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**This article was first published in the July 2012 Irish edition of Accounting and Business magazine.**

Economic value (or 'shareholder value') is defined as 'the present value of the future cashflows of a company, of a particular project or decision'. That means the calculation of economic value may be applied to something much smaller than an entire business's valuation, such as a specific commercial decision. Such a decision could be whether to invest in a brand, whether to make some organisational change or simply whether to hire in some special skills. It is often referred to as EVA or 'economic value added'.

Present value can be seen from either a management or a shareholder perspective. So that means that the valuation assessment can be arrived at from internal data or from purely outside estimations, in which case there are bound to be differences. Where internal figures are superior to external data, the company could well be undervalued.

### EVA is the key

This series will take you on a much more detailed journey of what economic value is and how it can provide an extra dimension on top of or instead of reliance on accounting profit for making key business judgments. It follows on naturally from my earlier series on strategy and strategic thinking. All strategic options need some financial quantification, and the purest and the best way of doing this is through EVA. Indeed, this series starts where we left off last month – in being able to turn into numbers the financial attractiveness that we saw in the strategic option grid.

### Where does it come from?

Economic profit comes from two main sources of value:

• the forecast value of net cashflows (over a planning period)

• the lump of value at the end of that period (the 'terminal value').

The forecast period is that over which estimates of cashflows can be made based on meaningful assumptions and taking into account the degree of uncertainty that surrounds these. It could be anything from as little as three years to as many as 10 – or even more in exceptional situations, such as in the aero-engine industry. The cashflow is discounted (or reduced) from the future value to the current or 'present' value by the following formula: the end year one cashflow X 1/(1 + the cost of capital).

Here the 'cost of capital' is the return needed by suppliers of capital to compensate them for:

• the rate of inflation;

• risk;

• parting with that money for a period of time.

The third element – the deprival cost over time – is called, rather enigmatically, the 'time value of money'– economists love their jargon!

Normally we expect to have a cash stream that goes on for a period, so the second year's cashflows need to be reduced to present value terms effectively twice or: the end year two cashflow X 1/(1 + the cost of capital) X 1/(1 + the cost of capital). Or, end year two cashflow times the discount factor, squared.

While this isn't the most exhilarating of calculations to do – thankfully, computers can do it – the way in which the compounding works is of interest. For instance, if we take the discount factor first as 8% and second as 10%, it would have the following effect for a cashflow of £100 at year 10:

- for 8%, £100 X 0.68 = £68;
- for 10%, £100 X 0.57 = £57.

Two things are of interest here:

1) There is a sizable reduction in value as a result of the compounding effect over time and thus longer-term investments have to be extra laden with incoming cash to support this burden.

2) Different costs of capital have an impact on the economic value of a business as a result of the compounding effect, so while not being the most important value driver, the cost of capital is still significant.

The 'terminal value' is significant, too. Even with a planning horizon of 10 years the terminal value – which is the value of cashflows often carrying on into perpetuity – is often 40% and more of the total value.

Where the planning horizon is as short as, say, five years, the terminal value can be worth as much as 70% of the total value. As most of the focus and thinking is likely to be on the more immediate planning horizon, then the fact that the terminal value may contain, at best, softer assumptions can be forgotten. Arguably, more thinking about the environmental and competitive factors at the end of the formal planning horizon is therefore needed, too.

### The seven key value drivers

The seven key value drivers that need to be thought about in an economic valuation are:

- the sales growth rate (SGR);
- the operating profit margin (OPM);
- the incremental working capital investment (IWCI);
- the fixed capital investment – the replacement fixed capital investment (RFCI) and the incremental fixed capital investment (IFCI);
- the corporate tax rate;
- the cost of capital;
- the competitive advantage period (CAP).

The SGR is taken from the profit and loss account. It is the percentage of sales growth (the increase) divided by the base sales, times 100, and is expressed as a percentage. It can be calculated historically from the year-on-year growth experienced over the past few years – assuming that this is a good guide to the future. Normally you would take a quick look at this to understand the trends and what might have been behind these, and then take a deeper look at the new trends and factors going forward. In particular, one-off factors in the past should be identified and isolated out.

Unlike conventional accounting evaluations, the SGR calculation enables the growth dynamics of a business or of a decision to be factored directly into the valuation.

The OPM is also taken from the profit and loss account. It is the percentage which the operating profit is of that year's sales. The operating profit is that profit line before interest and tax – and also before depreciation. Depreciation, which is a non-cash item, therefore needs to be excluded.Again, the same forecasting principles apply for this calculation: look at past trends, isolate any one-offs, then take a more forward-looking view which factors in any discontinuities. Obviously the resulting numbers are only as good as the quality of the underlying assumptions.

Both the SGR and the OPM are normally very important indeed in economic evaluation. They are also typically the hardest assumptions (along with the competitive advantage period) to arrive at.

After considering the operation value drivers listed above, calculate the investment of cash required to sustain and grow the business for the resulting net cashflows. To do this, you take out any investment in any additional working capital – usually pro rata to the increases – to support sales growth. Likewise, some fixed capital is normally needed both to replace equipment as it wears out and also to increase any assumed additional capacity to meet sales growth.

The IWCI and the IFCI are usually derived on a percentage basis from past trends. The RFCI is either worked out from specific known needs or a crude estimation is made by assuming that it approximates to the rate of depreciation. Isolating the right figures from the profit and loss account can be a little fiddly and you are advised to do a second check of this once you are finished. Even for an experienced analyst it is very easy to pull the wrong figures out from a complex profit and loss account.

The capital adjustments will vary a lot in their relative significance. For instance, in the MBA case study of valuing the acquisition of Marvel Entertainments the capital assumptions are relatively minor. Of course, in capital-intensive industries such as pharmaceuticals, oil or utilities these assumptions can play a huge role. In one joint venture once contemplated by aero-engine maker Rolls-Royce, for example, the effect of the IWCI was huge as there were 18 months' worth of debtors!

The corporate tax rate is usually relatively straightforward: the tax charge divided by the OPM. Obviously, that's a bit of a simplification, and we will be looking at the cost of capital in greater detail in the next article in this series.

So bringing it all together in a full EVA model you have, year-on-year for the forecasting period:

- the new sales, based on the SGR;
- operating profit margin, based on the new sales times;
- the new OPM percentage.

From this you have to subtract:

- investment adjustment assumptions (IWCI+RFCI+IFCI);
- corporate tax charge on operating profit (at the assumed tax rate).

This calculation would give the forecast future cashflows. These would then be discounted over the planning period and would be added to the terminal value to give the total value of the strategy.

Space precludes this article from going into the detailed calculations for the capital movement adjustments needed too.

### Strategic EVA

EVA is a tool for strategic thinking and should be used by accountants to support managers doing just that.

It is cashflow-based, brings in a longer-term time horizon, and takes into account the need for a balance of return to risk for shareholders in a way unlike accounting profit.

It responds to seven strategic value drivers – two operational, two investment-based, two financial and one competitively based.

In the next article we will learn more about this elegant model and also illustrate its application in practice.

*Dr Tony Grundy is an independent consultant and trainer, and lectures at Henley Business School in the UK*