Professional Documents
Culture Documents
IN FINANCIAL ECONOMICS
971214
by
Fredrik Weissenrieder
Department of Economics
Gothenburg University
and
Consultant within Value Based Management
Anelda AB
V. Hamngatan 20
S-411 17 Gteborg
Sweden
STUDY NO 1997:3
VALUE BASED MANAGEMENT:
Economic Value Added or Cash Value Added?
by
Fredrik Weissenrieder
by
Fredrik Weissenrieder
Table of Content:
1 Introduction
2 Value Based Management
3 CVA and the concept of Strategic Investments
4 EVA
4.1 EVA's corrections - Do they work in practice?
4.1.1 Not enough adjustments are carried out
4.1.2 Irrelevant issues are discussed
5 EVA instead of Cash Flow?
5.1 EVA at H&M/Wal-Mart
5.1.1 EVA at store no 6
5.1.2 EVA at the parent
5.2 CVA at H&M/Wal-Mart
5.2.1 CVA at store no 6
5.2.2 CVA at the parent
5.3 EVA compared to CVA at H&M/Wal-Mart
5.4 The EVA leverage
6 Completing the "Circular Reference"
6.1 CVA vs. EVA using straight line depreciation
6.2 CVA vs. EVA using annuity depreciation
6.3 CVA vs. EVA, 1st adjustment
6.4 CVA vs. EVA, 2nd adjustment
6.5 Further real analysis of the concepts' capital bases
7 Market Value Added - MVA
8 Conclusion
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nism. We will then obtain relevant knowledge from our financial illustration of Business Reality. That
will give us the relevant feedback we need to improve the activities in the company's Business Reality.
The Business Reality's border line towards the capital markets' mechanism (the gray vertical line) can
easily be abused, as accounting abuses it today with the usage of P&L and balance sheets. We then
have little or no chance of achieving the knowledge that is necessary to manage our company the
way we should manage it. We will become greatly misinformed if we stand on the border, looking at
the Business Reality using "improper glasses". Our company will be managed by using something
else than Value Based Management as the large arrow down to the right, pointing to the left, tries to
illustrate (we lose our connection to the stock market). The company's so-called Strategic Feedback
Loop will not function. The Strategic Feedback loop is the continuous evaluation of strategies where
they are evaluated using information from the strategies to make necessary adjustments in the strategy. There seems to be an infinite amount of examples in companies where the Business Reality's
frontier does not work the way it should and can do, but rare are the examples where the frontier
functions the way it should and can. The Financial Simulation of the Business Reality must of course
be based on Discounted Cash Flow as concluded in the appendix
Financial Simulation of
Business Reality
Business Reality
Marketing
Intellectual
Capital
Productivity
Improvement
Operating
Cash Flow
Logistics
Economic
Life
Customer
Loyalty
C
U
S
T
O
M
E
R
S
Product
Mix
Strategy Value
Simulations
CVA
Value
Drivers
TQM
Pricing
Strategy
Investor
Relations
Real Options
R&D
Investment
Behavior
SIL
Operating
Flexibility
Efficiency
Improvement
Value Creation
Pre-strategy Value
Simulations
Capital
Cost
Customer
Satisfaction
Financial Markets'
Reality
Strategic
Investments
Capital
Structure
Accounting:
Profit/share
P/E-ratios,
Re, ROCE,
S
T
O
C
K
M
A
R
K
E
T
Capital
Allocation
A true VBM framework is consistent with the market's mechanism and our four factors that, according
to the market, determine value (Appendix 1). It must be simple but correct. In order to further increase
our knowledge about how to increase shareholder value we must be able to simulate, view, and analyze our business from this perspective - the Financial Markets' Reality. Our Investor Relation function
should be used to make sure that the company is priced correctly from the new perspectives VBM
gives us. All this can be accomplished by structuring the business reality by e.g. using the Balanced
Scorecard concept and link this to the relevant VBM framework of our choice.
Fredrik Weissenrieder, 1998
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The consulting market contributes four basic frameworks for VBM4: EVA5, CVA6, CFROI7 and SVA8.
As I mentioned earlier I will only focus on EVA and CVA in this paper.
Sales
Costs
Operating Surplus
+/=
Table 3.1
Fredrik Weissenrieder, 1998
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The Cash Value Added (CVA) represents the value creation from the shareholders' point of view. This
can be expressed using monthly, quarterly, or yearly data. It can also expressed as an index:
Operating Cash Flow
= CVA Index
Operating Cash Flow Demand
Equation 3.1
The CVA Index can be split up into four margins (in relation to sales):
These, together with sales, form the CVA concept's five major Value Drivers:
Operating Surplus Working Capital Movement Non - Strategic Investment s OCFD
Sales
= CVA
Sales
Sales
Sales
Sales
Equation 3.3
Table 3.2 shows a simple example of what a CVA calculation could look like in a company. It is an
example with only one Strategic Investment of 100. The Operating Cash Flow Demand is calculated
as the cash flow that will give the investment of 100 a Net Present Value of zero over the economic
life of 11 years and with a capital cost of 15%. Inflation is 3%. Tax can be included in the cash flow or
in the WACC, which is done here.
Sales
Costs
Operating surplus
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
160
170
250
185
200
215
200
-150 -155 -220 -160 -170 -180 -155
10
15
30
25
30
35
45
0
-1
9
-1
-3
11
-6
-1
23
5
-3
27
-1
-12
17
-1
-4
30
1
-3
43
17
-8
18
-6
18
5
19
8
19
-2
20
10
20
23
0,53
1,10
0,64
1,29
1,42
0,88
1,51
2,11
11
23
27
17
30
43
CVA Index
Average discounted CVA Index:
Strategic investments
Cash Flow
Table 3.2
-100
-100
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CVA is a concept solely based on cash flow, not even an opening balance using the current or adjusted balance sheet is used which is common in other so-called cash flow models (those are of
course not true cash flow models). There is, of course, much more to this concept (it is an entire financial management concept) but this is sufficient to be able to compare the framework to the EVA.
The Cash Value Added discussed in this paper has been developed in Sweden by Erik Ottosson and
Fredrik Weissenrieder, see Ottosson and Weissenrieder (1996). It should not be confused with The
Boston Consulting Group's Cash Value Added. Boston Consulting Group's CVA is a development of
their Cash Flow Return on Investment (CFROI) concept. The two models are not similar in their fundament, i.e. the way the models calculate the return and value of a business, or how they present
their result. They have unfortunately, though, been named using the same three words, but that is the
only similarity.
Fredrik Weissenrieder, 1998
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4 EVA
EVA (Economic Value Added) is a model based on a company's accounting. Its mechanism is therefore like accounting:
Sales
Operating Expenses
Tax
=
Operating Profit
=
Financial Requirement
EVA
Table 4.1
EVA's capital base is formed by the company's (or unit's) balance sheet:
Balance
Sheet
X
WACC
Financial Requirement
Year X
Figure 4.1
Example:
MSEK
Sales
Operating Expenses12
Tax
Operating Profit
1994
Financial Requirement
EVA
1995
1996
234
-200
0
34
258
-205
-3
50
305
-243
-10
52
1997 (budget)
420
-285
-28
107
-45
-11
-50
0
-60
-8
-62
45
Table 4.2
The "Financial Requirement" is calculated as the defined capital (an adjusted balance sheet) multiplied with a suitable WACC:
MSEK
Capital
WACC
Financial Requirement
1994
1995
375
12%
45
1996
417
12%
50
500
12%
60
1997 (budget)
520
12%
62
Table 4.3
Bennett Stewart has identified several errors made in accounting from the investor's perspective. He
therefore adjusts these in order to simulate cash flow. Which adjustments must be made in order to
simulate a cash flow situation? Examples are general and specific shortcomings in Accounting such
as13:
Inventory costing and valuation
Depreciation
Revenue recognition
Capitalization and amortization of R&D, marketing, education, restructuring charges, acquisition
premiums
Fredrik Weissenrieder, 1998
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Bennett Stewart has identified a total of 164 adjustments and corrections. This amount will probably
be different from country to country. There is, of course, much more to this concept but this is sufficient to be able to compare the framework to the CVA. There is software developed for EVA14.
4
Economic information has now turned
into traditional accounting. Management is no longer
able to measure
profitability or value.
"Cash Flow"
5
6
163 corrections/adjustments are
made. Here, EVA uses so-called
straight-line depreciation.
The logic behind figure 4.2 is that all companies have cash data to begin with. It is then put into the
economic framework used today at companies, i.e. accounting. The company will be at the far right
when the accounting process is finished. EVA's mission is to take us all the way back again because
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it is only at the point to the left that we are able to, in financial terms, simulate the company's Business Reality from the shareholders perspective.
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I understand why adjustments must pass these four tests. EVA will not be possible to implement in
real life if the ambition is set higher than that. This is unfortunate, because my opinion is that the concept is not too bad in theory, but just like accounting in real life.
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Table 5.1
The assumptions above are that one, or a number of, stores (SI:s) are opened each year and they are
estimated to each have an economic life of 20 years. The last H&M/Wal-Mart store therefore closes in
2009, according to our assumptions. For simplicity, I have chosen to have the same capital cost of
15% for every store. I also say that the inflation is 3% every year and that the stores earn the same
amount of money every year in real terms. Also, to make it simple, I say that the stores produce a
cash flow of 17% of the investment sum the first year which then increases with inflation in the following years. If we look at the net cash flow of H&M/Wal-Mart we can see that it is negative. We cannot stand in 1987 or in 1993, look at the "CF" line and say "So, how are we doing". The question and
its answer if one comes up, are not very relevant. So far, I agree with Bennett Stewart. EVA will
therefore go into H&M/Wal-Mart's P&L statement and balance sheet and after about 164 adjustments
produce the following figures17:
238
483
736 1,013 1,298 1,677 2,237 2,899 3,666 4,541 4,678 4,818 4,963 5,111 5,265 5,423
Financial Requirement
280
550
809 1,077 1,334 1,680 2,211 2,820 3,502 4,254 4,073 3,891 3,710 3,528 3,347 3,165
-42
-66
-73
-64
-36
-3
26
80
164
287
605
0.85
0.88
0.91
0.94
0.97
1.00
1.01
1.03
1.05
1.07
1.15
1.24
"EVA Index"
1.34
1.45
1.57
1.71
Table 5.2
Fredrik Weissenrieder, 1998
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The EVA model claims that it can, by the use of existing accounting, tell us what the profitability of the
company as a whole has been from the beginning to whatever year we have complete figures for
(here 1996). We have a steady growth in presented profitability over the years, from an EVA of -42 in
1981 to an EVA of + 2 257 in 1996. We also introduce, for the sake of the analysis, a new measure
that we can call the "EVA Index". It is simply the Operating Cash Flow divided by the "Financial Requirement"19. If the Index is 1.00 we meet our requirement, if it is below 1.00 we don't, and if it is
above 1.00 we return a cash flow above the requirement. We can see that it wasn't until 1987 that we
became profitable according to EVA.
400
300
200
100
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03
02
01
00
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05
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Graph 5.1
Graph 5.2 tells us that the investment ended up as a success in the remaining years under the assumptions we made. Expansion in identical investments will be heavy on profitability for three years
but will be extraordinarily profitable after that. Managers in the early years will be looked upon as
managers struggling with profitability while the managers in the later years will be looked upon as being very successful. The managers of this store are generously rewarded if bonus is based on the
change of EVA over time.
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600
EVA's Operating Profit, store no 6
EVA's Financial Requirement, store no 6
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400
300
200
100
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01
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00
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Graph 5.2
This will be reflected also at the aggregated level, the parent, since all investments made make the
5.1.2 EVA at the parent
same amount of money in relation to the investment sum. The heavy growth will show poor profitabilty
This will be reflected also at the aggregated level, the parent, since all investments made make the
same amount of money in relation to the investment sum. The heavy growth will show poor profitability for a number of years but the company will show profitability in year 1987 as presented in graph
5.3. Profitability boosts after the expansion is stopped in 1990. Again, the management responsible
for the expansion will probably not be looked upon as certain heroes while the ones that stopped it
probably will. If bonus is based on the change of EVA over time, the ones receiving bonus after 1991
(probably a new management) will be heavily rewarded while the ones before 1991 will be rewarded
to a much lesser degree.
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Graph 5.3
Fredrik Weissenrieder, 1998
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Graph 5.4 will further establish this picture. Profitability is further increased as time passes. The first
store is closed down in 2001 and after that one is closed each year. In 2009, only one store remains
and that one is closed down that year. The success factor here, according to EVA, is to avoid expansion.
7 000
6 000
5 000
4 000
3 000
2 000
1 000
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20
07
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05
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01
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Graph 5.4
238 483 736 1,013 1,298 1,677 2,237 2,899 3,666 4,541 4,678 4,818 4,963 5,111 5,265 5,423
804 1,030 1,331 1,775 2,301 2,909 3,603 3,711 3,823 3,937 4,056 4,177 4,303
209 268 346 462 599 757 938 966 995 1,025 1,056 1,087 1,120
CVA Index
1.26
1.26
1.26
1.26
1.26
1.26
1.26
1.26
1.26
1.26
1.26
1.26
1.26
Table 5.3
CVA does not include the Strategic Investments (the expansion) in the cash flow but will instead activate those using the Net Present Value method. I.e. it does not measure profitability at the "CF"-line in
table 5.1. The CVA concept periodizes the Net Present Value calculation, spreading the required Present Value, based on each Strategic Investment in a business unit, over the investments' economic
lives. The CVA concept uses the same original figures as the EVA concept did, that is from table 5.1,
but the conclusion will be different. Now, H&M/Wal-Mart will show profitability from the start in 1981!
The profitability will be the same over the chain's existence, 1.26 in CVA Index (OCF/OCFD).
This is because CVA introduces a fixed financial requirement, the so-called Operating Cash Flow
Demand. We create this "Demand" from the Strategic Investments we make, here the 10 stores. One
OCFD from each store, they can be looked upon separately or at an aggregated level. The Operating
Cash Flow Demand is the cash flow that is needed in order to end up with a Net Present Value of
zero when the investment has reached its economic life. The Operating Cash Flow from each investment is the same in real terms every year. The Operating Cash Flow Demand of H&M/Wal-Mart will
grow, in nominal terms, for two reasons; the growth in the number of stores until 1990 and the inflation adjustment every year of the existing stores' Operating Cash Flow Demand.
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100
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96
19
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Graph 5.5
The next graph, graph 5.6, illustrating the completed economic life will give us the same information,
which is that the investment has the same profitability over time and that it is profitable from year 1.
Growth in this concept will be rewarded from the first year.
600
CVA's Operating Cash Flow, store no 6
CVA's Operating Cash Flow Demand, store no 6
500
400
300
200
100
19
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Graph 5.6
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6 000
5 000
4 000
3 000
2 000
1 000
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Graph 5.7
This expansion is however stopped in 1991 but managers at the beginning of the company's life will
be viewed equally as the ones at the end. As they should (apart from the fact that they, if possible,
should keep on expanding). The same amount of money is made from each store (in relation to the
investments made) over the company's life. CVA illustrates that. I believe it is important to have an
economic framework that reflects Business Reality.
CVA's Operating Cash Flow, aggregated level
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Graph 5.8
Fredrik Weissenrieder, 1998
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200
100
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02
01
05
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-100
Graph 5.9
Graph 5.10 shows us the total effect from each of the two concepts. EVA will show lower profitability
in the beginning but much larger after half time compared to CVA. This despite the fact that each investment made makes the same amount of money in relation to the investment sum every year in real
terms. Again observe that the Net Present Value's of the two concepts are exactly the same. The
managers at H&M/Wal-Mart would become quite wealthy if EVA was used at their company and bonus was based on the change of EVA over time. Especially the ones who worked at the company after the expansion was stopped.
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4 000
CVA, aggregated level
EVA, aggregated level
3 000
2 000
1 000
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-1 000
Graph 5.10
Well, does this matter? Surprisingly many managers and controllers seem to be just fine with this
situation. They might say, "well, no, because all that matters is future cash flow any ways" which is of
course true but to say that our historic reflection of our company does not matter would be like saying
that company experience does not matter. Also, to say that we are not influenced by historic information would of course not be true either. Picture the two, out of several, following "others held equal"
scenarios:
1. Was the reason why H&M/Wal-Mart stopped expanding in this case due to the fact that the expansion period showed poor profitability using EVA? - It must of course be possible to see that
expansion is value creating if that is the case!
2. What if the profitability had been substantially lower, e.g. corresponding to a CVA Index of 0.70?
EVA would still show excellent profitability in the later years and expansion plans would surely be
presented. The expansion plans here would in more ways than one be influenced by the excellent
profitability given to us by the generous EVA concept. There is much room for mistakes in this
situation. - It must of course be possible to evaluate a business' profitability even if it is old and
written off in the accounting system!
EVA will in these cases hinder us from expansion when we create value and instead trigger us to expand when we destroy value. The answer to the question asked earlier "does it matter" seems to be
"yes".
If we isolate the concepts' capital bases at Store 6, the Operating Cash Flow Demand in CVA and the
Financial Requirement in EVA, we get the picture presented in graph 5.11. As expected, EVA's Financial Requirement falls rapidly while it increases (by inflation) in CVA. I should point out that EVA's
Financial Requirement would fall even quicker if depreciation was put into Operating Profit instead of
the Financial Requirement as is normally done. This will be further examined in 5.4.
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600
CVA's Operating Cash Flow Demand, store no 6
EVA's Financial Requirement, store no 6
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Graph 5.11
At the aggregated level we get the following picture, shown in graph 5.12. EVA's Financial Requirement decreases from year 1991 when the expansion is stopped. CVA's Operating Cash Flow Demand increases in nominal terms (however equal in real terms) until the first store is closed down,
then it decreases with the closing down-rate. Still, the Net Present Value of CVA's Operating Cash
Flow Demand equals the Net Present Value of EVA's Financial Requirement, but only in 1980. After
1980 will the Net Present Value of CVA's Operating Cash Flow Demand not equal the Net Present
Value of EVA's Financial Requirement. Management must decide how they want their company to be
presented internally and externally because the accounting way of doing things will not be taken for
granted in the future.
7 000
CVA's Operating Cash Flow Demand, aggregated level
EVA's Financial Requirement, aggregated level
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3 000
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Graph 5.12
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2,50
2,00
1,50
1,00
0,50
0,00
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
Graph 5.13
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The overall picture, over the store's full economic life, is presented in graph 5.14. EVA Index 2
reaches astronomic figures in the end, just as ROCE would present profitability.
35,00
30,00
25,00
20,00
15,00
10,00
5,00
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0,00
Graph 5.14
Graph 5.15 illustrates H&M/Wal-Mart's total profitability up until 1996. The CVA Index will always be
the same every single year in a business that in real terms makes the same amount of money in relation to the Strategic Investments made to create the business. The level of the EVA index will not be
based on that. The direction of EVA's profitability in relation to the investments made to create it will
depend on if the business is expanding (as it is here to begin with) if inflation changes etc, etc, instead
of showing true profitability.
2,50
2,00
1,50
1,00
0,50
0,00
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
Graph 5.15
The profitability in this simple H&M/Wal-Mart example is changing because the business is expanding
heavily to begin with, and EVA presents it as being unprofitable at that point. It then presents it as
being profitable just because the expansion ends. That is the only reason why EVA changes over
time in this example. Is this how we want to present profitability?
Fredrik Weissenrieder, 1998
21
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H&M/Wal-Mart generates the exact same amount of money every year! Why then, as in graph 5.16,
measure its financial performance as if it was increasing?
35,00
30,00
25,00
20,00
15,00
10,00
5,00
0,00
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
Graph 5.16
Some say that these errors in accounting/EVA are "cancelled out" or self-adjusted since a company
continuously makes investments, i.e. that the EVA curves in 5.16 are pushed down to where the CVA
Index is. It is my experience that this is a comment that arises when the person in question no longer
can explain the relationships between investments made and the cash flow they produce. The fact
that the errors in accounting, from the investors point of view, are cancelled out does to begin with not
improve the situation conceptually - what has caused what and why? Also, I think that the only way
we can find out if errors have been cancelled out or not is to compare EVA curves with something that
does not have the accounting's errors, e.g. to use the CVA curve as a benchmark. We must until then
live with uncertainties such as is my ROCE of 14% actually 4% and my EVA of 100 actually 100.
The distribution of accounting based measures as ROCE and EVA around true profitability is wide
too wide to grasp or ever understand.
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Lets go through those last adjustments using a (nominal) example. The investment of 2,000 in the example below has an economic life of 12 years. The WACC is 15% and estimated inflation is 3%. The
Operating Profit (here defined as the Operating Surplus adjusted for Working Capital, WC, movements but without depreciation) is a bit volatile so it does not increase with inflation as in the
H&M/Wal-Mart example. This unit experiences four investments after the initial investment is made.
Those are activated into the balance sheet. Those are normal investments that are necessary to
maintain the value and economic life of the unit as was planned/estimated in the decision process for
the initial investment. A major investment is almost always followed by investments that are made
(have to be made) because the major investment was made.
Year:
0
1
2
3
4
5
6
7
8
9
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Strategic investment
-2,000
Operating surplus + WC movement
300 450 450 600 900 700 600 800 600
24
Non-strategic investments
-150
-200
-250
-300
Cash Flow -2,000 150 450 250 600 650 700 300 800 600
Table 6.1
10
11
12
400
300
200
400
300
200
These are everything we need in order to do both CVA and EVA. CVA would look like this:
Year:
Operating Cash Flow
Operating Cash Flow Demand
CVA
Table 6.2
1
2
150 450
327 337
-177 113
3
4
250 600
347 358
-97 242
5
6
650 700
368 379
282 321
7
8
9
300 800 600
391 402 414
-91 398 186
10
11
12
400 300 200
427 440 453
-27 -140 -253
The Operating Cash Flow equals Operating Surplus adjusted for Working Capital movements minus
Non-strategic Investments. The Operating Cash Flow Demand is the cash flow that is necessary each
year (the same cash flow in real terms every year) to give the Strategic Investment a Net Present
Value of zero25. The CVA is the difference between the Operating Cash Flow and the Operating Cash
Flow Demand.
CVA has classified the investments that follow the initial investment of 2,000 as being "value maintaining" investments, not value creating. They have in other words not added extra value to the business. This does not mean that it is useless to make investment calculations to evaluate those (even
though they usually have to be made). However, the Net Present Value calculated will not be a value
that is added to the business if the Non-strategic Investment is carried out. It is instead the value that
will be lost from the initial investment if it is not carried out. This is of course in many aspects the
same thing but I believe it to be essential to realize that the Net Present Value a calculation generates
not always means that new value has been added to the company and therefore for the shareholders.
Value is added to a company when a strategic decision is taken (if it has a positive Net Present Value,
of course), not when decisions are taken to preserve a strategy's value.
1
2
300 450
467 494
-167 -44
3
4
450 600
465 505
-15 95
5
6
900 700
470 522
430 178
7
8
9
600 800 600
449 515 428
151 285 172
10
400
386
14
11
300
295
5
12
200
261
-61
Again, the Operating Profit consists of Operating Surplus adjusted for Working Capital movement.
The Financial Requirement is calculated as each year's opening balance of the fully adjusted balance
sheet, which includes the four investments since they are investments in large tangible assets, multiplied with the WACC plus that year's depreciation. It cannot be better than it is in table 6.3 if straightline depreciation is used.
We can see in graph 6.1 that CVA and EVA, straight line depreciation, are not very similar, even
though we have made a large number of adjustments. I claim that CVA is at the far left of the circle,
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figure 4.2. We then, obviously, need to make further adjustments in EVA because this situation is not
acceptable. Consider, though, that this is a very good and precise situation for EVA compared to EVA
in real life.
500
400
300
200
100
0
0
10
11
12
-100
-200
CVA
-300
Graph 6.1
We can see in graph 6.2 that the Operating Cash Flow Demand behaves as we can expect it to do. It
increases with inflation (3%) because it is only based on the Strategic Investment. A so-called Strategic Marginal Investment26 could occur in real life, which would increase the size of the capital base,
and hence the Operating Cash Flow Demand, but that has not occurred here.
EVA's Financial Requirement jumps however up and down in a seemingly random manner. This
business and its annual balance sheets are fairly isolated which enables us to make further analyses
of EVA's Financial Requirement in graph 6.3.
700
500
400
300
200
100
0
1
10
11
12
Graph 6.2
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Graph 6.3 analyses EVA's Financial Requirements further. The requirement from each of the five investments included in the capital base is rapidly falling, as can be expected from EVA using straight
line depreciation. It is clear that we cannot have a Financial Requirement that decreases like this, although it has always been like this in accounting. Bennett Stewart, together with others before him,
has identified this. He therefore suggests using the annuity method (sinking-fund depreciation) for the
Financial Requirement.
EVA's
EVA's
EVA's
EVA's
EVA's
700
600
500
400
300
200
100
0
1
10
11
12
Graph 6.3
1
2
300 450
369 414
-69 36
3
4
450 600
414 473
36 127
25
5
6
900 700
473 548
427 152
7
8
9
10
11
12
600 800 600 400 300 200
503 593 533 533 458 458
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500
400
300
200
100
0
0
10
11
12
-100
-200
CVA
-300
Graph 6.4
The reason for why EVA looks more like CVA is found in the Financial Requirement (because the
Operating Profit has not been changed), graph 6.5. CVA's Operating Cash Flow Demand is unchanged but EVA's Financial Requirement has changed substantially.
700
500
400
300
200
100
0
1
10
11
12
Graph 6.5
We can further analyse EVA's Financial Requirement as in graph 6.6. Here it is clear that substantial
changes have been made.
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EVA's
EVA's
EVA's
EVA's
EVA's
700
600
500
400
300
200
100
0
1
10
11
12
Graph 6.6
I would like to point out that the initial investment of 2,000 is in reality probably depreciated over 10
years in accounting, and not over 12 years as in this example. The only remaining asset in the capital
base would then be the fourth Non-strategic Investment. This is something that must be adjusted for
every asset if EVA is to function. Otherwise profitability will suffer even more at the beginning of a
project and be even better at the end than it automatically already does in EVA (as was shown in 5.4).
If I have understood Bennett Stewart's EVA concept correctly, this is as far as they take it. As the circle (figure 4.2) tries to illustrate, they have not reached the point at the far left yet. Two more adjustments are necessary in my opinion, which I do not think has been discussed in the EVA concept.
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Owners of a company should be concerned over statements like that. It indicates that the company's
knowledge about Business Reality (figure 2.1) has not been tied to the Financial Markets' Reality,
which surely will lead to sub optimization of the company's strategic assets (tangibles and intangibles)
and to inefficient and costly capital allocation. A few comments to the example in the previous paragraph:
The reasoning would e.g. result in a higher perceived value of intangibles or intellectual capital if
an expansion is stopped or if inflation rises (as explained in section 5). This is due to the, from the
investors' perspective, technical error in accounting's reflection of the Financial Markets' Reality
and should not have any effect on management's view on Business Reality.
Not only do they confuse an asset "at cost" (the equity) with an asset "at value" (the intangible or
intellectual capital) but also would the value of a company's (corrected/adjusted) equity be unchanged if the value if the intangibles or intellectual capital were to become zero? Of course not.
Neither would the value of the intangibles or intellectual capital (if measured as the stock market
value minus the equity) remain the same if all computers, desks and telephones were thrown out
of a bank or an insurance company.
The value of a company is created by a confluence of strategic assets, fixed and non-fixed. Fixed and
non-fixed - goes together like a horse and carriage. This is the relationship management must understand. Only then have they tied Business Reality to the Financial Markets' Reality. Bringing in accounting's investment concept only enhances confusion. Unfortunately this happens in most companies today.
An effective VBM concept structure the strategic assets to a capital structure that will include both
tangibles and intangibles and the concept will make no difference between the two. The capital will be
"at cost" and the discussion on the capital structure's (the strategic assets') value will become more
relevant. The comparison with a stock market value must be handled with caution. This is because
the stock market value will not only include the Present Value of current strategic assets (the Prestrategy Value, figure 2.1) but also the Net Present Value of the Strategic Investments that lie in the
future (the Strategy Value, figure 2.1). The Net Present Value of those future Strategic Investments
can be both positive and negative (a Net Present Value of zero in the average stock market company).
Graph 6.7 compares EVA, annuity method, 1st adjustment (Non-strategic Investments are put into the
operating cash flow instead of being activated) to CVA and the picture is much better than graph 6.4.
500
400
300
200
100
0
0
10
11
12
-100
-200
CVA
-300
Graph 6.7
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The Financial Requirement will then look even more like CVA's Operating Cash Flow Demand as we
can see in graph 6.8. It is now clear to us what the next adjustment must be.
700
600
500
400
300
200
100
0
1
10
11
12
Graph 6.8
10
11
12
-100
-200
CVA
-300
Graph 6.9
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We made the change in Financial Requirement that we discussed, we inflated it with actual inflation,
so it will be identical to CVA's Operating Cash Flow Demand.
700
600
500
400
300
200
100
0
1
10
11
12
Graph 6.10
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Years:
EVA's Financial Requirement, straight line depreciation
EVA's Financial Requirement, annuity depreciation
EVA's Financial Requirement, inflation adjusted annuity depreciation
CVA's Operating Cash Flow Demand
Table 6.5
1
388
310
262
262
2
363
301
262
262
19
74
182
262
262
20
64
177
262
262
400
350
300
250
200
150
100
EVA's Financial Requirement, straight line depreciation
EVA's Financial Requirement, annuity depreciation
50
0
0
10
11
12
13
14
15
16
17
18
19
20
Graph 6.11
As I wrote earlier in 5.3, EVA will trigger us to avoid expansion when it is profitable and to expand
when we shouldn't. Who wants to invest under these circumstances? Profitability will be low in the
early years if we e.g. make 300 per year and we then actually produce sufficient cash flow. On the
other hand, in year 17-18 will calls for a replacement be raised? The business might only be able to
give us a cash flow of 150 per year but this investment will be presented as being very profitable under those circumstances. This will undoubtedly have an effect on management's decision.
One can always argue that the Operating Cash Flow generated from a Strategic Investment should
be higher in the beginning when the product is competitive and lower at the end when it is less competitive. EVA's Financial Requirement, straight line depreciation, would then reflect this pattern. This
would however be an unfortunate mix up between an investment's Financial Logic and its Business
Logic. The knowledge we have, that a certain investment makes more in the beginning, is our Business Logic and can only be obtained if we separate it from the Financial Logic. The Financial Logic is
the, in real terms, constant benchmark, which enables us to obtain our Business Logic, a true Business Logic reflecting Business Reality and a Financial Logic reflecting the Financial Markets' Reality.
We will not be able to obtain that knowledge if we measure the investment as being equally profitable
over its economic life, an "EVA Index" of 1.00, as EVA would in this case.
Is this picture dramatically improved if we have an economic life of 10 years instead? No. As we can
see in graph 6.12 we still find a high requirement from the common EVA even if it does look a bit better than before.
We can also here express the Financial Requirement in percent. If we assume that 349 corresponds
to a nominal capital cost of 15%, then EVA straight line depreciation requires 21% the first year and
7% in the last year, an unwheighted average of 13.7%, not 15%. EVA using the annuity method requires 17% in the first year and 13% in the last year, an unwheighted average of 14.6%. CVA's Operating Cash Flow Demand and EVA, using inflation adjusted annuity, will both require 15% every year.
The Net Present Values are the same for each curve.
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Years:
EVA's Financial Requirement, straight line depreciation
EVA's Financial Requirement, annuity depreciation
EVA's Financial Requirement, inflation adjusted annuity depreciation
CVA's Operating Cash Flow Demand
Table 6.6
1
485
387
349
349
2
443
376
349
349
9
199
305
349
349
10
171
297
349
349
500
450
400
350
300
250
200
150
EVA's Financial Requirement, straight line depreciation
EVA's Financial Requirement, annuity depreciation
100
50
0
0
10
Graph 6.12
If we have an economic life of only 5 years as in graph 6.13 the picture will be further improved but
EVA's Financial Requirement will not be corrected.
We can also here express the Financial Requirement in percent. If we assume that 550 corresponds
to a nominal capital cost of 15%, then EVA straight line depreciation requires 19% the first year and
11% in the last year, an unwheighted average of 14.6%, not 15%. EVA using the annuity method requires 16% in the first year and 14% in the last year, an unwheighted average of 14.9%. CVA's Operating Cash Flow Demand and EVA using an inflation adjusted annuity will both require 15% every
year. The Net Present Values are the same for each curve.
Years:
EVA's Financial Requirement, straight line depreciation
EVA's Financial Requirement, annuity depreciation
EVA's Financial Requirement, inflation adjusted annuity depreciation
CVA's Operating Cash Flow Demand
Table 6.7
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1
680
579
550
550
2
603
562
550
550
3
531
546
550
550
4
462
530
550
550
5
397
515
550
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700
600
500
400
300
200
EVA's Financial Requirement, straight line depreciation
EVA's Financial Requirement, annuity depreciation
EVA's Financial Requirement, inflation adjusted annuity depreciation
100
0
0
Graph 6.13
MVA
Total
Value
(Market
Value)
Total
Capital
Figure 7.1
Market Value
21,000
166,000
142,000
32,000
2,000
99,000
7,000
Capital
20,000
44,000
85,000
29,000
4,000
100,000
2,000
MVA
1,000
122,000
57,000
3,000
-2,000
-1,000
5,000
MVA Index30
1,05
3,77
1,67
1,10
0,50
0,99
3,50
Table 7.1
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Stern&Stewart frequently have listings published in many countries of the current MVA rating. These
are often discussed in companies as something important and relevant, but are they? I agree with
Bennett Stewart on the fact that shareholder's wealth is maximized only by maximizing the difference
between the firm's total value and the total capital that investors have committed to it. One thing we
cannot do, however, is to define the Total Capital as something from a company's balance sheet. I
here want to refer to all previous sections of this paper that discusses the weakness of the balance
sheet and especially the section on tangibles and intangibles in 6.3.
In table 7.1 we find some Swedish companies. We know (without using the MVA) that some of those
create value and some do not. We also know how much because we can measure it by looking at the
stock development + dividends over time, which is the total return to the shareholders. So, does the
MVA increase our knowledge or understanding? If the balance sheets used as the defined capital
were adjusted for everything that we must adjust for when using EVA, then we would have a measure
that may increase our understanding of the company in question. We must then make at least the 164
adjustments Bennett Stewart suggests. We must adjust the assets' time period, in which they are depreciated over, for actual economic life. We must use real annuity, etc, etc. We must travel all the way
back on the circle 4.2.
We will not often see developments in balance sheets so extreme as the one we saw in graph 5.14. It
will look more like the development in graph 5.15 where additional investments are carried out. So,
you might think, what does my company's balance sheet look like in a graph like this? Well, I am
afraid the answer is "we will never know". The example in section 5 presents a highly theoretical
situation. It is a situation that is easy to analyse from EVA's point of view because the balance sheet
is "clean" in the sense that it only consists of the depreciated remains of actual investment made in
new stores, nothing more and nothing less, and the time period they are depreciated over equals actual economic life.
In reality, the asset side of the balance sheet is a mess from a non-accounting point of view. It will not
only consist of depreciated remains of actual (Strategic) Investments made in stores. It will also include items such as Non-strategic Investments, advances to suppliers, prepaid expenses and accrued income, inventories and supplies, etc, etc. Some randomly chosen assets will be (incorrectly, of
course) adjusted for market values, etc. The time periods the assets are depreciated over will not
equal actual economic life. The balance sheet will also leave out all Strategic Investments made in
intangibles discussed in 6.3. The list can be made very long which is exactly what Bennett Stewart
has done listing the possible adjustments in the EVA concept. These "errors" from the non-accounting
point of view will appear very different from one company to another, from one line of business to another. Some of the major differences will depend on if it is a local or multinational corporation, if the
company's assets have long or short lives (one company could look like graph 6.11 another like 6.13),
if the company is expanding or not, if it has been expanding in earlier years or not, etc, etc and finally,
of course, how the company chooses to present the balance sheet over time. Again the list can be
made very long and companies can therefore not be compared using the balance sheet as one of the
components (or a balance sheet with less than at least 50-100 large and relevant corrections/adjustments).
The "Capital" in an MVA calculation must be a fully adjusted balance sheet, any other capital would
make no sense in a calculation together with a market value. Since it is not possible to obtain information on the corrections/adjustments necessary to make, in order to close the circle for the balance
sheet in figure 4.2, those are not made. MVA listings are therefore not relevant and must be dismissed. They do not increase our knowledge or understanding, on the contrary.
Also, a company's balance sheet illustrates the investments made to generate the business as we
see it today. In other words, it is the capital base for the Present Value of the future cash flow that will
be generated from the business if no further Strategic Investments are made. The market value, however, is the sum of the Present Value of the future cash flow from the business without any further
Strategic Investments and the Net Present Value of the cash flow from future Strategic Investments.
The market values the company's ability to produce positive (or negative) Net Present Values in the
future. An MVA does therefore not present a value added of the business today, it also includes the
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Net Present Value of the companys future business. We compare apples with oranges. A financial
management concept must naturally be able to separate those two values.
The "punch-line" here is the Hufvudstaden case. Hufvudstaden is an old real estate company that
owns some of Sweden's most beautiful (commercial) estates. Hufvudstaden's MVA is extremely good.
This should come as a surprise to all of us because if you know the Stockholm Stock Exchange you
know that Hufvudstaden has destroyed shareholder value for the last 15 years because the stock is
valued at about the same value as it was 15 years ago31. It has not moved much over time, so is
Hufvudstaden's MVA really so great or is the ranking the result of a model unable to measure what it
tries to measure? By this time the question can easily be answered. Hufvudstaden's assets are often
written off or almost written off and inflation has done a terrific job on the rest of the assets. The MVA
of Hufvudstaden seems to make no sense what so ever because the "Total Capital" is in this case
obviously irrelevant. Despite its size (much larger than many other companies on the MVA listings)
Hufvudstaden is never included in any MVA listings. Everyone with knowledge about the Stockholm
Stock Exchange would dismiss any MVA listing with Hufvudstaden at the top half. The irrelevance of
MVA becomes very obvious in the Hufvudstaden case, it is not as obvious in other companies, which
however doesn't make the ranking of those less irrelevant. The MVA listings have the same problems
with all companies in the listings that it has with Hufvudstaden to a greater or lesser degree. However,
we do not know to what degree for any of the companies! This makes the listings, in my opinion, totally irrelevant. What would the ranking be if all of these "errors" from the investors' perspective were
adjusted? We'll never know.
Also, the long-term average of all companies' MVA's put together will be zero but this never seem to
be the case in the rankings presented. This is because the investors' opportunity cost of capital for the
stock market is the return from a weighted portfolio of all companies on the stock market (also the
companies' cost of equity, but not adjusted for specific risk). There are usually only a small amount of
companies that show negative MVA's. This is a strong indication on that there are severe miscalculations in the MVA listings.
Companies must therefore work to maximize the total return to the shareholders, i.e. the shares' value
increase + dividends, not the MVA.
8 Conclusion
Now I want to rise the obvious question. Why travel on the circle, figure 4.2, from the point to the far
left, all the way to the right, just to go all the way back again - from the point we began our trip? We
were there from the beginning, so why don't we stay there from the very beginning? As I pointed out
in section 5, it was not possible to measure historic profitability and value in incompleted businesses
from that point on the circle before CVA was developed. But now it is developed and is being implemented in Swedish multinational corporations. They will have a strategic and operational tool solely
focused on Strategic Investments (tangible and intangible), their cash flow, their economic life and
capital cost. Nothing more, nothing less. They will be able to tie the company's Business Reality to the
Financial Markets' Reality (figure 2.1).
Figure 8.1 tries to illustrate a Value Based Management process. Three already existing functions
must be improved if the Value Based Management is to be a success. The process is a success if the
total return to the shareholders (share value + dividends, not MVA as discussed in section 7) increases.
1. A correctly focused Value Based Management concept has the organization focusing on the relevant issues. It will be based on the four factors that determine value; Strategic Investments (tangibles or intangibles), the operating cash flow they generate, the Strategic Investments' economic
lives, and their capital cost. My experience is that it is crucial for the strategic dialogue that the
process is not disturbed by any irrelevant issues but instead gets a chance to focus on the relevant. Today with accounting, some relevant issues are discussed, many irrelevant issues are included while many relevant are excluded because accounting is not focused on the four factors
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that determine value. EVA might improve this, but then to a limited extent (depending on the ambition of the EVA implementation) so it will still be based on accounting and the issues accounting
triggers. EVA is not too bad in theory, but just like accounting in real life. This was mainly dealt
with in section 4.1.
2. A Value Based Management concept based on financial theory will give the company the possibility to increase the quality of the financial analyses made at the company (the possibility will turn
into ability when the company's knowledge within value theory and Value Based Management is
increased). EVA might provide the company with slightly better analyses but the quality will, in my
opinion, be far away from what it will be if the ambition is set higher than what realistically can be
achieved with EVA. This was dealt with in sections 5 and 6.
3. The two functions will have an effect on the intrinsic value of the company, which in the long run
will have an effect on the market value. If the company wants the intrinsic value of the company to
over time equal the market's valuation of the company, then also the Investor Relations function
must be Value Based. The company should e.g. communicate issues like the company's capital
allocation (where are Strategic Investments made?), investment strategies in the company's business groups, information on the company's profitable growth areas, analysis of the company's
Operating Cash Flow (the components), etc. Much like the Swedish company SCA is starting to
do. Some analysts and media might not immediately observe this new information since they not
observe the markets mechanism today, i.e. discounted cash flow. That will however only be a
matter of time because more and more of those now turn towards the discounted cash flow view.
Value Based
Management
1. Improved
internal dialogue
2. Improved
numeric analyses
Increased
Intrinsic value
3. Value Based
Investor Relation
Increased
market value
Figure 8.1; the Value Based Management process
Company's must now identify the VBM concept that will best fulfil this process (figure 8.1) for the
company in the future. Most company's I have discussed this with agree with me that discounted cash
flow will fulfil the process better than some concept that is based on a company's P&L statement and
balance sheet. Some company's will still chose EVA instead of CVA because they today have low
ambitions with their VBM process. If a company's ambition within Shareholder Value is set low then
EVA comes in handy. Making a few (1-10) corrections/adjustments in accounting is easy. If our ambitions are set higher so that we need to make more corrections/adjustments (>20) we might as well,
from an effort point of view, implement CVA. CVA requires some initial work when the company's financial management is re-established into cash flow (but surely less work than making ~20 adjustments in EVA) but will after the implementation is made be much simpler to use than EVA.
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Some EVA advocates may say "we keep it simple, EVA is all we need to know". It is simple because
it is just like accounting, which is the framework we know today. Accounting is, however, what we now
say we want to step away from. CVA is also simple - if you have some knowledge within corporate finance. CVA focuses on the relevant issues while EVA doesn't, and CVA is much more correct than
EVA is so I do not agree on the statement "EVA is all we need to know". We cannot be content with
EVA if our ambition concerning the quality of information from our VBM process is high or if we have a
high ambition on changing the organization towards understanding the meaning of the expression
Shareholder Value, only if it is low. In other words, if we want to travel more than ~10% on the circle
(figure 4.2) by correcting/adjusting accounting then we are much better off implementing a concept
that is based on the cash flow point to the left to begin with. Then we do not have to make any adjustments in our accounting to simulate cash flow because we simply measure discounted cash flow
where it arises.
It is all a matter of management ambitions. My experience is unfortunately that the ambition in this
area is low today, although I think that will change. It is difficult to say why the ambition is set so low,
but one can probably say that if engineers within mobile communications had the level of ambition in
their field that controllers and management have within performance measurement, we would still be
carrying our mobile phones in bags instead of in our pockets.
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+1,100
+100
+100
Price of bond
Figure 1
If the market interest rate for government bonds at the time of the purchase of the bond is 9.80% the
value of this bond is 1,005. How do we know that? Well (now the only tricky part of valuation comes
in), the market has a mechanism that is given to it by the participants on the market. We usually call it
"discounted cash flow" (DCF). The market discounts the future payments back to you using the market rate of 9,8%. (Observe that the bond's coupon rate of 10%, 100/1,000, is not the discount rate, it
is the cash flow.) When we want to simulate the capital market's mechanism to determine value we
use the following calculation to come up with the value of 1,005:
100
100
1,100
+
+
1,005 =
2
1,098 1,098
1,098 3
Equation A1
You will buy the bond if you believe that it is worth 1,005 or more to you. It is clear that value of the
bond to us is a factor of the investment (1,005), the cash flow (100), the economic life (3 years), and
the capital cost (9.8%). Nothing more, nothing less. Using other ways of presenting this such as
ROCE does not improve our knowledge of this bond or help us in valuing it. We would instead be
confused by these irrelevant measures.
Now, how does value work at the stock market? The stock market's mechanism is the same as the
bond market's mechanism. This can, in a simple way, be illustrated as follows:
Dividend
year 1
Dividend and
Dividend
sales price year 3
year 2
Price of stock
year 0
Figure A2
Fredrik Weissenrieder, 1998
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If the market rate32 is estimated to be 17% the market will value the stock in the following way using
DCF:
Value of stock =
Equation A2
Equation A3
In valuing, do we involve any other parameters but our investment, the cash flow (dividends), economic life (limited or infinite), and capital cost (17%)? No, of course not. Discussing or involving any
other concepts but the DCF approach above will only confuse us. Value is a function of those four
factors, nothing more and nothing less. We should at this point, to be correct, also involve the discussion on real options (because value is a function of that too) but I will leave that out to limit the paper
and to instead focus on the objective of it; to compare EVA and CVA. The conclusion from the comparison of the two frameworks would probably turn out to be the same with or without real options.
P/E ratios33, e.g., does not discuss those four variables and is therefore useless which can easily be
proven. You cannot pick a measure that excludes any of the four parameters mentioned above or
brings in any other. Yes, e.g. estimating the cost of equity is difficult but never believe that you have
found a way to calculate value (or reflect value) by using a method that excludes it!
A conclusion we can make so far is that value is a function of 1) investments 2) cash flow 3) economic
life and 4) capital cost. The mechanism that is used on the market to establish value using these four
factors is what we call discounting, hence the expression "Discounted Cash Flow".
This is the reason why we use DCF methods when we calculate on investments that we plan to make
in a company. There is no other reason why we should use DCF methods (such as the net present
value method). When we use these methods we look at the investment cost, we estimate and simulate future cash flow, we estimate and simulate economic life. We do our best to estimate what the investors' opportunity cost of capital is, e.g. using the Weighted Average Cost of Capital (WACC) concept or the Adjusted Present Value approach:
Cash Flow
year 2
Cash Flow
year 1
Cash Flow
year 3
Investment
Figure A3
We can now continue on the path of simulating the market's mechanism of illustrating and calculating
value (the WACC is here 14%):
Value of investment = - Investment +
Equation A4
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Our objective for doing this is to be able to establish and execute strategies and investments that increase shareholder value. We then need to be able to ask the right questions about the investment,
discuss the relevant issues, understand what we need to understand, etc, etc. Everything boils down
to that we must limit our economic framework to our four simple factors. Never discuss P/E-ratios,
profit per share, ROCE, balance sheets, P&L statements, book equity, goodwill, depreciation rates
Those do not reflect, illustrate or simulate value or profitability from the investor's perspective. They
never have and they never will.
So far so good. Most of us can generally and conceptually agree on this. But in practice something
peculiar occurs. After the investment has been made companies, analysts and media abandon this
thinking today even though a business still should be illustrated as it was in figure A3.
We enter the world we say in not correct to enter, i.e. the world of P/E-ratios, profit per share, ROCE,
balance sheets, P&L statements, book equity, goodwill, depreciation methods We try to follow up
the value creation and profitability of investments that we have made by using accounting34! Accounting does not handle any of our four factors the way we want a financial framework to handle
them and it does not discount, i.e. it disregards the time value of money35. Most of us may agree upon
that this focus on accounting cannot continue. Enormous values are destroyed every day due to bad
decisions that lead to inefficient and costly capital allocation. Those bad decisions are a result of the
poor information given to us by accounting. We can no longer assume that the capital markets will accept this and we must therefore illustrate our financials using the four factors that determines value.
Today's management must rethink: "What kind of information do I believe the organization need for
strategic decision making and for managing the company's current operations? If I could start all over
again with a fresh financial performance measurement framework, which would I choose?" I believe
the need for a new framework is tremendous. Choosing something for the only reason that it looks
much like what we see today from our current framework (accounting) would be a mistake.
11
"The quest for value, the EVA management guide", by Bennett Stewart. Published by Harper Business,
1991.
6
"CVA, Cash Value Added - a new method for measuring financial performance", By Erik Ottosson and Fredrik
Weissenrieder. Gothenburg Studies in Financial Economics, Study No 1996:1. (http://www.anelda.com)
7
E.g. "Internal Controls: Guidelines for Management Action", by Yuji Ijiri. Financial Executive, March 1980.
8
"Creating Shareholder Value", by Alfred Rappaport. The Free Press, 1986.
9
For more extensive information on CVA: "CVA, Cash Value Added - a new method for measuring financial
performance" (http://www.anelda.com) or "Cash Value Added - ett ramverk fr Value Based Management", by
Erik Ottosson and Fredrik Weissenrieder. Ekonomi&Styrning, 5/96. (http://www.anelda.com)
10
You can find Software for this at e.g. http://www.anelda.com.
11
The user should make a difference between what is operative Working Capital and what should be regarded
as financing Working Capital.
12
"Operating Expenses" includes depreciation, which I think is unfortunate. It should be included in the "Financial Requirement" instead, mainly for three reasons. Even though the calculated EVA is unchanged, it is probably better to have a pure Operating Cash Flow instead of an Operating Profit. The organization should become
more cash flow focused if depreciation is instead moved into the "Financial Requirement". The second reason
will be discussed later in 5.4 but concerns the, by accounting, abused balance sheet which the "Financial Requirement" is calculated from. The error will "leverage" as shown later on if depreciation is included in the "Operating Expense". Finally, if depreciation is put into the Operating Profit many will take that as a "normal investment level" (many actually do!) and try to invest at that level. This is very unfortunate, I believe. Many do not
consider the aspect of economic life of strategies but I think this will be discussed if this re-investment behavior
2
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can be ended. Investments that are considered must then stand on their own merits and not on some predestined investment level set by accounting principles.
13
"EVA: fact and fantasy" by Bennett Stewart. Journal of applied corporate finance, volume 7, number 2, summer 1994, BankAmerica.
14
You can find Software for this at e.g. http://www.crgroup.com/download_evaluator.htm
15
"EVA fact and fantasy", by Bennett Stewart.
16
"The Quest for Value" by Bennett Stewart. Page 4.
17
It is assumed that so-called straight-line depreciation is used, i.e. that the same amount is depreciated every
year during an investment's economic life. It is also assumed that all the corrections/adjustments necessary to
reflect a balance sheet that is based on the actual investments made are carried out (a total of about 164 corrections/adjustments) e.g. the "Financial Requirement" is here based on the balance sheet's opening balance.
Also, to maintain the analysis' simplicity, I have assumed that no other investments are made (i.e. outlays that
are considered investments in accounting) in a store after the initial investment. This is a bit unfair to the EVA
model because it will not look good at all due to this but this will be commented on later. This is a nominal calculation.
18
Observe that depreciation is included in the "Financial Requirement" not in the Operating Profit unless else is
stated. The Operating Profit then turns into an Operating Cash Flow.
19
If no, or only a few, adjustments/corrections are made in the P&L statement and in the balance sheet before
calculating EVA's "Financial Requirement", then the EVA Index is fully comparable with e.g. a company's Return
On Capital Employed, ROCE (if depreciation is taken in Operating Profit instead of here "Financial Requirement"). This is examined in 5.4 and is then called "EVA Index 2".
20
This might happen in companies like Astra in Sweden. They have implemented EVA's bonus system.
21
"EVA: fact and fantasy" by Bennett Stewart.
22
For more of my opinions on bonus read "If you have problems with your bonus system then you have problems measuring value creation and profitability!" by Fredrik Weissenrieder. Dagens Industri 961031.
(http://www.anelda.com)
23
This investment is treated as a Strategic Investment in CVA and as a tangible asset in accounting and hence
as an investment also in EVA. It does not necessarily have to be tangible since both CVA and EVA define an
outlay in e.g. R&D with an economic life of, as here, 12 years as an investment
24
This investment is treated as a cost in CVA because it maintains the value of the original Strategic Investment. It makes sure that the economic life of the Strategic Investment actually turns out to be 12 years as
planned/estimated and not substantially shorter. It does not add any further value so the CVA concept does not
activate the investment. In accounting, it is treated as an investment because it is tangible, which is activated
into the balance sheet. The balance sheet then forms EVA's capital base. The Non-strategic Investments are
depreciated over 5 years.
25
This is simply a real annuity. The difference between a calculation of an Operating Cash Flow Demand and
what most of us think of what a real annuity is, is that we use the actual outcome of inflation for historic analysis
and estimate inflation for the future. The inflation used is not the average over the period but instead one inflation rate for every year in the calculation. This is done because we believe that the threshold should be constant
over time.
26
These are investments that are made after an Initial Strategic Investment. Its objective is to increase the value
of the strategy, not to maintain it. Examples are major quantity increases or quality improvements.
27
For more on this read: "CVA, Cash Value Added - a new method for measuring financial performance", By
Erik Ottosson and Fredrik Weissenrieder. Gothenburg Studies in Financial Economics, Study No 1996:1.
(http://www.anelda.com)
28
"EVA: fact and fantasy" by Bennett Stewart.
29
The figures are from BolagsFakta (http://www.bolagsfakta.se) except for Hufvudstadens' which have been
calculated by me. Market values are based on the values at 961231. All figures are equity values and they have
been rounded off. The figures should therefore not be looked upon as being exactly true, only a symbolic base
for discussion.
30
Market Value/Capital = MVA Index
31
Hufvudstaden's largest and very competent owner, Custos AB, has hopefully changed the trend by now.
Hufvudstaden has become a "shareholder friendly" company.
32
This is the investors' opportunity cost of capital and the company's cost of equity. In other words, it is the estimated future long-term stock market index. It will be substantially higher than the, so-called, risk free market
rate of 10% that we used for the government bond. How much higher it is for the market in general, the market
risk premium (here 7,2%), and how different this is for different companies, e.g. expressed as beta, seems to be
a never-ending discussion. It is important to point out, however, that all companies have a cost of equity. A
company's cost of equity is not a modern phenomena. Companies had a cost of equity 200 years ago and they
have it today. However, since we now know have it we need to come up with the best possible estimate of what
this rate is, not what we want it to be. We will never be correct, but we should be able to find useful rates. I also
want to point out that this discussion should not be connected to any economic framework such as EVA, CVA,
Fredrik Weissenrieder, 1998
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CFROI, SVA, accounting, etc. The discussion is the same no matter which framework we choose to work with. I
want to point out at this stage that half (weighted) of the companies on the worldwide stock market will beat the
index and half of the companies will not since the index is an average. Half of the companies will therefore add
value relative to their cost of equity and half will not. Half of all investments made in a typical index company, a
company that follows the stock index, therefore have positive net present values and the other half have negative net present values. In a company that has a more positive development than the stock index we will find
more investments with positive net present values and vice versa.
33
Yes, you might "see" things if you use the P/E ratio, but you will not see what you want to see i.e. if a company's stock is priced right.
34
We must realize the difference between the need of data for controlling the company legally and the need of
data for understanding and learning our business. Today the data from the first tries to cover both needs.
35
Many more comments can be made on accounting and what the use of it may result in but this has been done
many times by others. The objective of this paper is instead to comment on what can be done instead.
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