204  Frameworks for Valuation on what today’s economists call a “replicating portfolio.” They argued that if a portfolio exists of traded securities whose future cash flows perfectly mimic the security you are attempting to value, the portfolio and security must have the same price. This is known as the law of one price. As long as you can find a suitable replicating portfolio, you need not discount future cash flows. Given the model’s power in valuing derivatives like stock options, there have been many recent attempts to translate the concepts of replicating port- folios to corporate valuation. This valuation technique, commonly known as real options, is especially useful in situations of great uncertainty. Unlike those for financial options, however, replicating portfolios for companies and their projects are difficult to create. Therefore, although option-pricing models may teach powerful lessons, today’s applications are limited. Chapter 39 covers valuation using options-based models. Summary Our exploration of the most common DCF valuation models has put a particu- lar focus on the enterprise DCF model and the economic-profit model. Each model has its own rationale, and each has an important place in corporate valuation. The remaining chapters in Part Two describe a step-by-step ap- proach to valuing a company. These chapters explain the technical details of valuation, including how to reorganize the financial statements, analyze re- turn on invested capital and revenue growth, forecast free cash flow, compute the cost of capital, and estimate an appropriate terminal value. 205 11 Reorganizing the Financial Statements Traditional financial statements—the income statement, balance sheet, and statement of cash flows—do not provide easy insights into operating perfor- mance and value. They simply aren’t organized that way. The balance sheet mixes together operating assets, nonoperating assets, and sources of financing. The income statement similarly combines operating profits, interest expense, and other nonoperating items. To prepare the financial statements for analyzing economic performance, you should reorganize each financial statement into three categories: operating items, nonoperating items, and sources of financing. This often requires searching through the notes to separate accounts that aggregate operating and nonoperat- ing items. This task may seem mundane, but it is crucial for avoiding the common traps of double-counting, omitting cash flows, and hiding leverage that distorts performance metrics, such as return on equity and cash flow from operations. Since reorganizing the financial statements is complex, this chapter breaks down the process into three sections. The first section presents a simple ex- ample demonstrating how to build invested capital, net operating profit after taxes (NOPAT), and free cash flow. The second section applies this method to the financial statements for Costco Wholesale, with comments on some of the intricacies of implementation. Finally, we provide a brief summary of ad- vanced analytical topics, including how to adjust for restructuring charges, operating leases, pensions, and capitalized expenses. An in-depth analysis of each of these topics can be found in the chapters of Part Three. Reorganizing the Accounting Statements: Key Concepts To calculate return on invested capital (ROIC) and free cash flow (FCF), it is nec- essary to reorganize the balance sheet to estimate invested capital, as well as to 206  Reorganizing the Financial Statements likewise reorganize the income statement to estimate NOPAT. Invested ­capital represents the investor capital required to fund operations, without regard to how the capital is financed. NOPAT represents the after-tax operating profit (generated by the company’s invested capital) that is available to all investors. ROIC and FCF are both derived from NOPAT and invested capital. ROIC is defined as ROIC NOPAT Invested Capital = and free cash flow is defined as FCF NOPAT Noncash Operating Expenses Investment in Invested Cap = + − ital By combining noncash operating expenses, such as depreciation, with invest- ment in invested capital, it is also possible to express FCF as FCF NOPAT Increase in Invested Capital = − Invested Capital: Key Concepts To build an economic balance sheet that separates a company’s operating as- sets from its nonoperating assets and financial structure, we start with the traditional balance sheet. The accounting balance sheet is bound by the most fundamental rule of accounting: Assets Liabilities Equity = + The traditional balance sheet equation, however, mixes operating liabilities and sources of financing on the right side of the equation. Assume a company has only operating assets (OA), such as accounts re- ceivable, inventory, and property, plant, and equipment (PP&E); operating li- abilities (OL), such as accounts payable and accrued salaries; interest-bearing debt (D); and equity (E). Using this more explicit breakdown of assets, liabili- ties, and equity leads to an expanded version of the balance sheet relationship: OA OL D E = + + Moving operating liabilities to the left side of the equation leads to in- vested capital: OA OL Invested Capital D E − = = + This new equation rearranges the balance sheet to reflect more accurately capital used for operations and the financing provided by investors to fund those operations. Note how invested capital can be calculated using either the operating method (that is, operating assets minus operating liabilities) or the financing method (debt plus equity).