VALUATION
MEASURING AND
MANAGING THE
VALUE OF
COMPANIES
FOURTH EDITION

McKinsey & Company
Tim Koller
Marc Goedhart
David Wessels

JOHN WILEY & SONS, INC.



VALUATION
MEASURING AND
MANAGING THE
VALUE OF
COMPANIES


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VALUATION
MEASURING AND
MANAGING THE
VALUE OF
COMPANIES
FOURTH EDITION

McKinsey & Company
Tim Koller
Marc Goedhart
David Wessels

JOHN WILEY & SONS, INC.


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About the Authors
The authors are all current or former consultants of McKinsey & Company’s corporate finance practice. Collectively they have more than 50 years
of experience in consulting and financial education.
McKinsey & Company is a management-consulting firm that helps leading
corporations and organizations make distinctive, lasting, and substantial improvements in their performance. Over the past seven decades, the
firm’s primary objective has remained constant: to serve as an organization’s most trusted external advisor on critical issues facing senior management. With consultants deployed from over 80 offices in more than 40
countries, McKinsey advises companies on strategic, operational, organizational, financial, and technological issues. The firm has extensive experience in all major industry sectors and primary functional areas, as well as

in-depth expertise in high-priority areas for today’s business leaders.
Tim Koller is a partner in McKinsey’s New York office. He leads the firm’s
Corporate Performance Center and is a member of the leadership group of
the firm’s global corporate finance practice. In his 20 years in consulting
Tim has served clients in North America and Europe on corporate strategy
and capital markets, M&A transactions, and value-based management. He
leads the firm’s research activities in valuation and capital markets. He was
formerly with Stern Stewart & Company, and Mobil Corporation. He received his MBA from the University of Chicago.
Marc Goedhart is an associate principal in McKinsey’s Amsterdam office
and a member of the leadership group of the firm’s corporate finance practice in Europe. Marc has served clients across Europe on portfolio restructuring, capital markets, and M&A transactions. He taught finance as an
v


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ABOUT THE AUTHORS

assistant professor at Erasmus University in Rotterdam, where he also
earned a PhD in finance.
David Wessels is an adjunct professor of finance at the Wharton School of
the University of Pennsylvania. Named by BusinessWeek as one of America’s
top business school instructors, he teaches courses on investment banking
and corporate valuation at the MBA and Executive MBA levels. David is also
a director in Wharton’s executive education group, serving on the executive
development faculties of several Fortune 500 companies. David, a former
consultant with McKinsey, received his PhD from the University of California at Los Angeles.


Preface
The first edition of this book appeared in 1990, and we are encouraged that

it continues to attract readers around the world. We believe that the book
has succeeded because the approach it advocates is grounded in universal
economic principles. While we continue to improve, update, and expand the
text as our experience grows and as business and finance continue to
evolve, the fundamental principles do not change.
The 15 years since that first edition appeared have been a truly remarkable period in business history, and managers and investors continue to
face the opportunities and challenges that emerged from it. For us, the
events of the Internet boom and its demise have only strengthened our conviction in the core principles of value creation. This may seem illogical,
given that one of the things we learned was that for some companies, during
some periods of time, the stock market may not be a reliable indicator of
value. Paradoxically, this has only strengthened our conviction that managers attune themselves even more to the underlying value of their company and how it can create more value, because signals from the stock
market may not always be reliable.
This book’s message is simple: Companies thrive when they create real
economic value for their shareholders. Companies create value by investing
capital at rates of return that exceed their cost of capital. These principles
apply across time and geography. This book explains the core principles, describes how companies can increase value by applying the principles, and
demonstrates the practical ways to implement the principles.
We wrote this book for managers (and future managers) and investors
who want their companies to create value. It is a how-to book. We hope that
it is a book that you will use again and again. If we have done our job well, it
will soon be full of underlining, margin notations, and highlighting. This is
no coffee-table book.
vii


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PREFACE

WHY THIS BOOK

This book began life as a handbook for McKinsey consultants. This beginning is reflected in the nature of the book. While it draws on leading-edge
academic thinking, its purpose is practical application. It aims to demystify
the field of valuation and to clarify the linkages between strategy and
finance.
We believe that clear thinking about valuation, and skill in using valuation to guide business decisions, are prerequisites for success. CEOs, business managers, and financial managers alike do not always understand
value well enough. But they must understand it if they are to do their jobs
well and fulfill their responsibilities.
In this book, we hope to lift the veil on valuation by explaining, step-bystep, how to do it well. We spell out valuation frameworks that we use in
our consulting work, and we bring these frameworks to life with detailed
case studies that highlight the practical judgments involved in developing
and using valuations. Most important, we discuss how to use valuation to
make good decisions about courses of action for a company.
This book will help business managers better understand how to:
• Decide among alternative business strategies by estimating the value
of each strategic choice.
• Develop a corporate portfolio strategy, understanding which business units a corporate parent is best positioned to own, and which
might perform better under someone else’s ownership.
• Assess major transactions, including acquisitions, divestitures, and
restructurings.
• Improve a company’s performance management systems to better
align an organization’s various parts to create value.
• Design an effective capital structure to support the corporation’s
strategy and minimize the risk of financial distress.

INTELLECTUAL FOUNDATIONS
Valuation is an age-old methodology in finance. Its intellectual origins lie in
the present value method of capital budgeting and in the valuation approach developed by Professors Merton Miller and Franco Modigliani ( both
Nobel laureates) in their 1961 Journal of Business article entitled “Dividend
Policy, Growth and the Valuation of Shares.” Our intellectual debt is primarily to them, but others have gone far to popularize their approach. In
particular, Professor Alfred Rappaport (Northwestern University) and Joel



PREFACE

ix

Stern (Stern Stewart & Co.) were among the first to extend the MillerModigliani enterprise valuation formula to real-world applications.

STRUCTURE OF THE BOOK
The book is organized in four parts. Part One provides the fundamental
principles of value creation. Part Two is a step-by-step approach to valuing a company. Part Three applies value creation principles to managerial problems. Part Four deals with more complex valuation issues and
special cases.
Part One provides an overview of value creation. Chapter 1 makes the
case that managers should focus on long-term value creation, despite the
capital market turmoil of the past several years. In Chapter 2 we develop a
picture of what it means to be a value manager through a detailed case
study based on the actual experiences of a CEO who needed to restructure
his company and create a culture dedicated to managing for value. Chapter 3 summarizes the basic principles of value creation using both a simple
case example and a rigorous derivation of these principles. Chapter 4 provides the empirical evidence supporting the discounted cash flow (DCF)
view of valuation.
Part Two—Chapters 5 through 12—is a self-contained handbook for
using discounted cash flow to value a company. A reader will learn how to
analyze historical performance, forecast free cash flows, estimate the appropriate opportunity cost of capital, identify sources of value, and interpret results. As further guidance to the practitioner, we walk through the
valuation of a company (Heineken) from an outside perspective, using publicly available information. We also show how to use multiples of comparable companies to supplement DCF valuation.
Part Three applies the value creation principles to the issues that managers face. Chapter 13 provides a framework for evaluating corporate performance, incorporating both short-term financial performance and indicators
of a company’s “health,” or its ability to create value over the long term.
Chapter 14 explains how to align a company’s performance management
process with value creation. Chapters 15 and 16 explore creating value
through mergers, acquisitions, and divestitures. Chapter 17 will guide managers as they make capital structure decisions to create value. Finally, Chapter 18 examines ways companies can improve their communications with the
financial markets.

Part Four—Chapters 19 through 25—is devoted to valuation in more
complex situations. We explore the challenges of valuing high-growth companies, companies in emerging markets, multibusiness companies, cyclical
companies, banks, and insurance companies. In addition, we show the way


x

PREFACE

uncertainty and flexibility affect value and the application of option pricing
theory and decision trees.

WHAT’S NEW ABOUT THE FOURTH EDITION
With the fourth edition, we continue to expand the practical application of
finance to real business problems, reflecting the economic events of the
past decade, new developments in academic finance, and the authors’ own
experiences. Most of the case examples and empirical analyses have been
updated, and we have reflected changes in accounting rules. We have enhanced the global perspective in the book, with extensive examples and
data from outside the United States, including discussions of both U.S.
and international accounting standards, as well as a chapter dedicated to
emerging markets.
We have substantially expanded or revised most chapters to add insights on practical applications. Among them:
• Do Fundamentals Really Drive the Stock Market? (Chapter 4), which describes the empirical evidence to support discounted cash flows, now
includes a discussion of the emerging area of behavioral finance.
• Frameworks for Valuation (Chapter 5) has been expanded to provide a
more detailed overview of the alternative DCF techniques, such as
the adjusted present value (APV) method.
• Forecasting Performance (Chapter 8) now includes practical tips on
building robust financial models.
• Estimating the Cost of Capital (Chapter 10) contains a new discussion

on the market risk premium based on recent empirical work as well
as alternative models to the Capital Asset Pricing Model (CAPM) and
practical ways to estimate beta.
• Calculating and Interpreting Results (Chapter 11) includes a more detailed
discussion of how to estimate the value of nonoperating assets and liabilities, such as unfunded pensions and stock options.
• Creating Value through Mergers and Acquisitions (Chapter 15) and Creating Value through Divestitures (Chapter 16) have added practical approaches to evaluating deals and estimating synergies.
• Valuing Flexibility (Chapter 20) incorporates a systematic approach to
comparing option pricing and decision trees as a way to value
flexibility.
• Cross-Border Valuation (Chapter 21) has been recast to account for the
fact that most major European and Asian companies have adopted
International Financial Reporting Standards.


PREFACE

xi

In addition, the fourth edition has five new chapters, including:
• Thinking about Return on Invested Capital and Growth (Chapter 6) introduces return on capital and growth as the key drivers of value. This
chapter helps executives forecast ROIC and growth by providing historical evidence on the long-term performance of companies.
• Using Multiples for Valuation (Chapter 12) explores how to use multiples to draw additional insights about valuation from comparable
companies, keeping the focus on DCF valuation.
• Performance Measurement (Chapter 13) explores the complexities of
measuring corporate performance, particularly the imperative to analyze a company’s long-term health on par with its short-term financial performance.
• Capital Structure (Chapter 17) provides a practical perspective on the
impact of capital structure on corporate value and explains how executives can use capital structure (including decisions about debt levels, dividends, and share repurchases) to support their corporate
strategies.
• Investor Communications (Chapter 18) grounds investor communications in rigorous analysis of a company’s value, its strategy story, and
its current and potential investor base.


VALUATION SPREADSHEET
An Excel spreadsheet valuation model is available on a CD-ROM or via web
download. This valuation model is similar to the model we use in practice.
Practitioners will find the model easy to use in a variety of situations:
mergers and acquisitions, valuing business units for restructuring or
value-based management, or testing the implications of major strategic decisions on the value of your company. We accept no responsibility for any
decisions based on your inputs to the model. If you would like to purchase
the model on CD, ISBN 0-471-70217-X, please call (800) 225-5945, or visit
www.WileyValuation.com to purchase the model via web download, ISBN
0-471-73389-X.



Acknowledgments

No book is solely the effort of its authors. This book is certainly no exception, especially since it grew out of the collective work of McKinsey’s corporate finance practice and the experiences of its consultants throughout
the world.
Most important, we would like to thank Tom Copeland and Jack Murrin, two of the coauthors on the first three editions of this book. We are
deeply indebted to them for establishing the early success of this book, for
mentoring the current authors, and for their hard work in providing the
foundations that this edition builds on.
Ennius Bergsma also deserves our special thanks. Ennius initiated the
development of McKinsey’s corporate finance practice in the mid-1980s. He
inspired the original internal McKinsey valuation handbook and mustered
the support and sponsorship to turn that handbook into a real book for an
external audience.
We would also like to acknowledge those who shaped our knowledge of
valuation, corporate finance, and strategy. For their support and teachings,
we thank Tony Bernardo, Bob Holthausen, Rob Kazanjian, Ofer Nemirovsky, Eduardo Schwartz, Jaap Spronk, Sunil Wahal, and Ivo Welch.

A number of colleagues worked closely with us on the fourth edition,
providing support that was essential to the completion of this edition.
André Annema, one of the longest serving members of our European corporate finance practice, led much of the analysis for three chapters: Do Fundamentals Really Drive the Stock Market? (Chapter 4) with assistance from
Terence Nahar and Fredrik Gustavsson; Creating Value through Divestitures (Chapter 16); and Cross-Border Valuation (Chapter 21). Bin Jiang,
with the support of Carrie Chen, conducted the analysis for Chapter 6,
Thinking about Return on Invested Capital and Growth, using the Corporate Performance database that she has been developing for McKinsey, and
xiii


xiv

ACKNOWLEDGMENTS

which was inspired by Dick Foster. Nidhi Chadda assisted with Chapter 12,
on Using Multiples for Valuation. Richard Dobbs co-wrote Chapter 13, Performance Measurement and Chapter 14, Performance Management, with
support from Paul Todd, Vanessa Lau, and Joe Hughes. Werner Rehm cowrote Chapter 15, Creating Value through Mergers and Acquisitions. Chapter 16, Creating Value through Divestitures, draws on work by Lee
Dranikoff and Antoon Schneider. Régis Huc supported the analyses for
Chapter 17, Capital Structure, which benefited from the credit rating models developed by Harry Markl and Michael Rudolf. Jean-Hugues Monier,
Paul Adam, and Yuri Maslov provided support in the preparation of Chapter 18, Investor Communications. This chapter also draws on work by Kevin
Coyne and Jonathan Witter. S. R. Rajan drove the work on Chapter 19, Valuing Multibusiness Companies. Marijn de Wit supported the case examples
in Chapter 20, Valuing Flexibility. William Jones and Gustavo Wigman contributed to Chapter 22, Valuation in Emerging Markets, and Alexandre
Amson and Fabienne Moimaux provided support for the analyses. Marco de
Heer’s dissertation formed the basis for Chapter 24, Valuing Cyclical Companies. Susan Nolen Foushee co-wrote Chapter 25, Valuing Financial Institutions. Meg Smoot, Yasser Salem, Martijn Olthof, and Neha Patel helped
prepare the analysis and valuation of Heineken that appears throughout the
book. Neha Patel and Yan Yang helped update the valuation model CD. We
thank them all for their insights and hard work.
We would like to thank again all those who contributed to the first three
editions. We owe a special debt to Dave Furer for help and late nights developing the original drafts of this book more than 15 years ago. The first three
editions and this edition drew upon work, ideas, and analyses from Carlos
Abad, Petri Allas, Buford Alexander, Pat Anslinger, Vladimir Antikarov, Ali

Asghar, Bill Barnett, Dan Bergman, Olivier Berlage, Peter Bisson, the late
Joel Bleeke, Steve Coley, Johan Depraetere, Mikel Dodd, Will Draper, Christian von Drathen, David Ernst, Bill Fallon, George Fenn, Russ Fradin,
Gabriel Garcia, Alo Ghosh, Irina Grigorenko, Keiko Honda, Alice Hu, Mimi
James, Chris Jones, Phil Keenan, Phil Kholos, David Krieger, Shyanjaw Kuo,
Kurt Losert, Bill Lewis, Perry Moilinoff, Mike Murray, Juan Ocampo, John
Patience, Bill Pursche, Frank Richter, David Rothschild, Silvia Stefini,
Konrad Stiglbrunner, Ahmed Taha, Bill Trent, David Twiddy, Valerie Udale,
Sandeep Vaswani, Kim Vogel, Jon Weiner, Jack Welch, David Willensky,
Pieter de Wit, and David Wright.
For help in preparing the manuscript and coordinating the flow of
paper, e-mails, and phone calls, we owe our thanks to our assistants, Kimberly Davenport, Lynette Murray, Eveline de Bruijn, and Denise de Jong.
We also extend thanks to the team at John Wiley & Sons, including
Pamela van Giessen, Jennifer MacDonald, and Mary Daniello.
Of course, we could not have devoted the time and energy to this book
without the support and encouragement of McKinsey’s corporate finance


ACKNOWLEDGMENTS

xv

practice leadership, in particular Richard Dobbs, Bernie Ferrari, Christian
Caspar, and Jan Willem Breen. We are also indebted to Fred Gluck, a former
managing director of McKinsey, who supported the creation of the corporate finance practice in the late 1980s and who played a vital role in creating
a knowledge-building culture within McKinsey.
Stuart Flack, in addition to providing moral support based on his experience with other book projects, ensured that we received superior editorial
support from McKinsey’s external publishing team.
Joanne Mason, along with Richard Dobbs and Bill Javetski, planned and
executed the launch of this book, helping us to get the word out, orchestrating articles, speeches, and meetings. When we thought our task complete
with the writing of the manuscript, they gently reminded us otherwise and

kept us going.
Dennis Swinford oversaw the production of the more than 300 exhibits
in this book, a truly Herculean task given the variety of formats and technologies employed. We are grateful for his hard work and patience.
Bill Javetski was in many ways the fourth author of this book. He edited
the entire manuscript, ensuring consistency of style and structure. Most
important, he served as our coach, sounding board, and occasional arbiter,
participating in every meeting and conference call among the authors, debating the structure of each chapter, and helping us find the best language
to make it accessible to every reader. Karen Schenkenfelder provided careful editing and feedback throughout the process. Sue Catapano diligently
checked important references.
The University Edition of this book includes end-of-chapter questions
and an instructor’s resource guide based on the material in this book. In addition, a professional workbook accompanies this book. We would like to
thank Professor Jeffrey P. Lessard at the Rochester Institute of Technology
for preparing the questions for the University Edition and for creating the
Valuation Workbook. This workbook, originally developed by Bill Foote, is an
important complement to the text for practitioners and students alike.
Finally, thank you to Melissa Koller, Monique Donders, Jennifer
Wessels, and our children. Our wives and families are our true inspirations. This book would not have been possible without their encouragement, support, and sacrifice.



Contents
Part One

Foundations of Value

1 Why Maximize Value?
2 The Value Manager

3
23


3 Fundamental Principles of Value Creation

47

4 Do Fundamentals Really Drive the Stock Market?
Part Two

71

Core Valuation Techniques

5 Frameworks for Valuation

103

6 Thinking about Return on Invested Capital and Growth
7 Analyzing Historical Performance
8 Forecasting Performance

135

161

233

9 Estimating Continuing Value

275


10 Estimating the Cost of Capital

297

11 Calculating and Interpreting Results
12 Using Multiples for Valuation

339

371

Part Three Making Value Happen
13 Performance Measurement
14 Performance Management

393
415

15 Creating Value through Mergers and Acquisitions
16 Creating Value through Divestitures
17 Capital Structure

437

465

487

18 Investor Communications


523
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CONTENTS

Part Four

Advanced Valuation Issues

19 Valuing Multibusiness Companies
20 Valuing Flexibility

547

559

21 Cross-Border Valuation

591

22 Valuation in Emerging Markets

621

23 Valuing High-Growth Companies
24 Valuing Cyclical Companies
25 Valuing Financial Institutions


655

671
681

Appendix A

Economic Profit and the Key Value
Driver Formula
711

Appendix B

Discounted Economic Profit Equals Discounted
Free Cash Flow
713

Appendix C

Adjusted Present Value Equals Discounted Free
Cash Flow
715

Appendix D

Levering and Unlevering the Cost of Equity

Appendix E


Leverage and the Price-Earnings Multiple

Index

729

719
725


VALUATION
MEASURING AND
MANAGING THE
VALUE OF
COMPANIES



Part One

Foundations of Value