Value-based management exemplifying effectiveness of economic value

Value-based management exemplifying effectiveness of economic value

Saturday, April 7, 2018 10:30 pm

Dada Adefolami

By Dada Adefolami

Value Based Management is the corporate governance principle and management approach that ensures corporations are managed consistently on long-term shareholder value creation. Also held responsible for creating value, managing value and measuring value.

The shareholder’s minimum expected return is the firm’s cost of capital, this becomes the discount rate. If value-based planning sounds familiar, that is not surprising. It is closely modeled on the discounted cash flow methods for evaluating capital investments. Instead of projects, however, the focus is on the payoff from the overall strategy the cost of capital, and value-based planning processes, intangibles and interdependencies, dealing with uncertainty, the business case and stakeholders.

EVA as a performance indicator is very useful. The calculation shows how and where a company created wealth, through the inclusion of balance sheet items. This forces managers to be aware of assets and expenses when making managerial decisions. However, the EVA calculation relies heavily on the amount of invested capital, and is best used for asset-rich companies that are stable or mature. Companies with intangible assets, such as technology businesses, may not be good candidates for an EVA evaluation.

Key insights
There are many insights and lessons to be learn on economic value added (EVA) are:
1. Economic value has many advantages over conventional accounting profit as it is cash flow based, deals with these cash flows over time, and makes an adjustment for the cost of capital.
2. The cost of capital takes into account the time value of money, inflation and risk
3. The value of a business is based on intelligent cash flow projections based on the seven value drivers.
4. Behind these value drivers are some deeper but equally important competitive drivers; if these are not understood then the numbers are not robust.
5. Economic value is generated when there is alignment of the business value system.
6. We need to deep-dive below the business value system to carry out a more specific value and cost driver analysis.
7. To estimate the value of a key business decision inventiveness is required to draw data in from a variety of sources; this is often referred to as the ‘hunt for value’.
8. EVA is a very powerful process to be used alongside and in support of strategic thinking.

Focusing on a process called value-based management, which involves putting EVA at the centre of corporate decision-making, planning, control and performance management. Underpinning value-based management is the premise that capital is not a free resource for the business – it has a cost and ‘economic rent’ to which to be return.

An equation for invested capital often used to calculate EVA is = Total Assets – Current Liabilities, two figures easily found on a firm’s balance sheet. In this case, the formula for EVA is: NOPAT – (Total Assets – Current Liabilities) * WACC.

The goal of EVA is to quantify the charge, or cost, of investing capital into a certain project or firm and to then assess whether it generates enough cash to be considered a good investment. The charge represents the minimum return that investors require to make their investment worthwhile. A positive EVA shows a project is generating returns in excess of the required minimum return.

The cost of capital
First in the EVA look at the weighted average cost of capital (WACC). For completeness, this cover the calculation of the cost of equity. Calculating this involves the capital asset pricing model (CAPM). The EVA formula is calculated using the following equation: EVA = NOPAT – (capital x cost of capital) In this formula, NOPAT stands for net operating profit after taxes. The figure used for cost of capital is often the weighted average cost of capital, or WACC.

The WACC is commonly referred to as the firm’s cost of capital. Importantly, it is dictated by the external market and not by management.
Perhaps the best way to illustrate the positive impact of financial leverage on a company’s financial performance is by providing a simple example. The Return on Equity (ROE) is a popular fundamental used in measuring the profitability of a business as it compares the profit that a company generates in a fiscal year with the money shareholders have invested. After all, the goal of every business is to maximize shareholder wealth, and the ROE is the metric of return on shareholder’s investment.

Also known as the profit and loss statement or statement of revenue and expense, the income statement is one of three major financial statements in the annual report and 10-K. All public companies must submit these legal documents to the Securities and Exchange Commission (SEC) and investor public. The other two financial statements are the balance sheet and the statement of cash flows. All three provide investors with information about the state of the company’s financial affairs, but the income statement is the only one that provides an overview of company sales and net income.

Financial statements provide an in-depth look into a company’s growth potential and liquidity risk, which makes them indispensable to investors looking for undervalued opportunities. Investopedia’s Fundamental Analysis Course provides a comprehensive introduction to the subject with over five hours of on-demand video, exercises, and interactive content. You’ll learn about everything from reading financial statements to interpreting financial ratios to capitalize on undervalued opportunities. 

The Capital Asset Pricing Model (CAPM), was first developed by William Sharpe (1964), and later extended and clarified by John Lintner (1965) and Fischer Black (1972). Four decades after the birth of this model, CAPM is still accepted as an appropriate technique for evaluating financial assets and retains an important place in both academic scholars and finance practitioners.

CAPM is based on an empirical investigation of share price movements which discovered that share prices in particular industries tend to move up or down relative to the overall market according to some constant called, for want of a better name, a beta. In addition, it was thought that the rate of return on an equity included the risk-free rate (Rf), while Rm was the average return on the whole market.

These concepts were all related together as:
1. return on equity (Re) = Rf + beta x (Rm – Rf)
Rm – Rf is therefore the ‘risk premium’.
So if the risk-free rate is 3 per cent and the return on the market is 8 per cent, then the risk premium is 5 per cent 8% minus 3%; if the beta is 1.5 a volatile stock we have the following return on equity:
1. Re = 3% + 1.5 (8% – 3%)
2. Re = 3% + (1.5 x 5%)
3. Re = 10.5%
A very important consequence of this is that equity risk or ‘systematic risk’ is already included in the equity cost of capital. That means that we should not also be increasing the WACC for project-specific risk, which should be taken into the calculations purely through risk and sensitivity analysis – risk must not be double-counted.

Another consequence is that it is not the job of managers to diversify business risk – the shareholders are managing that in their portfolios.
This is only a part of the cost of capital and one needs to factor in the cost of debt after tax and the gearing to establish the WACC.
When doing the calculations, it is essential to stand back and ask ‘does the result make sense?’. note capital is never free nor almost free. 
Value-based management
Accounting profit is based on the accrual principle and focuses on optimizing short-term profit. Value-based management ranks accounting profit secondary to or at best on a par with the emphasis on cashflows adjusted for the cost of capital.

This treatment involves a very big shift in perspective. The profound set of shifts involved means making far reaching changes to:
1. Financial planning and budgeting;
2. Strategic planning;
3. How we think about marketing – optimizing customer economic value
4. Cost management and budgeting – cost reductions are never pursued in isolation from thinking how resources can best be used to add value to the business;
5. Change management – organizational change is never pursued in isolation but will have a full business case based on the impact on value and cost drivers;
6. Brand valuation – the positive and negative effect of investing in or damaging the brand on future cash flows is estimated;
7. Managing intangibles – besides brands, other major areas of investment where the economic benefits are not obviously measurable are still subjected to some sort of broader-brush economic assessment which is founded on empirical analysis, such as learning and development, culture change, and so on;
8. Management processes – ruthlessly weeded out by focusing on whether the processes really add economic value or not;
9. Managing acquisitions – these very frequently end up destroying shareholder value for a number of reasons, such as inadequate financial valuation of pre- and post-acquisition strategies, the deal-making process, or during the often distracting and damaging process of integration;
10. Performance management – it is imperative that with value-based management the performance of senior managers is recognized and rewarded based on economic measures as well as, or instead of, short-term accounting profit.

Finally, Engine for EVA
Given the importance of a company’s capital structure, the first step in the capital decision making process is for the management of a company to decide how much external capital it will need to raise to operate its business. Once this amount is determined, management needs to examine the financial markets to determine the terms in which the company can raise capital. This step is crucial to the process, because the market environment may curtail the ability of the company to issue debt securities or common stock at an attractive level or cost. With that said, once these questions have been answered, the management of a company can design the appropriate capital structure policy, and construct a package of financial instruments that need to be sold to investors. By following this systematic process, management’s financing decision should be implemented according to its long-run strategic plan, and the manner in which it wants to grow the company over time.

Value-based management is the process for turning EVA into a practical reality. Fundamentally once you have got over the hurdle of understanding the technicalities of the cost of capital and discounting, it’s all downhill. The really interesting side to this is exploring the value and cost drivers, not only to understand how EVA has been created in the past, but how it might be in the future and in new ways.

A company needs financial capital in order to operate its business. For most companies, financial capital is raised by issuing debt securities and/or by selling common stock. The amount of debt and equity that makes up a company’s capital structure has many risk and return implications. Therefore, corporate management has an obligation to use a thorough and prudent process for establishing a company’s target capital structure. The capital structure is how a firm finances its operations and growth by using different sources of funds.

The study of a company’s optimal capital structure dates back to 1958 when Franco Modigliani and Merton Miller published their Nobel Prize winning work “The Cost of Capital, Corporation Finance, and the Theory of Investment.” As an important premise of their work, Modigliani and Miller illustrated that under conditions where corporate income taxes and distress costs are not present in the business environment, the use of financial leverage has no effect on the value of the company. This view, known as the Irrelevance Proposition theorem, is one of the most important pieces of academic theory that has ever been published. 

Unfortunately, the Irrelevance Theorem, like most Nobel Prize winning works in economics, require a number of impractical assumptions that need to be accepted to apply the theory in a real-world environment. In recognition of this problem, Modigliani and Miller expanded their Irrelevance Proposition theorem to include the impact of corporate income taxes, and the potential impact of distress cost, for purposes of determining the optimal capital structure for a company. Their revised work, universally known as the Trade-off Theory of capital structure, makes the case that a company’s optimal capital structure should be the prudent balance between the tax benefits that are associated with the use of debt capital, and the costs associated with the potential for bankruptcy for the company. Today, the premise of the Trade-off Theory is the foundation that corporate management should be using to determine the optimal capital structure for a company.

-Dada Suraju Adefolami, FIMC, CMC. Professor of Finance, School of Business Administration, UNEM University Costa Rica, is a Finance / Management Consultant and Certified Forensic Accountant. You can reach him via: [email protected]; 08052043855

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