Shareholder Value Demystified: An Explanation of Methodologies and Use (Strategic Resource Management Series)

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SHAREHOLDER VALUE DEMYSTIFIED

MARIA BARBERA MCom (UNSW) is the research officer of the Australian Centre for Management Accounting Development (ACMAD) at the University of New South Wales. Her position involves the preparation and commissioning of research documents that promote organisational innovation, effective resource management, and inter-organisational learning. RODNEY COYTE BCom (Melb) MCom (UNSW) AACS joined the School of Accounting at the University of New South Wales in 1992, and lectures there in business strategy, management and management accounting. He previously held a number of senior management positions including business planning manager and information technology manager for a unit of the Mars Corporation.

THE AUSTRALIAN CENTRE FOR MANAGEMENT ACCOUNTING DEVELOPMENT (ACMAD) is a member-driven and member-financed network of almost 100 organisations and universities. Its mission is to stimulate and facilitate learning about the innovative management of organisational resources. This series is one expression of its mission. ACMAD welcomes inquires. Further information about the Centre is provided on its website at: www.ace.unsw.edu.au/acmad THE INSTITUTE OF CHARTERED ACCOUNTANTS IN AUSTRALIA believes that the Strategic Resource Management series will contribute to the clarification of a range of significant issues facing managers and business professionals in the future. The practical insights and distinctive perspectives offered will greatly benefit our members and will add value to anyone who is a strategic business thinker. Other books in the series: Controls in Strategic Supplier Relationships Suresh Cuganesan, Michael Briers and Wai Fong Chua Innovative Management Accounting: Insights from practice Maria Barbera, Jane Baxter and William Birkett Organisational Learning and Management Accounting Systems: A study of local government Louise Kloot, Maria Italia, Judy Oliver and Albie Brooks

STRATEGIC RESOURCE MANAGEMENT

Maria Barbera

Rodney Coyte

SHAREHOLDER VALUE DEMYSTIFIED AN EXPLANATION OF METHODOLOGIES AND USE

A UNSW Press book Published by University of New South Wales Press Ltd University of New South Wales Sydney 2052 Australia www.unswpress.com.au © ACMAD 1999 First published 1999 This book is copyright. Apart from any fair dealing for the purpose of private study, research, criticism or review, as permitted under the Copyright Act, no part may be reproduced by any process without written permission. Inquiries should be addressed to the publisher. National Library of Australia Cataloguing-in-Publication entry: Barbera, Maria. Shareholder value demystified: an explanation of methodologies and use. Bibliography. ISBN 0 86840 697 X. 1. Corporations — Valuation. 2. Corporations — Valuation — Accounting. I. Coyte, W. (Rodney William). II. Title. (Series: Strategic resource management). 332.63221 Printer BPA, Melbourne

CONTENTS PREFACE ix INTRODUCTION xi 1 • • •

SHAREHOLDER VALUE IN CONTEXT 1 Organisational stakeholders 1 Organisational strategies 3 Organisational performance 4

2 • • • • • • •

THE INADEQUACIES OF TRADITIONAL ACCOUNTING MEASURES 6 Accruals, generally accepted accounting principles (GAAP) and cash flow 6 Short-term and long-term considerations 7 Ex-ante and ex-post considerations 7 The inadequacies of accounting earnings 7 The inadequacies of accounting return on investment 8 The inadequacies of accounting return on equity 9 The superiority of market-based measures 9

3 • • •

RAPPAPORT’S SHAREHOLDER VALUE ANALYSIS 11 The components of shareholder value 11 The measurement of shareholder value 12 The drivers of value 15

4 • • • •

STERN STEWART’S ECONOMIC VALUE ADDED MODEL 16 Calculating EVA 16 The drivers of value 19 Market Value Added 19 Economic profit 21

5 • • • •

TOTAL SHAREHOLDER RETURN AND TOTAL BUSINESS RETURN 22 Profitability 22 The cost of capital 24 Growth and free cash flow 25 The drivers of value 26

6 • • •

COMPARING THE MODELS 27 Comparison to traditional accounting 27 Accuracy 27 Summary 28

7 • • • • • • •

USING SHAREHOLDER VALUE CONCEPTS 31 The drivers of value 32 Strategy evaluation and implementation at corporate level 34 Setting targets 37 Strategy evaluation and implementation at business unit level 39 Linking shareholder value creation and performance measures 41 Focusing organisational effort 42 Communication 44

CONCLUSION 45 CASE STUDY 1 CASE STUDY 2 CASE STUDY 3

COCA-COLA AMATIL LIMITED48 QANTAS AIRWAYS LIMITED 53 RGC LIMITED 59

APPENDIX A APPENDIX B APPENDIX C

THE CAPITAL ASSET PRICING MODEL64 THE PERPETUITY METHOD 67 ADJUSTMENTS TO CAPITAL AND NOPAT IN EVA 67

REFERENCES 68

STRATEGIC RESOURCE MANAGEMENT

Organisations are devices for creating value through the effective use of resources. While they need to create value for all contributors of resources, a premium is placed on value creation for customers and shareholders. After all, an organisation is unlikely to be able to offer inducements to other resource contributors if it does not provide value to its customers. Also, shareholders are aware that failure in value creation for customers will be reflected in the value that they can receive. Value creation for customers and shareholders, then, is broadly regarded as the litmus test for judging organisational effectiveness. Value creation by organisations takes place against a backdrop of fast moving competition in resource and service markets, and increasingly rapid shifts in the value expectations of customers. Under these conditions it is insufficient to meet or beat the competition with present service offerings; new service offerings have to be invented and made competitive, as previous offerings cease to be serviceable and are thus devalued. As service offerings change, so will the materials, technologies, skills and processes that are needed to produce them. New service offerings require different constellations of resources and new relationships with new resource contributors. An organisation's strategies define how it proposes to create value for customers in terms of its service offerings over the immediate period and the opportunities it seeks over a longer term. Whether or not an organisation will be successful in these endeavours will depend on its capabilities for doing so. Strategies, then, have to deal with both the known (the creation of value through present service offerings) and the unknown (the invention of service offerings that will create value in an as yet unknown future). And capabilities need to sustain both the organisation's present effectiveness in offering services and its future renewal by capitalising on opportunities as they emerge. An organisation's success in strategy realisation or renewal will be dependent on its effectiveness and creativity in managing resources. This places a premium on strategic resource management and on new ways of understanding organisational resources, resourcing and resourcefulness. What are an organisation's resources, what forms do they take and how can they be used effectively and not wasted? What constellations of resources constitute strategic capabilities, useable now in meeting the competition and converting possibilities into future opportunities? And what strategic capabilities are sufficiently distinctive to constitute the core competences underlying an organisation's continuing identity? These questions are answered in the Strategic Resource Management Series. Each volume will address them in relation to particular subject matter, drawing on relevant theories and providing illustrations from contemporary organisational practice.

PREFACE

The interest of organisations in shareholder value has been amply demonstrated by the number of people attending ACMAD activities and other conferences on the subject, and by the frequent references to the methodologies in the financial press. ACMAD feels that, although interested, many firms are confused about the different methodologies and the claims made for them. This report is an attempt to redress this uncertainty. The aim of the report is to provide relevant information about shareholder value techniques and their use in value-based approaches to performance measurement, thereby assisting readers in their consideration of relevant issues. Specifically, this book: • • • • •

• •

identifies the inadequacies of traditional accounting measures as performance measures explains the rationale for the shareholder value approach describes and compares three of the major methodologies, highlighting their commonalities and differences identifies the ways in which consideration of shareholder value can be applied to strategy selection and implementation places shareholder value methodologies within organisations' frameworks for value creation, through a discussion of value-based management examines the role of shareholder value measurements in incentive compensation decisions relates the experiences of some Australian corporations which have adopted shareholder value techniques.

In addressing these areas, the report not only explores and compares the major methods, but also clarifies the purpose and use of the concept of shareholder value in both strategic and operational decision making. The conclusion considers the advantages and limitations of shareholder value analysis. This report should be of value to a range of managers.

Acknowledgments The authors wish to thank the organisations who agreed to participate in this project and the senior staff members of those organisations who gave their time and assistance. Thanks are also due to Mark Joiner (Boston Consulting Group), Denis Kilroy (KBA Consulting Group), the reviewers, and Professors Bill Birkett and Wai Fong Chua for their helpful comments. The opinions expressed in this document are those of the authors only and do not necessarily represent the views of the National or State committees of ACMAD.

INTRODUCTION

The quest to create value at an increasing rate over the long term is the focus of most contemporary business enterprises. While the term `value' means different things to different stakeholders, the emphasis in this report is on the creation and measurement of value for one specific stakeholder group: shareholders. For shareholders, value is created when a business, through the efficient management of its resources, earns a return greater than the cost of the capital employed to generate that return. This is not a new concept, but is one that has attracted the intense focus of managers and investors over the last decade. Shareholders are interested in the cash increments, over and above outlay, to be received over the life of their investment: that is the dividends and capital gain delivered. Whether or not these increments represent value is related to the risk associated with the investment — investors will require a higher return from investments that are seen to be risky. Arguably, share market prices incorporate expectations about the value creation potential and the risk of corporations. In view of the imperative for organisations to create value for their shareholders, how do organisations measure the value created by their operations? Traditionally, such measurement used accountancy-based indicators such as earnings, return on investment and return on equity. However, these measures are not based on cash-flow and do not take into account the full cost of capital (that is, the costs of equity and of debt). The suggested inadequacies of accountancy-based measures are summarised in Chapter 2. New methodologies include three which support the theory that a value maximising organisation will be interested only in investments which, in discounted cash flow terms, offer a return greater than the cost of capital. These three are: • • •

Shareholder Value Analysis (as proposed by Alfred Rappaport) Economic Value Added  (developed by Stern Stewart & Co.) Total Shareholder Returns and Total Business Returns (developed by the Boston Consulting Group).

These are not the only methodologies available. Indeed, every consulting firm appears to have devised its own variation. Nevertheless, these three incorporate the principles of shareholder value measurement and are sufficiently different to be of interest. They are described in Chapters 3 to 5 respectively and compared in Chapter 6. Having measured the shareholder value achieved through their operations, organisations are faced with the need for initiatives and actions which will impact favourably on that value into the future. To this end, they develop strategies (that is, patterns of resource allocation) and select those that, if implemented successfully, will optimally increase shareholder value. Again, shareholder value

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metrics are used: for example, to calculate the shareholder value that can be added by acquisitions or divestments, select between synergistic opportunities, make decisions about resource allocation, choose between potential product or service market portfolios and projects, and so forth. The concept of shareholder value is being adopted by many Australian companies. It is seen as facilitating, indeed enabling, growth, restructuring, product and customer selection, and profitability. Much depends, however, on how well it is understood, how well it is integrated into organisational thinking, strategic planning, decision-making, and operational activities, and how efficiently it is used as a motivational device. Understanding is facilitated by training, and integration is assisted by the introduction of valuebased management concepts. Motivation is sponsored by the introduction of value-based compensation which effectively links performance and shareholder value. Such aspects of value-based management are covered briefly in Chapter 7. Value, however, is not created by merely measuring financial performance. Organisations create value in their product or service markets in the face of competition, ever shorter life cycles, and high levels of uncertainty and ambiguity. In today's world, value creation depends on innovation, creativity and collective organisational capability (including the quality of management). While shareholder value approaches may provide description and give structure to organisational effort, they cannot substitute for the wellspring of creativity. Shareholder value creation is, after all, an outcome of organisational efforts and accomplishments.

A note on terminology, nomenclature and tradenames The terminology used in this area is extensive and rapidly changing. There are two reasons for this. Firstly, while shareholder value techniques developed by individuals or organisations were given specific names (which are in some cases trademarked), the concepts which underlie these proprietary names have now become generic. Thus people and journal articles use words such as `economic value', `value metrics', `shareholder value' without meaning to specifically refer to one or any of the proprietary methodologies available. Secondly, earlier books and articles principally addressed the shortcomings of accounting numbers, the rationale for shareholder value, and the application of shareholder value metrics to strategic choices. The focus of shareholder value has now shifted from the mathematics of shareholder value to its implementation, management and distillation throughout the organisation. In this report, proprietary systems are indicated by the use of proper names. For instance the Stern Stewart trademarked version is referred to as Economic Value Added or EVA. Where terms are used generically, lower case is adopted.

CHAPTER

1 SHAREHOLDER VALUE IN CONTEXT

Organisational stakeholders `An organisation is an association of productive assets (including individuals) which voluntarily come together to obtain economic advantages' (Barney 1997, p. 31). Thus, owners supply capital which is used to acquire assets, customers provide revenue, employees contribute expertise, government provides services, the community allows organisations to exist and confers advantages such as limited liability on corporations, suppliers provide inputs to production, and so on. Each of these groups can, however, withdraw its contribution from the organisation and, indeed, will do so unless the value received (in terms of income or satisfaction) is, after adjusting for risk, at least as large as that which could be expected from similar alternatives. In order to ensure that shareholders and the owners of other productive assets are willing to continue to remain associated with it, the organisation seeks an equilibrium between the `inducements' it must pay in return for the `contributions' it receives. The word `equilibrium' suggests that the organisation will seek to achieve some sort of a balance between its various stakeholder groups.

Value trade-offs One problem is that `value' is what a stakeholder group cares about; and different groups care about different things. The community values high

SHAREHOLDER VALUE DEMYSTIFIED

2

standards of corporate citizenship, and the provision of employment and opportunity; employees value personal involvement and job satisfaction, as well as remuneration; shareholders value investment return and capital gain; customers value quality, service, price, and so on. An organisation can rarely implement strategies that fully satisfy the performance demands of all groups, at least in the short term. Furthermore, the task of isolating and measuring performance for each stakeholder group would be overwhelming. For these reasons, the interests of certain stakeholders are usually emphasised over the interests of other stakeholders over time. Current organisational thinking concentrates on the creation of shareholder value. Copeland, Koller and Murrin (1996) justify this emphasis on shareholder value (as opposed to the weighted approach, which considers all stakeholder groups, adopted in continental Europe and some Asian countries) by demonstrating that shareholder value and national economic performance (as measured by GDP, productivity and job creation) are positively correlated: Empirical evidence indicates that increasing shareholder value does not conflict with the long-run interests of other stakeholders. Winning companies seem to create relatively greater value for all stakeholders: customers, labor, the government (via taxes paid), and suppliers of capital (p. 22) All claimants benefit when shareholders . . . use complete information and their decision-making authority to maximise the value of their own claim. The alignment of information and incentives within the equity claim is what makes this form of organisation (the modern corporation) the best competitive mechanism. Shareholders maximise the value of other claims in the attempt to maximise their own value (p. 27).

Cash generation In addition to creating value for the providers of capital (in order to compete with alternative investment opportunities), an organisation needs the cashgenerating ability to satisfy the financial claims of its stakeholders. It generates cash from operating its businesses: receiving revenue, and paying for investments in assets and expenses. Any additional cash required is obtained from two external sources: debt and equity. Both borrowing power and the market price of shares depend on the organisation's cash-generating ability. Lenders will not be prepared to deal, or will require a premium rent, if the risk of non-compliance with the terms of the loan is high. Equity holders will be unwilling to provide additional funds if their prospective reward, in the form of dividends and capital gain, is inadequate or uncertain when compared with other investment opportunities.

SHAREHOLDER VALUE IN CONTEXT

3

Organisational strategies In order to create value for their constituencies, organisations develop strategies: patterns of resource allocation that enable them to maintain or improve their performances in particular product and service markets. Organisational strategies are typified in management literature in three major ways: •

•

•

as a hierarchical structure, where the mission and objectives are determined by top management, business-level strategies are decided upon at business unit level, and appropriate tactics are devised at operational level as an on-going process through which a firm analyses its environment, resources and capabilities to determine how it might gain competitive advantage and leverage resources to increase that advantage as some combination of both.

Whichever approach is adopted, the identification of possible strategies does not obviate the need to select some strategies rather than others. Shareholder value metrics calculate the impact of potential product/service market portfolio choices, strategy alternatives, synergistic opportunities, resource allocation decisions, project choices and so forth on organisational value. This is done by calculating the potential net cash flows arising over time and adjusting them (by discounting, or subtracting a capital charge) for the cost of capital. It thus enables the selection of strategies which will, if they succeed as planned, optimally increase shareholder value. Similarly, decisions are made at business unit and operating levels about markets, technologies and processes, and the allocation of resources (people, technology, and capital) to activities, products or customer segments. Here, shareholder value analysis guides the creation of value through the identification and management of value drivers (those factors which have the greatest potential to enhance or diminish shareholder value). Once strategies are defined, the real work starts. How are these strategies to be implemented? What are the amounts and timing of revenue streams arising from a project (for a firm is basically a collection of short- and longterm projects)? What resources are required? What technologies will be used? What are the trade-offs between shareholder and customer value? How are costs to be measured and controlled? What are the critical performance factors? How are they to be measured? How can organisational effort be focused on shareholder value?

Driving value creation The ability to measure value is a technical exercise in the use of value-based financial performance metrics (such as those in Chapters 3 to 5) applied to

4

SHAREHOLDER VALUE DEMYSTIFIED

either the whole organisation, to units within it, or to projects within units. Measuring value more accurately is an important exercise and can promote understanding of what outcomes will have an impact on value. However, measurement in itself will not create shareholder value. In today's dynamic world, shareholder value creation depends on innovation, creativity, and collective organisational capability (including the quality of management). Techniques such as `value-based management' and `economic value management' are suggested as means of nurturing the capabilities of an organisation, promoting the ability to put those capabilities to good effect (for instance, by acquiring strategic assets, developing internal and external relational contracts, co-ordinating diverse skills and/or integrating streams of technology), and achieving the integration of shareholder value concepts and strategic and operational decision-making. Incentive compensation is believed to have an important role in encouraging the creation of shareholder value.

Organisational performance External and internal evaluations From a shareholder's perspective, the return on investment outlay in an organisation's ordinary shares is the present value of the dividends received throughout the life of the investment and the capital gain achieved on sale. Whether these returns constitute `value' depends on the opportunity cost of risk-free investment plus a margin for the risk related to the specific investment. Stock prices on share markets are not determined solely by the profit per share, or the net tangible assets per share. They reflect not only the current state of the company but also the expectations of investors regarding a company's future growth, risk and return profile and the quality of its management, in view of the expected future state of the economy and the relevant industry. The various shareholder value techniques described in the following chapters have been designed to reflect shareholder thinking. One test of their validity is the correlation between the result of the shareholder value calculation (whether undertaken inside the firm or by an external investor) and the stock market price. This issue is considered in Chapter 6. From the viewpoint of the organisation's management, shareholder value techniques are utilised, not only in the selection of strategies which will enhance value, but in the implementation and management of those strategies. Thus, employees at all levels of the organisation are trained in the

SHAREHOLDER VALUE IN CONTEXT

5

importance of shareholder value concepts and the role each can play in strategy selection and strategy implementation.

Relativities and benchmarks Shareholder value added, as measured by movements in the prices of stocks on the share market, provides organisations with an external benchmark. Such movements will not always be positive: prices may move up and down either broadly across stocks or across stocks operating in particular industries or sectors. However, whether prices are falling or rising, corporations can assess their relative performance against that of their competitors or peers, attempt to identify the factors or capabilities that separate top performing companies from others, and apply this understanding to the creation of reform programs targeted at key drivers of shareholder value or to the identification of higher value strategies (Kilroy 1997/1998). Internally, shareholder value analysis can be used to assess and compare the value created by individual business units or segments, and to reconsider current strategies where appropriate. The issues that arise from the above discussion are: • • • •

How should the change in a company's shareholder value be measured? How can the measure be used in evaluating and selecting strategies? How can the measure be used in guiding strategy implementation? How can the measure be used to drive performance improvements and wealth creation?

CHAPTER

2 THE INADEQUACIES OF TRADITIONAL ACCOUNTING MEASURES

Accruals, generally accepted accounting principles (GAAP) and cash flow The most common way of measuring corporate performance is through the use of accounting measures. This is understandable: the information is extensive and readily available; and produced in compliance with rules (accrual accounting and generally accepted accounting principles or GAAP) which are claimed to permit comparisons across firms. Accounting approaches typically use ratios derived from balance sheets and profit and loss statements to assess performance. Common ratios are those directed towards assessing: • • • •

profitability (with some measure of profit in the numerator and some measure of firm size or assets in the denominator) liquidity (that focus on the ability of a firm to meet its short-term obligations) leverage (that focus on the level of a firm's indebtedness) activity (that focus on the level of activity, usually in relation to time).

Other ratios, such as earnings per share (EPS) and price over earnings, combine accounting numbers with share market information.

THE INADEQUACIES OF TRADITIONAL ACCOUNTING MEASURES

7

Criticisms of the use of accounting-generated ratios, as bases for decisionmaking by internal and external users, include the following three: • •

•

Accrual accounting based measures do not equate with the cashgenerating ability of the firm. GAAP allows management some discretion in the choice of accounting methods. Managerial self-interest or a perceived need to protect the price of stock can lead to the use of methods (such as of depreciation, amortisation, asset valuation) which will smooth, increase or decrease income. Accounting practice typically undervalues intangible resources. Alternatively, it ignores such assets because of the difficulty of ascertaining an objective value.

Short-term and long-term considerations One problem for external users of accounting reports is the short-term bias built into accounting measures. In some instances (such as research and development expenditure, or marketing expenditure), GAAP does not allow capitalisation unless there is some degree of expectation or certainty that the expenditures will result in revenues adequate to cover incurred outlays. This conservatism in asset recognition may discourage managers from accepting projects with negative short-term effects on profits, even though long-term prospects may be good.

Ex-ante and ex-post considerations Accounting information is `ex-post': that is, it adopts a historical aspect in reporting on past events. Of itself, it provides neither external nor internal users with prospective information. External users, however, use accounting information (from annual reports and supplementary releases of information) to confirm their expectations about a company's success. Internal users typically use this historical information in strategic planning for subsequent periods.

The inadequacies of accounting earnings Rappaport (1986, p. 20) outlines five fundamental reasons why accounting earnings fail to measure changes in the economic value of the firm: • •

alternative accounting methods may be employed: different methods for depreciation, inventory valuation, goodwill amortisation, and so on both business risk (determined by the nature of the firm's operations),

8

• • •

SHAREHOLDER VALUE DEMYSTIFIED and financial risk (determined by the relative proportions of debt and equity used to finance assets) are excluded accrual based accounting numbers differ from cash flows from operations dividend policy is not considered the time value of money is ignored.

Other shortcomings of using earnings are that they do not consider the quality of earnings (merely the quantity) or distinguish earnings derived from operating and non-operating assets. Further, earnings growth does not necessarily lead to the creation of economic value for shareholders. If the rate of earnings is less than the cost of capital, then an increase in earnings will, in fact, correspond with a decrease in shareholder value.

Inadequacies of accounting return on investment Return on investment (ROI) is derived by dividing earnings by the total investment in the corporation (that is shareholders' equity plus total debt). Whereas the earnings figure provides an absolute measure of corporate performance, ROI provides a relative measure, as it takes account of the amount of resources used to generate the level of return. The ROI measure inherits the limitations of the earnings measure as it is, again, a measure based on accrual accounting. An ROI greater than the cost of capital does not necessarily lead to an increase in shareholder value, as it does not necessarily follow that the cash flow generated will exceed the cost of capital. As long ago as 1966, Solomon concluded that ROI is neither accurate nor reliable when compared with a cash flow method discounted for changes in the time value of money (known as discounted cash flow or DCF) for two main reasons. Firstly, ROI varies from the DCF return to an extent determined by: • • • •

the length of the project life the capitalisation policy the rate at which depreciation is recorded the lag between investment outlays and the recoupment of these outlays from cash inflows.

Typically ROI will understate rates of return during the early stages of an investment and overstate rates of return in later stages, as the undepreciated asset base continues to decrease. Secondly, ROI is affected by the rate of new investment. Faster growing companies or divisions will be more heavily weighted with more recent

THE INADEQUACIES OF TRADITIONAL ACCOUNTING MEASURES

9

investment projects leading to higher book-value denominators. Thus, their ROIs will be smaller than for a non-growth company investing at an identical rate of return (Rappaport 1986, p. 34).

The inadequacies of accounting return on equity Return on equity (ROE) is calculated in the same way as ROI, except that the investment figure used excludes the debt of the corporation. It shares all the shortcomings of ROI and, in addition, is more sensitive to leverage. An increase in earnings derived from new projects financed by additional debt will increase the measure, as long as the earnings are greater than the interest cost of the debt. However, ROE does not take into account the fact that the increase in the debt increases financial risk, and decreases the value of the business. Since the increase in financial risk increases the cost of capital, the company's economic value will be increased only if the additional debt generates a positive cash flow after discounting that cash flow by a higher (risk-adjusted) rate. A focus on ROE will encourage corporations to continue to borrow to finance growth as long as the return is greater than the cost of the debt. To the extent that this return is lower than the cost of capital (that is, the weighted average of the cost of debt and the cost of equity), which has also risen along with the increased financial risk, the economic value of the firm will decline. G Bennett Stewart III, co-founder of the management consultancy Stern Stewart & Co., paints a very clear picture of the limitations of the accounting model, from which ROI and earnings per share are generated, as a measure of value creation and, ultimately, as a guide to investment decisions. Using the results of research into share price movements following changes in accounting practices and the treatment of goodwill and expenditure on research and development, he offers evidence to demonstrate that share prices are determined by expected cash generation, and not by reported earnings: `A company's earnings explain its share price only to the extent that earnings reflect cash. Otherwise earnings are misleading and should be abandoned as the basis for making decisions ... and for determining (management) bonuses' (Stewart 1991, p. 28).

The superiority of market-based measures Recently, the concept of shareholder value (the net present value of expected cash flows discounted by the cost of capital) has gained prominence as a better measure of enterprise performance. In addition, shareholder value metrics are claimed to provide:

10

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•

a superior method of analysing and understanding `how much value the corporation and each of its business units [are] creating for shareholders and what the options [are] for improving performance' (Rappaport 1986, p. 52) a basis for restructuring and managing a corporation so that it creates value a means of sponsoring behavioural change in organisations towards decisions and actions consistent with shareholder wealth creation.

• •

Shareholder value is supported by modern finance theory, which proposes that economic value is the right yardstick for measuring business performance, since it reflects both risk and the time value of money. Broadly, shareholder value analysis is stated to provide a basis or methodology for managing a corporation which will: • • • • •

•

guide strategy formulation and selection at corporate, business unit and operational levels of the organisation assist management in reviewing and questioning current strategies and existing activities and structures provide the right criterion for pursuing business improvements and focusing such efforts in the right direction provide a powerful tool for setting priorities and, through a focus on value drivers, determine how to act upon them create value by redirecting managers' focus from accrual accountingbased profits and income statements alone to a focus on all the key factors that affect shareholder value help set a focus on the key value drivers in the business.

CHAPTER

3 RAPPAPORT’S SHAREHOLDER VALUE ANALYSIS

Rappaport presents a method for estimating the shareholder value of the total firm or business unit. This includes current value (that is, value created in the past), and the value expected to be created in the future. The `future' is divided into a specific forecast period (in Rappaport's example, three years), and the period beyond the forecast period.

The components of shareholder value The total economic value, or `corporate value', of a business entity is the sum of its shareholder value and its debt. Therefore: Shareholder value = corporate value - the market value of debt `Corporate value' is comprised of: • •

the present value of cash flow from operations during the forecast period; plus the residual value of the business (including marketable securities) at the end of the forecast period.

`Debt' is future claims to cash flow and would typically include both short and long term debt, capital lease obligations, unfunded pensions, and other

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claims such as contingent liabilities. Debt is, in most cases, the accumulation of several debt instruments. The yield to maturity is used to calculate the market value of each debt instrument which are then added. Note that the `market value of debt' is not the `face value of debt'. It is the amount that would have to be paid today if the debt were to be retired (Fera 1997).

The measurement of shareholder value In order to determine shareholder value, its elements (cash flow from operations, residual value, and debt) need to be measured in present value terms. This is achieved by using DCF analysis with the cost of capital as the discount rate. These elements are determined as follows:

Cash flow from operations Cash flow from operations equals cash inflows less cash outflows for the forecast period discounted by the expected cost of capital over the same period.

Note: Rappaport (1986, pp. 53-54) defines the `operating profit margin' as the ratio of pre-interest, pre-tax operating profit to sales. Although a non-cash item, depreciation expense is not added back in this section of the calculation. Instead, depreciation expense is deducted from fixed capital expenditures in the calculation of fixed capital investment. Incremental working capital investment is the net investment in accounts receivable, inventory, accounts payable, and accruals that is required to support sales growth.

The cash flow from operations for each year (calculated as described above) is then discounted by the cost of capital to compute present value. The present values for each year of the forecast period are summed to give the value of cash flow from operations over the forecast period. The appropriate forecast period is an issue to be considered by each organisation or business unit. Although business plans are usually based on three to five years, this period may result in inaccurate valuation if the business plan period does not match what Rappaport (1986, p. 77) calls `value growth duration', that is, `management's best estimate of the number of years that investments can be expected to yield rates of return greater than the cost of capital'.

RAPPAPORT'S SHAREHOLDER VALUE ANALYSIS

13

The cost of capital The cost of capital comprises the cost of debt and the cost of equity capital (the latter is typically called `the cost of equity'). It is determined by calculating the weighted average of the costs of debt and equity capital. For example, if a business is financed 40 per cent by debt at an after tax servicing cost of 8 per cent, and 60 per cent by equity at an estimated cost of 12 per cent, and this ratio is not expected to change significantly over the forecast period, its weighted average cost would be as follows: Weight (%)

Cost (%)

Debt

40

8

3.2

Equity

60

12

7.2

Cost of capital

Weighted cost (%)

10.4

The 10.4 per cent figure (the weighted average cost of capital or WACC) is the appropriate discount rate for this company to use, as it takes account of the claims of each group — shareholders and debtholders — in proportion to each group's targeted relative capital contribution over the forecast period.

Cost of debt The cost of debt is determined by taking the prevailing rate of interest charged and the tax rate incurred, and allowing for any expected changes over the forecast period.

Cost of equity Estimating the cost of equity over the same period is more complex and is based on the implicit rate of return required to persuade investors to purchase or retain the firm's stock. The starting point for estimating the cost of equity is the risk-free investment rate: the rate that can be earned on government securities, in particular, long-term treasury bonds. As investors expect to get a rate of return that will compensate them for the increased risk of investing in a specific company listed on the share market (rather than in treasury bonds), a premium for equity risk is calculated. This is the product of the market risk premium for equity (the excess of the expected rate of return on a representative market index such as the All Ordinaries Index over the risk-free rate), and the individual security's systematic risk: its `beta co-efficient': Risk premium = beta (expected return on market - risk-free rate) The value of the beta co-efficient is based on the degree to which the

SHAREHOLDER VALUE DEMYSTIFIED

14

individual security is more or less risky than the overall market. It is measured by the volatility of its return in relation to that of a market portfolio. Beta co-efficients for stocks are calculated by running a linear regression between past returns for that stock and past returns on a market index. (The beta co-efficients of all listed stocks are available from the Australian Graduate School of Management at the University of New South Wales.) In summary: Cost of equity

=

risk-free rate + the risk premium

=

risk-free rate + beta (expected return on market – risk-free rate)

Security analysts use the Capital Asset Pricing Model (CAPM) to determine the cost of equity for an individual company. The CAPM is described in Appendix A.

Residual value Residual value is the anticipated value of the entity beyond the forecast period. It often forms the largest component of a corporation's value. Its value depends on the assumptions made for the forecast period and an assessment of the competitive position of the business at the end of the forecast period. There is no unique formula for determining residual value: different methods suit particular circumstances. For instance, an entity adopting a harvesting strategy during the forecast period would use liquidation values; whilst an entity seeking to build its market share during the forecast period would calculate a going-concern value. The Perpetuity Method is a going-concern method of calculating residual value. This method recognises that market dynamics will not allow businesses enjoying excess returns to continue doing so indefinitely. Eventually, such a firm will face new competition. The Perpetuity Method is suggested by Rappaport as one method of calculating residual (or terminal) value and is described in Appendix B. Other methods are: • •

the use of public information to assess the market's expectation for a company's value growth duration (discussed in Rappaport 1986) the application to an organisation of Michael Porter's competitive structure in the light of the five forces of industries (discussed briefly in Fera 1997).

Valuing a strategy To estimate the expected shareholder value to be created by particular

RAPPAPORT'S SHAREHOLDER VALUE ANALYSIS

15

prospective strategic investments in the forecast period, the method is to calculate the value of the firm at the end of the forecast period; then subtract its current value (that is, the pre-strategy value): Value created by strategy = shareholder value - pre-strategy shareholder value The pre-strategy value is the current residual value of the business. It is based on current data and does not include any anticipated value creation from the entity's prospective investments.

The drivers of value Value drivers are the factors which drive value creation. Rappaport (1986) lists the financial drivers of shareholder value and presents a model of the way they relate to management decisions, valuation components (the factors used in measuring shareholder value), and the corporate objective of creating shareholder value. Figure 1 Financial drivers of shareholder value (following Rappaport 1986)

CHAPTER

4 STERN STEWART’S ECONOMIC VALUE ADDED MODEL

Since the beginning of the 1990s, EVA has become a widely advocated method of measuring single period enterprise performance. The methodology is claimed to be `the one measure that properly accounts for all the complex trade-offs involved in creating value' and therefore, `the right measure to use for setting goals, evaluating performance, determining bonuses, communicating with investors, and for capital budgeting and valuations of all sorts' (Stewart 1991, pp. 136, 4). EVA is the spread between the rate of return on capital and the cost of capital, multiplied by the `economic book value' of the capital employed to produce that rate of return.

Calculating EVA The formula for calculating EVA is: EVA

=

(rate of return – cost of capital) x capital employed

=

(rate of return x capital employed) – (cost of capital x capital employed)

=

net operating profit after tax (NOPAT) – (WACC x capital employed)

Note that this formula for evaluating the value created by an organisation or a business unit in the current year is identical to the formula to calculate Residual Income (RI) using WACC as the capital charge rate.

STERN STEWART'S ECONOMIC VALUE ADDED MODEL

17

As an example, for an organisation with NOPAT of $250 000, capital of $2 million, and a WACC of 10 per cent: EVA

=

NOPAT – (0.1 x $2 000 000)

= =

$250 000 – $200 000 $50 000

However, the figures for NOPAT and capital cannot be taken directly from conventional accrual accounting based financial statements. Stern Stewart has identified a total of 164 possible adjustments. The consultancy, however, recommends making an adjustment only when all the following apply: • • • •

it is likely to have a material impact on EVA managers can influence the outcome operating people can readily grasp the purpose of the adjustment the required information is relatively easy to track and derive.

Adjustments to NOPAT and capital Extrapolating from the formulae above:

This is, in essence, the ROE formula. The problems associated with this formula using accrual accounting-based numbers are specified in Chapter 2. The adjustments to NOPAT and capital in EVA are designed to counter those problems. In EVA, such adjustments are not confined to those required to convert accrual accounting based numbers to cash. Rather, adjustments are also made to: •

•

•

eliminate the effects of gearing (that is changes in the mix of debt and equity, as such changes confuse the effect of operating and financial decisions) include other financing factors such as preferred shareholders and minority interests (since capital employed and NOPAT should include all providers of funds) eliminate accounting distortions.

Some commonly made adjustments are: 1. To eliminate the effects of gearing: • interest-bearing debt and the present value of non-capitalised leases are added to common equity

SHAREHOLDER VALUE DEMYSTIFIED

18 •

interest expenses after tax on the debt and the leases are added to NOPAT. 2. To eliminate other financing distortions: • preferred dividends and minority interest provision are added to NOPAT • the value of preferred stock and minority interest are added to capital employed. 3. To convert to cash-based numbers: • taxes are charged to profit only when they are paid (thus also requiring adjustments to deferred tax reserve accounts) • goodwill amortisation is added back to NOPAT, and accumulated goodwill amortisation is added back to capital employed (The reasoning is that intangibles, if they are paid for, are not written off as they too must earn a return.) • restructuring charges that involve cash payments, and gains or losses on dispositions of assets, are adjusted in NOPAT (by adding where losses are sustained and subtracted where gains are made, after tax) and in the calculation of capital employed • provisions for bad debts and warranties, and other equity equivalent accounts are excluded (by adjustments) as these practices amount to taking up losses in advance of their occurrence. Other adjustments to accounting-based numbers are necessitated, not in order to achieve cash-based figures, but to reflect economic reality. For example, depreciation is not added back to profits in EVA. It is viewed as a true economic expense reflecting the operational use of plant. However, if an organisation's practice is to base depreciation charges on tax-based considerations, rather than the operational use of plant, it should be reworked and adjusted in NOPAT and capital employed. Similar considerations apply to research and development, and advertising and promotion expenditures. These are not written off in one go for EVA purposes; rather the write-offs are spread across the estimated useful life of the expenditures. Marketable securities and construction in progress are subtracted from capital employed (and presumably any income statement effects are also eliminated) if these are not part of `operations'. A list of adjustments taken from The Quest for Value (Stewart 1991) is shown in Appendix C. Note that this list is based on United States GAAP and thus includes items (such as LIFO reserves) not applicable in Australia.

STERN STEWART'S ECONOMIC VALUE ADDED MODEL

19

The cost of capital Stewart views the concept of cost of capital in the same way as Rappaport: WACC is used in EVA as in SVA. However, Stewart suggests that the immediate past three-year period be used for the weighting process: As the minimum rate of return on capital required to compensate debt and equity investors for bearing risk, the cost of capital is the cut-off rate to create value. The cost of capital is computed by weighting the after-tax cost of debt and equity by the relative proportions employed in the firm's capital structure on average over the trailing three years. (Stewart 1991, p. 743) The EVA calculation of the cost of debt and equity differs from that in SVA, in that the cost of debt is determined by the yield to maturity on a firm's own outstanding and publicly traded debt or, alternatively, on longterm bonds issued by companies of equivalent credit risk; and the cost of equity assumes that the risk premium typical of common equities is 6 per cent.

The drivers of value The drivers of value in EVA are profitability in current operations, and the amount and cost of capital employed. Stewart (1991, p. 138) states that three strategies will increase EVA: • •

•

improve operating profits without tying up any more capital draw down more capital on the line of credit so long as the additional profits management earns by investing the funds in its business more than covers the cost of the additional capital free up capital and pay down the line of credit so long as any earnings lost are more than offset by a savings on the capital change.

Market Value Added Whilst EVA is a single-period internal measure of a company's performance, Market Value Added (MVA) is a multiple period measure. Stewart (1991, p. 180) describes MVA as: . . . the stock market's assessment at any given point of time, of the net present value of all a company's past and projected capital investment projects. It reflects how successful a company has invested capital in the past and how successful investors expect it to be in investing capital in the future. It is therefore an absolute measure at any point of time. The change in MVA from one financial year to the next is equivalent to the EVA for that period. If EVA is positive for the period, MVA will increase; if EVA is negative for the period, MVA will decrease.

20

SHAREHOLDER VALUE DEMYSTIFIED

MVA can also be a cumulative measure of corporate performance. When assessing past performance, the organisation can calculate the market value added (or lost) between two specific dates. Used as a forward-looking measure, the MVA is the present value of anticipated EVAs with the cost of capital used as the discounting factor. MVA is calculated by the difference between a company's fair market price, as reflected primarily in its stock price, and the economic book value of capital employed: MVA = market capitalisation + borrowings - capital employed It is important to understand that, as capital employed includes all interest-bearing debt, that same interest-bearing debt must be added to market capitalisation to calculate the market value added. The methods of calculating market capitalisation plus borrowings, and capital employed are provided below. However, in less precise terms, MVA can be thought of as the difference between market capitalisation and shareholder's equity. Market capitalisation plus borrowings is calculated as: • •

the actual market value of ordinary shares at a date times the number of shares outstanding; plus the book value of: —preferred shares —minority interests —long-term non-interest-bearing liabilities (except deferred income tax) —all interest-bearing liabilities and capitalised leases and the present value of non-capitalised leases (estimated by discounting the minimum rents projected for the next five years by the implicit rate of interest); minus

•

the book value of marketable securities and construction in progress (because these items also are subtracted from capital).

Note that in the last two points above, book value is used. Stewart states: `Book value is used to approximate the market value of all items except common equity due to the absence of broad availability of quoted prices' (p. 744). As shown above, capital employed is subtracted from market value to obtain MVA. Capital employed is the same as that used for EVA: details of adjustments are listed under `Adjustments to NOPAT and capital' above (page 17). Broadly, capital employed is a company's net assets (total assets less non-interest bearing current liabilities) with three adjustments: 1. 2.

Marketable securities and construction in progress are subtracted. The present value of non-capitalised leases is added.

STERN STEWART'S ECONOMIC VALUE ADDED MODEL 3.

21

Certain equity equivalent reserves are added: • bad debt reserve is added to receivables • the accumulated amortisation of goodwill is added back to goodwill • R&D expense is capitalised as a long-term asset and smoothly depreciated over a period approximate to the economic life of the investment in R&D (Stewart suggests 5 years).

While Stewart shows that MVA moves with EVA, other authors (for example the Society of Management Accountants of Canada 1995, p. 22) point out that the former is sensitive to general market movements: `Weak companies can ride a rising market to big MVA gains that may prove ephemeral, while robust performers can unjustifiably lose MVA if their shares fall into a temporary rut'. This is undoubtedly true in the short term (witness the share market fluctuations in late 1997/early 1998). However, Stewart defends the long-term efficiency and sophistication of the share market and quotes evidence to support his stand (see Stewart 1991, pp. 56-67).

Economic profit Economic profit (EP) is similar to EVA, but does not involve adjustments to accounting numbers. It can be derived from an equity approach: EP = (ROE - cost of equity) X book value of equity or from a total capital approach EP = (ROI - book weighted WACC) X book value of capital (Kilroy 1996). As single period measures which are based on book values or adjusted book values (rather than market values), EP has its limitations. Nevertheless, such measures do, according to Kilroy (1997/98), give reasonably sound economic signals concerning strategy choices. EP is applied, not only to businesses and projects, but also to customers, customer segments, products and product packs.

CHAPTER

5

TOTAL SHAREHOLDER RETURN AND TOTAL BUSINESS RETURN Both these methods have been developed by the Boston Consulting Group (BCG). Total Shareholder Return (TSR) is what it says: the total return to shareholders — that is, the actual capital gain from the beginning to the end of the financial year plus any dividends paid. It is an ex-post measure used by top management and external users (investors) to compare an organisation's performance with the total market, or an appropriate index of peers. Total Business Return (TBR) is the internal proxy for TSR used by organisations for assessing future plans, internal business-unit performance, resource allocation strategies, and for implementing long-term incentives intended to drive changes in behaviour that generate increased shareholder value. TBR focuses on the factors which drive capital gains and dividends: profitability, growth through investment, and free cash flow.

Profitability For measuring profitability, the BCG suggests Cash Flow Return on Investment (CFROI): CFROI represents the sustainable cash flow a business generates in a given year as a percentage of the cash invested to fund assets used in the business. The result of the calculation can be expressed as a ratio if economic depreciation is

TOTAL SHAREHOLDER RETURN AND TOTAL BUSINESS RETURN

23

subtracted or as an internal rate of return (IRR) over the average economic life of the assets involved. CFROI is an economic measure of a company's performance that reflects the average underlying IRR on all investment projects (BCG2, p. 33)

Calculating CFROI: the IRR method The first step is to convert accounting data (income statement and balance sheet) into cash in current dollars. Adjustments, which will vary from organisation to organisation, are necessary. The process is as follows: 1.

Calculate the cash flow. This is: • net income after tax (but before abnormals); plus • depreciation and amortisation; plus • interest expense; plus • operating rental expense; plus • inventory and monetary items inflation adjustment. The resulting sum is the current dollar gross cash profit for the year.

2.

Calculate capital employed (cash invested to fund assets). Re-state all assets in current dollar equivalents (that is, historical investment before deduction of accumulated depreciation expressed in current dollar terms). It is necessary to ensure that all cash invested to fund assets, for example non-capitalised operating leases, are included. Capital employed equals: • book assets; plus • accumulated depreciation; plus • gross plant current-dollar adjustment; plus • non-capitalised operating leases; minus • non-debt liabilities. The result of this calculation is the current dollar gross cash investment.

3.

4.

Allow for asset lives, that is the fact that firms have differing asset lives and asset mixes that are relevant to the performance, and so to the value, of each business. This step involves the calculation of the amount of non-depreciating assets (land and inventory, net working capital and investments) which would remain at the end of the depreciating assets' working life. Calculate the IRR. Use present value principles to find the discount rate at which: cash profit income stream

non-depreciating assets +

released at the end of the depreciating assets' economic life

current dollar gross =

cash investment.

SHAREHOLDER VALUE DEMYSTIFIED

24

If the IRR exceeds the cost of capital in percentage terms, shareholder value is created. The converse is also true.

The cost of capital As with other value measuring approaches, TBR uses WACC. The formula is:

where: Ke = real cost of equity Kd = real pre-tax cost of debt D = market value of debt E = market cost of equity (BCG3, p. 2)

With regard to debt, inflationary expectations which are built into prevailing interest rates should be deducted if the real cost of debt is to be used. An analysis of long-term bonds will reveal long-run inflationary expectations. For the cost of equity, BCG does not recommend the use of the CAPM model, which it claims contains two assumptions which are increasingly under challenge: • •

that relative volatility (beta) is the only factor affecting the way the market discounts expected cash flows for an individual stock that the market risk premium remains stable.

Consequently, BCG estimates the cost of capital by relating market prices to current and expected future cash flows using its market-derived discount rate methodology, which prices equities like bonds: Under this method, current net cash flows are projected forward (for the market as a whole), allowing for the average rate of company growth and changes in profitability to move towards long-run averages. Armed with current market capitalisation and projected net cash flows (i.e. before interest, after capital expenditure), it is relatively simple to solve for WACC being applied by the market. The equation can be approximately expressed as:

The schematic is shown on the next page.

TOTAL SHAREHOLDER RETURN AND TOTAL BUSINESS RETURN

25

Figure 2 The Boston Consulting Group's recommended method for estimating the cost of capital

* Spot value is BCG calculated value of a company based on CFROI.

BCG has observed three common failings when organisations apply cost of capital concepts: 1.

2.

3.

Internal inconsistency, through: • the use of debt rates that reflect maturities significantly different from the expected life of the project or the depreciable assets • the use of inflation assumptions that do not reflect the inflationary expectations inherent in prevailing interest rates which are used to establish part of the discount rate • mixing the treatment of tax (for instance varying between before tax and after tax numbers) in the cash flows and the interest rate used • using book or proposed gearing of the particular project under review, rather than target or normal gearing for the company in market terms. Using minimum hurdle rates: that is hurdle rates set at the cost of capital. These will only meet investors' minimum expectations. The objective of managers should be to exceed this. Giving too much attention to cost of capital differences between divisions or business units. It is better to use a single discount rate, unless some business units have clearly different risk profiles.

Growth and free cash flow Growth in invested capital producing CFROIs which exceed market expectations is the second strategy for the achievement of capital gains. Growth is promoted by free cash flow (also referred to as operating cash flow). At the corporate level, free cash flow pays for dividends, share repurchase, debt

26

SHAREHOLDER VALUE DEMYSTIFIED

retirement, or investment growth — all of which have the potential to increase TSR. It consists of net cash flow derived by the business units and made available to the parent in a given year (BCG2). (Note that free cash flow is not relevant to understanding a company's performance over a single year, as it is determined by discretionary investments in fixed assets and working capital.)

Projecting future cash flows Stock market prices are the result of investors' expectations of a company's future cash flows. Investors are aware that a company which has grown very rapidly is not likely to sustain that rate of growth indefinitely. Similarly, companies which have been exceptionally profitable are unlikely to be able to sustain that level of profitability. Increased competition, new entrants into the market or the advent of substitutable products will inevitably force profits to normal levels. (Note the similarity between this view and Rappaport's Perpetuity Method.) On the other hand, investors are also aware that, although a company's profitability may be affected by a cyclical downturn, the upturn will restore profitability eventually. BCG believes that companies with the primary objective of maximising shareholder wealth must think like the market. Consequently, in projecting future cash flows, exceptionally high or low CFROI and investment growth are `faded' back to sustainable averages. This is termed the `cash flow fade concept'. It is particularly important when valuations incorporate high terminal values arising from growth or profitability assumptions beyond the planning horizon. The application of this concept means that computing the value of a business, given only its latest reported performance, involves: • • •

establishing current CFROI performance, using latest results projecting net cash flows by fading future CFROI and capital growth rates so they approach long-term market norms discounting the resulting cash flow using an appropriate cost of capital.

The drivers of value As indicated above, the BCG methodology offers three value drivers: ROI, growth, and free cash flow. The return on invested capital can be increased by either: • • •

gaining increased return on existing capital investing more capital at ROIs above the cost of capital reducing capital at ROIs below the cost of capital.

The growth implicit in the second method can, to some degree at least, be funded by free cash flow.

CHAPTER

6 COMPARING THE MODELS Comparison to traditional accounting The value-based models vary from the traditional accrual accounting-based model in that the former: • • • •

use cash flows, rather than accrual accounting based numbers (EVA is the exception with regard to depreciation) give equal weight to both income statement and balance sheet cash flows, rather than concentrating on income statement flows use discounted cash flows for decisions applying to entire businesses, rather than to capital spending proposals only use the weighted average cost of capital, rather than the time value of money, as the discounting factor.

Clearly, traditional accounting methods and the shareholder value methodologies vary in complexity, in that the value-based models start with accounting numbers and then make adjustments. Complexity is dependent on the number of adjustments: SVA is probably the simplest, followed by EVA, with TBR the most complex.

Accuracy Increasing the number of adjustments to accounting numbers achieves greater

28

SHAREHOLDER VALUE DEMYSTIFIED

levels of `accuracy' in measuring performance. Accuracy, however, can be a misleading word in this context. Organisations operate in product/service markets which are characterised by strong competition, rapidly changing technology, and short product life cycles. Ambiguity and uncertainty abound in a global world where both local and external events are often unpredictable and have widespread effects. In the midst of this level of change, organisations estimate the effect on shareholder value of potential strategies, investments, projects, technologies, and so on by estimating future cash flows, and the cost of capital. Behind these estimates are more estimates: of market size, market share, market growth rate, and selling price; of investment required and the residual value of investment; of operating costs, fixed costs, and the useful life of facilities. If the inputs to all value methodologies contain estimates, perhaps the level of accuracy, and therefore value to organisations, of each can be judged by the degree to which the outputs of the measurement process correlate with stock prices. Academic research long ago established that the movement of share market prices, after allowing for general market movements, does not correlate with the financial information contained in annual reports unless that information has cash flow effects. Anecdotal evidence (for instance in articles in recent Australian business magazines, and BCG publications, or the convictions expressed by executives of various companies using, or about to use, one of these methodologies) concerning the correlation of share market prices and calculated shareholder value measures suggests that, while all are good, the more complex the methodology, the better the correlation. Academic research of the correlation of EVA and stock market prices is inconclusive. Dierks and Patel (1997) report on three research findings: Lehn and Makhija found a significant positive correlation between EVA and MVA and stock market prices; a University of Washington study found that at best EVA added `incremental information in some settings'; while Dodd and Chen found that although stock returns correlated with EVA, the alignment was similar to that explained by residual income.

Summary As stressed previously, the use of value-based methodologies does not, of itself, create value. What they, and indeed traditional accounting measurement techniques such as ROI and ROE, provide is a more or less adequate indication of which organisational outcomes have an impact on shareholder value. Stewart (1991, pp. 75-76) summarises the shareholder view nicely:

COMPARING THE MODELS

29

... cost of capital can be used to divide projects and, in the aggregate, companies, industries, and even countries, into three categories: Group 1: Projects return more than the cost of capital. Because management can earn a greater return by investing capital inside the company than investors could by investing in the market, value is created. Group 2: Projects break even in economic terms. The return earned just covers the cost of capital, so that no value is created over and above the capital invested. Group 3: Projects, a favourite of many large, mature companies with cash to burn, return less than their cost of capital. Because the return earned on the capital invested within the company is less than investors could earn elsewhere, an economic, or opportunity loss is suffered and value is destroyed. In short, shareholder value will increase if the project generated a positive cash flow after either: • • •

discounting the cost of capital (SVA and MVA) subtracting a capital charge (EVA) comparing the IRR (adjusted for cash flow fade in the long term if necessary) with the cost of capital (TBR).

Table 1 provides a comparison of the shareholder value methodologies described in Chapters 3, 4 and 5. Table 1 A comparison of the shareholder value models For use by investors and top management Uses

Measurement

SVA Not suitable as changes in stock prices not incorporated

MVA Change in value over time

TSR Change in value over time

Change in (market capitalisation + borrowings – capital employed)

(Closing stock price X no. of shares) + dividends paid – (opening stock price X no. of shares)

30

SHAREHOLDER VALUE DEMYSTIFIED

For use within the organisation or business unit SVA Uses • Strategy evaluation (forecasts) • Investment/ divestment decisions • Past performance and benchmarking • Operational decisions • Incentive compensation Measurement • Net cash flows discounted by the cost of capital

Drivers of value

Complexity

Useful surrogate

• duration of value growth, sales growth, operating profit margin, income tax rate, working capital investment, fixed capital investment, cost of capital. • Relatively simple adjustments to accounting profit

• Threshold margin: the minimum level of operating profit at which shareholder value is created

EVA • Strategy evaluation • Investment/ divestment decisions • Past performance and benchmarking • Operating decisions • Incentive compensation

TBR • Strategic planning • Resource allocation • Incentive compensation

• NOPAT — (cost of capital X capital invested) i.e. residual income over period • Discount by the cost of capital if evaluating forecasts • Profit improvement, amount and cost of capital

• Estimated closing value of business + net cash flow for period – estimated opening value of business, i.e. IRR over period • Profitability, growth, free cash flow

• Complex adjustments to NOPAT and capital employed

• Complex adjustments to cash flow and capital employed. Includes restatement of assets in current dollar terms and inflation adjustments applied to monetary and inventory items. For projections, uses Cash Flow Fade Model. • At business unit level: Value = Earnings X P/E multiple Value = Free cash flow ÷ cost of capital

CHAPTER

7 USING SHAREHOLDER VALUE CONCEPTS

The measurement of shareholder value, of itself, achieves little except to alert management to the fact that value is or is not being created, and to provide an opportunity to benchmark financial performance in shareholder value terms against competing firms. The next step, then, is to ask what organisational changes, initiatives or actions contribute to the achievement of the desired outcome of being, in Stewart's terms, a `Group 1' organisation. Proponents of shareholder value believe that the answer lies in the adoption of value-based management (VBM), which is described by Copeland et al. (1996, p. 97) as `an integrative process designed to improve strategic and operational decision-making throughout an organisation by focusing on the key drivers of corporate value'. VBM operates at corporate, business unit and operational levels. Corporate managers formulate strategies based on the creation of shareholder value by the organisation as a whole. Business-unit and operational managers select strategies, set targets, develop tactics, design activities, and devise performance measures aligned to corporate objectives. This alignment of the goal of creating shareholder value, strategy evaluation and selection, targets, tactics, activities and performance measures is claimed by Copeland et al. to be why VBM is superior to other approaches (such as TQM, flatter organisations, empowerment, Kaizen, team-building) to improving organisational performance.

32

SHAREHOLDER VALUE DEMYSTIFIED

The drivers of value In Chapter 6 the drivers of value for shareholders were identified as return, cash flow and asset growth. Underpinning these drivers are Rappaport's seven drivers of financial value: • • • • • • •

revenue growth rate operating margin growth the cash tax rate working capital capital expenditure WACC competitive advantage period (or `value growth duration').

The next layer of drivers are those operational decisions, initiatives and actions which will have a beneficial effect on the seven financial drivers. Black et al. (1998, pp. 92-93) classify, under the financial driver headings, initiatives or tactics that Price Waterhouse has observed being used by global corporations to generate shareholder value, as follows: Revenue growth rate • Ensure profitable growth that will add value • Consider new market entry • Develop new products • Globalise the business • Develop customer loyalty programmes • Offer pricing advantage with new distribution orders • Develop focused advertising based on differentiation Operating margin growth • Modernise working practices • Restructure, including introducing multi-skilling • Cut costs by sharing services and outsourcing • Centralise and consolidate back office and finance functions (treasury, tax, corporate finance, financial systems) • Introduce business process re-engineering with IT system initiatives including consolidation and integration of billing, customer care, activity-based costing, data warehousing, network management and configuration Cash tax rate • Consider international holding structure

USING SHAREHOLDER VALUE CONCEPTS • • • •

33

Locate and exploit intellectual property and brands Use co-ordination centres Customs duty and transfer pricing planning Minimise foreign and withholding taxes

Working capital • Implement working capital reviews • Improve debtor management • Introduce supply chain management systems and just-in-time inventory methods Capital expenditure • Develop capital appraisal and utilisation reviews and project finance techniques • Weigh up lease versus buy decisions • Develop treasury, hedging and risk management systems WACC • Build management understanding of cost of capital • Calculate gearing/leverage optimisation • Calculate business-unit-specific WACC • Consider share buy-backs and de-merger of non-core business Competitive advantage period • Improve investor relations by providing predictable and sustainable financial performance • Improve business unit cash flow information • Return to core competencies • Develop executive performance reward schemes linked to share price improvement • Give all employees the opportunity to have an economic stake in the company • Incorporate strong risk management procedures A number of other operational value drivers, which can improve the seven financial drivers above, have been found in the literature or were identified by firms interviewed by ACMAD. They include: • • • • •

sales volume pricing market share capacity product mix

34 • • • • • • • • • • •

SHAREHOLDER VALUE DEMYSTIFIED selling terms cost improvements productivity wastage downtime product/service quality location decisions market and promotion capital budgeting innovative initiatives funding choices.

The challenge for the organisation, with a consciousness of the value drivers that apply, is to: • •

evaluate and implement strategies at a corporate level which will maximise value flow these through to business unit and operational levels.

In this way, decisions and actions throughout the organisation are all directed towards the objective of shareholder value. The number of potential value drivers means complexity in selecting the best strategies/initiatives (that is, the ones which will have the greatest effect on shareholder value). The need, according to BCG, is not to identify which aspects of operations have an impact on value (since most do), but which have the greatest potential for affecting the overall worth of the company. In BCG's view, the most effective value drivers must satisfy two requirements: 1. 2.

their impact on value must be substantial, whether it be positive or negative they must be manageable by the business.

Sensitivity analysis and value mapping are techniques to measure the impact of both negative and positive swings.

Strategy evaluation and implementation at corporate level At the corporate level, strategy evaluation is generally concerned with the long-term direction of the organisation and the scope of the organisation's activities, both illuminated by knowledge of the environment in which the organisation operates. Such issues often involve decisions concerning the existing or desired portfolio of investments, growth prospects, and related financing requirements.

USING SHAREHOLDER VALUE CONCEPTS

35

Portfolio analysis `Portfolio analysis' takes the view that a corporation is a portfolio of investments, to be managed to produce the best total return. Over the last ten years, many different approaches to the assessment of business units or segments have been developed around the world. (For example, BCG's `stars, question marks, cash cows and dogs' classifications, McKinsey's 3x3 matrix: see Lewis et al. 1993, Johnson and Scholes 1997). Proponents of shareholder value methodologies claim that shareholder value-based analysis can indicate whether a business unit has been earning at greater than the cost of capital. Wenner and Le Ber (1989) describe such a process. First, the original cost of each business and the incremental cash flows into and out of each business in the years between original investment and the current year is ascertained. When discounted by the cost of capital, this provides a figure representing the total net investment in each business. Second, the economic value (net present value of future cash flows and terminal value) of each business is calculated. The difference between these figures is the shareholder value expected to be contributed by each business. A negative figure does not necessarily mean that a particular business should be closed down or sold. However, it does mean that further analysis of current and prospective business strategies, operations and (perhaps) financing is required. It also raises the consideration of alternatives (such as the feasibility of outsourcing areas of operation). In Australia, firms appear to be increasingly applying shareholder value approaches to the evaluation of business unit performance. Pacific Dunlop, a diversified manufacturing organisation, for example, has recently stated its intention to measure each business within the group in EVA terms. Any business which is not providing a positive return will be restructured in terms of size, focus and allocation of capital. If, after this, it still does not make the grade then its sale may be an option (Knight 1996). Divestment decisions are not necessarily simple. Although each business unit within an organisation may have its own unique competitive problems and opportunities, there are often interactions between various business units. For example, an insurance company may have separate business units for life insurance, general insurance, and superannuation — but also a considerable `cross-sell' factor which may be lost in the event of the sale or closure of any one of these three.

Growth Shareholder value analysis is also claimed to be useful in assessing the desirability of growth in assets through expansion of existing activities, diversification, or acquisitions and takeovers. In broad terms, shareholder value

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methodologies assert that growth will increase shareholder value only if the new investments earn more than the additional cost of capital. Qantas Airways Limited adopted this principle in 1997 when it considered the appropriateness of making substantial investments in new international aircraft. The decision was not to do so at that time but, rather, to lease for the short-term or use surplus capacity of British Airways (its major shareholder) if necessary. The company's managing director explained that current low margins (resulting from strong competition in the Asian market) meant that increased investment in asset growth would actually damage the business as the resulting profit would be less than the cost of the additional money invested. A common way of achieving growth is through takeovers. In these cases, the reasons are often complex and based on expectations of operating benefits and synergies (such as economies of scale, technical and managerial skill transfer, control over supply or distribution) which may or may not eventuate. (Hubbard, in Lewis et al. 1993, lists 22 reported reasons for takeovers, only two of which relate directly to earnings. Shareholder value was not mentioned.) Further, return and cash flow do not necessarily move in tandem in growth situations: growth may either diminish cash flows but maintain or increase return, or increase cash flow but reduce return. Growth and risk are also interrelated. Black et al. (1998, p. 84) claim that shareholder value methodologies do not recognise the relationship between growth and risk (that is, the probability of actually being able to achieve the expected growth rate): Many companies are now struggling to fulfil aggressive growth and value agendas, but fewer recognise that taking risks is essential to both growth and return. Enterprises must integrate explicit measurements of risk into their strategic planning in order to identify the possible organisational, cultural, and financial changes that will be needed to achieve to achieve their SHV [shareholder value] and growth goals.

Financing In shareholder value terms, financing strategies are dependent on the availability and potential return of investment opportunities, and the cost of the finance. Should opportunities not be available (so the status quo is maintained) financing strategies would centre around the desired result of reducing the cost of capital by either: • •

reducing capital requirements; or changing the source and mix of debt and equity capital.

Share buy-backs (where corporations repurchase some proportion of their ordinary shares from shareholders) are one means of reducing capital which is

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consistent with shareholder value principles, if growth opportunities of a quality which will increase shareholder wealth are not available to the corporation. Reducing capital through the retirement of debt is a question of judgement. One argument is that debt reduction, by reducing risk, may reduce investors' required rates of return and therefore increase share price. However, as debt is the cheapest form of capital, a level of debt which is less than the optimal debt-carrying capacity of the organisation may in fact decrease share price. Changing the source and mix of capital may involve swapping debt for equity, debt swaps, revising terms of debt, and so on. In all cases, the aim is to optimise the gearing of the organisation. On the other hand, organisations may have numerous investment opportunities, and ready access to funding through equity, debt, or an optimal mix of the two. The task then is one of making investment decisions which will direct resources to where they make the highest contribution to shareholder value.

Resource allocation Organisations use economic value metrics to determine capital allocations to business units by prioritising proposals or projects according to their ability to increase shareholder value. Telstra Corporation, for example, intends to use EVA `to ration and better prioritise its huge capital expenditure program ... with the aim of lifting shareholder value ... over the longer term' (Lewis 1997, p. 7). Kilroy (1997) suggests that the management of value requires the establishment of a value-based business planning and resource allocation mechanism, which he calls an `Internal Capital Market' (Figure 3 on p. 38): The [internal] market operates in a similar way to the external capital markets by allocating capital and other resources on the basis of value creation potential. It is built around a strong business planning process which requires managers to consider alternative strategies, value their businesses under each alternative strategy, and build a business plan around the value-maximising strategy. The difference between this and other resource allocation models is the explicit recognition that product markets (the source of customer value) and capital markets (the source of shareholder value) are intimately involved in allocation decisions.

Setting targets Part of the language of shareholder value is the incorporation into decisionmaking of financial performance measures that are consistent with investment at or above the cost of capital. `Hurdle rates' of return are a way of establishing a target for key projects.

38

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Figure 3

Traditionally, companies have established hurdle rates for projects in ROI, DCF or payback period terms. However, as mentioned in Chapter 2, ROI is typically not based on cash flow and does not consider the cost of capital, and DCF, which is cash-flow-based, does not ordinarily use the cost of capital as the discounting factor. Payback is a relatively simple method which uses cash inflows and outflows, but lacks precision in estimating the profitability of projects and ignores the time value of money. The hurdle rate suggested by Rappaport (1986, p. 69) is the threshold margin, that is, the minimum operating profit margin (in cash flow terms) a business needs to attain to maintain shareholder value. Rappaport views it as a means of bridging the `valuation concepts of modern finance theory and the needs of corporate decision makers [with] an easily understood, operationally meaningful concept that enables managers to assess the value creation potential of alternative strategies'. It needs to be remembered, however, that at a rate of return equal to the threshold margin, growth will only maintain value, not increase it.

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While the threshold margin and other methods may be good overall guides, they are unlikely to be adequate for successful strategy implementation. Targets need to be tailored to the level of the organisation (strategic business units, functions, operations), based on key value drivers, and expressed in financial and non-financial terms. Short-term targets (one year) are linked to longer targets (say, three years and ten years). The tenyear targets express the unit's aspirations, the three-year targets set the gameplan to achieve the planned progress over the longer period, and the one-year targets set the immediate goals. Such targets may be accompanied by action plans which specify a series of steps the business unit will take to achieve its targets.

Strategy evaluation and implementation at business unit level Business unit managers also evaluate and select strategies from a range of possibilities. Within the bounds specified by corporate management, they take strategic decisions about the markets in which the unit participates, the technologies and processes utilised, the allocation of resources (people, technology and capital) to areas of activity, and how the performance of the business unit is to be measured and assessed. The strategy selection process at business unit level involves the identification and clear articulation of the alternative strategies which the business unit could pursue, as shown in Figure 4. Figure 4 The strategy selection process at business unit level

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Probably, additional data gathering or market research will be necessary before the valuation and the subsequent strategic decision can be made. Such information is usually derived from: • • • •

market related analysis and data return requirements product profitability analysis customer or customer segment profitability analysis.

By linking this information with value driver information, decisions and actions which will enhance shareholder value are made. Market related analysis requires information related to customer requirements or needs, industry structure and forces, competitor strengths and weaknesses and, importantly, in-house organisational, resources, and skills competencies that can be leveraged to obtain competitive advantage in the marketplace. Return requirements will typically be defined by corporate management in terms of shareholder value added. Ultimately, returns depend on revenues (competitive prices) and costs. Costs are the results of operational decisions in terms of the efficiency of activities and processes, and the effective use of resource inputs (technology, fixed assets, working capital, people and so on). Product profitability analysis is conventionally determined using shortterm ROI measures, but may be more useful if based on cash flow projections over the life cycle of the product. There are various ways in which product profitability can be improved. For example, resource consumption can be managed by reducing the costs of resource inputs, reducing the investment in assets, eliminating non-value activities, and/or improving productivity. On the revenue side, product differentiation can bring financial rewards by changing customer perceptions. Synergies between products can provide incremental sales or differentiation advantages. Customer or customer segment profitability analysis is an examination of which customers or customer segments provide most shareholder value, and analysing whether to enter or exit particular customer or customer segments and/or shift resources between different products or different customer groups. Large organisations in Australia are typically undertaking customer profitability analysis in terms of the differential economic value added. CocaCola Amatil Limited, for example, considers the economic value and growth potential of its four major customer groups (foodstores, route, vending, and key accounts), each of which displays differential revenue, cost, asset use and growth potential. A major bank segments its customers, identifies the needs of each segment, and designs and develops appropriate products which will

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create segment value. An insurance company takes an individual customer approach, calculating a `potential lifetime value' on the basis of current profitability, potential profitability, and a cross-sell factor.

Linking shareholder value creation and performance measures The strategic priorities and specific plans developed through value driver analysis feed into performance measures. To determine appropriate performance measures, organisations in one way or another establish financial and non-financial critical success factors (CSFs) or key performance indicators (KPIs) linked to value creation. For example Qantas Airways: • •

develops key performance targets for all levels of the organisation, from the highest to the lowest links personal and departmental performance to the delivery of shareholder value.

Another Australian company has, at group level, linked a balanced scorecard approach to EVA in assessing business unit performance. The process undertaken was described as follows: The group office wanted a set of about 16 measures from each of the business units and we wanted those measures to be consistent across the businesses so we could see how each one is performing. So first we looked at our overall vision of the organisation. The next step was looking at the strategies that the organisation as a whole had in place. And then looking at the four segments of the balanced scorecard as they support each of those strategies. A whole suite of measures was determined for each one of those strategies in the balanced scorecard approach. Then those measures (there were about 50 of them) were examined with regard to SVA. So all of the measures that are in there in the SVA approach are consistent with the strategies because that is how we got the initial fifty. And then the way you cull that down is to go back and have a look at which ones are going to have most effect on our SVA. We selected 16. And so we have kept it consistent - balanced scorecard, SVA and strategic planning. The 16 levers or drivers are the important ones. There will be, of course, a whole suite of backup drivers and levers. So if the business unit managements want to do a drill-down on what the group office say are the important ones, there might be four or five others that are important and then there might be four or five for each of those. But the business units themselves will be identifying and working on the backup drivers. The management of the businesses will be driving that. The best known balanced scorecard approach is that proposed by Kaplan and Norton (1996). This performance measurement methodology is claimed to have significant advantages in that:

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•

performance targets are derived directly from strategies and so consciously focus on the critical areas of the business financial measures, which report the results of actions already taken, are complemented by operational measures which are the drivers of future financial performance targets and measures cover a variety of perspectives: external (financial and customer) and internal (business processes and innovation and learning).

•

•

Focusing organisational effort Creating mindsets The shareholder value literature emphasises that long-term value creation requires the cultural transformation of the organisation. All employees need to have a broad understanding of shareholder value, and accept that shareholder value creation is the primary objective of the business. An equivalent term to value-based management, economic value management (EVM) is, according to Mayfield (1997, p. 32), a way to focus the organisation and to improve communication and understanding by providing a common `language': The great attraction of EVM is that, implemented effectively, it focuses the entire organisation and helps avoid confusion since it is one measure which is easily understood. Managers and employees are able to identify the key operating drivers for which they have responsibility because successful implementation of EVM assigns accountability to lower and lower levels of the organisation. They should be able to see how it links through into financial performance and therefore economic (and shareholder) value. EVM is a very effective `language' which promises to ease communication and improve understanding both inside the organisation ... and outside to shareholders and analysts alike.

Training There is some debate about the degree to which employees at various organisational levels need to understand the mathematical aspects of shareholder value methodologies (see the Case Studies). However, there is agreement that, at the very least, managers and employees need to understand what economic value is, how it can benefit the company, and how each employee can assist in its achievement. Corporations such as Coca-Cola Amatil and Qantas put considerable emphasis on educating employees in the principles of shareholder value creation, with the aim of encouraging involvement and changing behaviour.

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Incentive compensation The last link in the performance loop of an organisation is the reward system. Organisations and commentators alike mention the opportunity provided by value metrics to align the interests of managers and shareholders through incentive compensation. Indeed, Stewart believes this is perhaps the most important aspect of the methodology. While doubtless important, the use of value metrics for incentive compensation is not straight-forward. It is necessary to find the right balance between the rewarding (for the achievement of planned performance in the present) and motivating (seeking ever greater value creation in the future) aspects of incentive compensation. The Society of Managing Accountants of Canada (1995) quotes O'Byrne's proposal for a scheme with three elements: • • •

a target incentive award a fixed percentage interest in EVA improvement above the expected EVA improvement a bonus bank.

The target incentive award ensures that managers are competitively compensated for their efforts, thereby avoiding staff retention problems. While based on a labour market analysis, it is biased upwards because it is linked to the achievement of a target EVA. The fixed percentage interest component applies only to EVA improvement above the target. The bonus bank aligns management and shareholder interests in that it exposes managers to risk — the risk that they might suffer a negative `bonus'. Annual bonuses are banked forward rather than paid in full in the first year. In order for managers to cash in their bonus bank balance, they must continue to increase shareholder value. The bonus bank smooths the ups and downs of the business cycle and extends forward managers' time horizon for decisionmaking. Joel Stern also seeks to align the long and short terms. He suggests that management and employees be paid bonuses (one-third in advance, with the remainder delayed) according to their business unit's contribution to EVA (Jeanes 1996). The concept of a percentage of compensation being `at risk', which is inherent in this suggestion, is becoming common in Australian organisations. Kilroy (CFO, May 1998) suggests an incentive compensation system based around incremental cash flow and value creation: In submitting a business plan built around the value-maximising strategy, ... the business unit general manager is essentially saying to the CEO and the CFO `this is the value (or cash flow over time) that I can deliver to you' ... If he or she delivers

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the promised value, and it is greater than the expected cash flow under the current strategy, then value will have been created for the business. In some organisations, this understanding is formalised into a performance contract between the GM and the CEO. Rewards, then, should be linked to increases in shareholder value over time. For a listed company, the best way to do this is usually to focus on equity cash flow (which ultimately equates to dividends plus share price appreciation over time). For a non-listed company, the focus should be on incremental operating cash flow. One issue which remains open at present is the level or levels of the organisation to which incentive compensation based on shareholder value should be applied.

Communication As stated above, economic value concepts are believed to provide an effective `language' which promotes understanding and communication within the organisation. It is also claimed that the language is useful in communicating with investors, particularly the institutional investors who are the major shareholders. (Institutional investors today own or manage on behalf of clients a large percentage of the shares listed on the Australian Stock Exchanges). The benefits to corporations are that they can: • • •

ensure that the market has sufficient and appropriate information to evaluate the company at all times use the `right' (value-based) language in framing press releases ascertain how investors view a particular organisation's stock and the likely reactions of fund managers to alternative strategies.

Two companies recently told ACMAD of the importance they attach to communicating with existing and potential shareholders and understanding their expectations: Talking to the market about shareholder value is really trying to generate some option value. If you can convince them that something different from the typical fade model is actually going to occur, then you have option value. This is not rocket science. It is very simple stuff. TSR is the only model I have found that can give me any guide as to how potential shareholders out there value our stock and therefore a guide as to what we can do internally to try and improve that value. (Company 1) [Since adopting TSR] we have a better understanding of what the share market expects from us; and we are much better able to communicate with our large shareholders about what we are doing and what our objectives are. (Company 2)

CONCLUSION

Shareholder value methodologies differ from traditional accounting methods principally in their preoccupation with cash flows and their use of the cost of capital as the cut-off rate in determining value-adding investments. These two factors, it is believed, are what the market is concerned about, and therefore what corporations should be concerned about. By aligning the thinking of organisations and their shareholders, shareholder value methodologies are claimed to: •

•

•

•

•

provide a focus for all decision-makers within an organisation. This single focus on shareholder value directs and simplifies decision-making (particularly in times of change and uncertainty) and encourages all organisational members to `pull in the same direction'. provide a mechanism to facilitate the allocation of resources to areas of an organisation which have the capacity to use those resources in a manner which maximises shareholder value constitute a performance measurement system which enables benchmarking externally, and the internal alignment of shareholder value, strategic planning, operational activities and reward systems provide a management system which is more comprehensive than other management systems which have been proposed in recent years (such as quality, flexibility, empowerment, the team approach) in that economic value management can incorporate all these others and, with its own shareholder value focus, use them in a more directed manner provide a `language' which facilitates communication internally and externally.

There are, however, limitations. Successful implementation requires a strong belief in one or another methodology by top management, and a preparedness to commit substantial effort and resources to driving shareholder value thinking throughout the organisation. The methodologies are complex (some more than others) and differences of opinion exist with regard to the `right way' to measure some elements. For example, BCG challenges the value of published betas, preferring a marketderived discount rate methodology. This consultancy also advocates the use of a single organisation-wide discount rate unless some business units have clearly different risk profiles. The KBA Consulting Group, by contrast, believes that estimates of both the beta and the debt carrying capacity are necessary for each business unit. The need for precision in calculations is open to debate. It is evident that some organisations take a less formal approach to calculating, for example, the cost of capital. When asked to describe how it calculated its cost of equity, one organisation told ACMAD:

46

SHAREHOLDER VALUE DEMYSTIFIED What we do, we try to assume what our beta would be in regard to the market average return. So the market average — our estimation is that it is about 8% or 7% now (August 1997) for the risk free rate — the 10 year Commonwealth Government bond rate is the reference that you might use. The market premium for a listed company is approximately 5%. You might argue that it is not, but then others will argue that it is over the long run. So that's 12% and then we look at our beta in relation to that 5% excess. Is it a 0.8 beta or is it 1.2 or [what]? Now that's where there is a lot of subjectivity. I can't say what ours is - but there are arguments both ways, whatever it is. But we take into account how we feel about our organisation - is it blue chip? is it not blue chip? would people pay a premium to be guaranteed a steady rate of return? what are the earnings we have projected into the future? are they steady? are they going to be lumpy? how is our dividend flow? We would look at all those sorts of things to come up with what we think our beta is, take into account dividend imputation, franking credits, etc. and then bingo, you have got your cost of equity.

Another admitted `You can argue with the maths, you can kick it whichever way ...' but nevertheless argues: ... if I can get any form of model that gives me a better guide as to what the shareholder might do and the share price might be, then I'll use it. Because most organisations only ever look internally, and then they say `we've got all those you beaut plans, why the hell aren't they in the share price?' But, of course, the guy out there can't see them. And to me there is real value in having some form of anticipation of what the guy out there is thinking. Despite the adjustments made, shareholder value analysis is still based on accounting numbers. Hence, soft assets (for instance organisational capabilities, organisational cultures and structures which foster knowledge transfer and learning, the skills and know-how of employees, corporation reputation and customer base) are ignored. These are believed to have a large impact on profitability now, and an even larger impact on future growth and sustainability. Yet they are not captured in the balance sheet and shareholder value metrics do not include them in the asset base. (However, the value of soft assets can be captured by re-valuing the business in the management accounts at the present value of the expected cash flow under its current strategy, that is at market value.) Shareholder value methodologies underestimate creativity. Kilroy (1997/98, p. 165) believes that the emphasis on value drivers is overstated as there is a limit to the extent to which costs can be reduced or revenues increased under the current strategy. New strategies are needed because the goal posts are always moving: Management must continually seek to identify higher value strategies. As soon as a new and higher value strategy is communicated to the capital markets, the

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markets place a value on the new strategy. If the new strategy is well received, the company's share price rises ... The challenge then becomes to create value for those shareholders who invested at the new and higher share price. This challenge can only be met by continually bringing new ideas into play. We need to accept that shareholder value creation is a creative act, requiring a combination of creative and analytical thinking skills. Creativity should be grounded in analysis — but should not be suppressed by it.

CASESTUDY

1

Coca-Cola Amatil Limited Coca-Cola Amatil Ltd (CCA) is an Australian-based international beverage company and the most geographically diverse bottler of Coca-Cola trademarked products in the world. It is a very different company to that which existed in 1989. At the beginning of that year, Amatil Ltd, as it was then known, operated tobacco, beverage, snack foods, communications and packaging, and poultry businesses. A British tobacco company was its major shareholder. By 1996 it operated solely in the beverage business, held and operated Coca-Cola franchises in 18 countries, and had the United States Coca-Cola Company as its major shareholder. Its revenues in the 1997 year were $4.824 billion (compared with $842 million from its beverage operations in 1989) and it employed approximately 40 000 people worldwide.

The origins of economic value at CCA The enhancement of shareholder value has been an objective of Amatil Ltd for many years. At the time of the re-organisation and the change of name to Coca-Cola Amatil Ltd in 1988/89, it was a very conscious commitment. Dean Wills, the chairman and then managing director, commented as follows in the 1989 Annual Report: The company's prime objective has always been to enhance the value of its shareholders' investment. As the new Coca-Cola Amatil, we will continue to add value through the profitable growth of our businesses. This philosophy of long-term value creation through growth had underpinned the company's decision to divest itself of the broad range of businesses it had operated in earlier years and concentrate on beverages. It continued to guide decision-making about the best way to rapidly expand the beverage operations. CCA does not distinguish between EVA and SVA, believing that `trademark' methodologies in this context are irrelevant. However, the existence of trademark methodologies which employ different mathematical formulae make a description of the measurement system used by a particular organisation important. CCA uses accounting profit less a capital charge as the measure of economic profit and the change from one year to the next as the measure of economic value added. The cost of capital comprises the cost of debt based on a target debt/equity structure, and the cost of equity. For the cost of equity, it uses the Capital Asset Pricing Model, obtaining its beta factor from a database at the Australian Graduate School of Management at the University of New South Wales in Sydney.

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Economic profit and economic value added, however, are only two of a wide range of measures used at CCA. Others include: • • • •

market share accounting profit return on net assets net present values.

The process in place The term `economic profit' is frequently used in CCA. It is measured down to business unit level in some areas of the company's activities (for instance in Australasia) and to divisional level in overseas operations where the businesses are new and rapidly growing but as yet lack the required sophistication in their information systems to make measurement at business unit level feasible. A great deal of thought and planning went into the process of introducing the concept at business unit levels. Consultants were extensively used in the initial stages for all the usual reasons - the desirability of having an independent party involved, their usefulness as agents of change, the fact that they are extra resources, have different experiences, and so on. It was considered important to appoint consultants who were in agreement or in sympathy with the views of the company. A structured process was followed. It started with training sessions for business unit managers: explaining the company objective of creating shareholder value, what it meant theoretically, what it meant practically and how to manage for its achievement. This was followed by a pilot project using the consultants, and eventually, the methodology was `rolled out' in a number of different areas. The aim was to have managers who were thinking in the same sort of format as the organisational centre — that value is not just volume, not just profit, but also a strategic awareness of the business environment and a consciousness of the need to obtain an economic return on assets — and, through a more concrete understanding of the economics, making better decisions. Over time the concept of economic profit has been introduced to operational staff, using an explanatory manual expressed in simple terms. Another form of on-going education for staff has been the use of presentations in which pilot programs and their outcomes have been demonstrated. Resistance has not been a major problem although there was initially a certain amount of scepticism from operations people. This was alleviated by

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the fact that the company has been successful in terms in share price appreciation and many employees were current or potential shareholders as a result of their participation in the employee share plan or in the option scheme. Because of the company's corporate structure, internal disagreements about estimates did not occur. While management throughout the group is decentralised, the Board retains authority over capital matters and head office financial people set the measurement rules. The cost of capital is calculated at corporate level as it reflects the corporate debt-equity structure; hurdle rates, risk adjusted where appropriate, are also determined by head office; managers require head office approval for capital expenditure. Cost allocations to operational areas are made only where those areas have the ability to control the costs.

Compensation The company believes that there is a relationship between compensation and value creation but regards getting that relationship right as difficult. The approach adopted by CCA is to provide incentives and to take a long term view. Share ownership by all employees through the employee share plan is encouraged. Share options, which have for some years been offered to senior executives, are now offered to executives at lower organisational levels. In the near future, the company sees itself moving to a base level of compensation and an `at risk' portion, which may be a combination of both cash and equity, plus longer term incentives through both the share plan and through options.

Diagnostics The cash concept which underlies CCA's approach to shareholder value is used to assess acquisitions, proposed initiatives, business development plans, and specific plans such as distribution channel development. There have been instances when evaluation has led to plans being reworked. On other occasions, evaluation has led to the acceleration of plans. However, a negative net present value does not necessarily result in the rejection of a proposal; nor does a positive net present value mean the expansion or multiplication of an initiative. There are two reasons for this: •

discounted cash flows necessarily contain assumptions about future events. If assumptions are wrong, the answer may also be wrong. Therefore, it is imperative to understand the proposal and the assumptions behind it

CASE STUDY 1 •

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every firm operates in a strategic environment and there are sometimes actions that have to be taken for strategic reasons, even if they do not stack up from a cash point of view.

With regard to the impact of new concepts or philosophies on systems, it is considered that concepts always lead systems. Economic profit is no exception. Whilst the philosophy is entrenched in the organisation, the information systems are still catching up. The company is now at the stage where economic profit on individual product packs, calculated by a number of different measures, is available on line. It believes it is further ahead than a lot of companies in this regard. Currently, most of the focus is on getting the assets understood, accountability for, and control of them defined, and incorporating asset management into the existing systems.

Customers and suppliers The company recognises that it is necessary to create value for its customers as well as for itself. In line with this view, initiatives have been undertaken in working with trade customers to re-engineer processes. More importantly, the company feels that the use of economic profit has helped CCA management to understand retailers' capital and asset structures and appreciate how retailers think.

Implementation The cost of capital is defined in head office and is given to operations. Corporate policy is that, for example, tax and treasury are best centralised. So business units are not making tax or funding decisions and are evaluated on their trading profit line excluding items such as interest and tax. No adjustments are made to account for the differences between accounting and economic value. Indeed, this is not seen as useful as it is not compatible with CCA's view that any measurement of value is an indicative, not particularly precise technique which is useful in relationship with other pieces of information. It is felt that to go to extremes of accuracy is probably not adding much to the picture, and that issues such as tax and tax incentives have little to do with general management operating decisions. Neither is using economic value or economic profit to measure performance against other companies seen as useful. Internal benchmarking against other operations within the group is, however, at a high level of sophistication. Internally, economic value is regularly monitored at Board level and is an integral part of financial planning and budgeting at corporate and operational levels.

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Lessons At the corporate level, the application of shareholder value principles has been highly successful in CCA. Growth has been rapid, profitability good, and the share price has consistently outperformed the market. Internally, its use has facilitated organisational change and sponsored organisational learning. For example, operational managers now appreciate the impact of assets on value and sales people have a better understanding of the business and are thinking differently. There is a common language, desirable behavioural changes and a better level of internal debate. The following factors appear to have been instrumental in this success: • • • • •

•

the concept of economic value supports the principal objective of the company it is the basis of organisational strategy formation it is a philosophy or belief which has provided a basis for consistent decision-making throughout the organisation it has been consistently communicated internally and externally it was introduced correctly, with commitment by top management, a consistent approach, a willingness to start slowly and the persistence to keep going it is reinforced by the remuneration system.

In CCA's view, the calculation of economic profit and economic value added is an outcome, the result of the company's approach to the market, strategic planning and investment decisions. But the philosophy of shareholder value — the long term expectation of future value creation — must, in a decentralised operation, be the basis of all decision-making and an integral part of the thinking of all employees. As one of the finance people intimately involved with the introduction of economic value explained: It is important that [employees] understand it, but not only understand it, but adopt it and believe it rather than just adhere to it. There is a difference. You are not just filling out a travel expense form. It is a belief system and should influence behaviour. From that point of view, ownership of the concept by all is critical. If you don't have ownership, nothing will happen in terms of change.

CASESTUDY

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Qantas Airways Limited Qantas Airways Limited is a major player in the international and domestic airline business, ranking tenth in the world in terms of revenue passenger kilometres. In addition to passenger traffic, the company carries freight both internationally and domestically. Turnover is around $8 billion and market capitalisation at current prices (June 1997) about $2.7 billion. In the year ended 30 June 1997, operating profit before tax was $A403.7 million. Qantas commenced as a small privately-owned airline in Queensland on 16 November 1920. The name was originally an acronym of `Queensland and Northern Territory Aerial Services'. In 1947, the original company was acquired by the Australian Government and Qantas became Australia's international airline. Historically, domestic routes were covered by various privately-owned airlines (notably Ansett Airlines Limited) and by another Australian Government-owned airline, Australian Airlines (AAL). The government's privatisation programme resulted in the sale of AAL to Qantas in June 1992. In March 1993, British Airways acquired from the Australian Government a 25 per cent stake in the now integrated airline. Then, in July 1995, the portion of Qantas still owned by the government was floated on the Australian Stock Exchange. The available shares were purchased by institutional and individual investors. The view of Qantas top management is that, of its nature, an airline must operate as a network and that it is the network which creates value. Internally, the organisation is split into functional divisions: Airport Operations, Aircraft Operations, Commercial, Associated Businesses, Information Technology and Finance. There are several subsidiaries — including regional airlines, island resorts, and catering organisations — which, while managed independently on a day-to-day basis, are viewed as part of the group and are subject to central control with regard to investments, divestments, industrial relations issues, policies related to image, and standards of safety. The airline industry is one where intense competition has led to gradually declining prices, yet large capital expenditure on new technology is a regular requirement and the cost of inputs is constantly increasing. To increase, and even maintain, profitability requires a continuous reduction in costs. Qantas seeks to achieve this through investing in projects which offer cost savings and constantly revisiting the way it does business with regard to the type of customer service provided, supplier arrangements, the use of information technology which enhances efficiency, and work practices in every aspect of the business. Continuous improvement and business re-engineering is very

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much a way of life in the battle to be ahead of competitors, who are never far behind in engaging in change.

The origins of wealth creation In government-owned airlines in Australia, the prospect of privatisation has been a powerful driver of change. In the late 1980s and early 1990s when AAL appeared to be headed towards privatisation, there was an attempt to prepare the organisation for that event. With the help of the Boston Consulting Group (BCG) and under the leadership of the chief financial officer and his staff, AAL began to adopt a value-based management philosophy. With the purchase of AAL by Qantas, some of the employees most involved in this initiative left the company and went their own ways. In 1993, after the government's decision to privatise Qantas, they were brought back with a clear brief to get the company ready for public listing. Again, BCG was part of the team. The focus of performance evaluation is TSR, a long-term measure that looks at capital appreciation plus dividends. This, the finance people in the company believe, is the ultimate performance measure which will be maintained for the foreseeable future because it is the most accurate measure of wealth creation for the shareholders. TSR is a BCG-derived methodology which is claimed to be widely accepted, comprehensive, unbiased by size and suitable for benchmarking. Qantas's present group general manager for financial planning and control has watched its development since the late 1980s. At that time, he says, it was a new idea and there were not many believers. However, as time has gone by, evidence of its worth has accumulated, and converts are now numerous. In addition to firms, a large number of institutional investors have adopted the methodology as part of their assessment procedures. The fact that analysts, investors, and management are now sharing the same philosophy is seen as positive in that, if management delivers in terms of TSR, recognition by investors is certain. The drivers of TSR are profitability (ROI), asset growth, and cash flow. Profitability is cash-flow-based and termed CFROI (cash flow return on investment). It represents `the sustainable cash flow a business generates in a given year as a percentage of the cash invested to fund assets used in the business' (BCG2). The measure by itself is short-term in nature, and so ignores growth. However, it has the advantages of including the entire asset base required to generate cash flows (and so avoids accounting-based distortions, such as old assets, uncapitalised operating leases and intangibles) and measuring assets in current-dollar equivalents.

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A high CFROI alone, however, will not generate shareholder value. It is necessary to use these returns to acquire more assets which, in turn, will generate further high cash flow returns. The methodology recognises that it is a combination of profitability and growth in business that generates shareholder value. Free cash flow is the third driver of TSR. It can be used at the corporate level to pay dividends, repurchase shares, or retire debt, all of which can improve TSR performance. At the business-unit level, it is the cash flow which is available to be returned to the parent for the purposes above or used for further asset growth. The following comment indicates the way in which Qantas has `operationalised' the TSR philosophy: For investment appraisal, we use discounted cash flows and discounted paybacks but, if the investments are large, they form part of our longer term planning — we have a three-year corporate plan and, in view of the life of our aircraft assets, longer term plans — and we assess the impact of the investments on the forecast TSR. We use a modelling technique to forecast what our share price is going to be in the future. That forecast and the dividends we pay tells us what the TSR in the future is going to be. Our aim, when assessing investments, is to ensure that the TSR generated out of those investments is one that will satisfy the minimum requirements of our shareholders. It is obvious that, if shareholder value is to be enhanced, the TSR generated by investments must exceed the cost of equity. At Qantas, the cost of equity is assessed using the BCG methodology, which derives the cost from the marketplace: By looking at the cash flows generated by a business and the value that the market puts on the investment and the cash flows, we can calculate what investors believe the return on equity should be. If the cash flow is lower than anticipated, shareholders through the market mechanism adjust the price to reflect what they perceive to be the risk associated with the company's investments and their required cost of equity. We've used an analysis of our current market price to determine what our cost of equity is — but, of course, it is not only cash flows and the cost of equity that influences share price in the short term; there are things like market sentiment. We have also looked at the cost of equity of other airlines in other markets and at more traditional approaches such as the Capital Asset Pricing Model (CAPM). There are all sorts of experts out there who can tell you what your beta will be but we tend to avoid CAPM as we are convinced that the market-derived cost of equity is more appropriate.

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SHAREHOLDER VALUE DEMYSTIFIED But the ultimate check was talking to some of our large investors and talking with their analysts at a more educated level to try to find out the type of returns that they are expecting, given the type of industry and the gearing. The one large factor coming out of it is the relationship between the leverage of the company and the required returns. The debate about the impact of gearing on share price is not settled. Some believe that, if leverage is reduced by, for example, raising equity, there will be a negative impact on earnings per share and a reduction in share price. The other side, with which we agree, is that lower gearing means lower risk and, if the cash flow generated out of the business is the same, the value of the shares will increase. Although raising equity capital may cause earnings per share to drop, shareholders are, we believe, concerned about longer term value creation and a lower earnings per share does not automatically translate into a lower TSR.

The combination of cash flow return on the current value of investments and growth in assets is seen as vital.

The process that is in place Impending privatisation was the factor that led the finance director and his team to ask questions such as: Who are our new owners? What are their requirements? How do they measure performance? This led to theories of value creation and the need to manage the company in a way that would create value. Then followed a lengthy study of the way in which the company was managed, the types of performance evaluation that it was managed by and the tools that were employed. One result of this was the establishment of TSR at the corporate level. Another was a total transformation of the management and reporting processes to ensure that everything was consistent with the TSR objective. At corporate level and at operational level, Du Pont-style analyses are used to define the value drivers. These are, of course, structured in different ways but all are directed towards TSR elements. Sensitivity analysis was employed to identify which value drivers add most value at the end of the chain. From these value drivers, the company has developed key performance indicators (KPIs) and tracks, through the Du Pont analyses, the link between an improvement in a KPI and the impact on value. Currently, Qantas has three levels of reporting, all of which are directed towards TSR-related performance measures: • • •

to the Board of directors divisional reports to the managing director at operational level. The use of teams, both cross-functional and in individual functions, has been extensive in developing KPIs and designing Board and management

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reports, as well as in initiatives to improve efficiency and re-engineer processes. There is a formal three-year planning process both at corporate and at divisional level. Once the plan is approved, it is dis-aggregated into the budget for the first of the three years. Because of the company's investments in aircraft with a life of 20 years or more and a discounted payback of around 10-12 years, longer-term forecasts are also prepared. In addition, the formal corporate planning process for the three year period looks at wealth creation. The calculations are based on traditional accounting statements but the numbers and statements are converted into cash flows, as described earlier, so that they provide the value-added and the TSR. As indicated earlier, these new planning processes have impacted on investment decisions.

Implementation issues Acceptance roadblocks to the introduction of the shareholder value methodology have not been encountered although there was initially a certain amount of scepticism and a lack of understanding. Whether or not it is necessary for managers at divisional level to have a full recognition of the benefits of the TSR philosophy is questioned. Although it is essential that managers understand and accept that the ultimate objective of the company is to deliver value to shareholders and that the KPIs are directed towards this aim, it is doubtful that they need to understand the details of the link between the KPIs and TSR. Although continuously investing heavily in this area, Qantas agrees with comments made by other companies that information systems are `never up to scratch' as far as adequacy goes. Whilst the historical information provided is regarded as good, the perceived need now is for information systems which predict the future, thus allowing management to take actions to ensure that the future is what the company wants it to be. One example is the yield (quality of earnings from passenger traffic) management system: where on the basis of past patterns of demand, the company forecasts what the demand is going to be in the future and takes action in the marketplace to obtain a favourable result. The impact on suppliers and customers is generally good. Customer value is the focus of some of the KPIs selected as it is through customers that the shareholders get their returns. Nevertheless, there are occasions where customers expect to receive a level of servicing the full cost of which they are not willing to pay, and in these cases shareholders do not benefit. The issue is seen as one of balancing customer needs and wants and shareholder returns. Value-based management in itself is not seen as affecting relationships

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with suppliers. It is more the focus on costs that has resulted in relationships with suppliers becoming more straight-forward and honest. Compensation issues: At the time of the float, each employee received $500 of shares in Qantas Limited. This value was dictated by the tax laws at the time. Since that time, a further $500 share issue has been made to each member of staff. All executives participate in a performance-based reward scheme that provides for cash performance bonuses. The bonuses are paid on the achievement of pre-determined objectives, including planned profit levels and/or revenue improvement targets. Executive directors and certain senior executives also participate in an Executive Incentive Plan, which provides for a bonus which is related to Qantas's TSR ranking amongst the top 100 listed Australian companies, and the TSRs of a pre-determined basket of international airlines listed on overseas stock exchanges.

The value of the TSR concept The introduction of TSR has been quite costly in terms of commitment and effort. However, this cost is seen as worthwhile: We have an excellent understanding of the concepts; we have a better planning framework; we have better reporting; we have a better understanding of what the share market expects from us; and we are much better able to communicate with our large shareholders about what we are doing and what our objectives are. To us, the main thing that came out of TSR was the importance of growth in any strategy. It wasn't a matter of whether we grew or stayed as we were. It was a matter of finding out what creates value. And this is a combination of growth in profits and growth in the size of the business. We believe that all firms should try to understand what makes their share prices move the way they do and work from there to develop strategies that will deliver value to their shareholders. They need to understand their cost of capital and cost of equity, the gearing aspect and how all that impacts on the required return to shareholders. And then bring it in-house and start working on developing strategies that will deliver the cash flows and the growth that the shareholders want.

CASESTUDY

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RGC Limited RGC Limited (RGC) is an Australian listed company engaged in the mining of mineral sands, tin, gold, coal and base metals. Its origins go back many years to a time when a number of different organisations were engaged in the mining of various metals around Australia. In the early 1980s, these combined to form one group. Over recent years, the company has pursued a growth strategy, exemplified by the 1996 takeover of Pancontinental Ltd. The group has 13 active mining sites in Australia, Papua-New Guinea and the United States. In addition, it undertakes exploration in South America, Sri Lanka, Africa, Australia and Papua-New Guinea. The management structure is devolved, with each mining site having a great deal of autonomy. A small head office in Sydney, however, keeps a close eye on capital expenditure. For short-term planning, RGC uses a rolling 24-month forecast which is adjusted quarterly to adjust for latest expectations. The forecasts lead directly to the setting of targets for each of the company's mining sites. These targets are set and monitored by the general manager of each site and an executive committee member. They incorporate a degree of `stretch' and thus motivate, focus on controllable variables (production levels, cost, and safety), and are the basis for a variable component of the remuneration scheme. Longer term planning is undertaken through an annual strategy review which involves the Board of directors and is based on long-term site planning. Although long conscious of the need to provide value to shareholders and aware of economic value techniques, RGC has only recently begun to investigate the adoption of the BCG's TSR/TBR methodology.

RGC's current methods RGC uses a composite of profit-based measures (accounting profit, return on investment, return on equity, and earnings per share) to assess corporate performance. Net present value, internal rate of return and the payback method are used for asset acquisitions, make or buy decisions, and business acquisitions and mergers. The most pervasive method for ongoing management is a sophisticated Du Pont analysis initially introduced to the organisation some years ago by the BCG and now an integral part of the operations. The Finance Director described what he found when he joined RGC: The Du Pont Charts covered corporate, divisional and operational levels. At each level, the components were taken out to the right, and actually broken down

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The high-level components of the Du Pont charts have for some years been the basis for monthly Board reporting which focuses on profit, cash flow, return on operating assets and key performance indicators. The company has found this a useful way of capturing the major performance measures, financial and non-financial, for each operation. In addition, it has been seen as: • • • •

appropriate for the businesses in that it provides managers with the necessary information to manage their businesses understandable to operational people encouraging an `ownership' mentality sponsoring a consciousness of operating assets, costs and cash flow.

Cost, in particular, is important to mining companies which are mainly price takers on their products. The price element in revenue is largely uncontrollable as it depends predominantly on the world market price for the various metals and on the United States-Australian dollar exchange rate. The focus then is on what can be controlled: cost, and being on the low end of the cost curve for the industry. The logic is simple. There will be commodity price fluctuations, and companies with the lowest costs are likely to survive longer. At the strategic level, the company calculates the cost of debt on a group basis, not at divisional or operational levels. To charge a rate of interest to a division has traditionally been seen as just another set of allocations. Thus, instead of allocating a capital charge to divisions, the company takes the desired return on shareholders' funds and converts that into an appropriate long-term return for each division. Although a rule of thumb, experience has shown this to be a reasonable approximation and something that people can understand. The optimal level of debt is also considered to exist only in a conceptual sense. Practically, the level of debt is seen to be a function of the available projects/investments that the organisation wishes to undertake. If the demand for capital is low, it does not make sense to borrow more than you need. If the demand is great and cash flow expectations from new projects are adequate, the organisation may go above its theoretical optimal level for a period of time. Of course, not all investment decisions are straight forward. The estimated cash inflows and outflows and the discounting rate applied are necessarily based on assumptions about an investment that can be variable to

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a substantial degree. If a project or investment is extremely good and offers substantial returns, the fact that the calculation is not exactly accurate does not matter. If it is marginal, the validity of the assumptions is very important. It is reasonable to say that `simplicity' and `understandability' have long been the watchwords at RGC. Unnecessary complexity and intricacy are to be avoided.

The reasons for considering the adoption of the BCG methodology Recently, RGC has become disenchanted with the use of accrual accountingbased numbers as the basis for future planning. The company's finance director believes that the existing strategic process does not adequately recognise value lost or value created, or provide an adequate basis for decisions about investments. Two points at issue are investment decisions in existing mines and the treatment of exploration costs. With regard to investment decisions in existing mines, he commented: We have in some cases been spending money chasing volume and not necessarily value. You can get caught up in the reinvestment trap. You've got an ore body which is declining and the costs are going up and the revenue coming down. You have invested so much in it — and if you don't spend some more money, the mine will stop. But if you do spend the money, you know that you will not recoup the additional investment. We need a new way of looking at these decisions. Exploration costs are expenses, according to RGC. To capitalise such costs and carry them on the balance sheet may lead to fluctuations in profit results, as exploration costs need to be written off if no ore body is found. The result is that profit fluctuates, not as a result of operational factors but because of success or failure in exploration. However, the major asset of a mining company is the ore in ground and, as it is mined over time, the asset has progressively less and less value. In mining, the critical issue for the long term is that reserves are replaced so that the firm stays in business. Companies must either discover or buy resources so that they can maintain their productive capability. Clearly, exploration has value and is an investment for the long term future of the organisation. Indeed, in assessing the success of an organisation in the resources industry, successful exploration is a major component. The RGC accounting treatment (expensing exploration expenditure), whilst very conservative, does not reflect such value on the balance sheet. This leads to potential misunderstanding of the nature of the expenditure by decision-makers both within and outside the organisation. The answer is not necessarily to capitalise exploration expenditures on the balance sheet but, rather, to ensure that the value of such expenditures is recognised in strategic decisions.

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These issues led the company's top management to rethink the strategic process and to consider the adoption of a different perspective on investment strategy. Accordingly, BCG were consulted and the company is currently considering the adoption of TSR and CFROI at the corporate level. The advantages are seen as: •

• • •

the BCG methodology's capacity to develop a model that has the ability to, with some reliability, predict share price and thus provide insights on the gap between where a firm is and where it needs to be if it is to be competitive on a shareholder return basis the enhanced ability of the organisation to make portfolio decisions based on value the enhanced ability to plan for the creation of option value which shareholders will incorporate into share price the ability to monitor the group's performance against that of its peers on a TSR basis. This is especially important in the mining industry because, as in any cyclical industry, there are times when TSR will be negative. The critical performance issue is whether you are doing as least as well as your peers.

Issues RGC questions the need to change in any substantial way its performance measurement structure at business unit level: I don't know that it is important to take shareholder value-based measures right down through the organisation — although there do need to be linkages to operational performance. There has to be people at the edge between strategy and operations and those people will have to cross the hurdle between one and the other. We are going to have to think carefully about how we build these linkages. What you need is effective decision making and performance monitoring throughout the organisation, which meets the operational needs yet can be demonstrated to add shareholder value. To me this is all about the measures and getting them to link in a hierarchy. I don't believe the dis-aggregation (from corporate to divisional to operational management) has to be: (i) perfect; or (ii) complete. The points that really matter are that your people understand the linkages and make better decisions. This means keeping decision criteria and performance measures simple.

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Compensation is another issue. For some time in RGC, a percentage of every employee's remuneration has been `at risk', that is dependent upon the performance of the division against key performance indicators. These indicators at the operational level include output, safety, and cost per unit of output — and will not necessarily change. However, the company believes that, if TSR is to be introduced successfully, it should be the primary measure for executive incentives: I don't think anybody has ever got executive compensation right in terms of incentive payments. There are, and always were, times when executives win and times when they lose. There is no such thing as a perfect system. The best you can do is to focus executives on the critical drivers. Get executives focused on the right things and the inequities over time should balance out. RGC was at an early stage in its investigation of shareholder value concepts when it merged in late 1998. The company's thinking at that time pointed to the need for shareholder value methodologies to be flexible enough to suit different businesses' need or desire for simplicity versus complexity, precision versus approximation, and perfect versus partial integration throughout the organisation. As the finance director said: `It's absolutely useless putting in complex measures if people can't use them to make better decisions. It defeats the purpose.'

APPENDIX

A

The Capital Asset Pricing Model Calculating the cost of equity capital brings us more deeply into the world of finance theory. The staple tool of security analysts in determining the cost of equity capital is the Capital Asset Pricing Model (CAPM). CAPM is an `idealised portrayal of how financial markets price securities and thereby determine expected returns on capital investments. The model provides a methodology for quantifying risk and translating that risk into estimates of expected return on equity' (Mullins 1982, p. 105). The model is based on a series of simplifying assumptions and the categorisation of risk into two types: systematic and unsystematic. Unsystematic risk is the risk that is peculiar to the company and can be diversified away by holding a portfolio of shares. Systematic risk is the portion of risk related to the movement of the share market that cannot be diversified away. Consequently, for investors with well diversified portfolios only systematic (that is, market) risk matters (Mullins 1982, p. 107). To measure systematic risk, financial analysts normally use the stock's beta factor, which can be regarded as a measure of the stock's volatility relative to the market's volatility. For example, a stock with a beta of 1.00 — an average level of systematic risk — rises and falls at the same percentage as a broad market indicator such as the All Ordinaries Index. These conceptual building blocks culminate as the CAPM risk/expected return relationship (based on the proposition that only systematic risk measured by beta matters). The CAPM states that stocks are priced such that: Rs = Rf + risk premium Rs = Rf + Bs(Rm - Rf) where: Rs = the stock's expected return (the company's cost of equity) Rf = the risk free rate Rm = the expected return on the share market as a whole Bs = the stock's beta. The risk-free rate is the return on a risk-free investment such as a treasury bill. The risk premium is measured as: beta X the expected return on the market — the risk-free rate As the financial literature generally defines the cost of equity (Ke) as the expected return on a company's stock then the CAPM model can be used to obtain an estimate of the cost of equity:

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Ke = Rs = Rf + Bs(Rm - Rf) where: Ke = the company's cost of equity Determining the cost of equity involves developing estimates for future values of the risk free rate (Rf), the expected return on the market (Rm), and beta (Bs).

APPENDIX

B

The Perpetuity Method The Perpetuity Method provides a means of calculating the residual value of an organisation which is going concern. It is based on the assumption that market dynamics will mean that new businesses enjoying excess returns (above the cost of capital) will eventually face new competition. This in turn will create excess capacity, drive down margins and reduce the returns of all competitors in that industry to the minimum acceptable or cost of capital rate. The method assumes that after the forecast period the business will earn, on average, the cost of capital on new investments. In this situation, periodby-period differences in future cash flows do not alter the value of the business. As a consequence these future cash flows can be treated as if they were a `perpetuity' or an infinite stream of identical cash flows (Rappaport 1986, p. 61). The present value of a perpetuity then is the value of the annual cash flow divided by the rate of return as follows:

Using the perpetuity method, the residual value is determined as:

For example, say the Company X generated $25 million in cash flow in the previous year. If it were to continue to generate $25 million annually into perpetuity, and its cost of capital is 12.5 per cent, the value of the company would be equal to $200 million, that is:

APPENDIX

C

Adjustments to capital and NOPAT in EVA The following is adapted from Stewart 1991, p. 112. For further details regarding the nature of these adjustments, refer to pp. 113-17 of this source. For EVA calculation, add the following to `capital': • • • • • • • •

deferred tax reserve LIFO reserve cumulative goodwill amortisation unrecorded goodwill (net) capitalised intangibles full-cost reserve cumulative unusual loss/gain after taxes other reserves, such as: — bad debt reserve — inventory obsolescence reserve — warranty reserve — deferred income reserve.

For EVA calculation, add the following to NOPAT: • • • • • • •

increase in deferred tax reserve increase in LIFO reserve goodwill amortisation increase in (net) capitalised intangibles increase in full-cost reserve unusual loss/gain after taxes increase in other reserves.

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Barney, Jay B, Gaining and Sustaining Competitive Advantage, Addison-Wesley, 1997. Black A, Wright P and Bachman JE, In Search of Shareholder Value: Managing the Drivers of Performance, Financial Times Management, 1998. Boston Consulting Group, Drivers of Value, Managing for value series, Boston Consulting Group [BCG4]. Boston Consulting Group, Estimating the Cost of Capital, Managing for Value Series, Boston Consulting Group [BCG3]. Boston Consulting Group, Financial Benchmarking, Managing for Value Series, Boston Consulting Group, 1995 [BCG1]. Boston Consulting Group, Shareholder Value Metrics, Shareholder Value Management booklet 2, Boston Consulting Group [BCG2]. CFO, `How to measure value creation', CFO, May 1998, pp. 48-50. Copeland T, Koller T and Murrin J, Valuation: Measuring and Managing the Value of Companies, 2nd ed., John Wiley, 1996. Dierks PA and Patel A, `What is EVA and how can it help your company?', Management Accounting, November 1997, pp. 52-58. Fera N, `Using shareholder value to evaluate strategic choices', Management Accounting, November 1997, pp. 47-51. Jeanes M, `EVA looking for likely companies', Australian Financial Review, 13 December 1996, p. 36. Johnson G and Scholes K, Exploring Corporate Strategy: Text and Cases, 4th ed., Prentice Hall, 1997. Kaplan RS and Norton DP, The Balanced Scorecard: Translating Strategy into Action, Harvard Business Press, 1996. Kilroy D and Zmood S, `Calculating business unit costs of capital', Australian Corporate Treasurer, 12, 1997, pp. 13-16. Kilroy D, `Managing for value: the role of the corporate treasurer in a value-managed company', Australian Corporate Treasurer, 6, 1997, pp. 21-24. Kilroy D, `Measuring, creating and managing shareholder value', Reward Management Bulletin, December 1997/January 1998, pp. 159-65. Kilroy DB and McKinley MT, `Stop analysing and start thinking: the importance of good thinking skills in a value-managed company', Management Decision, 35, 3, 1997, pp. 18593. Knight E, `EVA: PacDun's new mistress', Sydney Morning Herald, July 19 1996, p. 37. Lewis G, Morkel A and Hubbard G, Australian Strategic Management: Concepts, Context and Cases, Prentice Hall, 1993. Lewis S, `Telstra on the EVA of performance campaign', Australian Financial Review, 18 December 1997, p. 7. Mayfield John, `Economic value management: the route to shareholder value', Management Accounting, 75, 8 September 1997. Mullins DW, `Does the capital asset pricing model work?', Harvard Business Review, January/February 1982, pp. 105-114. Rappaport Alfred, Creating Shareholder Value: The New Standard for Business Performance, The Free Press, 1986. Society of Management Accountants of Canada, Improving Shareholder Wealth, Management Accounting Issues paper 11, 1995. Solomon E, `Return on investment: the relation of book yield to true yield', Research in Accounting Measurement, American Accounting Association, 1966. Stewart G Bennett III, The Quest for Value: A Guide for Senior Managers, Harper Business, 1991. Wenner DL and Le Ber RW, `Managing for shareholder value from top to bottom', Harvard Business Review, November/December 1989, pp. 52-65.