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This article was first published in the March 2012 UK edition of Accounting and Business magazine.
In this fifth and final article, we will summarise the key insights from the first four articles, go a little further into the cost of capital, and consider value-based planning processes, intangibles and interdependencies, dealing with uncertainty, the business case and stakeholders.
Key insights to date
There are many insights and lessons to be drawn from the first four articles in this series on economic value added (EVA). Eight of the main ones are:
- Economic value has many advantages over conventional accounting profit as it is cashflow-based, deals with these cashflows over time, and makes an adjustment for the cost of capital.
- The cost of capital takes into account the time value of money, inflation and risk.
- The value of a business is based on intelligent cashflow projections based on the seven value drivers.
- Behind these value drivers are some deeper but equally important competitive drivers; if these are not understood then the numbers are not really robust.
- Economic value is generated when there is alignment of the business value system.
- We need to deep-dive below the business value system to carry out a more specific value and cost driver analysis.
- To estimate the value of a key business decision (such as the coin-locked supermarket trolleys investigated in last month’s article), inventiveness is required to draw data in from a variety of sources; this is often referred to as the ‘hunt for value’.
- EVA is a very powerful process to be used alongside and in support of strategic thinking.
In this final article, we will be focusing on a process called value-based management, which involves putting EVA at the centre of corporate decision-making, planning, control and performance management. Underpinning value-based management is the premise that capital is not a free resource for the business – it has a cost and ‘economic rent’ to which we will now return.
More on the cost of capital
The first article in this EVA series looked at the weighted average cost of capital (WACC). For completeness, here we cover the calculation of the cost of equity. Calculating this involves the capital asset pricing model (CAPM).
CAPM is based on an empirical investigation of share price movements which discovered that share prices in particular industries tend to move up or down relative to the overall market according to some constant called, for want of a better name, a beta. In addition, it was thought that the rate of return on an equity included the risk-free rate (Rf), while Rm was the average return on the whole market.
These concepts were all related together as:
- return on equity (Re) = Rf + beta x (Rm – Rf)
Rm – Rf is therefore the ‘risk premium’.
So if the risk-free rate is 3% and the return on the market is 8%, then the risk premium is 5% (8% minus 3%); if the beta is 1.5 (a volatile stock) we have the following return on equity:
- Re = 3% + 1.5 (8% – 3%)
- Re = 3% + (1.5 x 5%)
- Re = 10.5%
A very important consequence of this is that equity risk (or ‘systematic risk’) is already included in the equity cost of capital. That means that we should not also be increasing the WACC for project-specific risk, which should be taken into the calculations purely through risk and sensitivity analysis – risk must not be double-counted.
Another consequence is that it is not the job of managers to diversify business risk – the shareholders are managing that in their portfolios.
Obviously this is only a part of the cost of capital and one needs to factor in the cost of debt after tax and the gearing to establish the WACC (see the second article in this series for how this works).
When doing the calculations, it is essential to stand back and ask ‘does the result make sense?’. Two MBA students recently came up with a WACC of 0.3% and 0.0% respectively; unless their home country is on another planet, those figures just have to be wrong – capital is never free nor almost free.
Accounting profit is based on the accrual principle and focuses on optimising short-term profit. Value-based management ranks accounting profit secondary to (or at best on a par with) the emphasis on cashflows adjusted for the cost of capital.
This treatment involves a very big shift in perspective as shown in the box on this page. The profound set of shifts involved means making far reaching changes to:
- financial planning and budgeting;
- strategic planning;
- how we think about marketing – optimising customer economic value (as in the case of coin-locked supermarket trolleys that appeared in the previous article in this series);
- cost management and budgeting – cost reductions are never pursued in isolation from thinking how resources can best be used to add value to the business;
- change management – organisational change is never pursued in isolation but will have a full business case based on the impact on value and cost drivers;
- brand valuation – the positive and negative effect of investing in or damaging the brand on future cashflows is estimated;
- managing intangibles – besides brands, other major areas of investment where the economic benefits are not obviously measurable are still subjected to some sort of broader-brush economic assessment which is founded on empirical analysis, such as learning and development, culture change, and so on;
- management processes – ruthlessly weeded out by focusing on whether the processes really add economic value or not;
- managing acquisitions – these very frequently end up destroying shareholder value for a number of reasons, such as inadequate financial valuation of pre- and post-acquisition strategies, the deal-making process, or during the often distracting and damaging process of integration;
- performance management – it is imperative that with value-based management the performance of senior managers is recognised and rewarded based on economic measures as well as, or instead of, short-term accounting profit.
Four stories to illustrate the above points
Story 1: When BP once went through a profound exercise to shift its culture from hierarchical to empowered, some of the key players in the culture change team asked me to see if we could put an economic value on the culture change after the event. After getting an enormous headache over a period of three days in trying to prove general efficiencies, I suggested taking a different tack. We drew up a list of key business breakthroughs that would almost certainly never have happened without the culture-change project. These alone were worth around £500m (critical incident analysis). Subsequently BP went on – with much thanks to this programme – to become the world’s second-biggest oil company; the longer-term ‘emergent value’ from this ranking is in the billions.
Story 2: Diageo, the global drinks business that purveys Guinness, Smirnoff, Malibu and many other spirit brands, also adopted value-based management as its core management process. Coincidentally I sowed the seed of the idea in 1990 when I piloted the concept through my PhD research with some very senior finance people in the company who went on to become the change catalysts for value-based management there later in the decade. Around 2005 I worked with Diageo again to introduce the strategic option grid (see my earlier strategy series).
During that second encounter, the director of global supply strategy was asked to go to South Africa in case the main board needed his input on some matters. He was very uncomfortable about this as he didn’t feel that it was likely to add value. Translating it into EVA language, he went back to the board and said he had really big concerns about whether it would really add value and that it was going to cost well over £6,000 with the travel and three days of his time.
As a countersuggestion, he offered to attend by teleconference on a standby basis. When the appointed time came he just sat and watched the phone for a while – unsurprisingly, it never rang. This story highlights the very practical and everyday advantages of using the concept of EVA via value-based management and also how well it links with the strategic option grid.
Story 3: Last month’s article covered the business case for coin-locked trolleys, which break even just by reducing damage and loss; when other benefits are factored in, the economic value over cost ratios are so great that investing in them is a no-brainer.
Story 4: Applying similar principles to the economic value of learning and development in the very challenging environment of policing showed that the ratio of value to cost was over 10 for advanced interviewing techniques (such as in a murder investigation – the average murder costs £1m to investigate – and for personal arrest training). These studies were with West Midlands Police. I am hoping to work on valuing countermeasures to urban riots next!
An engine for EVA
Value-based management is the process for turning EVA into a practical reality. Fundamentally once you have got over the hurdle of understanding the technicalities of the cost of capital and discounting, it’s all downhill. The really interesting side to this is exploring the value and cost drivers, not only to understand how EVA has been created in the past, but how it might be in the future and in new ways.
We have seen in this series diverse examples from Virgin Galactic, Tesco, Manchester United, Kellogg’s, Rolls-Royce aero engines, supermarket trolleys, BP, Diageo and the police to give a flavour of what can be done.
Dr Tony Grundy is an independent consultant and trainer, and lectures at Henley Business School