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UNLOCKING SHAREHOLDER VALUE
Paul Nichols
A Hawksmere Report published by Thorogood
IFC
A Hawksmere Report
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U
UNLOCKING SHAREHOLDER VALUE
Paul Nichols
A Hawksmere Report published by Thorogood
IFC
A Hawksmere Report
UNLOCKING SHAREHOLDER VALUE
Paul Nichols
published by Thorogood Ltd
Published by Other Hawksmere Reports published by Thorogood: Economic and Monetary Union – key implications for your business
Thorogood Limited 12-18 Grosvenor Gardens London SW1W 0DH. Thorogood Limited is part of the Hawksmere Group of Companies.
John Atkin
Financial Techniques for Business Acquisitions Ian Smith
© Paul Nichols 1998 All rights reserved. No part of this publication may be reproduced, stored in
Dynamic Budgetary Control
a retrieval system or transmitted in any form
David Allen
recording or otherwise, without the prior
or by any means, electronic, photocopying, permission of the publisher.
Evaluating and Monitoring Strategies David Allen
Debt Recovery and The Legal System Roger Mason
This Report is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, re-sold, hired out or otherwise circulated without the publisher’s prior consent in any form of binding or cover other than in which it is published
The Internet as a Business Tool
and without a similar condition including
Brian Salter and
the subsequent purchaser.
this condition being imposed upon
Naomi Langford-Wood
No responsibility for loss occasioned to Employment Law Aspects of Mergers and Acquisitions
any person acting or refraining from action as a result of any material in this publication can be accepted by the author or publisher.
Michael Ryley
Achieving Business Excellence, Quality and Performance Improvement
A CIP catalogue record for this Report is available from the British Library. ISBN 1 85418 137 8
Colin Chapman
Printed in Great Britain by Print In Black Limited.
The author Paul Nichols graduated as an economist but has spent a career in corporate finance. Part of that time has been spent overseas in Paris and Lagos, Nigeria. He has travelled extensively in Europe and Africa.During this period he concentrated mainly on pricing and corporate planning but also spent some time running a captive equipment leasing operation for a large multinational. He was for a time seconded to the staff of the Price Commission under the last Labour government. He is now director of Future Forward Ltd, a company specialising in corporate finance training. Its objective is to give both academic and practical training to both finance staff and middle management on such subjects as planning,pricing, financial analysis, business case development and, of course, shareholder value generation. Although he normally works with corporates in this country and overseas he has given tutorials on behalf of Hawksmere on pricing, corporate management and shareholder value.
Contents Introduction .....................................................................................1
1
WHERE IT ALL BEGINS
Total Shareholder Return .................................................................5 The failure of traditional measures...................................................5 Profit as an inadequate measure ......................................................8 Cash as a better measure..................................................................9 The missing funding cost ...............................................................10
2
SHAREHOLDER VALUE ANALYSIS – WHERE THE NEW WORLD STARTED
What drives cash flow? ..................................................................13 The level of sales............................................................................14 The operating profit margin ..........................................................14 Taxation payments .........................................................................14 Investment of funds in working capital .........................................15 Investment of funds in fixed capital ..............................................15 Summary ........................................................................................16
3
THE COST OF CAPITAL
The cost of debt .............................................................................18 The cost of equity ..........................................................................19 Problems ........................................................................................20 The value growth potential period ................................................20 Summary ........................................................................................21
4 5
A WORKED EXAMPLE
Calculating shareholder value ........................................................23 Pricing implications – the threshold margin..................................28
UNLOCKING THE DRIVERS: THE OPERATING PLAN
Corporate strategy .........................................................................31 Turnover growth rate.....................................................................32 Operating profit margin .................................................................33 Turnover and margin together .......................................................35 Value growth potential period .......................................................35
6
UNLOCKING THE BALANCE SHEET DRIVERS
Fixed capital investment ................................................................39 Capital asset approval ....................................................................41 Working capital investment ...........................................................42 Tax payment...................................................................................43 Summary ........................................................................................45
7
ALTERNATIVE METHODOLOGIES
Total Shareholder Return (TSR) .....................................................47 Cash Flow Return on Investment (CFROI) ....................................48 Economic Value Added (EVA™) .....................................................50 Cash Value Added ...........................................................................52 So which model to use? .................................................................53 CVAª versus EVA™ .........................................................................54 Charting conclusions .....................................................................56
8
THAT COST OF CAPITAL AGAIN
Leasing ...........................................................................................60 Market value...................................................................................62 So what? .........................................................................................64
9
WHAT ABOUT THE OTHER STAKEHOLDERS – THE SCORECARD DEBATE
Who to satisfy? The stakeholder or shareholder? ...........................69 Debate 1: Stakeholders...................................................................69 Debate 2: Shareholders...................................................................70 A stakeholder society .....................................................................71
10
IS IT ALL JUST A FAD?
A one off? .......................................................................................74 A logical analysis? ...........................................................................75 Widespread usage ..........................................................................76
APPENDIX Bibliography ...................................................................................79
Introduction ‘What is the use of a book’, thought Alice, ‘without pictures or conversations?’ Alice’s Adventures in Wonderland A number of books and articles have been written on the subject of shareholder value and many are listed in the bibliography at the end of this report. As a generalisation, however, they have one thing in common: they are written by people who are seeking to propound their own particular model of shareholder value.This report is hopefully different. Its intent is to review objectively all the different models.By not overtly favouring any one over the others it will inevitably offend those who believe their own favourite to be supreme.My only justification is that I leave it to the reader to reach his/her own conclusion as to superiority on the basis of objective comment. I am aware that some readers will want to obtain copies of the published accounts of companies referred to in the text so they can verify what is written. I have made it easier for them to do this by wherever possible limiting examples to just two companies, IBM and Eli Lilly. IBM is well on the road to recovery from the collapse in its fortunes that it suffered in the early nineties. Its current CEO, Lou Gerstner was appointed by the shareholders with a very clear message to reinstate shareholder value growth. The invitation to the first shareholders’ meeting after Gerstner’s appointment is in itself an interesting menu of items for the new head to concentrate on, representing as it does proposals on his remuneration and the basis of its calculation.There had been no obvious tradition of managing shareholder value within the company prior to Gerstner’s appointment. Different divisions within the company had been measured primarily on market share,revenue growth and the expense/revenue ratio. Focus on balance sheet ratios, levels of taxation and other drivers of shareholder value was limited to specialist staff groups rather than management.This is changing judging both from comments in the Annual Report and the results that Gerstner has generated. Eli Lilly the pharmaceutical company was there before them. They have embraced the EVA™ concept developed by consultants Stern Stewart.They even publish their Economic Value Added result in their Annual Report. All management is expected to understand the EVA™ concept which appears to be well embedded into the planning and capital evaluation processes.Many of the senior management have incentive packages linked to EVA™ performance.
1
INTRODUCTION
Both companies have much to be admired and both benefit from excellent management.Nothing in this report is intended to be critical of their performance or the way in which they are managed. Nor is this report intended to be a comprehensive financial comparison of the two.Their choice has been dictated by their quality and the fact that they are at different stages in the quest for improved shareholder value. One further point of introduction: there has been much debate in recent years as to the purpose of a commercial enterprise.Essentially the argument has been about whether a company owes allegiance to a number of stakeholders – society, customers,employees etc.– or only to one supreme stakeholder,the shareholder.
‘I get paid to make the owners of the company increasingly wealthy with each passing day. Everything else is just fluff’ Roberto Giozueta, the late Coca-Cola CEO
This debate is explored in some detail in Chapter 9. Until then the whole report is written on the assumption that the only objective is the satisfaction of the shareholder.Any pandering to other stakeholders is merely a means to an end. Employees, customers etc. are only kept happy as a way of generating extra wealth for the shareholder.The choice of Eli Lilly and IBM is useful given this assumption.Lou Gerstner’s predecessor,John Akers was widely reported to have been removed by institutional investors because he had destroyed so much shareholder value.The outgoing chairman of Eli Lilly,Randall Tobias,on the other hand is able, in his 1997 report to say Eli Lilly ‘leads all peer competitors in total shareholder return,a remarkable 422 % since the beginning of 1993.’In the 1997 Annual Report for IBM, Gerstner opens his review with the words ‘Dear fellow investor’ and notes that ‘IBM’s market valuation – the ultimate measure of our performance – grew by $23 billion in 1997.Our stock price surpassed its all-time high and continued to climb,rising 38% over the year.Since our major restructuring in 1993, our market-place worth has increased by more than $73 billion.’ The hope is that this report will help readers to emulate their performance in their own companies. Paul Nichols
2
Where it all begins T O TA L S H A R E H O L D E R R E T U R N T H E FA I L U R E O F T R A D I T I O N A L M E A S U R E S P R O F I T A S A N I N A D E Q U AT E M E A S U R E CASH AS A BETTER MEASURE THE MISSING FUNDING COST
chapter
1
Chapter 1: Where it all begins ‘Where shall I begin please, your majesty?’ he asked. ‘Begin at the beginning,’ the king said, gravely,’ and go on till you come to the end: then stop.’ Alice’s Adventures in Wonderland
‘We remain committed to maximising shareholder value’ IBM Corporation ‘Creating value for shareholders must be our key objective’ United Biscuits plc ‘Our primary objective is to create shareholder value’ Blue Circle plc
There was no reason to pick these particular quotes from Annual Reports.In the last five years or so it seems to have become mandatory for chairmen to make similar statements and virtually every set of published accounts contains them. While it may be the accepted norm to talk about shareholder value it is less clear that there is a common view about what it means and how it should be calculated. The shareholder receives benefit in two ways: •
An appreciation in share price (market value)
•
Dividend payments.
4
CHAPTER
1:
WHERE
IT
ALL
BEGINS
Total Shareholder Return One measure that encapsulates these two elements is Total Shareholder Return (TSR), published in a number of journals but perhaps most notably in Fortune magazine.This measure takes an assumed holding in shares in a company at the beginning of a period, assumes that all dividends are immediately reinvested in further stock and then, adjusting for rights issues etc., gives the percentage by which the portfolio has grown in value.As such it is a very fair statement of the return a shareholder has received.
The failure of traditional measures Figure 1 shows industries ranked in order of their TSR for 1997. It also shows other measures for those same industries for 1997. Figure 2 shows the rankings of those industries for each of the measures. For example, airlines are ranked as number 17 in terms of profit as a percentage of revenue, number 10 in terms of profit as a percentage of assets and 21st in terms of TSR.The important point is that there is very little correlation between any of the rankings.Airlines gave the best TSR performance for the year yet was twentieth out of 32 in terms of profitability – perhaps the most common measurement used by industry.The traditional measures of company performance – margin, return on assets, even earnings per share – show hardly any relationship to TSR.Yet many of the chairmen who state in their Annual Reports that shareholder value is their key objective are probably managing their businesses on a day to day basis using those same traditional measures which apparently show no relationship to the shareholder value improvement they all claim to be seeking. Clearly these traditional measures are not what drives return to the shareholder and nor are they adequate measures to be employed internally as a way of measuring whether that growth will be achieved. Even TSR itself has a major limitation: it is entirely historical in nature. It measures whether shareholder value growth has been achieved. It does not measure what will happen in the future.As such it is a perfect measure to demonstrate whether shareholder value has increased but we will need other measures to help us achieve that increase.
5
CHAPTER
1:
WHERE
IT
ALL
Return on revenue
Return on assets
Return on equity
EPS growth %
BEGINS
Returns by industry (as published in The Fortune 1000 April 1998) Return to investors % ‘97
‘87-‘97
1997
1997
1997
1987-‘97
Airlines
61
14
5
6
16
11
Commercial banks
60
25
14
1
16
12
Div. financials
52
27
11
2
17
18
Engineering/constr.
51
19
3
4
10
11
Food & drug stores
45
17
2
4
10
6
Food
43
18
3
7
17
10
Insurance (life & health)
42
23
8
1
11
12
Insurance (P&C)
41
20
9
3
12
9
Publishing & printing
38
14
7
7
15
8
Vehicles & parts
37
14
4
4
17
6
Metal products
36
17
8
7
17
12
Telecommunications
36
17
6
2
6
3
Computers/data serv.
35
17
5
7
14
14
Pharmaceuticals
34
23
14
13
27
14
Speciality retailers
32
13
2
5
11
9
Industrial equipment
31
15
5
6
16
9
Utilities
27
14
8
3
11
1
Gen merchandisers
26
17
3
4
12
8
Computers
24
12
5
5
16
10
Petroleum refining
22
14
5
6
14
7
Aerospace
20
21
5
6
21
7
Electronics/equip
20
17
5
7
15
9
Chemicals
19
14
6
6
17
7
Food services
19
18
2
4
12
15
Wholesalers
18
15
1
3
11
9
Rubber/plastic
15
15
5
7
14
6
Scientific/photo
13
14
7
7
14
10
Healthcare
10
22
2
3
7
17
Forest/paper
6
10
2
2
4
-4
Apparel
-1
12
7
9
19
6
Metals
-5
14
4
5
13
8
Mining
-9
12
12
6
16
3
(Note: all percentages represent the median for the companies listed. Industries with fewer than 10 companies listed have been excluded) Figure 1: Industries ranked by 1997 TSR
6
CHAPTER
1:
WHERE
IT
ALL
BEGINS
Returns by industry (As published in The Fortune 1000 April 1998) Return on revenue %
Return on assets %
Return on equity %
EPS %
% return to investors
1987-’97
‘97
‘87-’97
21
6
Aerospace
17
10
2
22
Airlines
20
15
12
10
1
20
Apparel
9
2
3
28
30
30
Chemicals
12
11
6
24
23
25
Commercial banks
2
31
9
6
2
2
Computers
21
18
13
13
19
29
Computers/data serv
14
3
17
5
13
11
Diversified financials
4
28
4
1
3
1
Electronics/equip
15
4
15
15
22
13
Engineering/constr
25
19
28
9
4
8
Food
24
5
8
11
6
10
Food & drug stores
28
20
29
25
5
15
Food services
29
23
23
3
24
9
Forest/paper
31
29
32
32
29
32
General merchandisers
26
21
22
19
18
14
Healthcare
30
24
30
2
28
5
Industrial equip
18
12
11
16
16
17
Insurance (P&C)
5
25
21
14
8
7
Insurance (life/health)
8
32
25
7
7
4
Metal products
6
6
5
8
11
12
Metals
22
16
20
21
31
23
Mining
3
14
10
30
32
31
Petroleum refining
19
13
19
23
20
24
Pharmaceuticals
1
1
1
4
14
3
Publishing/printing
10
7
14
20
9
22
Rubber/plastic
16
9
18
26
26
19
Scientific/photo
11
8
16
12
27
21
Speciality retailers
27
17
26
18
15
28
Telecommunications
13
30
31
29
12
16
Utilities
7
27
24
31
17
27
Vehicles and parts
23
22
7
27
10
26
Wholesalers
32
26
27
17
25
18
Figure 2: Rankings of industries using various traditional measures
7
CHAPTER
1:
WHERE
IT
ALL
BEGINS
Profit as an inadequate measure All of the traditional measures use profit in some form as the basis of measurement and it is this fact that invalidates them as measures of either past or future shareholder value. The problem is that profit itself has become a doubtful measure. The accounting rules that determine how profit is to be calculated have become so complex that ‘profit’ is now an opinion of the accountants rather than a factual statement of anything. Take some examples: •
A company buys in goods for 100 and sells them for 150.We say they have made a profit of 50.They replace those goods with more at a cost of 110.We still say they have made a profit of 50 – unless we use LIFO rather than FIFO as our inventory costing methodology in which case they have made a profit of 40. So perhaps two companies are making in reality the same profit but one shows it at 50,the other at 40.All the traditional measures would show the second company as performing less well. In fact, if by using LIFO it could deflate taxable profit and thereby delay tax payment it is actually performing better than the first company.
•
Many companies will make entries for goodwill and the value of intangible assets such as brand names when acquiring other companies. While there are now recognised common accounting rules as to how those intangible assets are to be valued there remains considerable uncertainty as to how they should be applied.Where there is a degree of consistency it is to include a value for a brand where it has been purchased but not where it has been generated internally.Until recently there was little consistency as to how goodwill should be accounted – asset, charge against profit, charge against reserves – or over what period it should be amortised.
•
As a generalisation the principle of prudence means that when a company seeks to reduce its profit levels by creating only debatably valid accruals auditors will seldom seek to challenge them.
•
The principle of historical cost accounting leaves assets potentially under valued.The fact that some companies will seek to inflate their profits by upwardly revaluing while others do not leaves profit comparison at least complex if not impossible.
•
And then there is lease accounting, pension funding, the treatment of deferred taxation…
8
CHAPTER
1:
WHERE
IT
ALL
BEGINS
The objectives of the accountant are to: •
on the one hand demonstrate how management have exercised their responsibility of stewardship over the company they have been entrusted to run, and
•
on the other hand provide valid information to readers of the accounts.
The sad fact is that the modern world is too complex for any set of accounting rules and conventions to satisfy both these laudable objectives and at the same time provide a monitoring system for shareholder value. Before we made the business world so complex there was relatively little difference between profit and cash flow. Depreciation would always have been there as a difference but many of the other differences that exist today are inventions of modern times. Profit is a man-made opinion. Cash is, on the other hand,a fact.It is far less open to inadvertent distortion by accounting transactions. Take the LIFO/FIFO example produced earlier. Both companies have received cash of 150,both have paid out 210 and both have the same quantity of physical inventory.The cash flows are fact.It is only when profit is struck that one opinion says that profit is 40 and the other says 50.
Cash as a better measure The Companies Act now recognises this, which is why a cash flow statement is required in the Annual Report along with the P & L and Balance Sheet. The trouble is that even this has become complex and its format is scarcely the basis for simple analysis. Nevertheless, one common thread that runs through most of the new models used to measure shareholder value is the use of cash rather than profit as the measurement basis.Even when profit is still the base measure, as far as possible accounting distortions are eliminated to such an extent that what is left looks more like cash than the original published profit. Whether you accept this attack on the validity of profit as a measure is almost immaterial.The fact is that the professional analysts who advise their clients as to whether to buy or sell a particular share have reached this conclusion.They do use the modern shareholder value models. We may have made the world complex but one truism remains – the only reason a share increases in value is because more people want to buy it than want to sell it.If,therefore,analysts are using new techniques as the basis for their recommendations,and if their clients continue to act on their advice then share prices (and thus shareholder value) will perform in line with those models in a self-fulfilling prophecy.
9
CHAPTER
1:
WHERE
IT
ALL
BEGINS
The missing funding cost If cash is the more reliable measure then we should look at where that cash comes from.A company has two sources of funding – debt and equity.The cost of the debt appears in the P & L in the form of an interest charge,deductible in arriving at both the profit and in computing tax liability.Yet in the traditional accounting form, equity is free.There will of course be dividends (though these are treated as a distribution of profit rather than subtracted in arriving at profit and they are not tax deductible) but these represent only a part of the cost of equity.This equity appears in the accounts under two main headings: •
Original and subsequent share issues
•
Retained earnings
Given that the financial institutions will have received their interest payments then all other funding, including funds remaining in the business to finance future business belong to the shareholder. He wants a return and as in our discussion on TSR he wants this return in either or both dividend and share price appreciation. This required return would be higher than the cost of debt partly because the latter is reduced by its tax-deductible status, and partly because the shareholder is volunteering to take risk. He could have put his money into the building society or some other relatively risk free instrument and received a return not dissimilar to the interest paid to the bankers.Instead,he has chosen to invest his money (or allowed his money to stay invested in the form of retained earnings) in the company.The banker will receive his interest (so long as the company stays in business) regardless of the company’s performance. Fortunately bankers do not expect a higher rate of interest just because a company has had a good year. Nor unfortunately will they normally take a lower charge in bad years. It is the shareholder who is carrying that risk. He recognises that in bad years he may get nothing and indeed if the company founders he will be last in a long line of creditors with less likelihood of recovering his investment than the bankers. In return for that risk he expects a commensurate return – and it is extremely unlikely that in most cases the dividend cheque is sufficient recompense. We will return to the calculation of the cost of equity in Chapter 3 but for the moment it is sufficient to note that: •
it is not recorded fully anywhere in the accounts
•
it will be a higher cost to the company than the cost of debt.
10
CHAPTER
1:
WHERE
IT
ALL
BEGINS
This absence of a significant part of the cost of capital is the basis of the second major contribution to thinking in the discussion on shareholder value (the first having been the preference for the use of cash over profit). Again, it matters not whether you are convinced by this argument.The fact is that financial analysts are. How they apply the principle varies from analyst to analyst but all current thinking on the management of shareholder value takes into account the full cost of capital including the cost of equity. So long as analysts are thinking that way,forming their views and recommendations in that way then management who want to enhance shareholder value must manage their businesses taking the full cost of capital into account.
11
Shareholder Value Analysis – where the new world started W H AT D R I V E S C A S H F L O W ? THE LEVEL OF SALES T H E O P E R AT I N G P R O F I T M A R G I N T A X A T I O N P AY M E N T S I N V E S T M E N T O F F U N D S I N W O R K I N G C A P I TA L I N V E S T M E N T O F F U N D S I N F I X E D C A P I TA L SUMMARY
chapter
2
Chapter 2: Shareholder Value Analysis – where the new world started ‘Why, sometimes I’ve believed in six impossible things before breakfast’ Alice in Through the Looking Glass Of course, many of today’s experts will claim that they developed their own methodologies without the help of others and in some cases perhaps this is true. I have no reason to argue with them.It is worth noting,however,that the plethora of consultant models seems to have only really started after the 1986 publication of Alfred Rappaport’s book Creating Shareholder Value and his explanation of his concept of Shareholder Value Analysis. Rappaport’s basic concept is that a company is worth its future cash flows (note – not profit) discounted at an appropriate cost of capital (note – not just the cost of debt). As such he embraced the two flaws in traditional profit-orientated thinking. In truth Rappaport did not invent either the concept of a full cost of capital nor the idea of discounting future cash flows. Both these concepts had been around for years and had formed the basis of much of the thinking on capital project evaluation. It was his use of the concepts and the way in which he applied them to the management of shareholder value that was the innovation. In Chapter 3 we will discuss the ‘appropriate cost of capital.’ For the moment we should concentrate on an understanding of the source of future cash flows.
What drives cash flow? Rappaport argued that there were only five factors that affected cash flow other than the receipt of capital and the payment to its providers (interest, dividend etc.): •
The level of sales
•
The operating profit margin earned on it
•
Taxation payments
•
Reinvestment of funds in working capital
•
Reinvestment of funds in fixed capital.
13
CHAPTER
2:
SHAREHOLDER
VALUE
ANALYSIS
–
WHERE
THE
NEW
WORLD
STARTED
The level of sales This is clearly the major source of cash to a company.In a traditional Discounted Cash Flow (DCF) exercise one would have taken cash paid by customers rather than revenue booked. Because Rappaport wants to lead on to the management of shareholder value he breaks this customer cash flow into two parts – the sales value and the amount not yet paid by the customer and still reflected in the debtors element of working capital.In fact,for the sake of consistency with other measures he assumes that the sales volume for the last period is known and that what needs to be forecast is the percentage rate by which that known value will grow.
The operating profit margin By taking both the revenue level and the operating profit margin Rappaport includes all the cost and expense cash outflows in between. Where a cost or expense has been deducted in arriving at profit but has not resulted in a cash payment during the same period this will be reflected in changes in working capital.The only exception would be depreciation. His approach is to deduct depreciation on existing assets from the investment in new capital.We might wish to speculate as to why he has done this when what he is after is cash flow and the more traditional approach would have been to add depreciation back to the profit line. Undoubtedly, however, by treating depreciation in the way he does and by including changes in working capital in these first two elements he manages to include all cash flows associated with profit before tax.
Taxation payments There is no such easy solution here.The accounting conventions on the treatment of tax in published accounts and the associated treatment of deferred tax force Rappaport to totally ignore booked tax liability and simply take the cash tax payment made by the company. He looks for the percentage of the operating profit margin that is actually paid in the year in which the margin is achieved. There is a clear mismatch of timings here.We may in the year 2000 be paying tax based on profits in 1998 but it is the relationship of this payment to the year 2000 margin that Rappaport is interested in.The following example assumes a constant operating profit margin growth of 10%, a statutory tax rate of 40% and ignores interest as a tax-deductible charge.Assuming there is a one-year lag in the payment of tax:
14
CHAPTER
2:
SHAREHOLDER
VALUE
ANALYSIS
–
WHERE
THE
NEW
WORLD
Year 1
Year 2
Year 3
Year 4
Profit
100
110
121
133
Tax booked
40
44
48
53
Tax paid
40
44
48
Tax cash %
36
36
36
STARTED
The percentage that interests Rappaport is the 36% i.e. tax paid as a percentage of the operating profit in the year in which the tax is paid. While we may accept that this is not the way accountants will traditionally look at tax liabilities we might also concede that it may well be the way in which we manage our personal affairs!
Investment of funds in working capital This, as has been explained, is necessary to convert the first two measures into cash flow. It is also of course needed to pick up cash movements that do not affect profit in the current period such as purchases for inventory.For consistency with all the previous measures which are stated as percentages this is shown as the percentage of additional revenue (i.e. the absolute value that derives from the sales growth percentage) that needs to be reinvested in working capital.
Investment of funds in fixed capital As already noted this is shown net of depreciation.As with the working capital it is the percentage of additional revenue that is reinvested in fixed capital.
15
CHAPTER
2:
SHAREHOLDER
VALUE
ANALYSIS
–
WHERE
THE
NEW
WORLD
STARTED
Summary The five drivers are therefore: •
The sales growth percentage
•
The operating profit margin percentage
•
The percentage of operating profit that goes out in cash tax payments
•
The percentage of additional revenue invested in additional working capital
•
The percentage of additional revenue invested in fixed asset capital.
These five drivers form the basis of Shareholder Value Analysis as developed by Alfred Rappaport.To apply them however we need to know the ‘appropriate cost of capital’and have an understanding over how long a period into the future we should be making a forecast. These two areas will be discussed in the next chapter.
16
The cost of capital THE COST OF DEBT THE COST OF EQUITY PROBLEMS THE VALUE GROWTH POTENTIAL PERIOD SUMMARY
chapter
3
Chapter 3: The cost of capital ‘With a name like yours, you might be any shape, almost.’ Alice in Through the Looking Glass This is a subject over which financial academics have argued for decades but one which I will keep as simple as possible.We have already noted in Chapter 1 that a company’s funding – its capital – comes in the form of debt and equity. If we can establish the cost of each one of these and weight these costs according to the relative importance of debt and equity to the business (its gearing) then we can establish the weighted average cost of capital – the WACC.
The cost of debt This is the relatively easy part in that it requires very little judgement. It is the after tax cost of borrowings. If we wished to get sophisticated we could make allowances for such things as: •
If some of the debt will mature in the relatively near future and will need to be replaced with more expensive funding we may wish to reflect this higher potential debt cost in the calculation of WACC.
•
It may be that the company is in its early days and has the promise of additional (so-called mezzanine) debt at a different rate than that being paid at present.Arguably this future debt should in some way be built into the calculation.
•
The company may have some ‘hidden’ debt. For example, it may have decided to take equipment on an operating lease rather than borrow from the bank.This begs the question as to whether the lease obligation should be treated as a liability and included with debt and the item involved regarded as a capital asset.This question is discussed further in Chapter 8.
Frankly it is hard to discuss these potential adjustments in isolation without knowing more details about individual company structures.Suffice it to say that in many companies any distortions caused by such items are likely to be less than errors in forecasting the future and for the purposes of our analysis at least at this stage we can ignore them.
18
CHAPTER
3:
THE
COST
OF
CAPITAL
The cost of equity We discussed the motives of the shareholder in the first chapter.The return he requires will be a function of three forces: •
The return he could have received by investing in something which is essentially risk free – say Government Gilts
•
The extra return he needs because he has decided to invest in shares in companies rather than put his money into this safe haven
•
If he were to put his money into a portfolio of shares one might argue that he was minimising, or at least managing, his risk in that if the share price of one company fell that of another might rise.At the same time there may be some companies whose share prices do not rise as much as others when the general price level rises but equally do not fall as much as the overall market when that falls. For each company therefore there is a risk factor by which the second force must be multiplied – the so-called Beta factor. If a company’s shares move in line with the overall market then the Beta for that company will be one. (Incidentally there is such a thing as the Alpha factor which need not trouble us here but as far as I am aware nobody has yet described a Gamma factor.With the whole of the Greek alphabet at our disposal it just shows the potential future opportunity for academics and consultants!)
Calculating the cost of equity in this way is said to be using the Capital Asset Pricing Model. There are other methodologies but CAPM is by far the most common and therefore the one I assume for the purposes of this report.
19
CHAPTER
3:
THE
COST
OF
CAPITAL
Example Suppose a company has the following funding: Debt: £300k for which the after tax interest rate cost is 6% Equity: £900k for which the CAPM calculations show a cost of 18% The WACC is then: Debt: Equity:
6x1 18 x 3
6 54
60 ÷ 4
=
15%
Problems As mentioned earlier there has been much academic debate over the years over the validity of this concept.This goes beyond the bounds of this report.There are, however, some serious practical issues to which we will return in Chapter 8.For the moment let us just accept that WACC,normally calculated using CAPM is the basis of all the shareholder value models discussed in this report. It is important to recognise that the cost of equity will inevitably be higher than the cost of debt for two principal reasons: •
The interest cost of debt is tax deductible
•
The shareholder requires a return higher than he could achieve by putting his money on deposit.
A high debt content is therefore good in that it reduces the WACC.Against this: •
it has to be paid in line with the agreement with the lender whereas there is normally no such contractual arrangement with the shareholder
•
the lower the equity content,in general,the more reluctant a bank will be to lend money.
The value growth potential period This is Alfred Rappaport’s term for the period over which future cash flows (resulting from his five drivers) are to be forecast before being discounted to a present value using the WACC.
20
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3:
THE
COST
OF
CAPITAL
There will be a period over which the analyst can see the company having a competitive advantage. During this period it will make returns above its WACC. After this period the company cannot be assumed to make returns above its cost of capital. If it were to make returns below its cost of capital one must assume the intelligent investor would remove his funds and the company would cease to exist. Therefore beyond this so-called value growth potential period the company must be assumed to make returns equal to its cost of capital. As with all the elements in shareholder value analysis the numbers are a matter of judgement.Anything a company can do therefore to lengthen its value growth potential period in the eyes of the investing analysts will tend to increase shareholder value.Analysts (and therefore company management) will consider such factors as: •
the extent to which it already shows itself to be better than its competitors – having what the consultants would call a ‘distinctive competence’
•
the value of, and the extent to which it manages its brands
•
the value of the patents it owns
•
prospects for successful results from research and development
•
whether the product set has a limited time value by virtue of its exposure to fashion.
Summary In the next chapter we will work through a simplified numerical example. At this stage however we have established that under Rappaport’s shareholder value analysis a company is worth its future cash flows (derived from revenue growth %, operating margin %, tax cash %, incremental working capital % and incremental fixed capital %) discounted by the weighted average cost of capital over the value growth potential period.
21
A worked example C A L C U L AT I N G S H A R E H O L D E R VA L U E P R I C I N G I M P L I C AT I O N S – T H E T H R E S H O L D M A R G I N
chapter
4
Chapter 4: A worked example ‘Write that down,’ the king said to the jury, and the jury eagerly wrote down all three dates on their slates, and then added them up, and reduced the answer to shillings and pence. Alice’s Adventures in Wonderland Although in the course of this report I will describe a number of different techniques and in some instances show examples of how they are calculated, this is the only case where I will demonstrate a detailed calculation.The purpose is to allow the reader to work through one example in detail in the hope that this gives enough understanding to follow the other methodologies.
Calculating shareholder value The premise is that we are given the eight elements needed to calculate shareholder value added using the Rappaport methodology, say: Value growth duration period . . . . . . . . . . . . . . . . . . . . . . . .5 years Sales last period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .£100m Sales growth rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16% Operating profit margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13% Incremental fixed capital investment rate . . . . . . . . . . . . . . . . .21% Incremental working capital investment rate . . . . . . . . . . . . . .15% Cash tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50% Cost of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14% Note:In this example these figures are all assumed to hold good for all five years. In practice it is no more difficult to complete the calculation if different numbers are assumed for each year. The result of the calculation is shown in Figure 3.The notes below show how the individual numbers were calculated.
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WORKED
EXAMPLE
Step 1: Calculate the pre-strategy value In this case the strategy is to make incremental investments totalling 36% of extra revenue each year in order to generate a 16% annual growth in revenue with a constant 13% profit margin. Without these investments the starting point is £100m of revenue with a 13% margin,half of which is paid out in tax leaving a cash surplus of £100,000 x 0.13 x 0.5 = £6,500k. If the cost of capital is 14% then a company that is generating an annual cash flow of £6,500 is worth £6,500 ÷ 14% = £46,430k. If this is not immediately apparent try the explanation in the box below.This pre-strategy value is now entered in Figure 3.
Why is it worth £46,430? If I need as an individual to receive a return of 10% on my investments and somebody offers me an opportunity to invest in something that will, in perpetuity, give me an annual income of £100 then I would be prepared to pay up to £1000 for that investment. If I paid £1000 then the £100 annual return would meet my 10% requirement.To arrive at the £1000 the (probably intuitive) arithmetic was to divide the annual return (£100) by the return required (10%): so 100 ÷ 0.10 = 1000. In the example above 6500 ÷ 0.14 = 46,430).
Step 2: Calculate the value of each year’s extra revenue In year 1 the firm will generate revenue of £116m given the 16% growth rate off the base of £100m, giving additional revenue of £16m.This figure will grow at 16% per year throughout the period, which gives the figures to slot in the far right hand column ‘delta revenue.’
Step 3: Calculate the cash flow from operations In year 1 there will be revenue of £116m on which a margin of 13% before tax will be achieved and then half of the answer will be paid out in tax leaving an operational cash flow of £7540.The same calculation is completed for each year and the answers put in the second from right column ‘cash flow from ops.’
24
CHAPTER
4:
A
WORKED
EXAMPLE
Year
Cash flow
Present value
Cum PV
Present value of RV
Cum PV + RV
Increase in value
Cash flow from ops
Delta revenue
1
1780
1561
1561
47243
48804
2375
7540
16000
2
2065
1589
3150
48072
51222
2418
8746
18560
3
2395
1617
4767
48915
53682
2460
10146
21530
4
2778
1645
6412
49773
56185
2503
11769
24974
5
3223
1674
8086
50647
58733
2548
13652
28970
Corporate value ..........................................................58733 Pre-strategy value ........................................................46429 Shareholder value add ................................................12304 ........12304 Assumptions Sales last period ........................................£100m Sales growth percentage ................................16% Operating profit margin ................................13% Fixed capital investment % ............................21% Working capital investment % ........................15% Cash tax rate ..................................................50% Cost of capital ................................................14% Figure 3: Calculating Shareholder Value
Step 4: Calculate annual cash flow and present value From the cash flow from operations we need to deduct the extra investment in fixed capital (21%) and working capital (15%) – a total of 36% of incremental revenue.To get the annual cash flow therefore take the operational cash calculated in column 8 and deduct 36% of the delta revenue shown in column 9. Put the answer in column 2.For example,for year 1,7540 – (36% x 16000) = 1780.Because this cash flow accrues a year hence we need to discount it by one year at the cost of capital thus for year 1, 1780 ÷ 1.14 = 1561, the value to be written in column 3.Subsequent years are computed in the same way except that whereas for the first year we discounted by one year, for year two we need to discount by two years etc.Thus in year two present value of 1589 is cash flow of 2065 ÷ 1.14 2. Present values are now shown on a cumulative basis in column 4.
25
CHAPTER
4:
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WORKED
EXAMPLE
Step 5: Calculate the present value of the residual So far in calculating the value of the business we have shown for year 1 that it generates a cash flow which in present value terms is worth £1561k to us. However in terms of value to us as a business it is in addition worth what we could sell it for at the end of year 1 if we chose so to do. Even though similar numbers are used in the calculation this is not double counting.We can enjoy the benefit of the cash flow of 1561 generated during the year and then enjoy a second benefit if we were to sell the business at the end of the year.This value at the end of the year is calculated in the same way that we calculated the prestrategy value but we are now dealing with a company that has moved on.At the end of the first year we have a company generating operational cash flow of £7540 which will therefore at that point be worth 7540 ÷ 0.14 (see step 1) = 53857.This of course is what the company will be worth to us at the end of year 1.To bring it back to a present value and thus make it compatible with our other calculations we need to discount it by one year (and, as before, more in future years) thus 53857 ÷ 1.14 = 47243, the value which goes in column 5.We can now add this figure each year to the cumulative present value of the cash flows to tell us what the business will have been worth to us at the end of each of the years.Thus at the end of the first year the business will have been worth £48,805k versus the pre-strategy value of £46,429k. Even by the end of the first year therefore the business has generated extra shareholder value over and above the cost of capital equal to £2,376k (48805 – 46429). In year 2 there is a further £2,418 and at the end of the five year period there is positive shareholder value add of £12,304k.This is shown both in column 6 as the difference between the final addition of the present values of cash flow and residual value and the prestrategy value and in column 7 as the sum of the individual years.
26
CHAPTER
4:
A
WORKED
EXAMPLE
Year
Cash flow
Present value
Cum PV
Present value of RV
Cum PV + RV
Increase in value
Cash flow from ops
Delta revenue
1
1780
1529
1529
39429
40958
-5470
7540
16000
2
2065
1523
3052
39285
42338
1379
8746
18560
3
2395
1518
4570
39142
43712
1374
10146
21530
4
2778
1512
6082
38999
45081
1369
11769
24974
5
3223
1507
7589
38857
46446
1364
13652
28970
Corporate value ..........................................................46446 Pre-strategy value ........................................................46429 Shareholder value add ......................................................17 ..............17 Assumptions Sales last period ........................................£100m Sales growth percentage ................................16% Operating profit margin ................................13% Fixed capital investment % ............................21% Working capital investment % ........................15% Cash tax rate ..................................................50% Cost of capital ................................................14%
Required hurdle rate is 16.425% Assumes: •
The market values the company at £58733 (figure 3)
•
All capital is equity
Figure 4: Calculating the required hurdle rate
Conclusions from the calculation What the calculation shows is that (always assuming this strategy does deliver the forecasted 16% growth at a constant 13% margin etc.) the shareholder will receive positive shareholder value of £12,304k in present value terms over the five year period. He would have been happy with whatever his element of the 14% WACC was. In the event he received more – to the tune of £12304k. This, however, is only true if the shareholder had valued the company at its prestrategy value of £46,429 which would assume he was either unaware of, or did
27
CHAPTER
4:
A
WORKED
EXAMPLE
not believe in,management’s strategy to generate 16% growth through investments. Suppose however he had believed in the company strategy and had valued the company at £58,733. (For the sake of simplicity I have assumed for the purpose of this discussion that the company is 100% equity funded with no debt.) Management now deliver returns in excess of the cost of capital (otherwise there would have been no shareholder value added).Now,because the shareholder has believed in the strategy and valued it at the present value of its success (£58,733) they must deliver at a higher return than WACC just to give the shareholder his 14% return. How much higher is shown in Figure 4. In order to give the shareholder his 14% return, management must on average achieve hurdle rates on projects of at least 16.425%.This is a point we shall return to in more detail in Chapter 8. For the moment let us just record that where the shareholder is valuing the company at more than pre-strategy value then management must achieve hurdle rates in excess of the WACC in order to avoid a negative shareholder value add.That most companies use the simple WACC calculation as the basis for approving projects, that few share values at present are as low as a crude pre-strategy calculation would justify and that most management say they intend to generate shareholder value add is a triangle where the sides simply do not meet.
Pricing implications – the threshold margin What we did in the calculation shown in Figure 3 was effectively to deduct the present value of future investments from the present value of the benefits that were to flow from them: A
B
Present value of incremental business
=
Present value of investment in new capital
=
(incremental sales) (margin on sales) (1 – tax rate) cost of capital (incremental sales) (investment rate) 1 + cost of capital
Of course,if there had been no increase in shareholder value then A would equal B.Assuming A does equal B and simplifying the equation to extract the value of the operating margin we get: (working + fixed capital investment rates) (cost of capital) Margin on sales = (1 + cost of capital) (1 – tax rate)
28
CHAPTER
4:
A
WORKED
EXAMPLE
For any project it is therefore possible to calculate the profit margin needed to have no increase or decrease in shareholder value – the so-called threshold margin.This has significant implications on the way in which a company prices. We know that pricing is not an arithmetic exercise.It is an art rather than a science, taking into account the dynamics of customer demand, competition, the nature of the product and costs etc.The fact is,however,that many organisations delegate pricing responsibility with the stricture that offerings must yield a given profit percentage.The threshold margin is vital in such situations since it allows target profit margins to be flexed depending on the cost of capital, changes in tax incidence, the requirement for additional fixed capital and the implications on working capital of any variation in normal terms and conditions. It can, for example, be used for any product to see what reduction in profit margin could be sustained without any reduction in shareholder value as a result of a customer agreeing to pay in advance rather than in arrears. This is not ‘cost plus’ pricing. It is a far more sophisticated concept that perhaps for the first time links profit margin to both the balance sheet and shareholder return.
29
Unlocking the drivers: the operating plan C O R P O R AT E S T R AT E G Y T U R N O V E R G R O W T H R AT E O P E R AT I N G P R O F I T M A R G I N TURNOVER AND MARGIN TOGETHER VALUE GROWTH POTENTIAL PERIOD
chapter
5
Chapter 5: Unlocking the drivers: the operating plan But the principal failing occurred in the sailing, And the Bellman, perplexed and distressed, Said he had hoped, at least, when the wind blew due East, That the ship would not travel due West The Bellman’s Speech Having now understood how each of the Rappaport drivers affect the growth of shareholder value.The first three will be considered here: •
Turnover growth rate
•
Operating profit percentage
•
Value growth potential period
It is entirely wrong to bracket these together under the general heading of ‘operating plan’, excluding the other two, fixed and working capital as if these latter two had no place in the operating plan. Of course they do – and the more a company focuses on the management of shareholder value the more that is the case.The problem is that in too many companies the operating plan does only focus on revenue growth and profitability with the plan period being the unconsidered definition of the third.In one sense therefore this is the easy chapter. This is the area in which the business manager is already skilled. He already puts a lot of effort into growing turnover and improving margin as part of the normal operating and strategic planning processes.
Corporate strategy Whatever the company does stems from the goals it has decided upon and the strategies it is deploying to achieve them.Turnover and margin result from these initial strategic decisions.The answer will be different for a company manufacturing cars than for a company running restaurants. An obvious comment but it is amazing how often a company comes to grief because it starts to do things which have no consistency with any thought through strategy. It is beyond the scope of this report to describe how strategy should be formulated. Suffice it to say that if the company has gone properly through the process it should have no difficulty in answering, for example, the following:
31
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UNLOCKING
THE
DRIVERS:
THE
OPERATING
•
The nature of the product – what are we going to sell?
•
The nature of the service – pre, during and post delivery?
•
The nature of the market – who are we selling to and where are they?
•
The quality of the product – are we selling high quality or ‘cheap and cheerful’?
•
What is different about us,why should people buy from us,what is our ‘unique selling proposition’?
•
What are competitions strategies and why are ours better?
•
What are the strengths and weakness of the management and the overall organisation?
•
What has the history of our company taught us about the things that work and the things that do not?
PLAN
Turnover growth rate Turnover growth results from two sources: •
Things the company does
•
Factors dictated by the environment in which it exists
For the company its major actions are going to include: •
Product design and manufacture
•
Management of distribution
•
Pricing policy
•
Incentives and compensation
•
Product quality
•
Customer satisfaction issues
•
Other marketing strategy elements (advertising etc.)
Yet however good the actions of the company, it exists within an industry framework.Whatever the company’s strategy is it has to take into account not only the benefits of that environment but also its constraints.If the norm in the industry is a 5% margin then it is just as unlikely that an individual company will make 25% as it is that it can sell its product for £100 when competition are selling theirs for £10.A number of tools exist to help understand this environment: •
PEST analysis (Political, Environmental, Sociological and Technological factors that can impact a business and the achievement of its goals)
32
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5:
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THE
DRIVERS:
THE
OPERATING
•
Michael Porter’s 5 Forces model (The level of rivalry between players in an industry and how that in turn is impacted by the threat of new entrants,the threat of substitutes,the power of suppliers and the power of customers)
•
Several different models help to give an understanding of competition, what their strengths and weaknesses are and how they will react to actions we take.
•
Even traditional tools such as the Boston Consulting Group grid (Stars, Cash Cows etc.) and Value Chain analysis help to position the company in the environment in which it exists.
PLAN
Business schools and management textbooks constantly invent new tools and models to be used to help managers understand their businesses. This report assumes that the reader is already familiar with them and indeed already uses the appropriate ones in his/her business.
Operating profit margin Many of the same factors that externally affect the turnover growth rate also affect the operating profit margin – level of competition,government regulations,state of the economy etc. Equally, all the internal factors which affect turnover can also affect margin. In addition, margin is affected by the cost/expense structure within the enterprise.This has to be much more than blanket refusal to spend money.The cost/expense structure must be related to the nature of the product and the pricing structure. If the strategy is to build a perception of high quality/value in the customer’s mind then there should be no reluctance to price for that perception. It cost something to generate it in the mind of the customer. Policies such as skimming (charging a lot when your product is perceived as being unique) and prestige pricing (charging for perceived high quality associated with the brand) are perfectly acceptable if targeted at the right market.These policies are perfectly acceptably applied by the likes of Gucci and Rolex.To do otherwise would be to reduce shareholder value. Figure 5 shows the options available.
33
CHAPTER
High
5:
UNLOCKING
THE
DRIVERS:
Perceived value
OPERATING
PLAN
• Wasting investment • Unwittingly selling commodity rather than value
• Skimming • Prestige pricing • Capitalise on market perceptions
Sell value
Waste money
Pricing policy relative to value
Sell on price
Kill market
Low
THE
• Cost focus • Commodity business • Sell on price
• Gouging
High
Price level
Low
Figure 5: Pricing policy relative to value
Using the opposite logic to that employed above, it is perfectly acceptable for your customer to have no perception of the quality of your product (bottom right hand box) in which case you seek to differentiate your product only on price. You market on price and preserve your margins by concentrating on being the low cost producer. If you or your company are in the other two boxes,however,this would be totally unacceptable. In the bottom left you are seeking to charge for a quality that the customer does not recognise. Even if he buys in the short-term there will be a long-term backlash and either way you will kill the market. In the top right box you are simply charging less than you could (should?) and thereby unjustifiably reducing returns to the shareholder – wasting his money. One obvious though necessary point: it is almost immaterial what the quality actually is.What matters is the customer’s perception of it.You might have the most advanced, best engineered product possible but if the customer does not
34
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THE
DRIVERS:
THE
OPERATING
PLAN
see it that way you will not be able to charge for that quality hence the comment about building perception in the top right hand box.
Turnover and margin together With so much commonality between the two it is appropriate to sum up the factors together that affect these first two shareholder value drivers. •
Competition – its level, its nature and its strategy
•
Pricing strategy and brand values
•
Corporate size
•
The state of the relevant economy
•
The nature of the industry and its norms
•
The level of marketing investment
•
The availability of resources
•
Internal efficiency
This list deliberately mixes up the factors that are driven by the outside and those that relate to the individual concern.The reality is that there is no need for a distinction.Success comes by having something that beats the competition – and that sentence combines both the individual and the outside.
Value growth potential period While the previous two drivers constitute major elements in the average operating or strategic plan this one normally does not.If the strategic planners have chosen a five-year horizon for their deliberations this does not mean there is a five-year value growth potential period (VGPP). Like quality, the VGPP is in the eye of the beholder, in this case the investor or potential investor. It is the period during which this investor believes the enterprise will have the competitive edge to deliver returns above the cost of capital as defined in Chapter 3. At the extreme it is easy to think of examples of companies with different lengths of VGPP. There would be on the one hand a company created just to manufacture and market the latest television toy.They have no follow-on strategy and they are perfectly happy to close down after a year of very successful business meeting the demands of the nation’s youth.At the other extreme is the pharmaceutical company with a proven track record of developing successful drugs with an on-
35
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THE
DRIVERS:
THE
OPERATING
PLAN
going research program and a number of drugs still in patent.This latter company may be deemed to have a VGPP way beyond its strategic planning horizon whereas the former has little future beyond next month. Yet the VGPP, although defined by the investor, is subject to the influence of management.If the chairman of that pharmaceutical company were to state that he were closing down the research facility or that there were no potentially successful drugs in the pipeline then investors would immediately shorten their view of the VGPP. Importantly, in the process, they would reduce the amount of shareholder value add. So,in a sense VGPP is just like turnover growth rate and operating profit margin. It is a driver of shareholder value. It can be influenced by management action and the larger it is the greater the shareholder value result.As such management must be conscious of their responsibility to manage the company in a way which maximises the VGPP.They must be concerned about such areas as: •
Are they really taking (and communicating to analysts) a long-term strategic view?
•
Do they have a good track record of R & D success that they have efficiently harnessed?
•
Do they own an enviable portfolio of patents?
•
Have they developed enviable brands?
•
Do fashion trends or economic cycles significantly influence their product?
•
Are they maximising their position in the market? (e.g.Porter’s 5 forces model again)
•
Do they demonstrate a distinctive capability that separates them from the competition? This may be in the nature of their product range, in the nature of the organisation or its management; it is something that seems to give the company a long lasting competitive edge
•
Do they have executive incentive schemes geared to long-term shareholder value growth?
•
Do they have a balanced risk management attitude?
In this area,although the shareholder will make up his own mind the role of the chairman/CEO is key.Take the example of IBM.Only a few years ago the perceived wisdom was that the era of the large central processor was past and that the future lay with distributed intelligence through the personal computer. So long as this belief prevailed (reinforced by IBM’s own presence in the PC market and by the fall in large processor sales volumes) the investors shortened their view
36
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THE
DRIVERS:
THE
OPERATING
PLAN
of IBM’s VGPP. Although there were other factors this was a major element in the dramatic fall in that company’s share price.The new chairman however has challenged that perceived wisdom.His view is that undisciplined distribution of PC intelligence results in chaos and inefficiency. His view is that the future lies in the interconnection of those PCs and their linkage into internets and intranets. To do that efficiently requires greater use of the central mainframe. He was successful in convincing Wall Street that there was merit in this argument.The analysts lengthened their view of the VGPP and the share price went up.When the link-up between Compaq and Digital was announced one might have expected IBM’s shares to have fallen in value at the birth of a worthy competitor across the board. Instead, IBM’s shares have continued to rise as the market sees the linking of a PC supplier with another company who has credible mainframe competence as confirmation of chairman Gerstner’s view of the future.
37
Unlocking the balance sheet drivers F I X E D C A P I TA L I N V E S T M E N T C A P I TA L A S S E T A P P R O VA L W O R K I N G C A P I TA L I N V E S T M E N T T A X P AY M E N T SUMMARY
chapter
6
Chapter 6: Unlocking the balance sheet drivers ‘Take some more tea,’ the March Hare said to Alice, very earnestly. ‘I’ve had nothing yet,’ Alice replied in an offended tone, ‘so I can’t take more.’ ‘You mean you can’t take less,’ said the Hatter: ‘It’s very easy to take more than nothing’ Alice’s Adventures in Wonderland In this chapter we will consider the three final drivers of cash flow and therefore of shareholder value: •
Fixed capital investment
•
Working capital investment
•
Tax payment
Fixed capital investment The first problem here is a definition problem. It is obvious from the worked example in Chapter 4 that the fixed capital investment is an up-front investment from which future benefits flow.In reality there may be four differences between this definition and that applied by accountants when they decide whether or not to capitalise something: 1.
There are a number of items capitalised in the accounts that will in reality not generate a return.We all like to think we bring value to our companies yet is the new boardroom furniture, validly capitalised in the accounts, really going to generate a flow of future benefit? Depending on the company there could be many such items – (even perhaps the whole of the head office!) – where regardless of the accounting treatment,in a shareholder analysis such as that completed in Chapter 4, they should be treated as outgoing cash expense rather than capital expenditure.
2.
Even if we had decided that the boardroom furniture was a genuine, value producing asset which should be regarded as capital in the shareholder value calculation, is the same true when it comes to be replaced? There will be a number of instances where assets, perhaps fully depreciated,need to be replaced.The new assets are quite correctly
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put on the balance sheet yet the original cash flow projection may have assumed an ongoing future positive benefit stream originating from only the one capital injection.In these instances the replacement capital should,in shareholder value terms,be regarded as a cash expense outflow. 3.
Imagine you build a factory complete with plant and equipment.The initial analysis compared the future benefits against the initial investment. At a subsequent date you realise that you need to install additional plant to achieve the originally expected gains.The accountants would certainly treat this as further expenditure to be capitalised. In shareholder value terms,however,it might be more appropriate to treat it as cash expense incurred to achieve the originally anticipated benefits.
4.
There will be a number of types of expense that accountants will usually expect, expenditures which would be expected to generate future shareholder value and perhaps should therefore be treated as capital in a shareholder value analysis. Since accountancy rules are not totally precise, these categories will differ from company to company and from situation to situation.They might include expenses such as research and development, corporate advertising perhaps even some training expenses.Just as some items that the accountants have decreed should be capitalised may be more appropriately treated as expense so the reverse is true: some items expensed by the accountants may be more validly treated as capital expenditure in shareholder value analysis.
Whether these adjustments are made in any particular situation and indeed how assets and their residual values should be valued is a matter of taste – and a matter to which consultants address themselves,a subject we will return to in Chapter 7.
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Capital asset approval For most companies the use of discounted cash flow techniques, net present value and internal rate of return already mean that capital expenditure goes through processes which evaluate its returns against the total cost of capital. In order to calculate the Net Present Value (NPV) and to have something against which to compare an Internal Rate of Return (IRR) result some percentage discount criteria has to be introduced – the hurdle rate. It is normal to use the WACC percentage as discussed in Chapter 3. However, in many cases this is adjusted, for example: •
To provide some kind of buffer against projected benefits not materialising in the way assumed in the business case a higher figure than WACC is used.
•
A multinational will invariably have a different hurdle rate by country reflecting its view of the relative instability of the various political and economic circumstances.
•
Some companies will have a pre-set view of relative risk and have a range of hurdle rates to reflect these differences. For example, there may be a higher rate for business cases that forecast an increase in revenue than for those which rely on a reduction in cost for their viability. The argument is that the benefits in the latter are more within the control of the enterprise whereas in the former it requires positive decisions on the part of less controllable customers to buy.For business cases involving the purchase of other companies the even greater uncertainty may be reflected in a yet higher hurdle.
•
Management may dictate a hurdle rate higher than the WACC as a way of rationing scarce funds.They may assume that proponents of really attractive cases that nonetheless fall below the hurdle will battle their cases through the management system.
•
There will be some companies who take the messages of Chapter 8 to heart and use a hurdle rate that recognises the gap between market and book valuation of equity.
Similar reviews are required to make a choice between lease and purchase.Too often, however, the evaluation of new capital spend is as far as many companies go. In truth some of the methods used to evaluate shareholder value penalise capital investment. Consider Figure 6 where recent annual capital expenditures are compared between a company that measures itself on shareholder value using the Economic Value Added methodology (Eli Lilly) with a company (IBM) which probably uses other methodologies (and certainly does not publish EVA™ results). IBM’s results show a continuing growth in capital expenditure whereas Eli Lilly
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shows a constant decline.This does not of course mean that the lower or the higher the expenditure the better.What it does mean is that capital expenditure can only be justified when returns from it enhance shareholder value.The more that is realised the more stringent management will be in agreeing to expenditure. IBM
Eli Lilly
1993
3232
633
1994
3078
576
1995
4744
551
1996
5883
444
1997
6793
366
Figure 6:Annual capital expenditure ($m)
The important thing, however, is not just to evaluate new capital expenditure before the event but equally important is to make sure that the expenditure actually delivers the returns it promised at the evaluation stage. Too often this postexpenditure monitoring is ignored to the detriment of shareholder value enhancement.
Working capital investment Investments in working capital and fixed capital have an identical effect on shareholder value yet the former seldom receives the same management attention as the latter.Just as with capital expenditure it is wrong to assume that the lower the investment the better. The important thing is to make working capital expenditures in line with an agreed strategy.A high level of accounts receivable may well be acceptable in a company where flexibility in terms and conditions is seen as a differentiator and where payment delays are properly priced.For similar reasons a high level of inventory may be necessary to support a conscious decision to differentiate by having quick delivery in return for which the customer pays an above average price.What is not acceptable is to allow long payment delays or high inventory levels without those being the result of conscious decision and properly priced.Too often the large customer, who probably has a below normal price because of his size exceeds agreed payment terms without penalty and the supplier is afraid to press too hard for payment for fear of giving offence. While this may be understandable, management must realise that somebody is suffering as a result of the delayed payment – the shareholder.Many of the companies who have used Activity Based Costing in recent years to help them better understand their businesses have found that this combination of low
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price and long payment delay means that those they previously thought of as their most favoured customers in fact represent the least profitable element of their revenue. Whatever the strategy and the level of working capital that results, working capital has to be managed efficiently. There is no excuse for slack debtor or inventory processes and management must take full advantage of techniques such as supply chain management and just-in-time inventory. Of course, payment delays and inventory levels have always been the focus of management attention.The change that has to be made is one of degree.Reducing working capital can have just as positive an impact on shareholder value as increasing turnover and it therefore requires an equal level of attention from management. Once one realises that a high level of working capital can detract from generating shareholder value then of course it follows that a high level of cash is not the good thing one might have expected it to be. Whereas high inventory and receivables may have been the results of conscious decisions which will lead to enhanced value, it is seldom the case that high levels of cash will have such a positive result. They would invariably be better used to buy value-enhancing assets.Where the expectation of the shareholder is particularly high it may well be that the best use of the surplus cash is in buying back shares in the open market as both IBM and Eli Lilly have done in recent years.
Tax payment This final item is not the tax charge booked in the P & L. It is the actual payment made to the tax authorities.As such it can beneficially reflect actions taken by the company to both reduce tax liability and to delay payment. Too often management focuses on the charge in the P & L.While this is not unimportant, the complexities of the accountant’s treatment of deferred taxation have effectively eliminated the effect of many actions taken to delay payment from it.Take Eli Lilly and IBM again: Both companies are liable to a common 35% US tax rate yet IBM had to book a rate of 47% in 1995.At last in 1997 they are able to book a rate below the statutory rate of 35%,a feat which Eli Lilly had managed to do in 1995 and 1996 (and which they did again in 1997 if you ignore the effect of the goodwill adjustment and the one-time disposal). IBM had a one-off problem in 1995 associated with some write-offs at the time of the Lotus acquisition but even with this out of the way they still have an opportunity to emulate the low effective rate of Eli Lilly.Notice
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also how Eli Lilly managed to have deferred liabilities in excess of deferred assets in 1996.
Eli Lilly
IBM
1995
1996
1997
1995
1996
1997
35
35
35
35
35
35
General credits
-1
-1
-8
Internationals
-10
-8
-7
2
2
-3
2
2
6
9
2
-1
-1
1
-2
1
25
25
47
37
33
Statutory rate
Acquisitions Other Effective rate
26
Disposals
-15
Goodwill adj.
165
Published accounts
26
25
N/A
47
37
33
Deferred tax assets
63
33
224
145
134
122
Deferred tax liabilities
-61
-41
-196
-114
-104
-96
2
-8
28
31
30
26
Net
(Note:All figures, including deferred tax assets and liabilities are expressed as a percentage of that years booked profit on continuing operations before tax.) Figure 7: Statutory versus actual tax rates
This is a complex area and the appropriate experts need to be involved.This report can go only so far with very specific messages: •
The accounting for tax has allowed management to make the mistake of focusing too much on the P & L charge and not enough on the size of the cheque actually being written.
•
Tax is a payment just like any other cost or expense.
•
If one can legitimately reduce one’s tax liability this is as effective as reducing any other cost or expense.
•
If one can legitimately find ways of delaying the actual payment of tax shareholder value is enhanced.
•
Although tax is a specialist area, management have to be aware that the tax effects of their decisions will impact shareholder value as much as if not more than many other decisions.
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Summary The chart below is an attempt to summarise some of the more important management attention areas discussed in the last two chapters.
Turnover growth rate
Operating profit margin
• Understand market • Understand competition
• Ensure profitable growth
• Continuous product development
• Consider outsourcing
• Focus on customer satisfaction and loyalty
• Business process reengineering
• Focused marketing
• Optimise size
• Ensure differentiation
• Price for value
Value growth potential period
Cash tax rate
• Investor communication
• Consider corporate structure
• Consistent R & D • Strategic thinking
• Optimise use of lower tax countries
• Brand development
• Manage customs duties
• Sound risk management
• Manage transfer pricing
• Long-term management incentives
• Minimise foreign and withholding taxes
Fixed capital
Working capital
• Ensure strong approval process
• Efficient review process
• Ensure post expenditure monitoring
• Manage debtors
• Develop treasury techniques to manage interest rate and currency risk
• Consciously restructure • Continuous benchmarking
• Link with pricing • Minimise inventory through value chain analysis and ‘Just in Time’ processes
45
Alternative methodologies T O TA L S H A R E H O L D E R R E T U R N ( T S R ) CASH FLOW RETURN ON INVESTMENT (CFROI) ECONOMIC VALUE ADDED (EVA™) CASH VALUE ADDED SO WHICH MODEL TO USE? CVA™ VERSUS EVA™ CHARTING CONCLUSIONS
chapter
7
Chapter 7: Alternative methodologies What I tell you three times is true The Hunting of the Snark
Total Shareholder Return (TSR) The first question one has to ask is ‘why have different models to measure shareholder value?’We already have a measure,Total Shareholder Return (TSR) referred to briefly in the first chapter.Why do we need others? There are basically two answers to this question: 1.
TSR is a factual statement of what has happened.It looks at the market value of a share at the beginning of the period, assumes that any dividends are immediately re-invested in more shares,adjusts for stock splits,rights issues etc.and calculates the percentage increase that the shareholder would have made given the share price at the end of the period.It says nothing about what might happen in the future.As such it only tells us what has happened, not what might yet be.
2.
Because it only gives that historical statement it does not seek to analyse what might have caused any increase in shareholder value.As such while it is a fair assessment of what management has achieved it does not tell us why and is of little help to managers in their attempts to add value.
What is needed are tools that seek to analyse the causes of value-add so that the constituent elements can then be used by management in their businesses. In the post-Rappaport environment a number of such tools have emerged and there is scarcely a consultancy that does not have its own favoured model.All consultancies will of course argue that by using their particular solution a rise in TSR is guaranteed. Indeed, some will even go so far as to suggest that once a company is known to be adopting their particular product,share values will rise without management taking any further action. Much as the various proponents will argue that their own methodology is the most appropriate there is probably more in common between the competing models than there is difference.They all adopt similar principles:
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•
Unadjusted profit as reported in the accounts is not a good measure of shareholder value.
•
Something closer to cash flow is a better measure.
•
Shareholder value is a function of the difference between wealth created and the cost of funding the capital needed to generate that wealth.
Although the different methodologies have these major similarities there are differences and to explore these they have been divided into three broad types.
Cash Flow Return on Investment (CFROI) This title is something of a catchall for a variety of different approaches. In concept it is little different from the basic Rappaport logic with the arithmetic of Chapter 4. Different consultancies will present the results in different ways. It is common to look at the IRR of future cash flows and compare this to the WACC though again the methods of presentation will vary. One of the more popular methods used in the UK is the Price Waterhouse ValueBuilder in which they calculate the ‘Value Return on Investment’ (VROI) – a very similar concept to the Rappaport shareholder value add of Chapter 4.An example is shown in Figure 8. Here the post-strategy value is compared to the pre-strategy value with the increase expressed as an index of the present value of projected investments.This index (called VROI) shows that shareholder value is being created when it is greater than one. It is a useful measure if wanting to compare various strategies but only really works when there is a reasonable amount of capital expenditure,absence of which can result in a misleadingly high measure.As such, like many of the models, it can if not responsibly used act as a disincentive to investment. The Q ratio is a measure of the extent to which the proposed strategy has converted the use of assets into value for the shareholder. In a perfect market a high Q ratio ought to lead to a market price for the company’s shares in excess of book asset values.
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CHAPTER
Year 0 Profit after tax (PAT)
16.0
Assets employed (nominal)
80.0
Cash flow Discount factor Present value (pv)
7:ALTERNATIVE
METHODOLOGIES
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
12.0
14.0
12.0
14.0
16.0
12.0
0.9
0.8
0.7
0.6
0.5
0.4
10.4
10.6
7.9
8.0
8.0
5.1
Residual value
200.0
Present value of residual
84.6
Present value of cash flows
50.0
Total post-strategy pv
134.6
Assets employed (infl. adj)
95.5 VROI calculation
Net investment
5.0
8.0
6.0
7.0
8.0
4.0
Discount factor
0.9
0.8
0.7
0.6
0.5
0.4
Present value
4.4
6.0
3.9
4.0
4.0
1.7
Total present value
24.0
Total pv (post-strategy)
134.6
Pre-strategy value = year 0 PAT/WACC
106.7
Value increase post-pre strategy
27.9
VROI = value increase/PV investment
1.2
Q ratio = total PV poststrategy/assets (inflation adjusted)
1.409
(Assume WACC = 15%.Assume inflation = 3%)
Figure 8:VROI and Q ratio calculation (From In search of Shareholder Value by A.Black, P.Wright Ïand J. E. Bachman reprinted with the kind permission of Financial Times Management)
In general, the various different versions of CFROI: •
look at cash flow rather than profit
•
allow for assumptions on inflation
•
make a distinction between strategic assets acquired to generate value and purely book assets, some of which may be more appropriately categorised as expense outflows
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•
make some assessment of the residual value of the company at the end of the value growth potential period (normally using the perpetuity method as used above and in Chapter 4)
•
compare the anticipated rate of return of proposed strategies with the WACC
•
can be used to judge historical performance as well to evaluate the future impact of proposed strategies
•
can be applied to individual projects as well as to the enterprise as a whole
•
try to explain what has caused any increase in value.
Economic Value Added (EVATM) This concept, developed by the Stern Stewart consultancy has a wide following particularly in the United States. Although its principles are similar to other models the method of presentation is somewhat different.This method shows the amount by year that a company has added in terms of value rather than looking at the overall value of strategies and their total effect on the business.Calculating EVA™ requires two distinct steps: 1.
The accounts are adjusted to: •
give a common set of accounting policies to all companies calculating EVA™
•
convert profit to something much more akin to cash flow.
Stern Stewart have a menu of over 160 potential adjustments to the audited accounts (although they say only a handful are actually applied to any individual company).The major principles adopted are: •
Investment decisions taken by the company should result in assets regardless of how they are treated in the accounts. Thus some training expense, perhaps some marketing expense will be capitalised.Most notably goodwill expense that has been written off will normally be reinstated as an asset.
•
Assets once created cannot be eliminated by accounting action. The healthcare company that Eli Lilly bought in 1994 for $4.1 billion, most of which was accounted for as goodwill, has been prudently revalued in the 1997 accounts and an ‘asset impairment’ of $2.4 billion was booked in the published accounts. Not in the EVA™ calculation however.The company recorded an EVA™ value for 1997 of $751 million despite a published book loss of $385.1 million.
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WACC is applied to the asset base and the resulting absolute cost of capital deducted from the adjusted net operating profit after tax (NOPAT) to arrive at the additional value over and above the cost of capital created by management action.
Stern Stewart have a sister measure,Market Value Added (MVA) which compares the market value of the company as measured by the stock market with the capital injection required over the years to generate such value.They claim that the MVA™ represents the market’s view of the discounted value of future EVA™ .Although like EVAtm this has received significant publicity with MVA™ league tables appearing in a number of publications it has been criticised for four basic reasons: •
It is subject to the same unaudited accounting adjustments as EVA™
•
It requires going back to the company’s inception to analyse inputs
•
Significant performance by small companies never appears in the league tables simply because MVA™ is an absolute rather than a percentage measure.A study has been conducted by Dr. Rory Knight in which he analysed companies using what he termed the Value Creation Quotient which expresses market value as a percentage growth over capital injected.
•
Unlike EVA™, it is totally backward looking seeking to evaluate how well a company has performed for the benefit of the shareholder. Surely, it is argued, the shareholder is going to be more interested in a direct measurement such as TSR rather than the somewhat more philosophical MVA™.
A simplified version of an EVA™ calculation is shown in Figure 9. Here two companies are compared.By all traditional measures company B is to be preferred. It is larger, it has a better return on capital employed (ROCE) and a higher profit margin.The problem is of course that the traditional way of portraying profit takes no account for the size and cost of equity. Once this is taken into account, company A is the better,with company B not even making enough profit to cover the cost of its capital.
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COMPANY A
COMPANY B
Revenue
400
800
Operating profit
200
400
85
195
600
1000
Tax* Capital Debt/equity ratio
50/50
10/90
Interest rate
10%
10%
Cost of equity
15%
25%
Net operating profit after tax (NOPAT) Interest:
10% x 300
115 30
10% x 100
10
Traditional profit after tax
85
Cost of equity: 15% x 300
45
25% x 900 40
ROCE:
14.2%
(195/1000) Profit % after tax
195
225
ECONOMIC VALUE ADDED (EVATM ) (85/600)
205
-30
19.5% 21.25%
24.4%
(Note:This example,for the sake of simplicity ignores the accounting adjustments that would be made in computing EVA™ . *Includes the tax effect of interest.) Figure 9: EVATM calculation. So which is the best company?
Cash Value Added This model,developed by the Swedish consultancy,FWC AB starts with cash flow rather than profit and makes the same distinction as most models between strategic and book assets.An illustrative calculation is shown in Figure 10.
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(Assume WACC = 15%.Assume annual inflation at 5%)
YEAR 0
YEAR 1
YEAR 2
YEAR 3
YEAR 4
YEAR 5
Operating cash flow
180
270
350
390
430
Operating cash flow demand (OCFD)
273
287
301
316
332
-93
-17
49
74
98
Initial investment
1000
Cash value added CVATM Index
0.66
Average discounted CVATM Index
1.03
0.94
1.16
1.23
1.30
Figure 10: Cash Value Added calculation
To calculate CVA™, first establish what FWC call the Operating Cash Flow demand (OCFD).This is the flow of cash,growing at the annual inflation rate (of 5% in the above example) which gives a net present value of zero on the original (1000) investment using the WACC (15%) as the discount rate.An annual CVA™ index is then computed by expressing the projected operating cash flow as an index of the OCFD.In years when this is above one the business will be generating value in excess of the cost of capital. On the assumption that it makes no sense to eliminate strategies just because they do not cover the cost of capital in all years a discounted CVA™ index is computed by dividing the present value of the operating cash flow by the present value of the OCFD again using WACC as the discount rate. Providing this is above one then the projected strategies are forecast to add value.
So which model to use? There may be no reason apart from consultant competition to select one model rather than another.All of them achieve the basic objective of giving management a tool to help in the management of the business to generate shareholder wealth. At the same time it does make sense for individual companies to settle on one main measure if only to ensure focused attention. While it is not impossible to compare the results of CVA™ and EVA™ it is more difficult to bring CFROI into the comparison. One could certainly argue that it is the purest, being perhaps the one closest to the Rappaport concept. On the other hand it is a more complex methodology to grasp particularly when
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compared to EVA™ .Certainly it conforms to the traditional ways of judging capital expenditure and therefore perhaps it is a methodology that can sit alongside one of the others rather than be seen as an alternative.As to which version of CFROI, this really is a matter of personal preference and frankly the confidence management feel for a particular consultant may well be of more importance than the specific detail of his model.
CVATM versus EVATM To illustrate the comparison between these two models consider the example in Figure 11. Imagine this represents a business which: •
invests 2000 in assets to be depreciated over 10 years
•
in year 1 it makes a 17% return in cash flow terms
•
that same absolute return grows at an annual inflation rate of 3%
•
cost of capital is 15%.
(Note: To simplify comparison we will assume that the EVA™ accounting adjustments convert to cash flow minus depreciation.)
Calculation detail a)
Cash flow: In year 1 this represents 17% of 2000 = 340 which thereafter grows at 3% per year
b)
OCFD.This is the calculated set of numbers which grow at 3% per year and which give an NPV of 2000 if discounted at 15%
c)
CVATM is the difference between columns a and b
d)
CVATM index is column a divided by column b
e)
Profit is arrived at by deducting one years depreciation (10 years straight line) from column a
f)
EVATM is calculated by deducting the cost of capital, being 15% of the depreciating asset value from the profit
g)
Average is simply the crude mean average of the column whereas ‘discounted value’takes all the numbers in the column and discounts them at 15%
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CHAPTER
Year
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a
b
c
d
e
f
Cash flow
OCFD
CVA™
CVA™ Index
Profit
EVA™
0
-2000
1
340
359
-19
0.9
140
-160
2
350
370
-20
0.9
150
-120
3
361
381
-20
0.9
161
-79
4
372
392
-20
0.9
172
-38
5
383
404
-21
0.9
183
3
6
394
416
-22
0.9
194
44
7
406
429
-23
0.9
206
86
8
418
442
-24
0.9
218
128
9
431
455
-24
0.9
231
171
10
444
468
-24
0.9
244
214
Average .........................................................-22.................................................................+25 Discounted value.......................................-107 ...............................................................-107 Figure 11: EVATM/CVATM comparison
Some conclusions can be drawn: •
The two calculations give conflicting results.CVA™ shows a consistently negative result whereas EVA™ shows some negative years and some positive. CVA™
Year
Project 1
Project 2
EVA™
Total
Total CVA™ Index
Project 1
Project 2
Total
1
-19
-19
0.9
-160
-160
2
-20
-20
0.9
-120
-120
3
-20
-20
0.9
-79
-79
4
-21
-21
0.9
-38
-38
5
-21
-21
0.9
3
3
6
-22
33
11
1.01
33
-100
-67
7
-23
34
11
1.01
86
-22
64
8
-23
35
12
1.01
128
57
185
9
-24
36
12
1.01
171
136
307
10
-25
37
12
1.01
214
215
429
Average ............................................-4 ................................................................................+53 Discounted value .........................-48 .................................................................................-48 Figure 11a: EVATM/CVATM comparison – the effect of a second project
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Although the discounted values for both methods are the same the arithmetic average shows the project to be positive using EVA™ but negative using CVA™.
Now to complicate matters imagine a second project, also for 2000, is started in year 6 which is to be depreciated over 5 years.This one makes a 40% return in its first year and again cash flow grows by the anticipated 3% inflation.The result is shown in Figure 11a. Immediately the investment is made the EVA™, which had just turned positive in year 5 turns negative.This clearly gives the impression that the second project is bad news for the business when of course exactly the opposite is the case. The two projects together, in truth, do not recover the cost of capital but the second project did improve the situation. This is shown by looking at the discounted value,which is the same for both methods.Proponents of CVA™ will, however,claim it was easier to see from the consistent annual CVA™ indices and hidden by the fluctuating EVA™ results.Incidentally,it is totally invalid to compare the two methods or to assess the viability of any project or strategy by taking the arithmetic mean average of the annual results rather than discounted values. I have done so in these examples because I know that some managers (and even some professionals!) will do so and will unfortunately believe the answer. We can now therefore draw some comparisons between the two methodologies: •
EVA™ is simpler to compute and arguably simpler to explain
•
Perhaps therefore EVA™ is more appropriate for publication
•
EVA™ requires a number of adjustments to audited accounts which are not themselves subject to audit
•
EVA™ already has a broader acceptance than CVA™
•
EVA™ can act as a deterrent to investment
•
If cash flow is the important item to measure then why start with profit as EVA™ does rather than cash as CVA™ does?
•
Assuming constant year by year numbers CVA™ shows a constant profitability throughout the investments life whereas EVA™ shows an increasing profitability.
Charting conclusions Having calculated shareholder value in whichever way management prefers,the final step is to turn the answer into some sort of meaningful graphic.
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25
METHODOLOGIES
A 480
Sales growth rate x threshold spread
20
15
B 200
10
C 40
5
0
5
10
15
20
Value growth duration period (in years) -5
D -6
-10
SBU
Sales growth rate %
A
12
X
X
Value growth period
=
Threshold spread
=
2
24
20
480
Index
B
10
1
10
20
200
C
8
1
8
5
40
D
6
-1
-6
1
-6
Figure 12: The Value Creation Potential Index
Here again consultants will have their own preference though there is a degree of commonality. Rather than show a variety of essentially similar charts, Figure 12 demonstrates the ‘Value Creation Potential’index proposed by Alfred Rappaport. The index makes use of the threshold margin explained in Chapter 4. The ‘threshold spread’is the difference between the threshold margin and the margin actually forecast for the particular Strategic Business Unit (SBU).The theory is that this type of analysis would highlight SBU D as a candidate for closure and shows the significant superiority of SBU’s A and B over the others.
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There are, however, a number of dangers in this approach: •
It assumes that each SBU is a totally separate entity where this is often not the case.In IBM although they may manage the high-end machines, mid-range and PCs as separate SBUs within the overall corporation the presence of each one enhances the others.In Eli Lilly significant profits from one drug or disease area are used to fund the research in another. As such it may be wrong to assume that decisions can be taken for any particular SBU without any impact on others.
•
It assumes that it is possible to strike a true profit for each of the SBUs. In many companies doing so will involve significant allocation exercises and inevitably these reduce the reliability of the resulting answers.
•
There is a risk, as with many management models, of accepting an over-prescriptive action plan.Just because SBU C is less attractive than A or B does not mean it should be abandoned. It may be that the assumptions used in calculating the numbers should be reviewed or it may be that improvement strategies should be explored etc.
The message is the same as for many management models: the model is there as a tool to help decision making but it is still the management, not the tool, that take the decision.
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That cost of capital again LEASING MARKET VALUE S O W H AT ?
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Chapter 8: That cost of capital again Curiouser and curiouser Alice’s Adventures in Wonderland In Chapter 3 we discussed the cost of capital and said that all models of shareholder value tended to use the Weighted Average Cost of Capital (the WACC). For a long period this has been a perfectly adequate method of calculating the cost of a company’s funding.In two respects,however,there now have to be some serious doubts: •
Leasing – if a company uses leasing as a way of funding its capital, particularly off-balance sheet operating leases rather than using other forms of finance, should this affect the cost of capital in any way?
•
Market value – is it right to continue to use the book value of equity when the latest stock market bull run has left so many market values significantly higher than book values?
Leasing Over the last 20 years there has been a significant growth in the use of leasing as a means of financing capital particularly computers.Accountancy rules have changed to reflect this growth. Under current accounting regulations the outstanding obligations under finance (or capital or full-pay-out) leases are shown as a liability on the balance sheet and the item involved appears as an asset even though it is not actually owned by the enterprise. Operating leases however, (that is where the lessor is assuming a degree of residual value risk such that over the life of the lease he does not receive the full original purchase price for the lessee) are not shown on the balance sheet (though they are covered in a note to the accounts). There has been much discussion in recent years over the wisdom of this treatment, which largely goes beyond the scope of this report. It is clearly wrong to show a rental car as an asset simply because one hires it for a couple of days. On the other hand it seems capricious not to show a travel company’s aircraft as assets (and the associated liability to pay) simply because they were leased on an operating lease.
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There is also some difference of opinion on the distinction between operating and finance leases. In the US there seems a fairly clear dividing line: where the residual value held by the lessor is less than 10% then it is classified as a capital lease. In the UK the distinction is more one of judgement (though the US 10% rule is often applied). But there are no accounting rules as to how WACC should be calculated and the analyst has to exercise his own judgement. The question is whether, since the finance lease obligation appears as a liability, that liability should be treated as part of debt in the WACC calculation. Surely, the argument goes, a lease is just as much funding from the leasing company as normal borrowing is funding from the bank. Equally the company is receiving the benefit of the asset apart from the technicality of actual ownership and it should be treated as an asset in the calculation of shareholder value. Like other assets it should earn at least the company WACC and the fact that the company has chosen to lease rather than buy should be reflected in the WACC calculation. The counter arguments run as follows: •
The accounting rule is somewhat arbitrary. A lease appears on the balance sheet if there is a 10% residual value but not if there is a 11% residual. Surely if leases are to be taken into account there ought to be some consistency and the decision ought to be based on the importance of the asset to the business rather than an accounting rule that is constantly under debate.The problem is then where to draw the line. If one does include the 11% residual item does one also include the car leased for a couple of days? And is the 99-year lease on the office an asset?
•
Leasing an asset rather than buying it is a decision to use leasing company funds rather than the company’s own funds.As such it is a way of conserving funds rather than a use of them. The accounted liability should not figure in the calculation of WACC.Whether the use of the asset makes sense should come from a comparison of the IRR benefit of having it to the implied rate of interest in the lease.
On balance I favour reflecting both the lease debt and the value of the asset for both finance and operating leases.Obviously short-term rentals would be excluded and in the case of long leases (for example, property) I would only take the debt obligation (and an appropriate asset value) for a reasonable period of time (say, five years). There can, however, be no rigid rule. The treatment of leasing debt has to be handled appropriately for each company. Most shareholder value models will include leasing as suggested here but there will be situations where this treatment is inappropriate.
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Market value There has been much written over the years on the calculation of the so-called beta factor and its use in the calculation of the return that an investor expects to receive on his investment. It is not necessary for us to join that debate. Let us assume that the calculation is correct. In calculating WACC the cost of equity is applied to that element of a company’s funding relating to original share capital and retained earnings (so-called shareholder funds). The flaw in this is that the investor has no perception of shareholders’funds being equal to his investment. His investment is what he could sell the shares for on the market today. Note that this is regardless of when he bought the shares. If he paid £10 per share today then we would all agree that his investment is £10. However, if he had bought the shares 15 years ago for £1, by continuing to hold them he is making a decision to invest what he could sell them for,£10.Whether that £10 is more, less or equal to the equity value per share that appears in the accounts is irrelevant to him. This would not matter if there were no significant difference between the book value of equity and the market value. However, there is, if only because of the significant rise that has taken place in the stock markets in recent years.The current norm is for market value to be around three to five times book value and in some case significantly more.At the end of 1997 IBM’s market value was around five times its book value and in the case of Eli Lilly the comparable factor was a staggering 15 times.Figure 13 shows the impact of this consideration.A number of different debt/equity ratios are assumed and with constant cost of debt and cost of equity assumptions,WACC is calculated for each gearing assumption. There is then a calculation for what is termed the real cost of equity.This leaves the gearing ratio the same but assumes,in the case of real cost (a) that with market values being five times book values then five times the 17% return is needed on book equity.The 17% and 6% assumptions are not unrealistic so with a 1997 gearing of around 55% IBM would have a WACC of approximately 10% but its real cost of capital is closer to 42%. Of course if IBM intended to pay off some of its debt and wanted to take a view of future, strategic gearing then both numbers might be higher. In the case of Eli Lilly, 1997 gearing was around 30%. On the above assumptions its WACC would be under 14% but the real cost of capital would be 180%. Real cost (c) shows the lower book/market relationship of three times, approximately the level IBM had been a year earlier. Even at this level, the real cost of capital to IBM would have been 29% with the 50% gearing it had at that stage.
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Debt Equity D/E ratio
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AGAIN
9.3 10.4 10.9 11.5 12.6 13.7 14.8 15.9 17
Real cost (a): market = 5 x book value Real cost (b): market = 15 x book value
All cases assume: Cost of debt = 6% Cost of equity = 17%
Real cost (c): market = 3 x book value
Figure 13: The real cost of capital
Some people will reasonably argue that in making this comparison between book and market value (or indeed in calculating WACC itself) any goodwill written off should be added back to book equity. Purely for the sake of simplicity I have made no such adjustment in the above illustration. Of course many people argue that there is no need to calculate what I have called the real cost of capital and that it is correct to use book rather than market equity values.Their contention is that market value is somewhat ethereal and open to the whim of the market whereas the book value is real and comparatively static. I find this unconvincing.There is nothing ethereal about market value to me, a shareholder.On the contrary,I find the book value irrelevant in judging whether a company in which I have invested is performing well.
Impact on market price Few companies will be able to make returns at the level of the real cost of capital and in the summer of 1998 falls in US and UK stock markets were therefore inevitable (with probably more falls still to come).What has also been noticeable is the apparent sensitivity to expected changes in interest rates.While one of the reasons for the over-valuation of stock markets was the generally low levels of interest rates forcing capital into potentially more rewarding equities, the fact is that this is not enough to justify the ridiculous levels to which the markets have risen. However, the calculation in Figure 13 is very sensitive to interest rate expectation.Suppose we take a 50% geared company with market value five times book value with a WACC of 11.5% and a real cost of capital of 6%. Suppose now
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that the market expectation is that this will fall by 2% before tax, in round terms a 1% fall after tax.With no change in any of the other factors real cost of capital is now: Debt: say 5% x 0.5 (gearing) Equity say 15% x 0.5 (gearing) x 5 (market/book ratio)
2.5 37.5 40.0
That expectation of a 1% fall in the after-tax cost of funds has produced a 6% fall in the after-tax real cost of capital, thereby making such returns just that little bit less unachievable. Not surprisingly therefore every time interest rates have been reduced or are rumoured to fall the slide in the markets pauses or even reverses to a greater degree than can be explained by any disparity between bond and equity yields.
So what? There are several important implications of this analysis: •
It must be understood that to the extent that the various shareholder value models use WACC rather than the real cost of capital then they may be overstating the results.
•
In using WACC as a hurdle rate in evaluating capital projects companies are understating the true cost of their funds. If in the case of IBM it were to have approved projects that just met the WACC hurdle rate of 11.5% during 1997 then it would not have delivered the 17% that it judged the shareholder required (assuming it judged 17% to be the right number). It would have made sense for IBM to use a hurdle rate of around 30% that more closely reflected the market value of its equity and for all I know it did so.But this adjustment would be more difficult for Dell or some of the other stars of the NASDAQ. It is also more difficult for IBM now that the real cost of capital on the above assumptions would be nearer to 42%.
•
Although Eli Lilly has a very high market/book relationship along with several companies in the pharmaceutical sector the IBM ratio is not unusual.The stock market is therefore assuming that companies will be delivering returns significantly higher than their WACC.Across the board this is unlikely to be true.This disparity between WAAC and the real cost of capital is therefore a tangible measure of the extent to which the stock markets are currently over-valued.
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•
Adopting this approach clearly increases the cost of equity capital compared to debt. It now makes eminent sense for a company to use surplus funds (or even borrow funds) to buy back its own stock.This is an action that not only are examples of Eli Lilly and IBM but ones which also many British companies from Hogg Robinson to BT have taken.
•
The more successful a company is in increasing the market’s perception of its success, so the greater the likely gap between market and book value. If IBM were to grow its market value to eight times book value then the real cost of capital,leaving all other factors unchanged,would rise from 42% to 65%.There are presumably people in IBM who are hoping that as profitability improves and the share price rises so the good days will return and the easier it will be to get pet projects approved.This analysis suggests that precisely the opposite is true:the more successful a company becomes the harder it is to generate shareholder value at the new higher level of performance.
AGAIN
But does this mean that Eli Lilly should only be approving projects that achieve an impossible 180%? If so,then investment would cease and shareholder returns would dwindle. The answer is ‘no!’. The truth is that there is a fundamental difference between the two companies. With no disrespect intended towards IBM (for whom I hold the highest regard) They may never again set the world alight with some new invention.There will doubtless be brilliant new computer technology both software and hardware. There will be amazing new applications and IBM will continue to be successful for many years to come. But that success will come more from its ability to survive in a highly competitive market. It would be right therefore to use the real cost of capital in evaluating new investment. In the current inflated state of the stock market it may make sense to discount stock levels a little pending an overall market correction but that is a matter of degree rather than principle. Eli Lilly on the other hand may well come up with a new product with dramatic returns. Prozac, its anti-depressant drug is nearing the end of its patent life but the market is expecting the company to market equally successful products.At some point somebody will come up with the cure for heart disease or diabetes or osteoporosis and who knows, it may be Eli Lilly. So for Eli Lilly, 180% is not the hurdle rate for normal capital projects.Nor is the stock market valuing them on the assumption that they are.The truth is that the stock market is assuming (gambling?) that there will be new drugs that earn dramatic levels of return. For the management of Eli Lilly therefore the challenge is to manage investors expectations.If,for whatever,reason the market reached the conclusion that there
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were to be no future products with the success potential of Prozac then there would be no justification for the high share price and TSR would become negative. The fact that EVA™ may still remain positive would be of no consequence to the investor.The reality today is that the market does believe in future wonderproducts (though interestingly not from all pharmaceutical companies). Now, of course I have no inside knowledge about whether Eli Lilly have some world beating product in the pipeline any more than I have knowledge that IBM do not. What is apparent is that the market has made up its own mind and management must understand this and manage both their companies and market expectations accordingly.
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What about the other stakeholders – the scorecard debate W H O T O S AT I S F Y ? T H E S TA K E H O L D E R O R S H A R E H O L D E R ? D E B AT E 1 : S TA K E H O L D E R S D E B AT E 2 : S H A R E H O L D E R S A S TA K E H O L D E R S O C I E T Y
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Chapter 9: What about the other stakeholders – the scorecard debate ‘The question is,’ said Humpty Dumpty, ‘which is to be master – that’s all’ Through the Looking Glass
‘It is time we killed a myth, the myth that it is the shareholders who run the business, and that it is for them that we all work’ Charles Handy in ‘Beyond Certainty’ ‘A business corporation is organised and carried on primarily for the profit of the stockholders’ Michigan Supreme Court ruling in a case brought by shareholders against the Ford Motor Company ‘The business of business is to make profits. We have always challenged this. For us the business of business is to keep the company alive and breathlessly excited, to protect the workforce, to be a force for good in our society and then, after all that, to think of the speculators. I have never kow-towed to the speculators or considered them to be my first responsibility. They play the market without much concern for the company or its values. Most are only interested in the short-term and quick profit; they don’t come to our AGM and they don’t respond to our communications. As far as I am concerned, I have no obligation to these people at all.’ Anita Roddick, 1991
‘These people’ removed her from her position as chief executive of The Body Shop in May 1998.
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Who to satisfy? The stakeholder or shareholder? The basic question is whether a company’s management have to regard the satisfaction of all stakeholders (employees, customers, suppliers, government, shareholders, society etc.) as their objective or whether the satisfaction of all of these is merely a means to achieve the only real objective, the satisfaction of the shareholder.
Debate 1: Stakeholders Those who take the so-called holistic view (i.e. that all stakeholders need to be satisfied) use the following arguments: •
The idea that the shareholder is supreme comes from the days when the shareholder really was the owner and played a large part in the management of the company. Today the shareholder is more of a financier than owner, moving money around to get the best return.
•
In the past there was some validity in the view that the providers of the capital did own the company since their money had been used to buy the physical assets that constituted the company.Today the value of a company is more likely to be in the skills and talents of its workforce than in its physical possessions.A company is its history,its relationships, its reputation and shareholders do not own these.
•
The purpose of a company is not to maximise shareholder wealth; it is to produce goods and services that people want.
•
Even in the days when the shareholder really was the owner and to that extent represented the company, those owners were the source of community charity,the providers of welfare to their workforces and the major patrons of the arts.Now that the shareholder stands somewhat remote from the company, the company itself has to exercise those responsibilities.
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Debate 2: Shareholders The counter arguments would be: •
It is a fact.The shareholders do own the company and appoint (and remove) its management.
•
A company has a responsibility to act within the law.It is up to society to enact those laws and there can be no further responsibility asked of the corporation.
•
Very often a corporation will do things to satisfy other stakeholders but it does it purely as a means to an end:it will get better productivity out of a well motivated workforce, more business out of satisfied customers, better service out of contented suppliers etc. To spend shareholders funds on actions that do not increase shareholder wealth, albeit indirectly, is theft.
•
It works.The major advances in computing,pharmaceuticals et al have come from western economies where the shareholder is supreme. The Japanese economy has been successful more on the back of copying western innovation but then delivering it more efficiently than a possibly too complacent West (cars, computers etc.)
•
Without the shareholder being there as the final judge there is nothing to make the management run the company in an efficient way. Prices may be too low or employees overpaid in an attempt to satisfy customers and employees. Pressures from society and workers may be such that in the absence of strong shareholder sanction there is nothing to make management take uncomfortable decisions like reducing the size of the workforce. In that case, if performance were sub-optimised the classical economic view would be that the factors of production were not being used in an optimal way in the economy as a whole.
•
Satisfying everybody is not possible.The best that can be achieved is an optimum balance that may well mean sub-optimising each element. Sub-optimisation can never be good.
This last criticism has given rise to the use of a new term ‘shareholder symbiosis’, a term coined by Arthur Andersen. It goes beyond mere balance of the different stakeholders and looks for ‘the growth of each stakeholder but not at the expense of the others.’ It looks for a company to move ‘beyond the limitations of stakeholder balance to a mutuality that enables each to flourish in a system where all must flourish.’ Looking for this as a goal seems admirable – but perhaps it was something we were always looking for.
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An arguably more balanced view was taken by the 1993 RSA Inquiry Tomorrow’s Company which argued that the satisfying of all shareholders was not only valuable in itself but was actually required in order to increase shareholder value. If the debate is worthwhile it has to be possible to see differences between companies who look for stakeholder balance (or even symbiosis) and those who are clear about recognising the superiority of the shareholder over other stakeholders. Presumably, in the extreme, the company who rejects the holistic approach will never measure customer or employee satisfaction,will never make charitable donations or second employees to non-profit organisations.Of course this is not true.Any sensible organisation will do all these things.They may even give some employees a staff responsibility to identify,for example,how customer satisfaction might be improved or research what needs to be done to improve employee morale. For these individuals the primary goal may then be improved customer or employee satisfaction.The key question is whether management at the highest level sees such satisfactions as an end in themselves or a means of delivering improved shareholder value. The realignment of Anita Roddick’s responsibilities at The Body Shop where she was replaced as chief executive serves as a salutary reminder that shareholders who feel they are being asked to yield value so that other stakeholders can be satisfied ahead of them have powerful ways of correcting the balance.
A stakeholder society It is clearly an argument that will run and run.The debate even got a prod from an unexpected source when Tony Blair, in the run-up to the 1997 British general election talked of the need for a ‘stakeholder society’. Apparently this term was inspired by discussions he had had with John Kay, (then principal of the London Business School) who has been a strong supporter of the balanced stakeholder approach. In reviewing Kay’s book The business of economics in November 1996 The Economist said: ‘(Kay) is seen as something of a hero by Tony Blair’s New Labour and something of a villain by right-wingers. He does not believe that the purpose of companies is to maximise profits for their shareholders.They are not, he argues, owned by the shareholders in any meaningful sense but are ‘social institutions’.Shareholders are just one of several groups of stakeholders with claims on the firms. Others include customers, employees, suppliers and so on.
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This is either trivial or meaningless. Few companies, bar perhaps monopoly utilities, can afford to have a miserable workforce or disgruntled customers. If, that is,they want to be successful.Presumably that means making money for their shareholders.’ For most of us therefore the debate is irrelevant. All stakeholders need to be satisfied and those satisfactions need to be measured. Very often this will not involve sub-optimisation.If it appears to do so then the most important objective is the satisfaction of the shareholder. Management who ignore this may not stay in their jobs long enough to satisfy anybody else.
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Is it all just a fad? A ONE OFF? A L O G I C A L A N A LY S I S ? WIDESPREAD USAGE
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Chapter 10: Is it all just a fad? ‘Contrariwise,’ continued Tweedledee, ‘if it was so, it might be, and if it were so, it would be: but as it isn’t, it ain’t. That’s logic’ Alice in Through the Looking Glass Each time we go through an airport lounge,there on the bookstall we find books on the latest management fad.Travellers will notice that the subjects covered by these books a decade ago are totally different from those on today’s bookstalls. A decade ago the perceived wisdom was that Total Quality Management was the key to corporate success.We were told the ‘Quality is Free’;we were taught how to measure failure rates and we started to re-engineer corporate processes with ‘Just in Time’ manufacturing first on the list. Books on these subjects no longer take up the majority of shelf space.It seems now that the key issues are strategic planning and shareholder value.The question is whether these too will turn out to be simply fads or whether they represent a fundamental change in the way in which companies are managed. Answering this question requires a short comparison between the different focuses of bookshelf attention.
A one off? The drive in the 1980s for improved quality was perhaps necessary. Much of western industry,and particularly sectors of it (like the car industry),had become complacent and output quality had suffered.At the same time internal processes received inadequate attention. As a result, western industries became prime targets for competition, particularly from Japan. So it was timely for us to read up on the works of Cosby, Demming et al. was right that we employed their principles.And then what? We found that we had moved to a new,improved quality plateau along with our competitors.We had improved quality control,eliminated a lot of the waste, re-engineered our processes. Contrary to what the gurus had told us we found it was neither a continuous process nor free.We discovered that while there were significant benefits in an initial major improvement,subsequent improvements beyond this did not often pass the cost justification test.We had made the major one-off improvement.We had changed people’s attitudes towards quality. Perhaps we had beefed up the quality control function but in general we found that having made the initial major
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improvement we had nowhere further to go.Quality management had done the west a great service but it was not going to be the basis of a new way of management. The same can be said of the 1980s fashion for re-structuring.Headcount in many companies was dramatically reduced – and then what? It was a one-off action that could not be continued indefinitely. Yet other concepts from earlier decades still survive. The Boston Consulting Group’s matrix, developed in the 1960’s is still taught in the business schools and still used by management.We still use SWOT techniques and develop PEST analyses and we will certainly still be doing so long after the last quality circle has drawn its last fishbone diagram.Why? Because these are tools of dynamism. They do not simply take us to a new plateau. They add to our tool-bag of management techniques.They have changed the way in which we manage. The development of shareholder value analysis techniques over the past decade represents a similar permanent change in the way managers manage.It does not simply take us to a new plateau. Shareholder value analysis in its various forms gives us a different way of managing. It may take a few years for it to become endemic but few can doubt that as the knowledge and awareness spreads so it will change the nature of management.
A logical analysis? The basic concept of shareholder value analysis is not only very simple, it is also very logical: 1.
Accounting has become so complicated that the concept of profit is no longer sufficient or even useful as a means of understanding wealth generation.
2.
Cash is more real and therefore more meaningful.
3.
The level of cash flow is influenced by just 5 drivers: •
turnover growth rate
•
operating profit margin
•
Taxes paid
•
investment in working capital, and
•
investment in fixed capital.
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That cash flow needs to be: •
viewed over a foreseeable period
•
costed using the coat of capital of the enterprise.
5.
Managing the five drivers and also optimising the above two elements provides a structure for the generation of shareholder value.
6.
Managers work for the shareholders. If they fail to deliver value they will be removed.
If it is that simple and logical why have we not always known about it? In a sense of course we have. Most of the arithmetic in shareholder value is no more than traditional discounted cash flow. What is new is its application to something other than capital projects and the thought that identifying the drivers is a way of management.We have reached this conclusion for two basic reasons: •
A realisation that accounting has become so complex that profit is no longer a sufficiently reliable way of measuring wealth generation.
•
Competition among financial institutions to provide better returns for their increasingly better informed clients in an increasingly competitive market.
Neither of these reasons is going to go away and the logic remains sound. Shareholder value management is here to stay.
Widespread usage The fact is that like it or not financial institutions are using the new techniques. They use the analysis to advise their clients on whether to buy or sell shares. It is a fact of the market that if enough people sell shares because their advisors think that prices will fall then prices will fall and the advisors will have been proved right. If management want to continue to generate wealth for their shareholders, therefore, they must use the same techniques in the management of their businesses that the institutions are using to formulate their buy or sell opinions. This is not to say that there will be no changes in technique in the future. Undoubtedly consultants and academics will continue to refine the different models but the basic principles are likely to remain the same. Meanwhile a growing number of companies,like Eli Lilly,are reporting shareholder value numbers in their published accounts and paying at least senior management
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incentives on their contribution.This means an internal measurement process and a change in management thinking. If there is any merit in the old dictum ‘what you measure is what you get’then they are on the road to generating value for their shareholders. For those companies shareholder value is no fad. It has become an integral part of corporate life. What we now have is a new way of managing businesses; a way that not only allows us to measure the wealth that we are creating but more importantly tells us which levers to pull. We now know that by managing Rappaport’s 5 basic cash drivers, by focusing on the cost of capital and by lengthening the value growth potential period we will grow value for our shareholders – and the shareholders are expecting nothing less.
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Bibliography
appendix
Bibliography
Books In Search of Shareholder Value – Managing the Drivers of Performance, Dr Andrew Black, Philip Wright & John E Bachman, Financial Times Pitman publishing The Quest for Value, Bennett Stewart, Harper Collins Creating Shareholder Value, Alfred Rappaport,The Free Press Value Based Management: Developing a Systematic Approach to Creating Shareholder Value, James A Knight, Irwin Professional Publishing Value Creation Among Britain’s Top 500 Companies,Dr Rory Knight,Templeton College Oxford The Business of Economics, John Kay, Oxford University Press Beyond Certainty The Changing World of Organisations, Charles Handy, Hutchinson Living Tomorrow’s Company, Mark Goyder, Gower
Journals EVA™ Fact and Fantasy, Bennett Stewart, Journal of Applied Corporate Finance, volume 7, number 2, summer 1994, BankAmerica. The Balanced Scorecard, Robert S Kaplan & David P Norton, Harvard Business Review, Jan – Feb 1992 Economic Value Management – The route to Shareholder Value,John Mayfield, Management Accounting, volume 75, number 8, September 1997 Is your Company ready for VBM?, R J Bannister & Ravin Jesuthasen, Journal of Business Strategy, Mar/April 1997, volume 18, number 2 The Virtuous Cycle of Shareholder Value Creation, Jacques Bughin & Thomas E Copeland. McKinsey Quarterly, number 2, 1997
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APPENDIX:
BIBLIOGRAPHY
Calculating Shareholder Value In A Turbulent Environment, Roger W Mills & Bill Weinstein. Long Range Planning, volume 29, number 1, February 1996 Eli Lilly is Making Shareholders Rich, Justin Martin, Fortune International, volume 134, number 5, September 9th 1996 Valuing Companies – a Star to Sail By,The Economist August 2nd 1997 Shedding Light on Stakeholders,Richard Bull,Management Consultancy,May 1997 Using Apv:A Better Tool For Valuing Operations,Timothy A. Luehrman, Harvard Business Review, May – June 1997 No Incentive For Bad Management, Joel Stern, Corporate Finance, March 1994 How Eva Measures Up,Tony Jackson. Financial Times, October 7th 1996 A value system for shareholders, Vanessa Holder, Financial Times, March 20th 1995 Which Numbers Count, Judith Oliver, Management Today, November 1996 A Rewarding Approach To Value,Andrew Sawers, Financial Director, June 1997
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