Financial leverage and corporate valuation
Introduction
Auditors are the troops who watch battle from the safety of a hillside and when the battle is over come down to count the dead and bayonet the wounded.
ANONYMOUS
Introduction
This chapter will integrate material from previous chapters into one single web supporting corporate value and it will show the relationships that exist between many of the ratios covered so far. Specifically it will:
- establish the financial leverage links between ROTA and ROE
- examine further the great importance of ROE
- tie together – operating efficiency measures
– leverage ratios
– valuation factors
so as to identify and quantify the drivers of corporate value.
To accomplish this we will make much use of the V chart (valuation chart).
Financial leverage
The term ‘financial engineering’ has become quite popular. It is used in relation to schemes that increase the return to the shareholders from a given return earned by the company.
The material that follows will give some appreciation of this.
The concept of leverage, or gearing, was looked at briefly in chapter 10. It was seen that high leverage could substantially increase the return to the shareholder. This chapter will explore further the impact of leverage and the specific elements that link ROTA and ROE.
We have seen in chapter 6, figure 6.3, that the US Consolidated Company Inc. showed the following values:
| 17.9% 27.6% |
Financial mechanisms have been used to transform a pretax return of 13.3 per cent from the total company into an after-tax return of 19.6 per cent to the shareholders. This is leverage in action. The financial variables that link these two values are laid out diagrammatically in figure 13.1, viz:
| debt to equity ratio | 1.5 times |
| average interest cost | 2.8% |
| tax rate | 32% |
Figure 13.1 The links between return on total assets and return on equity
In figure 13.2, the US Consolidated Company Inc. accounts are displayed together with a chart that shows in geometric form the relationships between all these elements. The chart is referred to as the V Chart (valuation chart). It integrates in one diagram the financial variables that determine a company’s valuation in the stockmarket.
V chart
Figure 13.2 shows the chart and the accounts of the US Consolidated Company Inc. from which it has been constructed. It looks formidable at first sight because there seem to be so many parts to it.
However, we will work carefully through it. There are approximately six separate steps. Each step is simple in itself. The result of the exercise will be total comprehension of quite a difficult subject. Once this is achieved the remaining material will be very easy to follow.
 | |
| Step 1 The chart is constructed on a base that represents the total funds in the business divided between total equity ($208.90) and total non-equity ($307.90). | |
| Step 2 Where equity and non-equity meet we draw to scale a vertical line representing ROTA (17.9 per cent). | |
| Step 3 At the extreme left of the base we place a vertical line representing the average cost of all non-equity funds (2.8 per cent). (The amount of ‘free’ funds in the balance sheet, e.g. accounts payable, accounts for this apparently low value.) | |
| Step 4 At the extreme right of the base we erect a vertical line to represent ROE (before tax). | |
| Step 5 We join the upper limit of the ‘Interest’ line (Step 3) to the upper limit of the ‘ROTA’ line (Step 2) and extend this diagonal to meet the ROE line (Step 4). | |
| Step 6 The point where these two lines meet represents ROE value (before tax). | |
For the US Consolidated Company Inc. the ROE (before tax) figure is 40.5 per cent. Corporation tax charged in the accounts averages 32 per cent. We deduct this amount to arrive at ROE (after tax) 27.6 per cent.
Figure 13.2 V chart for the US Consolidated Co. Inc.
V chart dynamics
To understand the dynamics of financial leverage, we can look on the upper diagonal of the chart as a cantilevered beam that is anchored at its left extremity to the ‘Interest’ vertical. It is pushed upwards by the ROTA piston.
The point of intersection with the ROE (before tax) line is determined by three factors:
- its ‘anchor’, i.e., average interest cost
- ROTA value
- the relative values for ‘equity’ and ‘non-equity’.
We can write this in an equation:
We can use either the chart or the formula to track a change in any of the input values to its effect on ROE (before tax). By allowing for tax, we can get to ROE (after tax).
Three examples are shown in figure 13.3.
We have identified and quantified the variables that link the ROTA to ROE. It only remains to link ROE to company value. When this is complete we will be able to trace a path from the shop-floor variables right through to stock-market value. This will be addressed in the next section.
Figure 13.3 Effects of changes in values on V chart
Market to book ratio
In figure 13.4, the accounts for the Example Co. plc are repeated together with data relating to the number of shares and their market price and the following ratios are calculated.
| Book/asset value per share | $11.25 |
| Market capitalization – company | $720 |
| Return on equity (ROE) | 16.6% |
| Earnings yield | 8.3% |
With the market/book ratio we express the relationship that exists between a company’s value on the stock exchange and the underlying asset/book value as shown in the balance sheet. This ratio can be calculated for the company in total or for one share in the company.
| The company: | |
|---|---|
| Market capitalization | $720 |
| OF – balance sheet | $360 |
| Market/book ratio ($720/$360) | 2 times |
| One share | |
|---|---|
| Share market price | $22.5 |
| Book/asset value | $11.25 |
| Market/book ratio ($22.5/$11.25) | 2 times |
However neither of these calculations identify the factors that drive the market/book ratio. For this we must look to a third set of relationships.
The ROE figure tells us the rate of return that the company is delivering to the shareholders. The earnings yield figure is the rate of return investors require to hold the share. The market/book ratio falls out of the relationship between these two:
| ROE | 16.6% |
| Earnings yield | 8.3% |
| Market/book ratio (16.6%/8.3%) | 2 times |
Figure 13.4 The importance of ROE in the market to book ratio
This concept is of crucial importance. It illustrates the fact that investors decide on the rate necessary for a particular business. Then they mark that business at a premium or a discount, depending on whether the return delivered by the business is greater or less than the required rate.
Importance of ROE
ROE drives company value. There are those who will dispute this statement. With good logic they will argue this is too simple an explanation because ROE is a short-term accounting measure. It does not take into account future growth prospects, etc. Nevertheless we can say that, other things being equal, the most important driver of value is ROE.
We have identified the drivers of ROE in the previous section. The most important are ROTA and the debt/equity ratio. The factors that drive ROTA are ‘margin’ and ‘turn’ (sales/total assets ratio) as we saw in chapter 7. Standing behind the ‘margin’ and ‘turn’ are all the operating ratios. So it is ROE that brings together all the operating and financing characteristics of the business.
We therfore can trace a path from the shop floor to stockmarket value.
However we need to examine a little more the factors that help the stockmarket decide on the earnings yield it will demand from a particular company.
Figure 13.5 lists the main influencing factors under the headings:
- Company
- Industry
- Economy.
Investors are buying the expected future returns of the company. If growth prospects are good this will promise high returns. However they trade off risk against return. For a high perceived risk they will look for a high return.
So they weigh up the prospects for:
- the economy overall
- the industrial sector
- the particular company.
The main items for consideration under each heading are shown in figure 13.5.
Figure 13.5 The importance of the return on equity ratio and earnings yield relationship
Corporate valuation model
In figure 13.6 we are now able to pull together the various sections of the overall corporate valuation model.
Section A repeats the operating performance model given in chapters 6 and 7.
Section B shows the financial gearing model given earlier in this chapter.
Section C brings in the stockmarket ratios covered in chapter 12.
This completes the chain that links shop floor value drivers to the stockmarket value. Figures from the US Consolidated Company Inc. accounts are used for the various nodes in the model. There is an arithmetical link between each node in the chain that produces the final corporate value of $1,876.5bn.
The total number of independent variables in the model that can be influenced by management can now be identified:
- the cost percentages in the profit and loss account:
– material
– labour
– overheads - the main asset groups in the balance sheet:
– fixed assets
– inventories
– accounts receivable - debt to equity ratio
- interest rate/free v paid borrowings
- tax rate.
Note: An increase in the debt/equity value has a double effect, it increases return on equity but it also increases risk and therefore normally results in a higher ‘earnings yield’ value. The increase in return on equity should increase corporate value but if debt/equity is pushed beyond a prudent level the resulting increase in the yield will actually reduce total value.
One can work back from a desired end result to determine what the value of any single input variable must be, if other inputs remain constant. For instance, if the management set a target of 21.5 per cent for ROE, they could work back to determine that the value of ROTA needed to deliver that is 14.4 per cent.
Figure 13.6 Overall corporate valuation model for the US Consolidated Co. Inc.
