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McKinsey on Finance

Do fundamentalsor emotionsdrive the stock market? 1Emotions can drive market behavior in a few short-lived situations.But fundamentals still rule.

The right role for multiples in valuation 7A properly executed multiples analysis can make nancial forecastsmore accurate.

Governing joint ventures 12Better oversight isnt just for wholly owned businesses.

Merger valuation: Time to jettison EPS 17Assessing an aquisitions value by estimating its likely impacton earnings per share has always been awed. Now its likely to beat wrong.

Perspectives onCorporate Financeand Strategy

Number 15, Spring2005

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McKinsey on Finance is a quar terly publication written by expertsand practitioners in McKinsey & Companys Corporate Finance practice.This publication offers readers insights into value-creating strategiesand the translation of those strategies into company performance.This and archived issues of McKinsey on Finance are available online atwww.corporatenance.mckinsey.com.

Editorial Contact: [email protected]

Editorial Board: James Ahn, Richard Dobbs, Marc Goedhart, Bill Javetski,Timothy Koller, Robert McNish, Dennis SwinfordEditor: Dennis SwinfordDesign and Layout: Kim BartkoDesign Director: Donald BerghManaging Editor: Kathy WillhoiteEditorial Production: Sue Catapano, Roger Draper, Thomas Fleming,Scott Leff, Mary ReddyCirculation: Susan CockerCover illustration by Ben Goss

Copyright 2005 McKinsey & Company. All rights reserved.

This publication is not intended to be used as the basis for trading in the

shares of any company or for undertaking any other complex or signicantnancial transaction without consulting appropriate professional advisers.No part of this publication may be copied or redistributed in any formwithout the prior written consent of McKinsey & Company.

Correction: In the Autumn 2004 issue, The scrutable East included anexhibit that forecast GDP in billions of dollars; this unit of measure shouldhave been trillions . Our apologies.

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McKinsey on Finance Spring 20052

Systematic patterns of behavior. Even if individual investors decided to buy or sellwithout consulting economic fundamentals,the impact on share prices would still belimited. Only when their irrational behavioris also systematic (that is, when large

groups of investorsshare particularpatterns of behavior)should persistentprice deviations occur.Hence behavioral-nance theoryargues that patternsof overcondence,overreaction, andoverrepresentationare common to many

investors and that such groups can belarge enough to prevent a companys shareprice from reecting underlying economicfundamentalsat least for some stocks,some of the time.

Limits to arbitrage in nancial markets. When investors assume that a companysrecent strong performance alone is anindication of future performance, theymay start bidding for shares and drive upthe price. Some investors might expect acompany that surprises the market in onequarter to go on exceeding expectations. Aslong as enough other investors notice thismyopic overpricing and respond by takingshort positions, the share price will fall inline with its underlying indicators.

This sort of arbitrage doesnt alwaysoccur, however. In practice, the costs,complexity, and risks involved in settingup a short position can be too high forindividual investors. If, for example,the share price doesnt return to itsfundamental value while they can still holdon to a short positionthe so-called noise-

trader riskthey may have to sell theirholdings at a loss.

Momentum and other matters

Two well-known patterns of stock marketdeviations have received considerableattention in academic studies during thepast decade: long-term reversals in shareprices and short-term momentum.

First, consider the phenomenon of reversalhigh-performing stocks of the past few years typically becomelow-performing stocks of the next few.Behavioral nance argues that this effectis caused by an overreaction on the part of investors: when they put too much weighton a companys recent performance, theshare price becomes inated. As additionalinformation becomes available, investorsadjust their expectations and a reversaloccurs. The same behavior could explainlow returns after an initial public offering(IPO ), seasoned offerings, a new listing, andso on. Presumably, such companies had ahistory of strong performance, which waswhy they went public in the rst place.

Momentum, on the other hand, occurswhen positive returns for stocks over thepast few months are followed by severalmore months of positive returns. Behavioral-nance theory suggests that this trendresults from systematic underreaction:overconservative investors underestimatethe true impact of earnings, divestitures,

and share repurchases, for example, sostock prices dont instantaneously react togood or bad news.

But academics are still debating whetherirrational investors alone can be blamedfor the long-term-reversal and short-term-momentum patterns in returns. Somebelieve that long-term reversals result

Behavioral-nance theory argues that patterns of overcondence, overreaction,and overrepresentation are common tomany investors and that such groups canbe large enough to prevent a companys

share price from reecting underlying economic fundamentals

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merely from incorrect measurementsof a stocks risk premium, becauseinvestors ignore the risks associated witha companys size and market-to-capitalratio. 2 These statistics could be a proxy forliquidity and distress risk.

Similarly, irrational investors dontnecessarily drive short-term momentumin share price returns. Prots fromthese patterns are relatively limited aftertransaction costs have been deducted. Thus,small momentum biases could exist even if all investors were rational.

Furthermore, behavioral nance stillcannot explain why investors overreactunder some conditions (such as IPO s) andunderreact in others (such as earningsannouncements). Since there is nosystematic way to predict how markets willrespond, some have concluded that this isa further indication of their accuracy. 3

Persistent mispricing in carve-outsand dual-listed companies

Two well-documented types of marketdeviationthe mispricing of carve-outsand of dual-listed companiesare used tosupport behavioral-nance theory. The classicexample is the pricing of 3Com and Palmafter the latters carve-out in March 2000.

In anticipation of a full spin-off within ninemonths, 3Com oated 5 percent of its Palmsubsidiary. Almost immediately, Palms

market capitalization was higher than theentire market value of 3Com, implying that3Coms other businesses had a negativevalue. Given the size and protability of the rest of 3Coms businesses, this resultwould clearly indicate mispricing. Whydid rational investors fail to exploit theanomaly by going short on Palms sharesand long on 3Coms? The reason was that

the number of available Palm shares wasextremely small after the carve-out: 3Comstill held 95 percent of them. As a result,it was extremely difcult to establish ashort position, which would have requiredborrowing shares from a Palm shareholder.

During the months following the carve-out, the mispricing gradually became lesspronounced as the supply of shares throughshort sales increased steadily. Yet whilemany investors and analysts knew aboutthe price difference, it persisted for twomonthsuntil the Internal Revenue Serviceformally approved the carve-outs tax-freestatus in early May 2002. At that point, asignicant part of the uncertainty aroundthe spin-off was removed and the pricediscrepancy disappeared. This correctionsuggests that at least part of the mispricingwas caused by the risk that the spin-off wouldnt occur.

Additional cases of mispricing betweenparent companies and their carved-outsubsidiaries are well documented. 4 Ingeneral, these cases involve difcultiessetting up short positions to exploit theprice differences, which persist until thespin-off takes place or is abandoned. In allcases, the mispricing was corrected withinseveral months.

A second classic example of investorsdeviating from fundamentals is the pricedisparity between the shares of the same

company traded on two different exchanges.Consider the case of Royal Dutch Petroleumand Shell Transport and Trading, whichare traded on the Amsterdam and Londonstock markets, respectively. Since these twinshares are entitled to a xed 6040 portionof the dividends of Royal Dutch/Shell, youwould expect their share prices to remain inthis xed ratio.

Do fundamentalsor emotionsdrive the stock market?

2Eugene F. Fama and Kenneth R. French,Multifactor explanations of asset pricinganomalies, Journal of Finance , 996,Volume 5 , Number , pp. 5584.

3Eugene F. Fama, Market efciency, long-termreturns, and behavioral nance, Journal of Financial Economics , 998, Volume 49,Number 3, pp. 283306.

4Owen A. Lamont and Richard H. Thaler,Can the market add and subtract? Mispricing

in tech stock carve-outs, Journal of Political Economy , 2003, Volume , Number 2,pp. 22768; and Mark L. M itchell, Todd C.Pulvino, and Erik Stafford, Lim ited arbitragein equity markets, Journal of Finance , 2002,Volume 57, Number 2, pp. 55 84.

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Over long periods, however, they have not.In fact, prolonged periods of mispricingcan be found for several similar twin-sharestructures, such as Unilever (Exhibit ).This phenomenon occurs because largegroups of investors prefer (and are preparedto pay a premium for) one of the twinshares. Rational investors typically do nottake positions to exploit the opportunityfor arbitrage.

Thus in the case of Royal Dutch/Shell,a price differential of as much as30 percent has persisted at times. Why?The opportunity to arbitrage dual-listedstocks is actually quite unpredictable and

potentially costly. Because of noise-traderrisk, even a large gap between share pricesis no guarantee that those prices willconverge in the near term.

Does this indict the market for mispricing?We dont think so. In recent years, theprice differences for Royal Dutch/Shell andother twin-share stocks have all become

smaller. Furthermore, some of theseshare structures (and price differences)disappeared because the corporationsformally merged, a development thatunderlines the signicance of noise-traderrisk: as soon as a formal date was set fordenitive price convergence, arbitrageursstepped in to correct any discrepancy.This pattern provides additional evidencethat mispricing occurs only under specialcircumstancesand is by no means acommon or long-lasting phenomenon.

Markets and fundamentals: Thebubble of the 1990s

Do markets reect economic fundamentals?We believe so. Long-term returns oncapital and growth have been remarkablyconsistent for the past 35 years, in spiteof some deep recessions and periods of very strong economic growth. The medianreturn on equity for all US companies hasbeen a very stable 2 to 5 percent, andlong-term GDP growth for the US economyin real terms has been about 3 percent ayear since 945. 5 We also estimate that theination-adjusted cost of equity since 965has been fairly stable, at about 7 percent. 6

We used this information to estimate theintrinsic P/E ratios for the US and UK stockmarkets and then compared them with theactual values. 7 This analysis has led us tothree important conclusions. The rst isthat US and UK stock markets, by and large,have been fairly priced, hovering near their

intrinsic P/E ratios. This gure was typicallyaround 5, with the exception of the high-ination years of the late 970s and early980s, when it was closer to 0 (Exhibit 2).

Second, the late 970s and late 990sproduced signicant deviations fromintrinsic valuations. In the late 970s,when investors were obsessed with high

5US corporate earnings as a percentage of GDP have been remarkably constant over the past35 years, at around 6 percent.

6Marc H. Goedhart , Timothy M. Koller, andZane D. Williams, The real cost of equit y,McKinsey on Finance, Number 5, Autumn2002, pp. 5.

7Marc H. Goedhart , Timothy M. Koller,and Zane D. Williams, Living with lowermarket expectations, McKinsey on Finance ,Number 8, Summer 2003, pp. 7 .

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short-term ination rates, the market wasprobably undervalued; long-term real GDP growth and returns on equity indicatethat it shouldnt have bottomed out at P/E levels of around 7. The other well-knowndeviation occurred in the late 990s, whenthe market reached a P/E ratio of around30a level that couldnt be justied by3 percent long-term real GDP growth or by

3 percent returns on book equity.

Third, when such deviations occurred,the stock market returned to its intrinsic-valuation level within about three years.Thus, although valuations have beenwrong from time to timeeven forthe stock market as a wholeeventuallythey have fallen back in line witheconomic fundamentals.

Focus on intrinsic value

What are the implications for corporatemanagers? Paradoxically, we believe thatsuch market deviations make it even moreimportant for the executives of a companyto understand the intrinsic value of itsshares. This knowledge allows it to exploitany deviations, if and when they occur,to time the implementation of strategicdecisions more successfully. Here are someexamples of how corporate managers cantake advantage of market deviations.

Issuing additional share capital when thestock market attaches too high a valueto the companys shares relative to theirintrinsic value

Repurchasing shares when the marketunderprices them relative to their intrinsicvalue

Paying for acquisitions with shares insteadof cash when the market overprices themrelative to their intrinsic value

Divesting particular businesses attimes when trading and transactionmultiples are higher than can bejustied by underlying fundamentals

Bear two things in mind. First, we dontrecommend that companies base decisionsto issue or repurchase their shares, todivest or acquire businesses, or to settletransactions with cash or shares solelyon an assumed difference between themarket and intrinsic value of their shares.Instead, these decisions must be groundedin a strong business strategy driven by thegoal of creating shareholder value. Marketdeviations are more relevant as tacticalconsiderations when companies time andexecute such decisionsfor example, whento issue additional capital or how to pay fora particular transaction.

Second, managers should be wary of analyses claiming to highlight market

deviations. Most of the alleged casesthat we have come across in our clientexperience proved to be insignicant oreven nonexistent, so the evidence shouldbe compelling. Furthermore, the deviationsshould be signicant in both size andduration, given the capital and timeneeded to take advantage of the types of opportunities listed previously.

Do fundamentalsor emotionsdrive the stock market?

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Provided that a companys share priceeventually returns to its intrinsic value inthe long run, managers would benetfrom using a discounted-cash-owapproach for strategic decisions.What should matter is the long-termbehavior of the share price of a company,not whether it is undervalued by 5 or

0 percent at any given time. Forstrategic business decisions, the evidencestrongly suggests that the market reectsintrinsic value. MoF

Marc Goedhart ([email protected])is an associate principal in McKinseys Amsterdamofce, and Tim Koller ([email protected]) is a partner in the New York ofce.

David Wessels ([email protected]),an alumnus of the New York ofce, is an adjunctprofessor of nance at the Whar ton School of theUniversity of Pennsylvania. This article is adaptedfrom the authors forthcoming book, Valuation:Measuring and Managing the Value of Companies ,fourth edition, Hoboken, New Jersey: John Wiley& Sons, available at www.mckinsey.com/valuation.Copyright 2005 McKinsey & Company.All rights reserved.

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Running head 7

Senior executives know that not allvaluation methods are created equal. Inour experience, managers dedicated tomaximizing shareholder value gravitatetoward discounted-cash-ow ( DCF )analyses as the most accurate and exiblemethod for valuing projects, divisions, andcompanies. Any analysis, however, is onlyas accurate as the forecasts it relies on.Errors in estimating the key ingredientsof corporate valueingredients such as acompanys return on invested capital ( ROIC ),its growth rate, and its weighted averagecost of capitalcan lead to mistakes invaluation and, ultimately, to strategic errors.

We believe that a careful analysis comparinga companys multiples with those of othercompanies can be useful in making suchforecasts, and the DCF valuations theyinform, more accurate. Properly executed,such an analysis can help a companyto stress-test its cash ow forecasts, tounderstand mismatches between its

performance and that of its competitors, andto hold useful discussions about whetherit is strategically positioned to create morevalue than other industry players are. As acompanys executives seek to understandwhy its multiples are higher or lower thanthose of the competition, a multiples analysiscan also generate insights into the key factorscreating value in an industry.

Yet multiples are often misunderstoodand, even more often, misapplied. Manynancial analysts, for example, calculatean industry-average price-to-earnings ratioand multiply it by a companys earningsto establish a fair valuation. The use of the industry average, however, overlooksthe fact that companies, even in the sameindustry, can have drastically differentexpected growth rates, returns on investedcapital, and capital structures. Even whencompanies with identical prospects arecompared, the P/E ratio itself is subject toproblems, since net income comminglesoperating and nonoperating items. Bycontrast, a company can design an accuratemultiples analysis that provides valuableinsights about itself and its competitors.

When multiples mislead

Every week, research analysts at CreditSuisse First Boston ( CSFB) report the stockmarket performance of US retailers bycreating a valuation table of comparablecompanies (exhibit). To build the weeklyvaluation summary, CSFB tracks eachcompanys weekend closing price andmarket capitalization. The table alsoreports the projections by CSFBs staff for each companys future earnings pershare ( EPS). To compare valuations acrosscompanies, the share price of each of themis divided by its projected EPS to obtain aforward-looking P/E ratio. To derive TheHome Depots forward-looking P/E of 3.3, for instance, you would divide the

companys weekend closing price of $33 byits projected 2005 EPS of $2.48.

But which companies are truly comparable?For the period covered in the exhibit, HomeDepot and its primary competitor, Lowes,traded at nearly identical multiples. TheirP/E ratios differed by only 8 percent, andtheir enterprise-value-to- EBITDA (earnings

The right role for multiples in valuation

A properly executed multiples analysis can make financial forecastsmore accurate.

Marc Goedhart,Timothy Koller, andDavid Wessels

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before interest, taxes, depreciation, andamortization) ratios by only 3 percent. Butthis similarity doesnt extend to a largerset of hard-lines retailers, whose enterprisemultiples vary from 4.4 to 9.9. Why sucha wide range? Investors have differentexpectations about each companys abilityto create value going forward, so not everyhard-lines retailer is truly comparable. Tochoose the right companies, you have tomatch those with similar expectations forgrowth and ROIC .

A second problem with mutiples is thatdifferent ones can suggest conicting

conclusions. Best Buy, for instance, tradesat a premium to Circuit City Stores whenmeasured using their respective enterprise-value multiples (6.3 versus 4.4) but ata discount according to their P/E ratios( 3.8 versus 22.3). Which is rightthepremium or the discount? It turns out thatCircuit Citys P/E multiple isnt meaningful.In July 2004, the total equity value of this

company was approximately $2.7 billion,but it held nearly $ billion in cash. Sincecash generates very little income, its P/E ratio is high; a 2 percent after-tax returnon cash translates into a P/E of 50. Sothe extremely high P/E of cash articiallyincreases the companys aggregate P/E.When you remove cash from the equityvalue ($2.7 billion $ billion) and divideby earnings less after-tax interest income($ 22 $8), the P/E drops from 22.3 to 4.9.

Finally, different multiples are meaningfulin different contexts. Many corporatemanagers believe that growth alone drivesmultiples. In reality, growth rates andmultiples dont move in lockstep. 2 Growthincreases the P/E multiple only whencombined with healthy returns on investedcapital, and both can vary dramaticallyacross companies. Executives and investorsmust pay attention to growth and to returnson capital or a company might achieve itsgrowth objectives but forfeit the benets of a higher P/E.

The well-tempered multiple

Four basic principles can help companiesapply multiples properly: the use of peers with similar ROIC and growthprojections, of forward-looking multiples,and of enterprise-value multiples, as wellas the adjustment of enterprise-valuemultiples for nonoperating items.

1. Use peers with similar prospects for

ROIC and growthFinding the right companies for thecomparable set is challenging; indeed, theability to choose appropriate comparablesdistinguishes sophisticated veterans fromnewcomers. Most nancial analysts startby examining a companys industrybutindustries are often loosely dened. Thecompany might list its competitors in its

Enterprise value equals market capitalizationplus debt and preferred shares less cash notrequired for operations.

2Nidhi Chadda, Robert S. McNish, and WernerRehm, All P/Es are not created equal,McKinsey on Finance , Number , Spring2004, pp. 25.

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annual report. An alternative is to use theStandard Industrial Classication codespublished by the US government. A slightlybetter (but proprietary) system is the GlobalIndustry Classication Standard ( GICS)recently developed by Morgan StanleyCapital International and Standard & Poors.

With an initial list of comparables inhand, the real digging begins. You mustexamine each company on the list andanswer some critical questions: why arethe multiples different across the peergroup? Do certain companies in ithave superior products, better accessto customers, recurring revenues, oreconomies of scale? If these strategicadvantages translate into superior ROIC sand growth rates, the companies thathave an edge within an industry willtrade at higher multiples. You mustbecome an expert on the operatingand nancial specics of each of thecompanies: what products they sell, howthey generate revenue and prots, andhow they grow. Not until you have thatexpertise will a companys multiple appearin the appropriate context with othercompanies. In the end, you will have a moreappropriate peer group, which may be assmall as one. In order to evaluate HomeDepot, for instance, only Lowes remainsin our nal analysis, because both arepure-play companies earning the vastmajority of their revenues and prots fromjust a single business.

2. Use forward-looking multiples

Both the principles of valuation and theempirical evidence lead us to recommendthat multiples be based on forecast ratherthan historical prots. 3 If no reliableforecasts are available and you must relyon historical data, make sure to use thelatest data possiblefor the most recent

four quarters, not the most recent scalyearand eliminate one-time events.

Empirical evidence shows that forward-looking multiples are more accuratepredictors of value. Jing Liu, Doron Nissim,and Jacob Thomas, for example, comparedthe characteristics and performance of historical and forward industry multiplesfor a subset of companies trading on theNYSE, the American Stock Exchange, andNasdaq. 4 When they compared individualcompanies against their industry mean, thedispersion of historical earnings-to-price(E/P) ratios was nearly twice that of one-year forward E/P ratios. The three alsofound that forward-looking multiplespromoted greater accuracy in pricing. Theyexamined the median pricing error for eachmultiple to measure that accuracy. 5 Theerror was 23 percent for historical multiplesand to 8 percent for one-year forecastedearnings. Two-year forecasts cut the medianpricing error to 6 percent.

Similarly, when Moonchul Kim and Jay Ritter compared the pricing powerof historical and forecast earnings for

42 initial public offerings, they foundthat the latter had better results. 6 Whenthe analysis moved from multiples basedon historical earnings to multiplesbased on one- and two-year forecasts,the average prediction error fell from55.0 percent, to 43.7 percent, to 28.5 percent,respectively, and the percentage of

companies valued within 5 percent of their actual trading multiple increasedfrom 5.4 percent , to 8.9 percent, to36.4 percent, respectively.

3. Use enterprise-value multiples

Although widely used, P/E multipleshave two major aws. First, they aresystematically affected by capital structure.


3A note of caution about forward multiples:some analysts forecast future earnings byassuming an industry multiple and usingthe current price to back out the requiredearnings. As a result, any multiple calculatedfrom such data will reect merely theanalysts assumptions about the appropriateforward multiple, and dispersion (even whenwarranted) will be nonexistent.

4 Jing Liu, Doron Nissim, and Jacob K.Thomas, Equity valuation using multiples,

Journal of Accounting Research , Volume 40,Number , pp. 3572.

5To forecast the price of a company, the authorsmultiplied its earnings by the industry medianmultiple. Pricing error equals the differencebetween the forecast price and the actualprice, divided by the actual price.

6Moonchul Kim and Jay R. Ritter, ValuingIPO s, Journal of Financial Economics ,Volume 53, Number 3, pp. 40937.

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For companies whose unlevered P/E (theratio they would have if entirely nancedby equity) is greater than one over thecost of debt, P/E ratios rise with leverage.Thus, a company with a relatively high all-equity P/E can articially increase its P/E ratio by swapping debt for equity. Second,the P/E ratio is based on earnings, whichinclude many nonoperating items, such asrestructuring charges and write-offs. Sincethese are often one-time events, multiplesbased on P/Es can be misleading. In 2002,for instance, what was then called AOL Time Warner wrote off nearly $ 00 billionin goodwill and other intangibles. Eventhough the EBITA (earnings beforeinterest, taxes, and amortization) of thecompany equaled $6.4 billion, it recordeda $98 billion loss. Since earnings werenegative, its P/E ratio wasnt meaningful.

One alternative to the P/E ratio is the ratioof enterprise value to EBITA. In general,this ratio is less susceptible to manipulationby changes in capital structure. Sinceenterprise value includes both debt andequity, and EBITA is the prot availableto investors, a change in capital structurewill have no systematic effect. Only whensuch a change lowers the cost of capital willchanges lead to a higher multiple. Even so,dont forget that enterprise-value-to- EBITA multiples still depend on ROIC and growth.

4. Adjust the enterprise-value-to-EBITA

multiple for nonoperating items

Although the one-time nonoperating itemsin net income make EBITA superior toearnings for calculating multiples, evenenterprise-value-to- EBITA multiplesmust be adjusted for nonoperating itemshidden within enterprise value and EBITA,both of which must be adjusted for thesenonoperating items, such as excess cashand operating leases. Failing to do so can

generate misleading results. (Despite thecommon perception that multiples are easyto calculate, calculating them correctlytakes time and effort.) Here are the mostcommon adjustments.

Excess cash and other nonoperating assets.Since EBITA excludes interest income fromexcess cash, the enterprise value shouldntinclude excess cash. Nonoperating assetsmust be evaluated separately.

Operating leases. Companies withsignicant operating leases have anarticially low enterprise value (becausethe value of lease-based debt is ignored)and an articially low EBITA (becauserental expenses include interest costs).Although both affect the ratio in thesame direction, they are not of the samemagnitude. To calculate an enterprise-value multiple, add the value of leasedassets to the market value of debt andequity. Add the implied interest expenseto EBITA.

Employee stock options. To determine theenterprise value, add the present value of all employee grants currently outstanding.Since the EBITAs of companies that dontexpense stock options are articially high,subtract new employee option grants (asreported in the footnotes of the companysannual report) from EBITA.

Pensions. To determine the enterprise

value, add the present value of pensionliabilities. To remove the nonoperatinggains and losses related to pension planassets, start with EBITA, add the pensioninterest expense, deduct the recognizedreturns on plan assets, and adjust forany accounting changes resulting fromchanged assumptions (as indicated in thefootnotes of the companys annual report).

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Other multiples too can be worthwhile, butonly in limited situations. Price-to-salesmultiples, for example, are of limited usefor comparing the valuations of differentcompanies. Like enterprise-value-to- EBITA multiples, they assume that comparablecompanies have similar growth rates andreturns on incremental investments, butthey also assume that the companiesexisting businesses have similar operatingmargins. For most industries, thisrestriction is overly burdensome.

PEG ratios 7 are more exible thantraditional ratios by virtue of allowing theexpected level of growth to vary acrosscompanies. It is therefore easier to extendcomparisons across companies in differentstages of the life cycle. Yet PEG ratios dohave drawbacks that can lead to errors invaluation. First, there is no standard timeframe for measuring expected growth;should you, for instance, use one-year, two-year, or long-term growth? Second, theseratios assume a linear relation betweenmultiples and growth, such that no growthimplies zero value. Thus, in a typicalimplementation, companies with lowgrowth rates are undervalued by industryPEG ratios.

For valuing new companies (such as dot-coms in the late 990s) that have small salesand negative prots, nonnancial multiplescan help, despite the great uncertaintysurrounding the potential market size and

protability of these companies or theinvestments they require. Nonnancialmultiples compare enterprise value to anonoperating statistic, such as Web site

hits, unique visitors, or the number of subscribers. Such multiples, however,should be used only when they lead tobetter predictions than nancial multiplesdo. If a company cant translate visitors,page views, or subscribers into protsand cash ow, the nonnancial metricis meaningless, and a multiple based onnancial forecasts will provide a superiorresult. Also, like al l multiples, nonnancialmultiples are only relative tools; they merelymeasure one companys valuation comparedwith anothers. As the experience of the late

990s showed, an entire sector can becomedetached from economic fundamentalswhen investors rely too heavily on relative-valuation methods.

Of the available valuation tools, adiscounted-cash-ow analysis deliversthe best results. Yet a thoughtful analysisof multiples also merits a place in anyvaluation tool kit. MoF

Marc Goedhart ([email protected])is an associate principal in McKinseys Amsterdamofce, and Tim Koller ([email protected]) is a partner in the New York ofce.David Wessels ([email protected]),an alumnus of the New York ofce, is an adjunctprofessor of nance at the Whar ton School of theUniversity of Pennsylvania. This article is adaptedfrom the authors forthcoming book, Valuation:Measuring and Managing the Value of Companies ,fourth edition, Hoboken, New Jersey: John Wiley

& Sons, available at www.mckinsey.com/valuation.Copyright 2005 McKinsey & Company.All rights reserved.


7PEG multiples are created by comparinga companys P/E ratio with its underlyinggrowth rate in earnings per share.

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12 McKinsey on Finance Spring 2005

Governing joint ventures

Better oversight isnt just for wholly owned businesses.

James Bamford andDavid Ernst

Corporate governance has become a toppriority for executives of public companies.Yet too few of them have raised the bar forgoverning joint ventures, whose nancial-management systems, most executives tellus, just arent as good as those of whollyowned businesses. Such systems, we hear,dont regularly incorporate joint venturesinto the standard corporate-planning andreview process, and parent companiesdont pay enough attention to them. Wherestandards exist at all, they are informal andvary quite widely.

This neglect is risky. Most large companiestoday have ten or more sizable jointventures accounting for 0 to 20 percentof their annual revenues, income, or assets.And in our experience, the effects of weakgovernancechronic underperformance, afailure to adapt and evolve, and excessivemanagerial costshelp sink many suchpartnerships.

More than a decade ago, the CaliforniaPublic Employees Retirement System(Calpers), hoping to improve theperformance of corporate boards,established a set of corporate-governanceguidelines. Applying them to jointventures, of course, calls for adjustments.Nonetheless, we believe that such guidelineswill not only help companies (and perhaps

their public shareholders) to assess thegovernance of their existing joint venturesmore clearly but also make their executivesbetter informed when they enter into newjoint ventures.

Indeed, guidelines such as these canmake the difference between good and badgovernancebetween governance that isfast, accountable, and transparent, on theone hand, and prone to gridlock, weakperformance management, mistrust, andstagnation, on the other. Our experiencewith many large joint ventures suggeststhat improving their governance can helptheir corporate parents to change theirstrategy, scope, nancial arrangements,and operations and to identify and reducethe risks they face. Those risks can beconsiderable: in a recent case, an industrialconglomerate discovered, 8 months afterthe fact, that one of its joint ventures hadexposed it to a $400 million liability.

Understand the challenge

Shareholders of public companies aretypically united by a common desire tooptimize returnsin the form, for example,of dividends and share price levelsand tomanage risks. By contrast, the governanceof joint ventures, which receive ongoingoperational resources from a few largeshareholders, is much more complicated(exhibit).

In joint ventures, for example, board

members (and others involved in thegovernance system) must manage what maybe the divergent strategic and economicinterests of the parent companies, whichoften have very different constraints, viewsof the market, and means of protingfrom the business. Likewise, the boards of joint ventures must secure and oversee theow of operational resources (including

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technology, raw materials, and staff)between them and their parent companies.These boards must also navigate throughother operational problems, such as thecreation of incentives for employees of theparent companies (such as engineers andsales reps) who interact with but arentemployed by the joint venture.

Whats more, the members of the boards of joint venturesalmost always employees of their parent companieshave to overcomeinherent conicts between the specicinterests of each of the parents and theoverall interests and health of the venture.As one former board member of a large

aerospace joint venture explained, It wasquite a dishonest system. You went into ameeting wearing two hats, as both supplierand owner. Each partners prime motivationwas to look after its own interests.

Toward a better model

Despite the differences between whollyowned businesses and joint ventures, many

of the basic tenets of good corporategovernance canand shouldbe appliedto both. The principles discussed here mightbe seen as the minimum needed to promoteaccountability, speed, transparency, and,ultimately, performance.

Appoint at least one outside director

Outsiders are now extremely rare on theboards of joint ventures. Yet an outsiderwho is explicitly charged with promotingthe interests of such a business and askingtough questions about its performanceand long-term direction can dramaticallyimprove its transparency, its bottom-line-performance orientation, and its overallreturns. Such an outside director is also ina position to argue on behalf of its strategywhen the parents have diverging interests.In the infrequent cases where joint ventureshave appointed outside directors, theexperience has been quite encouraging.

Consider, for example, the case of AeraEnergy, a multibillion-dollar upstream oiljoint venture that Mobil and Royal Dutch/ Shell formed in 996. The venture, initiallya wholly owned spinout of Shell, wasbuilt on the premise that to compete inthe mature and highly competitive heavy-crude business in California, Aera neededto operate in a manner very different fromthat of its major-oil-company parents. Ittherefore had to be quite independent. Akey part of establishing this independencewas the appointment of outsiders to the

board. In 996, when Shell created a60-40 joint venture with Mobils upstreamCalifornia assets, the partners agreed toretain the outsiders on the joint venturesboard and have them continue to chairthe audit and compensation committees. 2 Instead of choosing oil industry veterans,the parents sought out highly respectedexecutives from other industries. Eugene


These guidelines are a subset of McKinseysdraft joint-venture governance guidelines:more than 30 principles that companies shouldapply to their joint ventures. The guidelineshave grown out of our cl ient work with morethan 500 alliances and, more direct ly, outof McKinseys October 2004 roundtable forCEO s and directors.

2When Exxon merged with Mobil in 999, thenew company installed a board composedentirely of internal directors.

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Voiland, the CEO of Aera, believes that theoutside directors brought a fresh perspectiveto the business, promoted transparency andfrank discussion, and advanced the interestsof the joint venture as a whole (rather thanoptimizing one parents interests).

Designate lead directors or a

strong chairperson

Partners in a joint venture typicallyapproach the design of its board by pickingthree or four members each, withoutspecifying their individual roles. Suchboard members thus act as generalistsinstead of contributing specic skills.Ideally, however, companies should adopta highly specialized model of joint-venturegovernance by appointing board memberswith individual expertise who can providereal oversight and guidance in importantareas such as nance, manufacturing, andregulatory affairs.

As a rst step, each parent company shouldappoint a board member to functionas its lead director. This makes at leastone member a peer of the joint venturesCEO , with the power to challenge themanagement team and the responsibility forsecuring resources from the parents and formanaging the relationship with them. Oneprominent global chemical company insiststhat in every major joint venture, eachpartner must appoint a lead director whospends at least 20 days a year on its affairs(the norm for nonlead directors is 5 days).

In some casesespecially multipartyjoint ventures and consortiaa strongchair with oversight of strategy andbudget issues can serve the same purpose.Consider Sematech, an 8-year-old researchconsortium formed by more than a dozenleading semiconductor companies. Itschairman, O. B. Bilous, devotes time to

the consortium between board meetingsby working with the CEO to reviewand challenge the content of all boardpresentations and by serving as a soundingboard for the management team on keystrategic and operational issues. The chairmust bring real credibility to the role:Bilous assumed it after a career at IBM ,where, as a general manager of a majordivision of IBM Microelectronics, he hadstructured and served on the boards of fourvery large semiconductor-manufacturingjoint ventures. He is not, however,currently employed by Sematech or anyof its investors, so he is an independentnonexecutive chairman.

Review and reward the performance of

board members

Contrary to todays standard for corporategovernance, few joint-venture boardmembers are evaluated on their individualperformance, and compensation isonly obliquely, if at all, linked to theperformance of the venture they oversee.

Companies should rethink the way theyreview and compensate the members of theboards of joint ventures. For starters, inannual reviews board members should beevaluated by such criteria as their impactin shaping the joint ventures strategy, theirsuccess in fullling their risk-managementresponsibilities, their track record insecuring resources and attracting goodpeople, and their ability to secure timely

decisions from the corporate parents.Moreover, companies should considerlinking the directors compensationdirectly to the prot-and-loss statementor to other performance targets. To alignthe interests of the joint venture withthose of the inside directors and to ensurethat they have some skin in the game, atleast 5 percent of their total compensation

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15

should be linked to a common metric forthe performance of joint ventures. In fact,these businesses could steal a page fromnonequity alliances that reward their boardmembers and managers for exceptionalperformance by drawing down sums froma monetary fund whose size is linked tonancial targets.

Sponsor an external audit

Large joint ventures do a fairly good jobof generating basic nancial and operatingdatafor instance, the cost of goods sold,plant utilization levels, and product defectrates. But they tend to be less effectiveat understanding their own economics(including transfer price prots) from theperspective of their corporate parents andat generating the second-level managementdata 3 so essential to grasping the real issuesand prospects of a business.

The resulting lack of transparency aboutthe economics and transfer prices can bestartling. One industrial joint venturesparents extracted essentially all of their value through the sale of productsubsystems to itnot through its dividends,which were negligible. At no time did itsboard understand whether it was trulyprotable, because the governance systemmade the parents actual costs in buildingthese subsystems opaque. Indeed, theissue of transfer-pricing prots createddeep tensions in the relationship. Theparents referred to the annual meeting

on prices as the poker game, and theparents auditors called themselves theliars club because they had to smokeout each others pricing bluffs.

One US downstream oil industry jointventure that also depended extensively onits parents for key inputs, such as crudeoil and administrative services, provides

a contrast. Each year, its board hireda leading accounting rm to audit itsbooks. The accountants were asked topay particular attention to the parentcompanies transactions, such as crude-oilsupply and off-take agreements, therebyensuring that materials and services werefairly priced and that the board understoodthe total economics of the business.

Create a real challenge process

Too often, and for many reasons, jointventures are shielded from thoroughperformance scrutiny. For one thing, theyexist on the corporate periphery, outsidetheir parents normal reporting processes.Likewise, their parents may be reluctant toinvest scarce managerial resources in effortsto oversee them properly merely to capture,say, only half of the resulting benet. Indeed,the returns not only seem lower but alsomay take more effort to secure: changingan underperforming joint venture in asignicant way typically requires agreementby the parents, and that can be difcultif not impossibleto achieve. Nonetheless,a company making a large investment in ajoint venture should oversee it with the samelevel of intensity that would be devoted toother businesses of the same size.

One important consideration is how tocreate a rigorous reporting and reviewprocess that engages all of the corporateparents without subjecting the joint ventureto double jeopardythat is, to full and

separate reporting to all of its corporateparents, forcing it to meet different dataand format requirements and to reportfor different calendar years. Here, theexperience of one consumer-product-nancing joint venture is instructive. Toavoid double jeopardy, it was linked directlyinto one parent companys corporate-review process and treated like one of


3For example, information on the protabilityof different customer or product segments,assessments of key business risks, anddetailed comparisons with the performance of competitors.

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that companys wholly owned businessunits. The key difference is that the boardmembers from both parents participate inthese meetings and challenge proposalsfrom the parents perspective. In the oilindustry, the board of a multibillion-dollarjoint venture established an independentreview process, including a separate andvery strong nance and audit committeeas well as the aggressive use of outsideauditors to benchmark the performance of the business.

Let the ventures CEO run the business

We recognize that the board of a jointventure may, from time to time, haveto intervene in its operational affairs orstrategy decisionsfor example, during amajor downturn in its performance or afundamental change in its geographic orproduct scope. But we also believe thata board must empower a joint venturesCEO to operate as its true general manager,not only for the sake of fast and objectivedecisions, but also to attract and motivatestrong leaders. All too often, CEO s of jointventures lack the authority to run them,while board members act as quasi-operatorswho intervene haphazardly in tacticaldecisions.

One thing companies can do is to grantthe CEO the power to hire and re allemployees, or at least a veto. Anotheris to give the CEO a reasonably highdegree of sign-off authority on capital

expenditures and to establish beforehandwhat percentage of the dividends the jointventure will retain to invest. In addition,the board should develop and endorsea performance contract for the CEO essential not only to dene the boundariesbetween the CEO and the board but alsoto make sure that the corporate parents

have similar expectations about the jointventures performance.

The experience of a four-partner jointventure in the electric utility industryis illustrative. Although the board hadendorsed a strategic road map for the rsttwo years, it was exceedingly general andhadnt been codied consistently or evenformally approved by the board. Individualdirectors, trying to steer the business inone direction or another, made many back-channel requests to the CEO between boardmeetings, so that the original road mapbecame less and less relevant. The jointventure lost its focus, missed a key customerwindow, and nearly drove one of its parentsto exit.

To improve its business discipline, theboard recruited an experienced generalmanager as CEO . Before accepting thejob, he insisted that the board endorse athree-page memo identifying six objectivesfor his rst year. Each objective came withthree or four pinpoint deliverables and arelative weighting for evaluation. The result:the parents started to walk in lockstepduring year three, and the joint venturebecame more disciplined in business andoperational matters.

Few if any joint ventures now follow suchguidelines. But those that do have anopportunity to improve their performancematerially. MoF

Jim Bamford ([email protected]) is aconsultant and David Ernst (David_ [email protected]) is a partner in McKinseysWashington, DC, ofce. Copyright 2005McKinsey & Company. All rights reserved.

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Running head 17

Viewpoint

Merger valuation: Time to jettison EPS

Assessing an acquisitions value by estimating its likely impacton earnings per share has always been flawed. Now its likely tobe flat wrong.

Richard Dobbs,Billy Nand, andWerner Rehm

In any acquisition, its difcult to predictfuture cash ows and synergies. Managers,boards, and analysts in the United Statesand Europe have therefore generally testedthe relative attractiveness of a transactionby measuring its positive or negative impacton earnings per share ( EPS). Simplistic andawed as this approach may be, executivescould argue that it was valid as long asaccounting rules supported it.

That should have changed for US executives two years ago, when companiesusing US generally accepted accountingprinciples ( GAAP) stopped amortizinggoodwill. Under the new rules, nearlyevery acquisition shows a positive, oraccretive, impact on EPS before the costof restructuringmaking the EPS testcompletely unreliable as an indicatorof value created. Yet news releases andpublic comments from US executivesand Wall Street analysts continue todiscuss and assess acquisitions in terms

of EPS accretion or dilution. In addition,remuneration committees continue toevaluate management teams on their EPS performance. For European executives, therules on amortizing goodwill have onlyrecently changed. 2

With basically the same standard for theamortization of goodwill now established

in so many countries, its time forcompanies to drop, once and for all, theawed EPS accretion/dilution test as ameasure of an acquisitions value. Atbest, the test is inaccurate; at worst, itthoroughly misleads investors. A betterproxy, if executives need a new rule of thumb, would be an acquisitions impacton the acquirers economic protanotherimperfect measure but one that is betterthan EPS because it takes into account anacquisitions full economic cost.

A flawed test

Goodwill is the amount paid for acquiredcompanies above the fair value of theirbook assets. Under previous InternationalAccounting Standards, it was placed on theacquiring companys balance sheet and thenamortized over the duration of its usefullife or for 20 years, whichever was less. 3 This amortization in effect penalized thecompany for the cost of the acquisition andcould therefore restrain managers who mighttry to increase earnings through acquisitionsthat would destroy shareholder value.

Assessing the impact of acquisitions on EPS rather than on total net income correctsfor the dilutive effect of acquisitions thatinvolve the issuing of shares. When acompany uses cash to complete acquisitions,its earnings are reduced by the loss of interest income on the cash used in thetransaction or of the interest on theadditional debt. When it issues additional

shares to complete a transaction, EPS declines mathematically, since earnings arespread across a greater number of shares.

But the EPS accretion/dilution test doesntreect the actual value created by anacquisition. Writing off goodwill over20 years may penalize companies toomuchparticularly in industries with

The US GAAP changes also removed thepooling accounting approach, which allowedcompanies to avoid goodwill entirely. SeeNeil W. Harper, Robert S. McNish, and ZaneD. Williams, Shed no tears for poolingsdemise, McKinsey on Finance, Number ,Summer 200 , pp. 720.

2The European Union switched to theInternational Financial Reporting Standards(IFRS) in January 2 005. Now more than

60 countries require IFRS. An additional7 countries (Bahrain, China, Kazakhstan,Romania, Russia, Ukraine, and the UnitedArab Emirates) require some domesticcompanies to use IFRS, and a further 24allow all of them to use it. Australias AIFRS (Australian Equivalents to IFRS) resemblesIFRS with respect to the amortization of goodwill.

3Before the change, in 20 0 , the US GAAP hadpermitted up to 40 years of useful life forgoodwill.

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intangible assets like brands, which canendure longer than 20 years. Or it maypenalize companies too littleparticularlyin cash deals when the EPS calculationdoesnt charge for the acquisitions full costof capital. As a result, there is no correlationbetween the nancial markets impressionof the value created by a deal and itsaccretive or dilutive nature. In an analysisof 7 transactions larger than $3 billion byUS companies from 999 to 2000, we foundno correlation between the capital marketsreaction to a deal and the deals impact onthe acquirers EPS (Exhibit ).

The EPS test under new rules

Starting January , 2005, countries thathad been EU members in 2002 are requiring

public companies to adopt a consistentaccounting methodology: IFRS.4 As the US GAAP did earlier, IFRS has changed therules for the treatment of goodwill. 5 Underthe new rules for both of these accountingstandards, acquirers record it as an asset butdont amortize its value over time. Instead,companies must test the value of goodwill atleast annually. If the value has been impaired,

they must write it down and take a chargeagainst earnings. If it hasnt been impaired,the goodwill is assumed to have an indenitelife span and isnt amortized.

The new rules have no effect on the actualcash ow of the combined companies or onthe value created by a deal. They do, however,have a signicant impact on EPS accretion/ dilution in acquisitions that create goodwill:because it isnt amortized, most acquisitionswill now result in EPS accretion. This furtherundermines the EPS accretion/dilution testas an indicator of the value in a deal. It alsocreates a new danger for boards that use EPS to measure the performance of executives:these boards could be encouraging themto undertake value-destroying deals thatincrease EPS as measured under the newaccounting standards.

We illustrate this point with a sampleset of goodwill-creating transactions byUS companies in 999 and 2000. 6 Onaverage, under the old accounting standardsrequiring the amortization of goodwill,the earnings dilution for these deals was24 percent in the rst scal year after theacquisition and 2 percent in the second.Only 2 of the deals were accretive in thesecond year (Exhibit 2, part ).

Under the new rules, the picture would bevery different: 9 of the deals would havebeen accretive during both the rst and thesecond years (Exhibit 2, part 2). Across

all of these deals, the average accretionwould have been 3 percent in year two, ascompared with a 2 percent dilution in thesame year under the old accounting rules.The new standard has, in effect, completelyundermined the traditional rule of thumb.

Why? In essence, under the new rulesthe impact on the acquirers EPS doesnt

4Most of the ten EU accession countries eitherpermit or require ling in IFRS. Companiesthat already report in the US, Canadian, or

Japanese GAAP can continue to do so until

2007.5IFRS rule 3/I AS 36/38 is required for business

combinations with an agreement date on orafter March 3 , 2004. Under US GAAP, SFAS

42 is required for scal years after December5, 200 .

6The sample, including transactions valuedat more than $3 billion, excluded thetelecommunications, high-tech, and softwarecompanies that drove the market bubble of that period.

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7The pretax cost of debt X (1 tax rate) with atax rate of 35 percent.

8This example assumes that the capitalmarkets dont penalize the acquirer and thatthe exchange ratio can be set in relation tothe preannouncement share price plus the25 percent acquisition premium.

reect the full economic cost of theacquisition. Consider a hypotheticalexample (Exhibit 3). A company evaluatingthe acquisition of a business worth$400 million in the capital markets iswilling to pay a 25 percent premium, or$500 million in cash. For simplicitys sake,lets assume that the deal will create nosynergies and that the acquisition targethas a net income of $30 million. Theacquiring company decides to nance thedeal by raising debt at a pretax interest

rate of 6 percent. Obviously, this dealdestroys value because the company ispaying $500 million for an entity that isworth only $400 million (remember, nosynergies). Even so, next years earningsand therefore EPSincrease to 2.3, from2.0, because earnings from the acquiredcompany exceed the after-tax interestpayments that are required for the new debt.

This proposed acquisition would havereturns higher than the cost of the debtused to nance it but lower than the overallweighted average cost of capital, whichincludes the required return for equityholders. Raising debt to nance the dealplaces a sizable burden on the companysshareholders without compensating themfor the additional risk. Only when thereturn on invested capital is greater thanthe companys overall cost of capital iseach investor appropriately compensated.In our example, earnings of $30 millionon an investment of $500 million wouldbring a mere 6 percent return on investedcapital. While this exceeds the after-taxcost of nancing the debt at 3.9 percent, 7 itis below the overall cost of capital.

If instead the acquiring company exchangedshares to pay for the business it acquired,it would need to issue 2.5 million newshares to provide the 25 percent acquisitionpremium to the target companysshareholders. After the deal, the companywould have 52.5 million shares outstandingand earnings of $ 0 million. 8 The newcompanys EPS would rise to 2. , so thedeal would again be accretive. Regardless of the actual value created, a deal will alwaysbe earnings accretive if the acquirers P/Eratio is greater than the targets P/E ratio,including the acquisition premium.

No substitute for fundamentals

Therefore, when boards, executives, and

investors look at acquisitions, it is nolonger possible for them to rely on theEPS accretion/dilution test as a proxy forvalue creationif indeed they ever could.Remuneration committees in particularmust be wary of using EPS targets toevaluate management. In many countries,the executives would have an incentive topursue value-destroying deals to make the

Merger valuation: Time to jettison EPS

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EPS targets. Instead, boards, shareholders,and executives must fully understand everytransactions fundamentals, including adetailed perspective on how synergies willcreate value and an evaluation using adiscounted-cash-ow analysis.

While there is no perfect metric to provewhether a deal creates value, one measurecompanies could explore in their dialoguewith investors is a deals impact oneconomic prot, calculated with a charge

for goodwill at the full cost of capital. 9 This analysis is fairly well established. Infact, many companies already use economicprot for internal decision making. Adialogue about how long a deal will diluteeconomic prot forces managers to askhow long it will take the company tobegin earning its cost of capital on theacquisition. As with any measure, thisone cant be applied unthinkingly: somedeals create substantial value through thelong-term growth of the business whilediluting economic prot in the short term.Understanding the impact of an acquisitionon the dilution or accretion of economicprot could, however, provide a good basisfor communication and discussion.

Assessing the value of an acquisition byestimating its impact on EPS has alwaysbeen questionable. Under recent changes inaccounting standards, that approach hasbecome misleading and risky. Companies,

boards, and investors must take note. MoF

Richard Dobbs ([email protected]) is a partner in McKinseys London ofce;Billy Nand ([email protected]) andWerner Rehm ([email protected])are consultants in the New York ofce. Copyright 2005 McKinsey & Company. All rights reserved.

9Economic prot = invested capital X (returnon invested capital weighted averagecost of capital). See Tim Koller, MarcGoedhart, and David Wessels, Valuation:Measuring and Managing the Valueof Companies , fourth edition, Hoboken,New Jersey: John Wiley & Sons, 2005,available at www .mckinsey.com/valuation.

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