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SHAREHOLDER
VALUE
DEMYSTIFIED
Maria Barbera
Rodney Coyte
SHAREHOLDER
VALUE
DEMYSTIFIED
AN EXPLANATION OF
METHODOLOGIES AND USE
CONTENTS
PREFACE ix
INTRODUCTION xi
1
CONCLUSION 45
CASE STUDY 1
CASE STUDY 2
CASE STUDY 3
APPENDIX A
APPENDIX B
APPENDIX C
REFERENCES 68
Organisations are devices for creating value through the effective use of resources.
While they need to create value for all contributors of resources, a premium is placed
on value creation for customers and shareholders. After all, an organisation is unlikely
to be able to offer inducements to other resource contributors if it does not provide
value to its customers. Also, shareholders are aware that failure in value creation for
customers will be reflected in the value that they can receive. Value creation for
customers and shareholders, then, is broadly regarded as the litmus test for judging
organisational effectiveness.
Value creation by organisations takes place against a backdrop of fast moving
competition in resource and service markets, and increasingly rapid shifts in the value
expectations of customers. Under these conditions it is insufficient to meet or beat
the competition with present service offerings; new service offerings have to be
invented and made competitive, as previous offerings cease to be serviceable and are
thus devalued.
As service offerings change, so will the materials, technologies, skills and
processes that are needed to produce them. New service offerings require different
constellations of resources and new relationships with new resource contributors.
An organisation's strategies define how it proposes to create value for customers
in terms of its service offerings over the immediate period and the opportunities it
seeks over a longer term. Whether or not an organisation will be successful in these
endeavours will depend on its capabilities for doing so.
Strategies, then, have to deal with both the known (the creation of value through
present service offerings) and the unknown (the invention of service offerings that
will create value in an as yet unknown future). And capabilities need to sustain both
the organisation's present effectiveness in offering services and its future renewal by
capitalising on opportunities as they emerge.
An organisation's success in strategy realisation or renewal will be dependent on its
effectiveness and creativity in managing resources. This places a premium on strategic
resource management and on new ways of understanding organisational resources,
resourcing and resourcefulness. What are an organisation's resources, what forms do
they take and how can they be used effectively and not wasted? What constellations of
resources constitute strategic capabilities, useable now in meeting the competition and
converting possibilities into future opportunities? And what strategic capabilities are
sufficiently distinctive to constitute the core competences underlying an organisation's
continuing identity?
These questions are answered in the Strategic Resource Management Series. Each
volume will address them in relation to particular subject matter, drawing on relevant
theories and providing illustrations from contemporary organisational practice.
PREFACE
In addressing these areas, the report not only explores and compares the
major methods, but also clarifies the purpose and use of the concept of
shareholder value in both strategic and operational decision making. The
conclusion considers the advantages and limitations of shareholder value
analysis. This report should be of value to a range of managers.
Acknowledgments
The authors wish to thank the organisations who agreed to participate in this
project and the senior staff members of those organisations who gave their
time and assistance. Thanks are also due to Mark Joiner (Boston Consulting
Group), Denis Kilroy (KBA Consulting Group), the reviewers, and Professors
Bill Birkett and Wai Fong Chua for their helpful comments.
The opinions expressed in this document are those of the authors only and
do not necessarily represent the views of the National or State committees
of ACMAD.
INTRODUCTION
The quest to create value at an increasing rate over the long term is the focus of
most contemporary business enterprises. While the term `value' means different
things to different stakeholders, the emphasis in this report is on the creation
and measurement of value for one specific stakeholder group: shareholders.
For shareholders, value is created when a business, through the efficient
management of its resources, earns a return greater than the cost of the capital
employed to generate that return. This is not a new concept, but is one that
has attracted the intense focus of managers and investors over the last decade.
Shareholders are interested in the cash increments, over and above outlay, to
be received over the life of their investment: that is the dividends and capital gain
delivered. Whether or not these increments represent value is related to the risk
associated with the investment investors will require a higher return from
investments that are seen to be risky. Arguably, share market prices incorporate
expectations about the value creation potential and the risk of corporations.
In view of the imperative for organisations to create value for their shareholders, how do organisations measure the value created by their operations?
Traditionally, such measurement used accountancy-based indicators such as
earnings, return on investment and return on equity. However, these measures
are not based on cash-flow and do not take into account the full cost of
capital (that is, the costs of equity and of debt). The suggested inadequacies
of accountancy-based measures are summarised in Chapter 2.
New methodologies include three which support the theory that a value
maximising organisation will be interested only in investments which, in
discounted cash flow terms, offer a return greater than the cost of capital.
These three are:
These are not the only methodologies available. Indeed, every consulting
firm appears to have devised its own variation. Nevertheless, these three
incorporate the principles of shareholder value measurement and are
sufficiently different to be of interest. They are described in Chapters 3 to 5
respectively and compared in Chapter 6.
Having measured the shareholder value achieved through their operations,
organisations are faced with the need for initiatives and actions which will impact
favourably on that value into the future. To this end, they develop strategies (that
is, patterns of resource allocation) and select those that, if implemented successfully, will optimally increase shareholder value. Again, shareholder value
xii
metrics are used: for example, to calculate the shareholder value that can be
added by acquisitions or divestments, select between synergistic opportunities,
make decisions about resource allocation, choose between potential product
or service market portfolios and projects, and so forth.
The concept of shareholder value is being adopted by many Australian
companies. It is seen as facilitating, indeed enabling, growth, restructuring,
product and customer selection, and profitability. Much depends, however,
on how well it is understood, how well it is integrated into organisational
thinking, strategic planning, decision-making, and operational activities, and
how efficiently it is used as a motivational device. Understanding is
facilitated by training, and integration is assisted by the introduction of valuebased management concepts. Motivation is sponsored by the introduction of
value-based compensation which effectively links performance and
shareholder value. Such aspects of value-based management are covered
briefly in Chapter 7.
Value, however, is not created by merely measuring financial
performance. Organisations create value in their product or service markets in
the face of competition, ever shorter life cycles, and high levels of
uncertainty and ambiguity. In today's world, value creation depends on
innovation, creativity and collective organisational capability (including the
quality of management). While shareholder value approaches may provide
description and give structure to organisational effort, they cannot substitute
for the wellspring of creativity. Shareholder value creation is, after all, an
outcome of organisational efforts and accomplishments.
CHAPTER
1
SHAREHOLDER
VALUE IN CONTEXT
Organisational stakeholders
`An organisation is an association of productive assets (including individuals)
which voluntarily come together to obtain economic advantages' (Barney
1997, p. 31). Thus, owners supply capital which is used to acquire assets,
customers provide revenue, employees contribute expertise, government
provides services, the community allows organisations to exist and confers
advantages such as limited liability on corporations, suppliers provide inputs
to production, and so on. Each of these groups can, however, withdraw its
contribution from the organisation and, indeed, will do so unless the value
received (in terms of income or satisfaction) is, after adjusting for risk, at
least as large as that which could be expected from similar alternatives.
In order to ensure that shareholders and the owners of other productive
assets are willing to continue to remain associated with it, the organisation
seeks an equilibrium between the `inducements' it must pay in return for the
`contributions' it receives. The word `equilibrium' suggests that the
organisation will seek to achieve some sort of a balance between its various
stakeholder groups.
Value trade-offs
One problem is that `value' is what a stakeholder group cares about; and
different groups care about different things. The community values high
Cash generation
In addition to creating value for the providers of capital (in order to compete
with alternative investment opportunities), an organisation needs the cashgenerating ability to satisfy the financial claims of its stakeholders. It
generates cash from operating its businesses: receiving revenue, and paying
for investments in assets and expenses. Any additional cash required is
obtained from two external sources: debt and equity. Both borrowing power
and the market price of shares depend on the organisation's cash-generating
ability. Lenders will not be prepared to deal, or will require a premium rent, if
the risk of non-compliance with the terms of the loan is high. Equity holders
will be unwilling to provide additional funds if their prospective reward, in
the form of dividends and capital gain, is inadequate or uncertain when
compared with other investment opportunities.
Organisational strategies
In order to create value for their constituencies, organisations develop strategies:
patterns of resource allocation that enable them to maintain or improve their
performances in particular product and service markets. Organisational
strategies are typified in management literature in three major ways:
either the whole organisation, to units within it, or to projects within units.
Measuring value more accurately is an important exercise and can promote
understanding of what outcomes will have an impact on value. However,
measurement in itself will not create shareholder value.
In today's dynamic world, shareholder value creation depends on
innovation, creativity, and collective organisational capability (including the
quality of management). Techniques such as `value-based management' and
`economic value management' are suggested as means of nurturing the
capabilities of an organisation, promoting the ability to put those capabilities
to good effect (for instance, by acquiring strategic assets, developing internal
and external relational contracts, co-ordinating diverse skills and/or
integrating streams of technology), and achieving the integration of
shareholder value concepts and strategic and operational decision-making.
Incentive compensation is believed to have an important role in encouraging
the creation of shareholder value.
Organisational performance
External and internal evaluations
From a shareholder's perspective, the return on investment outlay in an
organisation's ordinary shares is the present value of the dividends received
throughout the life of the investment and the capital gain achieved on sale.
Whether these returns constitute `value' depends on the opportunity cost of
risk-free investment plus a margin for the risk related to the specific
investment.
Stock prices on share markets are not determined solely by the profit per
share, or the net tangible assets per share. They reflect not only the current
state of the company but also the expectations of investors regarding a
company's future growth, risk and return profile and the quality of its
management, in view of the expected future state of the economy and the
relevant industry.
The various shareholder value techniques described in the following
chapters have been designed to reflect shareholder thinking. One test of their
validity is the correlation between the result of the shareholder value
calculation (whether undertaken inside the firm or by an external investor)
and the stock market price. This issue is considered in Chapter 6.
From the viewpoint of the organisation's management, shareholder value
techniques are utilised, not only in the selection of strategies which will
enhance value, but in the implementation and management of those
strategies. Thus, employees at all levels of the organisation are trained in the
importance of shareholder value concepts and the role each can play in
strategy selection and strategy implementation.
CHAPTER
2
THE INADEQUACIES
OF TRADITIONAL
ACCOUNTING MEASURES
Other ratios, such as earnings per share (EPS) and price over earnings,
combine accounting numbers with share market information.
Criticisms of the use of accounting-generated ratios, as bases for decisionmaking by internal and external users, include the following three:
Accrual accounting based measures do not equate with the cashgenerating ability of the firm.
GAAP allows management some discretion in the choice of accounting
methods. Managerial self-interest or a perceived need to protect the price
of stock can lead to the use of methods (such as of depreciation,
amortisation, asset valuation) which will smooth, increase or decrease
income.
Accounting practice typically undervalues intangible resources.
Alternatively, it ignores such assets because of the difficulty of
ascertaining an objective value.
Other shortcomings of using earnings are that they do not consider the
quality of earnings (merely the quantity) or distinguish earnings derived from
operating and non-operating assets. Further, earnings growth does not
necessarily lead to the creation of economic value for shareholders. If the rate
of earnings is less than the cost of capital, then an increase in earnings will, in
fact, correspond with a decrease in shareholder value.
Typically ROI will understate rates of return during the early stages of an
investment and overstate rates of return in later stages, as the undepreciated
asset base continues to decrease.
Secondly, ROI is affected by the rate of new investment. Faster growing
companies or divisions will be more heavily weighted with more recent
10
CHAPTER
3
RAPPAPORTS
SHAREHOLDER
VALUE ANALYSIS
Rappaport presents a method for estimating the shareholder value of the total
firm or business unit. This includes current value (that is, value created in the
past), and the value expected to be created in the future. The `future' is
divided into a specific forecast period (in Rappaport's example, three years),
and the period beyond the forecast period.
the present value of cash flow from operations during the forecast
period; plus
the residual value of the business (including marketable securities) at the
end of the forecast period.
`Debt' is future claims to cash flow and would typically include both short
and long term debt, capital lease obligations, unfunded pensions, and other
12
claims such as contingent liabilities. Debt is, in most cases, the accumulation
of several debt instruments. The yield to maturity is used to calculate the
market value of each debt instrument which are then added. Note that the
`market value of debt' is not the `face value of debt'. It is the amount that
would have to be paid today if the debt were to be retired (Fera 1997).
Note: Rappaport (1986, pp. 53-54) defines the `operating profit margin' as the ratio of pre-interest,
pre-tax operating profit to sales. Although a non-cash item, depreciation expense is not added back
in this section of the calculation. Instead, depreciation expense is deducted from fixed capital
expenditures in the calculation of fixed capital investment. Incremental working capital investment is
the net investment in accounts receivable, inventory, accounts payable, and accruals that is
required to support sales growth.
The cash flow from operations for each year (calculated as described
above) is then discounted by the cost of capital to compute present value. The
present values for each year of the forecast period are summed to give the
value of cash flow from operations over the forecast period.
The appropriate forecast period is an issue to be considered by each
organisation or business unit. Although business plans are usually based on
three to five years, this period may result in inaccurate valuation if the
business plan period does not match what Rappaport (1986, p. 77) calls
`value growth duration', that is, `management's best estimate of the number of
years that investments can be expected to yield rates of return greater than the
cost of capital'.
13
Cost (%)
Debt
40
3.2
Equity
60
12
7.2
Cost of capital
10.4
The 10.4 per cent figure (the weighted average cost of capital or WACC)
is the appropriate discount rate for this company to use, as it takes account of
the claims of each group shareholders and debtholders in proportion to
each group's targeted relative capital contribution over the forecast period.
Cost of debt
The cost of debt is determined by taking the prevailing rate of interest
charged and the tax rate incurred, and allowing for any expected changes
over the forecast period.
Cost of equity
Estimating the cost of equity over the same period is more complex and is
based on the implicit rate of return required to persuade investors to purchase
or retain the firm's stock. The starting point for estimating the cost of equity
is the risk-free investment rate: the rate that can be earned on government
securities, in particular, long-term treasury bonds.
As investors expect to get a rate of return that will compensate them for
the increased risk of investing in a specific company listed on the share
market (rather than in treasury bonds), a premium for equity risk is
calculated. This is the product of the market risk premium for equity (the
excess of the expected rate of return on a representative market index such as
the All Ordinaries Index over the risk-free rate), and the individual security's
systematic risk: its `beta co-efficient':
Risk premium = beta (expected return on market - risk-free rate)
The value of the beta co-efficient is based on the degree to which the
14
Residual value
Residual value is the anticipated value of the entity beyond the forecast
period. It often forms the largest component of a corporation's value. Its value
depends on the assumptions made for the forecast period and an assessment
of the competitive position of the business at the end of the forecast period.
There is no unique formula for determining residual value: different
methods suit particular circumstances. For instance, an entity adopting a
harvesting strategy during the forecast period would use liquidation values;
whilst an entity seeking to build its market share during the forecast period
would calculate a going-concern value.
The Perpetuity Method is a going-concern method of calculating residual
value. This method recognises that market dynamics will not allow
businesses enjoying excess returns to continue doing so indefinitely.
Eventually, such a firm will face new competition. The Perpetuity Method is
suggested by Rappaport as one method of calculating residual (or terminal)
value and is described in Appendix B. Other methods are:
Valuing a strategy
To estimate the expected shareholder value to be created by particular
15
CHAPTER
4
STERN STEWARTS
ECONOMIC VALUE
ADDED MODEL
Since the beginning of the 1990s, EVA has become a widely advocated
method of measuring single period enterprise performance. The methodology
is claimed to be `the one measure that properly accounts for all the complex
trade-offs involved in creating value' and therefore, `the right measure to use
for setting goals, evaluating performance, determining bonuses,
communicating with investors, and for capital budgeting and valuations of all
sorts' (Stewart 1991, pp. 136, 4). EVA is the spread between the rate of return
on capital and the cost of capital, multiplied by the `economic book value' of
the capital employed to produce that rate of return.
Calculating EVA
The formula for calculating EVA is:
EVA
Note that this formula for evaluating the value created by an organisation
or a business unit in the current year is identical to the formula to calculate
Residual Income (RI) using WACC as the capital charge rate.
17
=
=
However, the figures for NOPAT and capital cannot be taken directly
from conventional accrual accounting based financial statements. Stern
Stewart has identified a total of 164 possible adjustments. The consultancy,
however, recommends making an adjustment only when all the following
apply:
This is, in essence, the ROE formula. The problems associated with this formula
using accrual accounting-based numbers are specified in Chapter 2. The adjustments
to NOPAT and capital in EVA are designed to counter those problems. In EVA, such
adjustments are not confined to those required to convert accrual accounting based
numbers to cash. Rather, adjustments are also made to:
eliminate the effects of gearing (that is changes in the mix of debt and
equity, as such changes confuse the effect of operating and financial
decisions)
include other financing factors such as preferred shareholders and
minority interests (since capital employed and NOPAT should include all
providers of funds)
eliminate accounting distortions.
18
interest expenses after tax on the debt and the leases are added to
NOPAT.
2. To eliminate other financing distortions:
preferred dividends and minority interest provision are added to
NOPAT
the value of preferred stock and minority interest are added to
capital employed.
3. To convert to cash-based numbers:
taxes are charged to profit only when they are paid (thus also
requiring adjustments to deferred tax reserve accounts)
goodwill amortisation is added back to NOPAT, and accumulated
goodwill amortisation is added back to capital employed (The
reasoning is that intangibles, if they are paid for, are not written off
as they too must earn a return.)
restructuring charges that involve cash payments, and gains or losses
on dispositions of assets, are adjusted in NOPAT (by adding where
losses are sustained and subtracted where gains are made, after tax)
and in the calculation of capital employed
provisions for bad debts and warranties, and other equity equivalent
accounts are excluded (by adjustments) as these practices amount to
taking up losses in advance of their occurrence.
Other adjustments to accounting-based numbers are necessitated, not in
order to achieve cash-based figures, but to reflect economic reality. For
example, depreciation is not added back to profits in EVA. It is viewed as a
true economic expense reflecting the operational use of plant. However, if an
organisation's practice is to base depreciation charges on tax-based
considerations, rather than the operational use of plant, it should be reworked and adjusted in NOPAT and capital employed. Similar considerations
apply to research and development, and advertising and promotion
expenditures. These are not written off in one go for EVA purposes; rather
the write-offs are spread across the estimated useful life of the expenditures.
Marketable securities and construction in progress are subtracted from
capital employed (and presumably any income statement effects are also
eliminated) if these are not part of `operations'.
A list of adjustments taken from The Quest for Value (Stewart 1991) is
shown in Appendix C. Note that this list is based on United States GAAP and
thus includes items (such as LIFO reserves) not applicable in Australia.
19
20
the actual market value of ordinary shares at a date times the number of
shares outstanding; plus
the book value of:
preferred shares
minority interests
long-term non-interest-bearing liabilities (except deferred income tax)
all interest-bearing liabilities and capitalised leases and the present
value of non-capitalised leases (estimated by discounting the minimum
rents projected for the next five years by the implicit rate of interest);
minus
Note that in the last two points above, book value is used. Stewart states:
`Book value is used to approximate the market value of all items except
common equity due to the absence of broad availability of quoted prices' (p.
744).
As shown above, capital employed is subtracted from market value to
obtain MVA. Capital employed is the same as that used for EVA: details of
adjustments are listed under `Adjustments to NOPAT and capital' above
(page 17). Broadly, capital employed is a company's net assets (total assets
less non-interest bearing current liabilities) with three adjustments:
1.
2.
21
While Stewart shows that MVA moves with EVA, other authors (for
example the Society of Management Accountants of Canada 1995, p. 22)
point out that the former is sensitive to general market movements: `Weak
companies can ride a rising market to big MVA gains that may prove
ephemeral, while robust performers can unjustifiably lose MVA if their shares
fall into a temporary rut'. This is undoubtedly true in the short term (witness
the share market fluctuations in late 1997/early 1998). However, Stewart
defends the long-term efficiency and sophistication of the share market and
quotes evidence to support his stand (see Stewart 1991, pp. 56-67).
Economic profit
Economic profit (EP) is similar to EVA, but does not involve adjustments to
accounting numbers. It can be derived from an equity approach:
EP = (ROE - cost of equity) X book value of equity
or from a total capital approach
EP = (ROI - book weighted WACC) X book value of capital (Kilroy 1996).
As single period measures which are based on book values or adjusted
book values (rather than market values), EP has its limitations. Nevertheless,
such measures do, according to Kilroy (1997/98), give reasonably sound
economic signals concerning strategy choices.
EP is applied, not only to businesses and projects, but also to customers,
customer segments, products and product packs.
CHAPTER
TOTAL SHAREHOLDER
RETURN AND TOTAL
BUSINESS RETURN
Both these methods have been developed by the Boston Consulting Group
(BCG). Total Shareholder Return (TSR) is what it says: the total return to
shareholders that is, the actual capital gain from the beginning to the end
of the financial year plus any dividends paid. It is an ex-post measure used by
top management and external users (investors) to compare an organisation's
performance with the total market, or an appropriate index of peers.
Total Business Return (TBR) is the internal proxy for TSR used by
organisations for assessing future plans, internal business-unit performance,
resource allocation strategies, and for implementing long-term incentives
intended to drive changes in behaviour that generate increased shareholder
value. TBR focuses on the factors which drive capital gains and dividends:
profitability, growth through investment, and free cash flow.
Profitability
For measuring profitability, the BCG suggests Cash Flow Return on
Investment (CFROI):
CFROI represents the sustainable cash flow a business generates in a given year
as a percentage of the cash invested to fund assets used in the business. The
result of the calculation can be expressed as a ratio if economic depreciation is
23
subtracted or as an internal rate of return (IRR) over the average economic life of
the assets involved. CFROI is an economic measure of a company's performance
that reflects the average underlying IRR on all investment projects (BCG2, p. 33)
2.
3.
4.
Allow for asset lives, that is the fact that firms have differing asset lives
and asset mixes that are relevant to the performance, and so to the value,
of each business. This step involves the calculation of the amount of
non-depreciating assets (land and inventory, net working capital and
investments) which would remain at the end of the depreciating assets'
working life.
Calculate the IRR. Use present value principles to find the discount rate
at which:
cash profit income
stream
non-depreciating assets
+
cash investment.
24
where:
Ke = real cost of equity
Kd = real pre-tax cost of debt
D = market value of debt
E = market cost of equity (BCG3, p. 2)
that relative volatility (beta) is the only factor affecting the way the
market discounts expected cash flows for an individual stock
that the market risk premium remains stable.
25
Figure 2 The Boston Consulting Group's recommended method for estimating the cost of capital
BCG has observed three common failings when organisations apply cost
of capital concepts:
1.
2.
3.
26
The growth implicit in the second method can, to some degree at least, be
funded by free cash flow.
CHAPTER
6
COMPARING
THE MODELS
Comparison to traditional accounting
The value-based models vary from the traditional accrual accounting-based
model in that the former:
use cash flows, rather than accrual accounting based numbers (EVA is
the exception with regard to depreciation)
give equal weight to both income statement and balance sheet cash
flows, rather than concentrating on income statement flows
use discounted cash flows for decisions applying to entire businesses,
rather than to capital spending proposals only
use the weighted average cost of capital, rather than the time value of
money, as the discounting factor.
Accuracy
Increasing the number of adjustments to accounting numbers achieves greater
28
Summary
As stressed previously, the use of value-based methodologies does not, of
itself, create value. What they, and indeed traditional accounting
measurement techniques such as ROI and ROE, provide is a more or less
adequate indication of which organisational outcomes have an impact on
shareholder value.
Stewart (1991, pp. 75-76) summarises the shareholder view nicely:
29
... cost of capital can be used to divide projects and, in the aggregate, companies,
industries, and even countries, into three categories:
Group 1: Projects return more than the cost of capital. Because management can
earn a greater return by investing capital inside the company than investors could
by investing in the market, value is created.
Group 2: Projects break even in economic terms. The return earned just covers
the cost of capital, so that no value is created over and above the capital
invested.
Group 3: Projects, a favourite of many large, mature companies with cash to burn,
return less than their cost of capital. Because the return earned on the capital
invested within the company is less than investors could earn elsewhere, an
economic, or opportunity loss is suffered and value is destroyed.
In short, shareholder value will increase if the project generated a positive
cash flow after either:
Measurement
SVA
Not suitable as
changes in stock
prices not
incorporated
MVA
Change in value over
time
TSR
Change in value over
time
Change in (market
capitalisation +
borrowings capital
employed)
30
Drivers of value
Complexity
Useful surrogate
duration of value
growth, sales growth,
operating profit
margin, income tax
rate, working capital
investment, fixed
capital investment,
cost of capital.
Relatively simple
adjustments to
accounting profit
EVA
Strategy evaluation
Investment/
divestment decisions
Past performance and
benchmarking
Operating decisions
Incentive
compensation
TBR
Strategic planning
Resource allocation
Incentive
compensation
NOPAT (cost of
capital X capital
invested) i.e. residual
income over period
Discount by the cost
of capital if evaluating
forecasts
Profit improvement,
amount and cost of
capital
Estimated closing
value of business +
net cash flow for
period estimated
opening value of
business, i.e. IRR
over period
Profitability, growth,
free cash flow
Complex adjustments
to NOPAT and capital
employed
Complex adjustments
to cash flow and
capital employed.
Includes restatement
of assets in current
dollar terms and
inflation adjustments
applied to monetary
and inventory items.
For projections, uses
Cash Flow Fade
Model.
At business unit level:
Value = Earnings X
P/E multiple
Value = Free cash
flow ÷ cost of capital
CHAPTER
7
USING SHAREHOLDER
VALUE CONCEPTS
32
The next layer of drivers are those operational decisions, initiatives and
actions which will have a beneficial effect on the seven financial drivers.
Black et al. (1998, pp. 92-93) classify, under the financial driver headings,
initiatives or tactics that Price Waterhouse has observed being used by global
corporations to generate shareholder value, as follows:
Revenue growth rate
Ensure profitable growth that will add value
Consider new market entry
Develop new products
Globalise the business
Develop customer loyalty programmes
Offer pricing advantage with new distribution orders
Develop focused advertising based on differentiation
Operating margin growth
Modernise working practices
Restructure, including introducing multi-skilling
Cut costs by sharing services and outsourcing
Centralise and consolidate back office and finance functions
(treasury, tax, corporate finance, financial systems)
Introduce business process re-engineering with IT system initiatives
including consolidation and integration of billing, customer care,
activity-based costing, data warehousing, network management and
configuration
Cash tax rate
Consider international holding structure
33
Working capital
Implement working capital reviews
Improve debtor management
Introduce supply chain management systems and just-in-time
inventory methods
Capital expenditure
Develop capital appraisal and utilisation reviews and project finance
techniques
Weigh up lease versus buy decisions
Develop treasury, hedging and risk management systems
WACC
Build management understanding of cost of capital
Calculate gearing/leverage optimisation
Calculate business-unit-specific WACC
Consider share buy-backs and de-merger of non-core business
Competitive advantage period
Improve investor relations by providing predictable and sustainable
financial performance
Improve business unit cash flow information
Return to core competencies
Develop executive performance reward schemes linked to share
price improvement
Give all employees the opportunity to have an economic stake in the
company
Incorporate strong risk management procedures
A number of other operational value drivers, which can improve the seven
financial drivers above, have been found in the literature or were identified
by firms interviewed by ACMAD. They include:
sales volume
pricing
market share
capacity
product mix
34
In this way, decisions and actions throughout the organisation are all directed
towards the objective of shareholder value.
The number of potential value drivers means complexity in selecting the
best strategies/initiatives (that is, the ones which will have the greatest effect
on shareholder value).
The need, according to BCG, is not to identify which aspects of
operations have an impact on value (since most do), but which have the
greatest potential for affecting the overall worth of the company. In BCG's
view, the most effective value drivers must satisfy two requirements:
1.
2.
35
Portfolio analysis
`Portfolio analysis' takes the view that a corporation is a portfolio of
investments, to be managed to produce the best total return. Over the last ten
years, many different approaches to the assessment of business units or
segments have been developed around the world. (For example, BCG's `stars,
question marks, cash cows and dogs' classifications, McKinsey's 3x3 matrix:
see Lewis et al. 1993, Johnson and Scholes 1997).
Proponents of shareholder value methodologies claim that shareholder
value-based analysis can indicate whether a business unit has been earning at
greater than the cost of capital. Wenner and Le Ber (1989) describe such a
process. First, the original cost of each business and the incremental cash
flows into and out of each business in the years between original investment
and the current year is ascertained. When discounted by the cost of capital,
this provides a figure representing the total net investment in each business.
Second, the economic value (net present value of future cash flows and
terminal value) of each business is calculated. The difference between these
figures is the shareholder value expected to be contributed by each business.
A negative figure does not necessarily mean that a particular business should
be closed down or sold. However, it does mean that further analysis of
current and prospective business strategies, operations and (perhaps)
financing is required. It also raises the consideration of alternatives (such as
the feasibility of outsourcing areas of operation).
In Australia, firms appear to be increasingly applying shareholder value
approaches to the evaluation of business unit performance. Pacific Dunlop, a
diversified manufacturing organisation, for example, has recently stated its
intention to measure each business within the group in EVA terms. Any
business which is not providing a positive return will be restructured in terms
of size, focus and allocation of capital. If, after this, it still does not make the
grade then its sale may be an option (Knight 1996).
Divestment decisions are not necessarily simple. Although each business
unit within an organisation may have its own unique competitive problems
and opportunities, there are often interactions between various business units.
For example, an insurance company may have separate business units for life
insurance, general insurance, and superannuation but also a considerable
`cross-sell' factor which may be lost in the event of the sale or closure of any
one of these three.
Growth
Shareholder value analysis is also claimed to be useful in assessing the
desirability of growth in assets through expansion of existing activities,
diversification, or acquisitions and takeovers. In broad terms, shareholder value
36
methodologies assert that growth will increase shareholder value only if the
new investments earn more than the additional cost of capital. Qantas
Airways Limited adopted this principle in 1997 when it considered the
appropriateness of making substantial investments in new international
aircraft. The decision was not to do so at that time but, rather, to lease for the
short-term or use surplus capacity of British Airways (its major shareholder)
if necessary. The company's managing director explained that current low
margins (resulting from strong competition in the Asian market) meant that
increased investment in asset growth would actually damage the business as
the resulting profit would be less than the cost of the additional money
invested.
A common way of achieving growth is through takeovers. In these cases,
the reasons are often complex and based on expectations of operating benefits
and synergies (such as economies of scale, technical and managerial skill
transfer, control over supply or distribution) which may or may not eventuate.
(Hubbard, in Lewis et al. 1993, lists 22 reported reasons for takeovers, only
two of which relate directly to earnings. Shareholder value was not
mentioned.) Further, return and cash flow do not necessarily move in tandem
in growth situations: growth may either diminish cash flows but maintain or
increase return, or increase cash flow but reduce return.
Growth and risk are also interrelated. Black et al. (1998, p. 84) claim that
shareholder value methodologies do not recognise the relationship between
growth and risk (that is, the probability of actually being able to achieve the
expected growth rate):
Many companies are now struggling to fulfil aggressive growth and value
agendas, but fewer recognise that taking risks is essential to both growth and
return. Enterprises must integrate explicit measurements of risk into their strategic
planning in order to identify the possible organisational, cultural, and financial
changes that will be needed to achieve to achieve their SHV [shareholder value]
and growth goals.
Financing
In shareholder value terms, financing strategies are dependent on the
availability and potential return of investment opportunities, and the cost of
the finance. Should opportunities not be available (so the status quo is
maintained) financing strategies would centre around the desired result of
reducing the cost of capital by either:
37
Resource allocation
Organisations use economic value metrics to determine capital allocations to
business units by prioritising proposals or projects according to their ability
to increase shareholder value. Telstra Corporation, for example, intends to
use EVA `to ration and better prioritise its huge capital expenditure program
... with the aim of lifting shareholder value ... over the longer term' (Lewis
1997, p. 7).
Kilroy (1997) suggests that the management of value requires the
establishment of a value-based business planning and resource allocation
mechanism, which he calls an `Internal Capital Market' (Figure 3 on p. 38):
The [internal] market operates in a similar way to the external capital markets by
allocating capital and other resources on the basis of value creation potential. It is
built around a strong business planning process which requires managers to
consider alternative strategies, value their businesses under each alternative
strategy, and build a business plan around the value-maximising strategy.
The difference between this and other resource allocation models is the
explicit recognition that product markets (the source of customer value) and
capital markets (the source of shareholder value) are intimately involved in
allocation decisions.
Setting targets
Part of the language of shareholder value is the incorporation into decisionmaking of financial performance measures that are consistent with
investment at or above the cost of capital. `Hurdle rates' of return are a way
of establishing a target for key projects.
38
Figure 3
39
While the threshold margin and other methods may be good overall
guides, they are unlikely to be adequate for successful strategy
implementation. Targets need to be tailored to the level of the organisation
(strategic business units, functions, operations), based on key value drivers,
and expressed in financial and non-financial terms. Short-term targets (one
year) are linked to longer targets (say, three years and ten years). The tenyear targets express the unit's aspirations, the three-year targets set the gameplan to achieve the planned progress over the longer period, and the one-year
targets set the immediate goals. Such targets may be accompanied by action
plans which specify a series of steps the business unit will take to achieve its
targets.
40
41
develops key performance targets for all levels of the organisation, from
the highest to the lowest
links personal and departmental performance to the delivery of
shareholder value.
42
Training
There is some debate about the degree to which employees at various
organisational levels need to understand the mathematical aspects of
shareholder value methodologies (see the Case Studies). However, there is
agreement that, at the very least, managers and employees need to understand
what economic value is, how it can benefit the company, and how each
employee can assist in its achievement. Corporations such as Coca-Cola
Amatil and Qantas put considerable emphasis on educating employees in the
principles of shareholder value creation, with the aim of encouraging
involvement and changing behaviour.
43
Incentive compensation
The last link in the performance loop of an organisation is the reward system.
Organisations and commentators alike mention the opportunity provided by
value metrics to align the interests of managers and shareholders through
incentive compensation. Indeed, Stewart believes this is perhaps the most
important aspect of the methodology.
While doubtless important, the use of value metrics for incentive
compensation is not straight-forward. It is necessary to find the right balance
between the rewarding (for the achievement of planned performance in the
present) and motivating (seeking ever greater value creation in the future)
aspects of incentive compensation.
The Society of Managing Accountants of Canada (1995) quotes O'Byrne's
proposal for a scheme with three elements:
44
the promised value, and it is greater than the expected cash flow under the
current strategy, then value will have been created for the business. In some
organisations, this understanding is formalised into a performance contract
between the GM and the CEO.
Rewards, then, should be linked to increases in shareholder value over time. For
a listed company, the best way to do this is usually to focus on equity cash flow
(which ultimately equates to dividends plus share price appreciation over time).
For a non-listed company, the focus should be on incremental operating cash
flow.
One issue which remains open at present is the level or levels of the
organisation to which incentive compensation based on shareholder value
should be applied.
Communication
As stated above, economic value concepts are believed to provide an
effective `language' which promotes understanding and communication
within the organisation.
It is also claimed that the language is useful in communicating with
investors, particularly the institutional investors who are the major
shareholders. (Institutional investors today own or manage on behalf of
clients a large percentage of the shares listed on the Australian Stock
Exchanges). The benefits to corporations are that they can:
CONCLUSION
46
Another admitted `You can argue with the maths, you can kick it
whichever way ...' but nevertheless argues:
... if I can get any form of model that gives me a better guide as to what the
shareholder might do and the share price might be, then I'll use it. Because most
organisations only ever look internally, and then they say `we've got all those you
beaut plans, why the hell aren't they in the share price?' But, of course, the guy
out there can't see them. And to me there is real value in having some form of
anticipation of what the guy out there is thinking.
Despite the adjustments made, shareholder value analysis is still based on
accounting numbers. Hence, soft assets (for instance organisational
capabilities, organisational cultures and structures which foster knowledge
transfer and learning, the skills and know-how of employees, corporation
reputation and customer base) are ignored. These are believed to have a large
impact on profitability now, and an even larger impact on future growth and
sustainability. Yet they are not captured in the balance sheet and shareholder
value metrics do not include them in the asset base. (However, the value of
soft assets can be captured by re-valuing the business in the management
accounts at the present value of the expected cash flow under its current
strategy, that is at market value.)
Shareholder value methodologies underestimate creativity. Kilroy
(1997/98, p. 165) believes that the emphasis on value drivers is overstated as
there is a limit to the extent to which costs can be reduced or revenues
increased under the current strategy. New strategies are needed because the
goal posts are always moving:
Management must continually seek to identify higher value strategies. As soon as
a new and higher value strategy is communicated to the capital markets, the
CONCLUSION
47
markets place a value on the new strategy. If the new strategy is well received,
the company's share price rises ... The challenge then becomes to create value
for those shareholders who invested at the new and higher share price. This
challenge can only be met by continually bringing new ideas into play.
We need to accept that shareholder value creation is a creative act, requiring a
combination of creative and analytical thinking skills.
Creativity should be grounded in analysis but should not be suppressed by it.
CASESTUDY
CASE STUDY 1
49
Economic profit and economic value added, however, are only two of a
wide range of measures used at CCA. Others include:
market share
accounting profit
return on net assets
net present values.
50
the fact that the company has been successful in terms in share price
appreciation and many employees were current or potential shareholders as a
result of their participation in the employee share plan or in the option
scheme.
Because of the company's corporate structure, internal disagreements
about estimates did not occur. While management throughout the group is
decentralised, the Board retains authority over capital matters and head office
financial people set the measurement rules. The cost of capital is calculated at
corporate level as it reflects the corporate debt-equity structure; hurdle rates,
risk adjusted where appropriate, are also determined by head office;
managers require head office approval for capital expenditure. Cost
allocations to operational areas are made only where those areas have the
ability to control the costs.
Compensation
The company believes that there is a relationship between compensation and
value creation but regards getting that relationship right as difficult. The
approach adopted by CCA is to provide incentives and to take a long term
view. Share ownership by all employees through the employee share plan is
encouraged. Share options, which have for some years been offered to senior
executives, are now offered to executives at lower organisational levels.
In the near future, the company sees itself moving to a base level of
compensation and an `at risk' portion, which may be a combination of both
cash and equity, plus longer term incentives through both the share plan and
through options.
Diagnostics
The cash concept which underlies CCA's approach to shareholder value is
used to assess acquisitions, proposed initiatives, business development plans,
and specific plans such as distribution channel development. There have been
instances when evaluation has led to plans being reworked. On other
occasions, evaluation has led to the acceleration of plans. However, a
negative net present value does not necessarily result in the rejection of a
proposal; nor does a positive net present value mean the expansion or
multiplication of an initiative. There are two reasons for this:
CASE STUDY 1
51
Implementation
The cost of capital is defined in head office and is given to operations.
Corporate policy is that, for example, tax and treasury are best centralised. So
business units are not making tax or funding decisions and are evaluated on
their trading profit line excluding items such as interest and tax.
No adjustments are made to account for the differences between
accounting and economic value. Indeed, this is not seen as useful as it is not
compatible with CCA's view that any measurement of value is an indicative,
not particularly precise technique which is useful in relationship with other
pieces of information. It is felt that to go to extremes of accuracy is probably
not adding much to the picture, and that issues such as tax and tax incentives
have little to do with general management operating decisions.
Neither is using economic value or economic profit to measure
performance against other companies seen as useful. Internal benchmarking
against other operations within the group is, however, at a high level of
sophistication.
Internally, economic value is regularly monitored at Board level and is an
integral part of financial planning and budgeting at corporate and operational
levels.
52
Lessons
At the corporate level, the application of shareholder value principles has
been highly successful in CCA. Growth has been rapid, profitability good,
and the share price has consistently outperformed the market. Internally, its
use has facilitated organisational change and sponsored organisational
learning. For example, operational managers now appreciate the impact of
assets on value and sales people have a better understanding of the business
and are thinking differently. There is a common language, desirable
behavioural changes and a better level of internal debate.
The following factors appear to have been instrumental in this success:
CASESTUDY
54
much a way of life in the battle to be ahead of competitors, who are never far
behind in engaging in change.
CASE STUDY 2
55
56
CASE STUDY 2
57
Implementation issues
Acceptance roadblocks to the introduction of the shareholder value
methodology have not been encountered although there was initially a certain
amount of scepticism and a lack of understanding. Whether or not it is
necessary for managers at divisional level to have a full recognition of the
benefits of the TSR philosophy is questioned. Although it is essential that
managers understand and accept that the ultimate objective of the company is
to deliver value to shareholders and that the KPIs are directed towards this
aim, it is doubtful that they need to understand the details of the link between
the KPIs and TSR.
Although continuously investing heavily in this area, Qantas agrees with
comments made by other companies that information systems are `never up
to scratch' as far as adequacy goes. Whilst the historical information provided
is regarded as good, the perceived need now is for information systems which
predict the future, thus allowing management to take actions to ensure that
the future is what the company wants it to be. One example is the yield
(quality of earnings from passenger traffic) management system: where on
the basis of past patterns of demand, the company forecasts what the demand
is going to be in the future and takes action in the marketplace to obtain a
favourable result.
The impact on suppliers and customers is generally good. Customer value
is the focus of some of the KPIs selected as it is through customers that the
shareholders get their returns. Nevertheless, there are occasions where
customers expect to receive a level of servicing the full cost of which they are
not willing to pay, and in these cases shareholders do not benefit. The issue is
seen as one of balancing customer needs and wants and shareholder returns.
Value-based management in itself is not seen as affecting relationships
58
with suppliers. It is more the focus on costs that has resulted in relationships
with suppliers becoming more straight-forward and honest.
Compensation issues: At the time of the float, each employee received
$500 of shares in Qantas Limited. This value was dictated by the tax laws at
the time. Since that time, a further $500 share issue has been made to each
member of staff.
All executives participate in a performance-based reward scheme that
provides for cash performance bonuses. The bonuses are paid on the
achievement of pre-determined objectives, including planned profit levels
and/or revenue improvement targets.
Executive directors and certain senior executives also participate in an
Executive Incentive Plan, which provides for a bonus which is related to
Qantas's TSR ranking amongst the top 100 listed Australian companies, and
the TSRs of a pre-determined basket of international airlines listed on
overseas stock exchanges.
CASESTUDY
RGC Limited
RGC Limited (RGC) is an Australian listed company engaged in the mining
of mineral sands, tin, gold, coal and base metals. Its origins go back many
years to a time when a number of different organisations were engaged in the
mining of various metals around Australia. In the early 1980s, these
combined to form one group. Over recent years, the company has pursued a
growth strategy, exemplified by the 1996 takeover of Pancontinental Ltd.
The group has 13 active mining sites in Australia, Papua-New Guinea and
the United States. In addition, it undertakes exploration in South America, Sri
Lanka, Africa, Australia and Papua-New Guinea.
The management structure is devolved, with each mining site having a
great deal of autonomy. A small head office in Sydney, however, keeps a
close eye on capital expenditure. For short-term planning, RGC uses a rolling
24-month forecast which is adjusted quarterly to adjust for latest
expectations. The forecasts lead directly to the setting of targets for each of
the company's mining sites. These targets are set and monitored by the
general manager of each site and an executive committee member. They
incorporate a degree of `stretch' and thus motivate, focus on controllable
variables (production levels, cost, and safety), and are the basis for a variable
component of the remuneration scheme. Longer term planning is undertaken
through an annual strategy review which involves the Board of directors and
is based on long-term site planning.
Although long conscious of the need to provide value to shareholders and
aware of economic value techniques, RGC has only recently begun to
investigate the adoption of the BCG's TSR/TBR methodology.
60
The high-level components of the Du Pont charts have for some years
been the basis for monthly Board reporting which focuses on profit, cash
flow, return on operating assets and key performance indicators. The
company has found this a useful way of capturing the major performance
measures, financial and non-financial, for each operation. In addition, it has
been seen as:
CASE STUDY 3
61
62
These issues led the company's top management to rethink the strategic
process and to consider the adoption of a different perspective on investment
strategy. Accordingly, BCG were consulted and the company is currently
considering the adoption of TSR and CFROI at the corporate level. The
advantages are seen as:
the BCG methodology's capacity to develop a model that has the ability
to, with some reliability, predict share price and thus provide insights on
the gap between where a firm is and where it needs to be if it is to be
competitive on a shareholder return basis
the enhanced ability of the organisation to make portfolio decisions
based on value
the enhanced ability to plan for the creation of option value which
shareholders will incorporate into share price
the ability to monitor the group's performance against that of its peers on
a TSR basis. This is especially important in the mining industry because,
as in any cyclical industry, there are times when TSR will be negative.
The critical performance issue is whether you are doing as least as well
as your peers.
Issues
RGC questions the need to change in any substantial way its performance
measurement structure at business unit level:
I don't know that it is important to take shareholder value-based measures right
down through the organisation although there do need to be linkages to
operational performance. There has to be people at the edge between strategy
and operations and those people will have to cross the hurdle between one and
the other. We are going to have to think carefully about how we build these
linkages. What you need is effective decision making and performance monitoring
throughout the organisation, which meets the operational needs yet can be
demonstrated to add shareholder value.
To me this is all about the measures and getting them to link in a hierarchy. I don't
believe the dis-aggregation (from corporate to divisional to operational
management) has to be:
(i) perfect; or
(ii) complete.
The points that really matter are that your people understand the linkages and
make better decisions. This means keeping decision criteria and performance
measures simple.
CASE STUDY 3
63
APPENDIX
APPENDIX A
65
Ke = Rs = Rf + Bs(Rm - Rf)
where:
Ke = the company's cost of equity
Determining the cost of equity involves developing estimates for future
values of the risk free rate (Rf), the expected return on the market (Rm), and
beta (Bs).
APPENDIX
For example, say the Company X generated $25 million in cash flow in the
previous year. If it were to continue to generate $25 million annually into
perpetuity, and its cost of capital is 12.5 per cent, the value of the company
would be equal to $200 million, that is:
APPENDIX
REFERENCES