)
Equity required against risk-weighted assets: RWA = credit + market + operational risk. Minimum CET1 is about 8–10.5% of RWA in total; most banks target more, e.g. 13%. Outside-in, you must approximate RWA by asset category to project future equity needs.
ABC Bank: β 1.1, rf 4.5%, MRP 5% → ke = 4.5 + 1.1×5 = 10%. Equity PV = $134.2M, market-to-book 1.4, P/E 11.6. CFE was negative in 2021–22 because ABC raised equity to lift its Tier 1 ratio from 4% to 8%. With equity at 8% of assets, a 1-pt rise in the loan rate moves ROE by about 12 pts. CFE ≠ dividends, because buybacks and issuance also count.
Pitfalls of equity DCF
1 · Sources of value creation
Know which business (lending spread, deposits, maturity mismatch) actually creates the value, using economic spread analysis.
2 · Leverage and business risk → ke
Lower the equity ratio and expected ROE rises, but ke rises too. With no taxes there's no value gain unless the extra deposits themselves create value. If the asset/liability mix or capital ratios change, don't leave ke unchanged.
3 · Tax penalty on equity capital
Equity gives no interest tax shield, so income earned on equity-funded assets is taxed. PV of the penalty = equity × tax rate. ABC raising $50M to buy risk-free bonds destroys 30% × 50 = $15M. It's captured implicitly if ke reflects leverage and risk.
Complications
- Loan loss provisions: among the most important value factors. Use through-the-cycle loss rates (losses correlate with the economy) and deduct them from future loan rates. Check whether reserves are under- or over-provisioned; any shortfall reduces equity value.
- Different value drivers by activity, so value segments separately like a multi-business company: interest-generating (retail, cards, wholesale lending) via economic spread and equity DCF; trading (large positions and risk capital, volatile; the average across the cycle is limited); fee businesses (asset management: small positions, minimal risk capital; drivers are AUM growth plus management and performance fees).
- Banks are highly levered and cyclical, so use scenarios, not point estimates.
Calculator · Bank equity value (equity DCF value driver)
Self-test: NI 50, book equity grows from 400 to 430, OCI −5. CFE?
CFE = 50 − 30 + (−5) = 15.The Value of ControlDamodaran on Valuation (2nd ed.) Ch. 13
5 determinants of value, and how to raise each
| Determinant | Ways to increase value |
|---|---|
| 1. Cash flow from existing assets: FCFF = EBIT(1−t)(1 − reinvestment rate) | Redeploy or divest assets earning < cost of capital (sell low-return stores); improve operating efficiency (replace costly outdated equipment); cut the tax burden (lower-tax location); cut maintenance capex and working capital (faster supply chain, less inventory) |
| 2. Expected growth during the high-growth period: new investments g = reinvestment rate × ROC; existing assets g = (ROCt − ROCt−1)/ROCt−1 | Raise the reinvestment rate and/or the return on capital. Better returns on existing assets also add growth |
| 3. Length of the high-growth period | Only valuable if returns exceed the cost of capital. Lengthen it by nurturing barriers to entry and competitive advantages (ties to Porter, Objective 1) |
| 4. Cost of capital | Make products less discretionary (lower operating risk); cut operating leverage (fixed costs); shift the financing mix (debt is cheaper); match financing to assets (ALM) |
| 5. Cash, cross-holdings, non-operating assets | Cash invested below market rates or at risk of being squandered; spin off or sell cross-holdings someone values more; manage pension assets better |
Probability of changing management
4 mechanisms
- Moral suasion: large or activist investors demand change
- Proxy contest: shareholders vote
- Board replaces management
- Hostile takeover
What makes change harder
- General status-quo bias in management
- Institutional constraints (initiating change takes a lot of capital)
- State restrictions on ownership changes
- Corporate charter anti-takeover rules (e.g. golden parachutes)
- Voting rights (Google's 10-vote class)
- One very large shareholder who is also a manager (Larry Ellison, Buffett, about 40%)
Change is empirically more likely when…
Stock and earnings performance are poor, the board is small, insider holdings are low, and the industry is very competitive.
What shifts the probability
Changes in corporate governance rules, publicity about company errors, or hostile takeovers elsewhere.
Implications for the voting premium
- It goes to zero if there's no chance of changing management.
- It is larger for poorly managed firms (big Va − Vb).
- It is larger the fewer voting shares there are relative to non-voting.
- It is larger the greater the % of voting shares available for trading.
Implications for acquisitions
- No rule of thumb on the control premium. It varies by firm and by why the firm underperforms (internal management vs external competition) and how quickly changes can be made (financing changes fast; a new plant slowly).
- The market price may already include part of the value of control, so paying a premium on top can be overpaying.
- Hostile deals are driven mainly by control. Synergy is separate and comes on top of control.
- Poor governance means lower stock prices.
Calculator · Value of control & voting shares
Self-test: SQ 1,000, optimal 1,300, P = 40%, 20 voting + 80 non-voting shares. Prices?
Market value = 1,000 + 300×0.4 = 1,120. Non-voting = 1,000/100 = 10.00. Voting = 10 + 300×0.4/20 = 16.00. Check: 20×16 + 80×10 = 1,120.The Value of SynergyDamodaran on Valuation (2nd ed.) Ch. 15
Operating synergies → higher cash flows
- Economies of scale (horizontal: two banks merging back offices and IT)
- Greater pricing power (less competition; horizontal mergers in industries with few players)
- Combining functional strengths (strong marketing + great products)
- Higher growth in new or existing markets (a US firm buying an emerging-market distributor)
Financial synergies → cash flows or a lower discount rate
- Cash slack: cash-rich, low-opportunity firm + cash-poor firm with high-return projects
- Tax benefits: use the target's losses or deductions; write up depreciable assets
- Debt capacity: less-correlated cash flows give more stable combined cash flows, more borrowing, a tax shield, and a lower cost of capital (assumes both were at optimal debt pre-merger)
- Diversification: controversial. Public investors can diversify themselves; it can help private firms
Valuing operating synergy: 3 steps
Two questions: what form will synergy take (it must raise cash flows from existing assets, raise growth, lengthen the growth period, or lower the cost of capital), and when will it hit cash flows (usually phased in over time)?
Cost synergies
One-time or ongoing. Bounded: you can't cut costs below zero.
Growth synergies
Higher returns on investment, more investment opportunities (higher reinvestment), or a stronger competitive position (excess returns last longer). Unbounded: Facebook paid $1B for Instagram, now thought to add $100B+.
Real-options view
Buying a small emerging-market firm is like buying an option to expand. Be skeptical, though: there may be other ways to expand, and DCF may still be best.
Valuing cash slack
Add the NPV of the projects the cash-poor firm would otherwise have to reject.
Tax example
Acquirer with $1B operating income and a 40% tax rate buys a firm with a $1B NOL: value ≈ 40% × $1B = $400M.
Debt capacity
Lower variability gives more debt, a tax benefit, and a lower cost of capital, so the combined firm is worth more.
Dubious synergies
- Accretive acquisitions: EPS rises only because the target's P/E was lower, perhaps for good reasons (lower growth, higher risk)
- Quick growth: buying growth is fine, but everything depends on the price paid
Who gets the synergy?
It depends on whose strengths are unique. If only the acquirer has the necessary components, it gets most of the gain. If its strengths aren't unique, bargaining power and the gains go to the target. In public deals the market acts as a counter-bidder, so acquirers keep less than in private deals.
Why bidders overpay
- Biased evaluation: bankers are paid only if the deal closes
- Managerial hubris: overestimating synergy
- Failure to plan for delivering synergy
What raises the odds of success
- Mergers of equals do worse (culture clashes)
- Concrete, immediate cost savings do better
- Repeated purchases of small private firms do better
- Subsidizing target shareholders: valuing a low-rated target at the strong acquirer's lower cost of capital.
- Wrong discount rate: discount synergy cash flows at the combined firm's cost of capital (reflecting non-diversifiable risk), never the riskless rate. Use the new business's rate if the synergy is a new line of business.
- Mixing control and synergy: value control first (fix the target's operations), then the incremental synergy. Paying more than control + synergy destroys the acquirer's value.
Self-test: A is worth 600. B is worth 300 status quo, or 360 if run optimally. Combined firm (B run optimally) with synergy = 1,050. A pays 470 for B. Good deal?
Control = 360 − 300 = 60. Combined without synergy = 600 + 360 = 960, so synergy = 1,050 − 960 = 90. Maximum justifiable price = 300 + 60 + 90 = 450. At 470, A overpays by 20 and destroys its own shareholders' value. Note that a naive "1,050 − 900 = 150 synergy" mixes control with synergy.Valuation Premiums and DiscountsCP311-110-26: Financial Valuation (Hitchner, 5th ed.) Ch. 10, pp. 507–545
Levels of value
Order: from a control value, apply the minority discount first (to reach marketable minority), then DLOM. Multiply, don't add: 20% DLOC and 20% DLOM give 1 − 0.8 × 0.8 = 36%, not 40%.
Liquidity vs marketability
Liquidity
The ability to quickly convert property to cash, or pay a liability, without significant loss of principal and without significant cost. Benchmark: actively traded public stock, i.e. an instant sale with cash within about 3 days at a broker's commission.
Marketability
The ability to convert property to cash at minimal cost, reflecting the capability and ease of transfer or salability. Anything liquid is marketable; marketable doesn't imply liquid. Later in the chapter the two are merged into one DLOM.
| Interest | Classification |
|---|---|
| Actively traded public stock (minority) | Liquid |
| Large block of public stock (blockage discount), thinly traded stock, restricted stock | Marketable illiquid |
| Control interest in a public company | Marketable illiquid |
| Control interest in a private company (avg about 9 months to sell; ~80% sell within 12 months) | Marketable illiquid |
| Real estate; machinery & equipment | Marketable illiquid |
| Minority interest in a private company | Non-marketable (hard to sell, no ready market, not impossible) |
The only valid terms are liquid, marketable illiquid, and non-marketable. "Liquid marketable" is redundant; "non-marketable illiquid" is redundant. Liquidity of public stock varies with bid-ask spread, market depth, trading volume, and price impact per dollar traded.
Entity-level vs shareholder-level
Entity-level discounts (affect the whole company)
- Key-person
- Contingent liability (e.g. hazardous waste)
- Contingent litigation
- Small-company risk
- Non-homogeneous assets
- Customer/supplier concentration
- Blockage / market absorption
Applied by raising the discount rate (income approach) or lowering the multiple (market approach).
Shareholder-level
Specific to an ownership interest (number of shareholders, shareholder agreements): strategic premiums, control premiums, DLOC, DLOM.
What level of value does each method produce?
| Method | Control or minority? | Marketable? |
|---|---|---|
| Income: capitalized CF / DCF | Control if control adjustments are made to the cash flows; minority if not (e.g. owner extracting excess comp). If no adjustments are needed, it equals both | Marketable (rates come from public data) |
| Excess earnings method | Control (only control can realize the underlying assets) | Marketable |
| Guideline public company | Control if adjusted, otherwise minority. Public multiples are "control neutral" (cleanly managed under scrutiny) | Marketable |
| Guideline transactions: public targets | Control (an M&A deal requires control) | Marketable |
| Guideline transactions: closely held targets | Control | Marketable but illiquid |
| Asset approach: net asset value | Control (only control can force a sale) | Usually marketable |
Control premium vs strategic premium
Control premium = the right to direct the company and/or divert cash flows. Strategic/acquisition premium = incremental value to a specific buyer. Acquisition data mixes the two, so control premiums are often overstated when acquisition premiums are used as a proxy. Better practice: analyze on an invested-capital basis. Control and marketability are related: a majority holder can create marketability through a sale, merger, or IPO.
Ownership spectrum (Exhibit 10.8)
Least impaired: 100% → >50% able to liquidate/merge → >50% but below a supermajority (e.g. 2/3 needed) → controls the board. Most impaired: <50%, can't affect the board, fragmented remainder. 50% has no control but has veto power (stalemates). Cumulative voting can win a board seat and a smaller DLOC. A 10% holder can have more say than ten 1% holders.
Debates to argue both ways
Do public stock prices reflect control?
Theory 1: yes, market prices aren't a pure minority level. Theory 2: no. Damodaran's view: part of the price already reflects the expected value of control (value × probability). Hostile deals that leave the target independent isolate control plus overpayment; average US premiums were 20–30% in the 1980s–90s, slightly higher for hostile deals. Synergy is on top of control, and the buyer shouldn't pay the full value of control. Conclusion: in public firms, minority and controlling interests may be so integrated that they are essentially similar.
DLOM on a controlling interest?
Against: the control owner sets the timing and amount of cash flows, and illiquidity is already priced. For: if values are benchmarked to liquid public stocks, a control sale still faces uncertain time to sell, transaction costs (due diligence, valuation, legal), and uncertain proceeds or structure (earn-outs, notes, buyer financing). US Tax Courts have allowed it. Typical range: 0–20%; option models are increasingly used.
Other controversies: whether earnings should always get control adjustments, whether restricted-stock and IPO studies are valid DLOM "starting points," and whether DCF or option models are sound for DLOM. Majority abuses that hurt minority holders (excess comp and perks, favorable related-party dealings) are limited by courts' fiduciary duty rulings.