By Dada Adefolami
The principal objective of financial management is to maximise shareholder wealth. This raises two key questions – how can we measure whether shareholder value is being created or destroyed, and which performance appraisal targets ensure that managers act in such a way as to generate shareholder value?
We therefore require a wealth metric for measuring shareholder value, and a performance metric to use for target setting. This article outlines the requirements for a system of metrics and then reviews some of the current contenders, including net present value (NPV), shareholder value analysis (SVA), economic value added (EVA), and cash flow return on investment (CFROI).
REQUIREMENTS
Traditional approaches to measuring managerial performance, such as profit and return on investment (ROI), have the significant disadvantage that they correlate poorly with shareholder value. As a result, managers could unwittingly destroy shareholder value while attempting to improve divisional performance. Attempts to develop more useful metrics have focused on incorporating three key issues:
In corporate finance, Economic Value Added (EVA) is an estimate of a firm’s economic profit, or the value created in excess of the required return of the company’s shareholders. Quite simply, EVA is the net profit less the opportunity cost of the firm’s capital. The idea is that value is created when the return on the firm’s economic capital employed exceeds the cost of that capital.
1. Cash is preferable to profit
Cash flows have a higher correlation with shareholder wealth than profits.
2. Exceeding the cost of capital
The return, however measured, must be sufficient to cover not just the cost of debt for example by exceeding interest payments, but also the cost of equity. Peter Drucker commented, in a Harvard Business Review article: ‘Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources… until then it does not create wealth; it destroys it.’
3. Managing both long and short-term perspectives
Investors are increasingly looking at long-term value. When valuing a company’s shares, the stock market places a value on the company’s future potential, not just its current profit levels.
Company announcements, about capital expenditure, research and development, or new investments are often treated as positive rather than negative factors by the market, even though these announcements may have a detrimental effect on short-term profits. New Textile companies, for example, clearly have a value despite the fact that many currently have no products.
Managerial target setting and performance appraisals are usually focused on the shorter term. The danger is that managers may be pressured to improve performance in the short-term at the expense of longer-term value. Hence Economic value added (EVA) is a measure of a company’s financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, and it attempts to capture the true economic profit of a company.
DISCOUNTED CASH FLOWS (DCF) AND NET PRESENT VALUE (NPV)
DCF is calculated by analyzing the discounted future cash flow. NPV and Internal Rate of Return are the methods used in Discounted Clash Flow. In NPV, the future cash flow is multiplied with a rate. While dealing with investments, the Discounted Cash Flow method is widely used by investors.
Most Finance expat will be familiar with the NPV approach to project appraisal. This method involves the following steps:
1. Determine the relevant, incremental cash flows for the project.
2. Discount the cash flows using an appropriate rate that reflects the risk of the project.
3. Accept the project if the NPV>0.
The main advantage of this approach is the high correlation between NPV and shareholder value. Theoretically, undertaking a project with a positive NPV of, say, N1m will increase the market value of the company concerned and hence shareholder wealth by N1m. Given that the main objective of financial management is to maximize shareholder wealth, managers have, in NPV, a powerful technique for evaluating projects.
What is lacking, however, is an operating performance measure for managers that will help them to maximize NPV. Some firms attempt to use cash flow targets but with mixed success. Depressingly, many more firms set targets based on traditional measures, such as profit and ROI, without resolving the inconsistency of using NPV for project appraisal and then ignoring it when appraising managers.
Net Present Value (NPV) is the difference between present value of future cash inflows and cash outflows. NPV is one of the most widely used investment appraisal techniques to evaluate the financial viability of capital projects. Here, all the future cash inflows and outflows will be discounted at the required rate of return from the project.
SHAREHOLDER VALUE ANALYSIS (SVA)
The SVA approach, described by Alfred Rappaport, is a variation of the DCF methodology in that it values the whole enterprise, not just individual projects.Shareholder value analysis (SVA) is one of several nontraditional metrics being used in business today. SVA determines the financial value of a company by looking at the returns it gives its stockholders and is based on the view that the objective of company directors is to maximize the wealth of company stockholders. Central to the approach are seven ‘value drivers’:
1. Sales growth
2. Operating profit margin
3. (cash) tax rate
4. Incremental working capital investment (IWCI)
5. Fixed capital investment to support current activity levels
replacement fixed capital investment – RFCI, and to support future growth
6. Incremental fixed capital investment – IFCI
7. Cost of capital
8. ‘Competitive advantage period’ or ‘value growth duration’ during which the firm is expected to generate superior returns in excess of its cost of capital.
Shareholder value analysis (SVA) is one of several nontraditional metrics being used in business today. SVA determines the financial value of a company by looking at the returns it gives its stockholders and is based on the view that the objective of company directors is to maximize the wealth of company stockholders.
The SVA technique involves the following steps:
1. Estimate the free cash flows within the competitive advantage period by reference to the value drivers.
2. Discount these cash flows, using either a company-wide weighted average cost of capital (WACC) or separate business unit discount rates.
3. Add to the result the present value of the firm at the end of the forecast period. This is known as the ‘residual value’, and is usually calculated by discounting simplified cash flows (e.g. zero or constant growth) beyond the competitive advantage period.
4. Add the market value of non-trade or non-operational assets to the result to get the corporate value that belongs to all investors.
5. The value of equity is then determined by deducting the value of debt.
Being an NPV approach, SVA satisfies requirements for a long-term value metric. It is thus widely used both by managers, and by potential investors seeking to discover undervalued companies. The seven value drivers can also be used for target setting and for assessing managerial performance in the shorter term. Managers are comfortable with concepts such as sales growth and margin, making the approach popular. The main problem, nevertheless, is that there are seven targets, not one, and these may be in conflict. For example, high growth may involve riskier strategies, which in turn will increase the cost of capital and require greater working capital investment.
Stockholders enjoy seeing the price of shares go up as well, validating their original investment.How to increase shareholder value as follows
1. Use a number of methods to increase profitability, raise revenue and increase the company share price to ultimately increase shareholder value.
2. Increase profitability by cutting costs and increasing efficiency.
3. Buy back shares that are outstanding on the open market.
The idea in shareholder wealth maximization model is that shareholders are the group that take the greatest risks and thus deserves special treatment is a fiction. In shareholder wealth maximization model, managers make decision on the basis of stock price maximization.
ECONOMIC VALUE-ADDED METHOD
The economic value added (EVA) approach is primarily a performance metric rather than a wealth metric. Stern Stewart & Co, the management consultancy that has trademarked EVA and is credited with popularizing the concept, describes EVA as ‘a simple financial measure of performance’.Value-added is used in several ways to indicate an enhancement to a product or an entity. By one definition, value-added is the difference between the cost of materials purchased by a firm and the price at which it sells the goods that use those materials.
EVA is the residual income that remains after net operating profit after tax (NOPAT) has been reduced by an additional charge; this charge is based on the return investors can be expected to require, given the amount of capital they have tied up in the business. Note that interest charges are not deducted to arrive at NOPAT, as financing costs are incorporated into the capital charge. Hence have:
EVA = NOPAT minus a capital charge
= NOPAT minus (capital x cost of capital)
It is therefore very clear if profits are sufficient to cover the cost of capital. This link can be made clearer by rewriting EVA, using the ‘spread method’ as:
EVA = (ROI – cost of capital) x capital, where ROI = NOPAT/capital
The full cost of capital so visible to managers should result in their being more careful when choosing to invest further funds, and exercising greater control over working capital investment.
Advocates of EVA argue that it also supports the NPV approach to investment appraisal. To this, the present value of future EVA figures can be calculated, giving the market value added (MVA) to the business. To calculate the value of equity, this needs to be added to the opening capital and then adjustments made for non-trade assets and debt, as for SVA.
Demonstrates that MVA and EVA should give a strong correlation with shareholder value in the same way as NPV and SVA. Stern Stewart & Co argue that managers can be assessed on EVA with confidence that their actions should lead to wealth creation.
While the focus on a single performance measure is seen to be a major advantage by many, the complexity of the calculations has deterred some, argue that it is hard for managers to see how their behaviour has affected the EVA .
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