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because this is specifically designed to highlight the relevant numbers. One

of the reasons that I place so much emphasis on the AFS is the way that it

makes the value calculation so clear.

A second reason for using the AFS format is the way that it works both for

plans and project evaluation. If all of our data are structured in this way it is

much easier to do things like exclude a project from a set of plan cash flows.

We will come to why we might want to do this shortly.

We have already seen on page 25 how to value a set of plan period cash

flows but I will repeat the approach here. This should also remind us once

again what the AFS for YMCC looks like:

YMCC Inc: Valuation of plan period cash flows $m

2009 2010 2011 2012 2013

Sales revenue 76.1 78.7 82.7 87.7 93.0

Variable costs âˆ’21.5 âˆ’22.5 âˆ’23.5 âˆ’25.3 âˆ’27.3

Contribution 54.6 56.2 59.2 62.4 65.7

Fixed costs âˆ’30.0 âˆ’31.8 âˆ’35.7 âˆ’36.6 âˆ’37.5

Amortisation âˆ’6.0 âˆ’5.7 âˆ’7.6 âˆ’7.7 âˆ’7.8

Pre-tax profit 18.6 18.8 15.9 18.1 20.4

Tax âˆ’6.5 âˆ’6.6 âˆ’5.6 âˆ’6.3 âˆ’7.1

Net profit 12.1 12.2 10.3 11.8 13.3

354 The three pillars of financial analysis

Table (cont.)

2009 2010 2011 2012 2013

Fixed assets 67.0 90.1 86.2 82.7 79.5

Accounts receivable 19.0 19.7 20.7 21.9 23.3

Accounts payable âˆ’12.6 âˆ’13.7 âˆ’10.7 âˆ’11.4 âˆ’12.2

Inventories 8.6 9.1 9.9 10.3 10.8

Net working capital 15.0 15.1 19.9 20.8 21.8

Capital employed 82.0 105.1 106.1 103.5 101.3

ROACE 17.4% 13.0% 9.8% 11.2% 13.0%

Profit 12.1 12.2 10.3 11.8 13.3

Amortisation 6.0 5.7 7.6 7.7 7.8

Working cap 1.3 0.0 âˆ’4.8 âˆ’0.9 âˆ’1.0

Capital investment âˆ’23.0 âˆ’28.7 âˆ’3.7 âˆ’4.1 âˆ’4.6

Funds flow âˆ’3.6 âˆ’10.9 9.4 14.4 15.5

Funds flow âˆ’3.6 âˆ’10.9 9.4 14.4 15.5

Discount factor 0.958 0.879 0.806 0.740 0.679

PV funds flows âˆ’3.5 âˆ’9.6 7.5 10.6 10.5

Cumulative PV âˆ’3.5 âˆ’13.1 âˆ’5.5 5.1 15.6

The value has been calculated as at the beginning of 2009 and cash flows

are all assumed to occur in mid-year. We can deduce this from the first yearâ€™s

discount factor of 0.958 which is the 9% CoC discount factor for first-year

cash flows. The cumulative present value is just $15.6m. This low number is

due to the initial-year negative funds flows caused by the capital investment

programme. This is a typical picture to emerge from a long-term plan.

Now this valuation can be viewed as a purely mechanical exercise. Indeed

the numbers will work in this way but the answer is certainly subject to what

practitioners call the â€˜GIGO effectâ€™. GIGO stands for â€˜garbage in equals gar-

bage outâ€™. If the numbers are based on poor assumptions, or worse are simply

wrong, then the value too will be poor or wrong. So the most important part

of the valuation of plan period cash flows is to check the assumptions and

also to ensure that the model has been audited and is faithfully converting

the assumptions into the correct cash flow.

The checking of assumptions covers three aspects. First, confirmation

that assumptions are expected values. Second, identification of any consid-

erations that should influence the TV calculation. Finally, confirmation that

the starting year of the plan does line up with published accounting data. All

of these aspects are important.

As regards the first, the calculated share price needs to be based on

expected value assumptions if it is to represent the implied market value of

355 The third pillar: What sets the share price?

the company. So if, for example, the valuation was deemed to represent a suc-

cess case rather than an expected value, the answer would need to be adjusted

in order to arrive at the right expected value of plan period cash flows. This

could be done in one of three ways. Either all of the assumptions would need

to be adjusted back to expected value levels. Or an alternative downside case

(or cases) would be computed and a probability-weighted approach applied.

The expected value would be the probability-weighted outcome of valuing the

various success and failure cases.9 The remaining method would involve use

of a Monte Carlo-based approach with all important assumptions assigned

probability distributions. My usual recommendation is to adopt the first

approach and simply ensure that all assumptions have a reasonable balance

of upside and downside.

As regards the second effect, the aim is to identify assumptions which will

have a particular impact on the TV. We will see in the next part that the usual

input to a TV calculation is the post-tax cash flow in the final year of the plan.

So any distortion in the final year will be magnified through the way that we

calculate TV. If, for example, there is a heavy spend in the final years of the

plan aimed at starting a new project then it would be important to ensure

that the TV reflected the benefit of this. The alternative would be to exclude

such costs from the plan and to deal with the value of growth projects as a

separate calculation. Distortions are not just concerned with excluding sig-

nificant one-off costs. They can also occur if insufficient allowance is made

for sustaining investment, in which case additional costs would need to be

included in the assessment of the steady state funds flow figure which will

feed into the terminal value calculation.

I will illustrate these adjustments later in this section in Step 2 where I cal-

culate the TV. For the present, however, we will simply assume that the final

year of the plan does not contain any unusual or one-off effects that would

otherwise distort the valuation.

As regards the check that the plan is consistent with published account-

ing data, one might well simply have assumed that this would be the case.

Experience, however, warns of the fact that this will not always be true. The

main reason for this is that a plan is usually agreed close to the end of a year

whereas the accounts may not be available until some months into the following

Suppose, for example, that the figure of $15.6m as the plan period cash flow value was deemed to be a

9

success case and it was considered that this would come about 60% of the time. If two other cases were

identified each with a probability of 20% and these had values of $10m and $5m then the expected

value of the plan period cash flows would be:

0.6 Ã— 15.6 + 0.2 Ã— 10 + 0.2 Ã— 5 = $12.4m.

356 The three pillars of financial analysis

year. We will almost certainly need to use the accounts to establish the value of

any liabilities as part of Step 3. Now my presentation above lacks this anchor in

published data and so is deficient. I always recommend that where numbers are

being used â€˜for realâ€™ they should be what I call â€˜anchoredâ€™ in the reality of pub-

lished accounting data. We will see how to do this with the Corus example.

One of the typical things that need to be allowed for as part of this third

check concerns when a plan is prepared on the assumption that some capital

spend will be completed before the plan period starts. If this is not done and

the spend carries over into the plan period, the plan must be adjusted. Another

item that will very often need to be checked is the working capital level. The

difference in working capital between reality and the assumptions made in a

plan that is finished a few weeks ahead of the year end can be considerable.

I need to conclude this consideration of Step 1 with a discussion of what

time period needs to be covered by the plan. A lot must depend on the amount

of detail which is available concerning the anticipated future financial per-

formance of the company. One should only prepare a plan for the period dur-

ing which it is meaningful to make assumptions about what its component

parts will be. The further one looks into the future the more the plan is likely

to become simply a series of steady-state assumptions. Once these assump-

tions are producing a steady trend in the post-tax funds flow one might as

well substitute a terminal value for the full plan. To do otherwise would, I

believe, be misleading to any decision maker.10

What can happen, though, is that although several items are being pro-

jected to follow a steady-state path, the overall post-tax funds flow may not

do this because, say, one or two items have not yet reached their steady state.

A typical example of this would concern a business that was utilising past tax

losses and so was paying virtually no tax in the early years of a plan. In such a

situation the post-tax funds flow would not follow a steady-state path until the

losses were used up. So the plan would ideally cover at least this initial period

plus, say, one or two years of steady-state performance at the end of the period.

This can lead to pressure to adopt very long plan periods. My general advice

is to avoid these because although they may appear to add precision, I become

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