Valuation: Measuring and Managing the Value of Companies
The McKinsey standard reference on value creation and ROIC.
Summary
This is the McKinsey valuation textbook, now in many editions, and it is the standard professional reference for discounted cash flow valuation and for value-based management. The conceptual foundation is that value is created by earning returns on invested capital above the cost of capital, and that growth creates value only when this condition holds. The authors state this as the value driver formula, in which value depends on return on invested capital, growth, and the cost of capital, and they use it throughout to distinguish decisions that create value from those that do not.
The analytical section covers the reorganisation of financial statements into invested capital and net operating profit after tax, which separates operating performance from financing decisions; the calculation and interpretation of return on invested capital and of free cash flow; the analysis of historical performance; forecasting; estimating the cost of capital; calculating continuing value; and calculating and interpreting the result.
The advanced sections cover valuing companies with non-standard characteristics including high growth, cyclicality, multiple business units, emerging markets, banks and flexible investment opportunities, and cover alternative approaches including multiples and economic profit. The management sections cover portfolio decisions, mergers and acquisitions, divestitures, capital structure and investor communication.
The book is a textbook, long and technical, and requires accounting knowledge. It is written by consultants and reflects a specific institutional approach. Its treatment of terminal value, which frequently constitutes most of a valuation, is more careful than most sources. It is the reference professionals use rather than a book to read through.
Key takeaways 8
- Value is created by earning returns on invested capital above the cost of capital, and growth creates value only when that condition holds.
- Growth in a business earning below its cost of capital destroys value, which means growth is not a goal independent of returns.
- Financial statements must be reorganised into invested capital and operating profit to separate operating performance from financing decisions.
- Return on invested capital and growth together determine free cash flow, which is what a valuation actually discounts.
- Continuing value frequently constitutes most of a discounted cash flow valuation, which makes its assumptions the most consequential in the model.
- Multiples are a form of discounted cash flow with the assumptions concealed, and they should be reconciled to explicit assumptions.
- Accounting figures must be adjusted for operating leases, pensions, capitalised expenses and other items before ratios mean anything.
- Market values reflect long-run cash flow expectations rather than short-term earnings, which is why earnings management does not move prices durably.
Who should read it
Analysts and finance professionals who need the standard technical reference for discounted cash flow valuation and value-based management.
About Tim Koller
Partner at McKinsey & Company and lead author of the firm's valuation textbook.
Valuation: Measuring and Managing the Value of Companies sets out discounted cash flow practice end to end - forecasting, return on invested capital and growth as the two drivers of value, cost of capital, and the treatment of non-operating items - and is the text most corporate finance training runs on. Value: The Four Cornerstones condenses the same framework into the few principles that hold when accounting rules and buyback fashions change.
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