Relevant to ACCA Qualification Paper P4
The principal objective of financial management is to maximise shareholder wealth. This raises two key questions – how can we measure whether shareholder value is being created or destroyed, and which performance appraisal targets ensure that managers act in such a way as to generate shareholder value?
We therefore require a wealth metric for measuring shareholder value, and a performance metric to use for target setting. This article outlines the requirements for a system of metrics and then reviews some of the current contenders, including net present value (NPV), shareholder value analysis (SVA), economic value added (EVA), and cash flow return on investment (CFROI).
REQUIREMENTS
Traditional approaches to measuring managerial performance, such as profit and return on investment (ROI), have the significant disadvantage that they correlate poorly with shareholder value. As a result, managers could unwittingly destroy shareholder value while attempting to improve divisional performance. Attempts to develop more useful metrics have focused on incorporating three key issues:
APPROACH 1: DISCOUNTED CASH FLOWS (DCF) AND NET PRESENT VALUE (NPV)
Most students will be familiar with the NPV approach to project appraisal. This method involves the following steps:
The main advantage of this approach is the high correlation between NPV and shareholder value. Theoretically, undertaking a project with a positive NPV of, say, $1m will increase the market value of the company concerned (and hence shareholder wealth) by $1m. Given that the main objective of financial management is to maximise shareholder wealth, managers have, in NPV, a powerful technique for evaluating projects.
What is lacking, however, is an operating performance measure for managers that will help them to maximise NPV. Some firms attempt to use cash flow targets but with mixed success. Depressingly, many more firms set targets based on traditional measures, such as profit and ROI, without resolving the inconsistency of using NPV for project appraisal and then ignoring it when appraising managers.
APPROACH 2: SHAREHOLDER VALUE ANALYSIS (SVA)
The SVA approach, described by Alfred Rappaport, is a variation of the DCF methodology in that it values the whole enterprise, not just individual projects. Central to the approach are seven ‘value drivers’:
The SVA method involves the following steps:
EXAMPLE 1
You have been asked to value a potential acquisition. The following information regarding the target is available:
Value the business using SVA.
Note: IFCI and IWCI are given as percentages of the movement in sales from one period to the next.
(W) DF = 0.519 x 1/0.14 = 3.707
Note: without further details, RFCI is often equated to the annual depreciation charge.
Being, in essence, an NPV approach, SVA satisfies our requirements for a long-term value metric. It is thus widely used both by managers, and by potential investors seeking to discover undervalued companies. The seven value drivers can also be used for target setting and for assessing managerial performance in the shorter term. Managers are comfortable with concepts such as sales growth and margin, making the approach popular. The main problem, however, is that there are seven targets, not one, and these may be in conflict. For example, high growth may involve riskier strategies, which in turn will increase the cost of capital and require greater working capital investment.
APPROACH 3: ECONOMIC VALUE ADDED (EVA)
The economic value added (EVA) approach is primarily a performance metric rather than a wealth metric. Stern Stewart & Co, the management consultancy that has trademarked EVA and is credited with popularising the concept, describes EVA as ‘a simple financial measure of performance’.
EVA is the residual income that remains after net operating profit after tax (NOPAT) has been reduced by an additional charge; this charge is based on the return investors can be expected to require, given the amount of capital they have tied up in the business. Note that interest charges are not deducted to arrive at NOPAT, as financing costs are incorporated into the capital charge. Therefore we have:
EVA = NOPAT minus a capital charge
= NOPAT minus (capital x cost of capital)
It is therefore very clear if profits are sufficient to cover the cost of capital. This link can be made more explicit by rewriting EVA, using the ‘spread method’ as:
EVA = (ROI - cost of capital) x capital, where ROI = NOPAT/capital
EXAMPLE 2
Using the same information as in Example 1, calculate the EVA for each year.
Solution
In this example, a more complex calculation must be made to obtain the capital figure as depreciation must be deducted from the running total, and any further investment (IWCI, RFCI, IFCI) added:
Note: cost of capital has been calculated using the capital b/f figures.
Making the full cost of capital so visible to managers should result in their being more careful when choosing to invest further funds, and exercising greater control over working capital investment.
Proponents of EVA argue that it also supports the NPV approach to investment appraisal. To see this, the present value of future EVA figures can be calculated, giving the market value added (MVA) to the business. To calculate the value of equity, this needs to be added to the opening capital and then adjustments made for non-trade assets and debt, as for SVA.
EXAMPLE 3
Using the EVA figures calculated in Example 2, calculate the market value of equity for the acquisition.
The result, often a surprise to students, demonstrates that MVA (and hence EVA) should give a strong correlation with shareholder value in the same way as NPV and SVA. Stern Stewart & Co argue that managers can be assessed on EVA with confidence that their actions should lead to wealth creation.
While the focus on a single performance measure is seen to be a major advantage by many, the complexity of the calculations has deterred some, who argue that it is hard for managers to see how their behaviour has affected the EVA .
The main problem with EVA, however, is the danger that managers with a short-term horizon will reject activities that have negative EVA in the first year, even though these activities will deliver positive MVA over the longer term. The adjustments to capital described below, such as capitalising research expenditure, should reduce such behaviour but cannot not eliminate it completely.
ISN’T EVA JUST RI REPACKAGED?
The EVA approach is very similar to the traditional method of calculating residual income (RI). The differences lie in how the component figures (NOPAT, capital, and cost of capital) are calculated. Stern Stewart & Co identified 164 performance measurement issues in its calculation of EVA from published accounts. The adjustments mainly involve:
The most common adjustments include:
APPROACH 4: CASH FLOW RETURN ON INVESTMENT (CFROI)
Cash flow return on investment (CFROI) is the product of Boston Consulting Group (BCG) and HOLT Value Associates.
CFROI is the long-term internal rate of return of the firm, defined in a similar way to the more familiar IRR. This method has the following steps:
BCG’s 1993 brochure mentions that the SVA approach was ‘developed especially for corporate planning and related applications’, in contrast to their model which was ‘designed as a tool to assist the institutional investor in picking stocks’.
The process of calculating corporate value in order to identify under-performing shares using CFROI is beyond the scope of both this article and the Paper P4 syllabus. In simple terms, this is done by calculating a countrywide CFROI figure and then using it to discount individual company cash flows. The main weakness lies in measuring managerial performance. Other criticisms include the following:
CONCLUSIONS
Shareholder value is a constant priority in many boardrooms. The need for a wealth metric and a performance metric has generated a range of solutions, but with mixed success. Ultimately, users choose the method best suited to their situation. CFROI is growing in use by potential investors, SVA is often chosen for corporate planning decisions, but EVA appears to offer the simplest and most consistent overall solution.
Steve Weaver is a freelance author