Introduction

• Description
• Approach to valuation (1)
• Approach to valuation (2)
• Value for the equity shareholders
• Discount factor
• Terminal (continuing) value
• Complete model

Capital, in the sense of capital value, is simply future income discounted or, in other words, capitalised.

IRVING FISHER (1867–1947)

Introduction

In chapter 12 we looked at various stockmarket ratios and traditional approaches to the measurement of corporate performance and value. These have been in use for many years, they are still widely used and they have served the business community well. However many practitioners have now come to the conclusion that something more is needed.

Global competition, worldwide recession, and complex financial instruments have shown up weaknesses in these traditional approaches. This has given rise to a search for more precise instruments of assessment. The search has not been in vain, and there are now exciting new developments in this area.

The most robust of these new techniques is that most commonly known as ‘shareholder value added’ (SVA)*, but the terms ‘economic value added’ (EVA), and ‘market value added’ (MVA) are also used.

These systems all have the same underlying approach. They adopt an economic rather than an accounting stance, and they look to the future rather than the past.

One of the problems with the purely accounting approach is that it relies largely on values that are historic. Furthermore these values are derived from accounting statements that are produced according to various accounting conventions. Often these conventions are more useful for auditing purposes rather than for performance assessment or valuation.

There are other issues that traditional approaches do not address explicitly such as risk measurement and future capital investment. There is no doubt that SVA methods provide a more comprehensive and philosophically sound basis for managerial decisions than those used in the past.

Description

The economic viewpoint is that value is determined by future cash flows rather than historic profit or balance sheet calculations. Cash is invested today in order to get a surplus back in the future. This future cash flow must fully repay the initial investment and also cover the cost of the funds over the period of investment. This cash flow technique has been used for many years in the assessment of capital projects (see chapter 16).

Let us say that we are faced with a capital project decision on whether we should spend $1m on a particular piece of equipment. We estimate future revenues and costs over the life of the equipment. We convert these into the extra cash in-flow that the equipment will produce. We combine that in-flow with other cash movements arising from working capital etc. Then we discount the total cash flow back to a net present value (NPV). We use that figure to assess the financial value of the investment.

The shareholder value approach is to use the same technique to assess the value of a company’s operations either in whole or in part.

However in regard to a company special considerations apply:

1. The returns from a company cannot be so neatly packaged as those from a single piece of equipment. In a company there will be many different operations each giving rise to a separate cash flow.
2. With a single piece of equipment there is usually a very definite and limited life span, but not so with a company.
3. In straightforward project appraisal, a very pragmatic approach to the selection of a discount factor is common. But what discount factor should be applied to the cash flows of a company overall? This is a very important consideration because the factor chosen will have a major bearing on the assessment.
4. Companies can be funded in many different ways. Various mixtures of equity and loan capital are used. How can these differences be accommodated?

It is these issues that will be explored in the following pages. We will use the SVA Sample Company Inc. shown in figure 17.1 to illustrate the discussion.

Figure 17.1 SVA Sample Company Inc.

Operating assets

Our first exercise is to re-arrange the balance sheet to separate out the net operating assets i.e. those assets that are fundamental to the operation of the business. Figure 17.2 illustrates this.

There may be assets in the balance sheet that are not essential to the existing operations, e.g. surplus cash holdings. This matter will be dealt with later.

There are three separate components:

1 Fixed assets	$2,500
2 Current assets	$7,500
3 Current liabilities *	$3,250

‘Current assets’ and ‘current liabilities’ are netted off to yield a figure for ‘net working capital’ (NWC) of $4,250. Accordingly, the net operating assets are:

1 Fixed assets	$2,500
2 Net working capital	$4,250

The funds in the balance sheet that match these operating assets we refer to as ‘invested capital’ (IC).

For this exercise we will assume that all of the items included in operating assets will respond spontaneously to changes in sales volume.

This assumption is reasonable for items in the ‘net working capital’ category. There is a direct linear relationship between ‘Accounts receivable’ and the level of sales. So also with inventory, even though the link is not so close. The same may be said of ‘Accounts payable’ on the liabilities’ side of the balance sheet. These are the three principal items in the NWC category.

In the case of ‘Cash’ we distinguish between the basic amount required for operating requirements and surpluses held for other purposes. This basic operating amount is a very small percentage of total assets and it can be loosely linked to volume of activity.

For a comment on the relationship between ‘fixed assets’ and sales see the following section.

Figure 17.2 Identify operating assets/funds

Approach to valuation (1)

Having identified the net operating assets, we will set about estimating the value of this company as determined by its expected future cash flows and the discount factor to be applied to these.

We will illustrate this for our example company using some very simple assumptions, such as a constant growth in sales of 10 per cent.

There will be two main components to the cash flow:

1. Operating profits after tax
2. Cash flows arising from movements in assets.

The first of these is normally positive (cash in-flow) and the second negative (cash out-flow). We have seen in chapter 14 that an increase in assets gives rise to a cash out-flow. If assets are currently fully utilized, the extra volume of sales will probably require extra assets in support.

We must make some assumptions about the future operations. These are:

1 Growth in future sales	10 per cent p.a.
2 Period of forecast	four years
3 Margin on sales	8 per cent
4 Tax rate	25 per cent
5 Fixed assets required	Linear to sales
6 Net working capital required	Linear to sales

Figure 17.3 shows expected sales, fixed assets and net working capital amounts forecast for the next four years on an assumed growth rate of 10 per cent.

Note: We have suggested that there is strong justification for assuming a linear relationship between ‘net working capital’ and sales. But it is not realistic to assume that fixed assets will move exactly in line with sales in any one year. However, over longer periods this assumption may hold true. We are using a simplified example here. In a practical application much thought would be given to assessing fixed asset and working capital requirements.

Figure 17.3 SVA Sample Company Inc. forecast sales, fixed assets and net working capital

Approach to valuation (2)

Figure 17.4 shows cash flow forecasts for the SVA Sample Company Inc. We take each of the three items forecast in the previous section and derive its corresponding cash flow:

Section A: Cash flow forecasts

A.1	Sales with growth rate of 10 per cent per annum.
A.2	We apply the sales margin percentage (8 per cent) to derive operating profit.
A.3	Tax is calculated at 25 per cent and deducted.
A.4	Net operating profit after tax (NOPAT). This is the figure we take for the positive operating cash flows per annum that arise from trading.

Section B: Fixed assets

B.2	The negative cash flow reflects the increase in value in FA each year.

Section C: Net working capital

C.2	The negative cash flow reflects the increase in value of NWC each year.

Section D: Overall cash flow

D.1	Cash flows from A, B, and C above are netted off to give values for expected net cash flows for each of the next four years.

Depreciation and cash flow

Figure 17.4 Cash flow forecasts

However in our simple illustration, we ignore this adjustment both in the income statement and again when we come to look at investment in fixed assets. In the latter case by taking only the net increase we ignore the investment required to maintain a constant level of assets. This could be equated to the depreciation charge. Consequently these two items cancel out.

Tax: We have charged tax at the full rate on operating profit. Would this not be shielded by our interest charge which would be deducted prior to the tax charge? The reason for the treatment used here is that the question of funding is ignored. We can say that for the moment we are assuming that funding is entirely from equity.

Total present value

In figure 17.5 we perform three exercises:

• We adopt a discount rate of 9.64 per cent
• We discount the four-year cash flow back to period zero
• We decide on a ‘terminal value’ at year 4 and discount it back.

The present value of the first four years of operation amounts to $550.

Terminal value

This is perhaps the most important number in the whole equation.

There are many approaches and formulae used to estimate it, but in this simple illustration we will assume that the company will have a market value equal to ten times its ‘net operating profit after tax’ (NOPAT):

Figure 17.5 Calculating present value

This is the amount we could sell the company for at the end of year 4. We can therefore treat this figure as if it were a cash in-flow in that year. We apply our discount rate of 9.64 per cent to give a present value of $7,598, but see figure 17.13 for the revised method.

The total present value for the company can now be stated as follows:

First four years	$550
Indefinite period beyond four years	$7,598
Total	$8,148

This sum of $8,148 is the value we have arrived at for the ‘operating business’. In due course we will translate this amount into a value for the equity shareholders (see figure 17.7, later).

Interpretation of present value

The illustration so far has shown how we can put a value on a company’s operations by considering a small number of value drivers:

1. Sales growth
2. Margin percentage
3. Tax percentage on profits
4. New fixed asset investment
5. New working capital investment
6. The discount factor.

Note that neither the existing assets employed nor the corresponding investment by the shareholders and others have entered into the calculation. Value lies solely in the future profitability of planned operations, the tax position, and the investment that will be required to support these operations.

While we do not utilize any balance sheet figures in our calculation of value, we are very interested in the relationship that exists between our calculated value and the underlying investment in the business.

If our newly determined value is greater than the investment shown in the balance sheet, then value has been created. In other words, the business today, valued in terms of its future prospects, has more than justified the investment that has gone into creating that business. If the result is less, then value has been destroyed.

Figure 17.6 shows the results of this comparison for the Sample Company.

• The operating assets and the corresponding funds are	$6,750
• The value derived for the operations is	$8,148
• There is a surplus of (value added)	$1,398

Figure 17.6 Comparison of present value of operations with balance sheet values

This surplus is a measure of management’s performance. It is a quantification of the planning, decision-making, and operating skills they have employed to bring the present business into being.

We can see what a powerful tool we have not only for decision-making, but for assessing and rewarding managerial performance.

Value for the equity shareholders

The calculated value of $8,148 relates to the operating business. We must now translate this into a value for the equity shareholders.

Two adjustments are required:

1. Non-operating assets

There may be assets in the balance sheet that are not essential to the existing business. The most obvious case is where a company, for one reason or another, holds a large cash balance. It may be that the company is planning future acquisitions.

The value of such assets must be added to that of the operations to arrive at the company value.

2. Non-equity funds

The equity shareholder stands at the end of the queue of those who provide funds to a business. The claims of those who provide loan and preference share capital have precedence.

All such prior claims must be deducted from the company value to arrive at the value for the equity shareholders.

SVA Sample Company

In figure 17.7 these calculations have been performed for the Sample Company. Note that:

• there are no non-operating assets in this case
• the total non-equity funds amount to $2,544
• the resulting equity value is $5,604.

The equity investment in the balance sheet amounts to $4,206, so the surplus is again $1,398. The total amount of the value added as a result of good management has accrued to the equity shareholders. Hence the term ‘SVA’ (shareholder value added) that is given to this technique.

Figure 17.7 Value of equity

We use the technique not only to calculate a value for a particular operating business, but also to compare and decide between alternative strategies for a particular operation. Furthermore its particular strength may not even be to look at an overall business, but rather to identify which of its component parts are adding value and which are destroying value.

In arriving at a value for the company we have skirted around some very important matters:

• The appropriate discount factor to be applied to the cash flows.
• The terminal value of the business, i.e., its continuing value at the end of the forecast period.

Discount factor

All the funds used to support the business have a cost. This cost is obvious in the case of loan funds. They carry a precise (but maybe varying) interest rate and their cost has always been charged against the profits of an operation.

In the case of common stock (equity) the cost is just as real but it has not always been so obvious. Indeed it is one of the main criticisms of more traditional methods of assessment that this cost has not been made more explicit and charged against operations. In the SVA method of assessment the cost of equity is fully assessed and charged. The method employed is to use a discount factor based on the weighted average cost of capital.

Weighted average cost of capital (WACC)

Figure 17.8 shows the calculation.

• We identify each source of funds and its corresponding cost. Some costs, such as interest on loans, are tax deductible, other are not. We must therefore express all charges in constant after-tax terms. For instance if a loan carries a 10 per cent coupon and the tax rate is 25 per cent, the after-tax cost is 8 per cent.
• We calculate for each source of funds its weighting, i.e., its percentage of the total. For instance if total funds are $200 and we have a loan of $50, we apply a weighting of 25 per cent to that loan.
• We multiply the cost of each source by its weighting to obtain its weighted cost. The sum of all the weighted costs is WACC.

See important note (to figure 17.8) on the correct weights to use for calculating WACC.

Figure 17.8 Weighted average cost of capital

The cost of equity capital

The cost of loan capital is simply the after-tax interest cost. The cost of common equity is not so easy to establish. It is an issue that has exercised many eminent minds over a number of decades.

The problem is that the cost of equity is not based on a contract but on the expectations.

The assessment of expected return will be based on the investor’s view of the following benefits (see figure 17.9):

• The stream of annual dividends
• The growth in the share market price.

The degree of confidence will be a function of the perceived risk of the investment. The investor knows that risk is inherent in business. He/she does not like to take risks and he/she will have to be rewarded for doing so. The higher the perceived risk the greater the return he/she will require.

The investor has a wide range of opportunities for investment. These can be classified into low-risk investments yielding relatively low returns, e.g. government securities, and higher-risk investments that must offer the promise of higher returns. Equity shares fall into this latter category.

Because we are dealing with estimates that exist in the minds of thousands of investors it is very difficult to quantify these factors. All we can do is to observe behavior in the market-place and try to construct models to explain that behavior.

Figure 17.9 The cost of equity capital

The capital asset pricing model

Models of considerable complexity have been derived for the purpose of estimating the cost of equity capital for a specific company. The most durable of these is that known as ‘the capital asset pricing model’ (CAPM).

It is based on the premise that investors require a minimum rate of return even when no risk is involved, and this required rate increases as the apparent risk increases.

The input values required by the model are:

1. The risk-free rate
2. The average return to equity shares across the total market
3. A measure of the riskiness of the specific share (its beta value).

1. Risk-free rate: This is taken to be the rate available on government bonds. In section A of figure 17.10 we assume a rate of 8 per cent and we plot it on the left-hand vertical of the chart.
2. The average rate of return that has been achieved by the total equity market over a specific time period: The returns on a sample of shares representative of the total market is plotted over a time period that is considered normal, i.e., when values were not artifically high or low. In section B of figure 17.10 we assume this rate to be 12.5 per cent. We assign it a risk coefficient of 1.0 and we plot it midway along the horizontal axis.
   The Market Premium is simply the value in (2) above less the value in (1) above, i.e., 4.5 per cent. (See section C of figure 17.10.)
3. Beta value: A measure of the specific firm’s risk profile compared to that of the total equity market. It measures the degree to which returns on the specific share have moved in unison with the overall market. Its normal range is from 0.5 (low risk) to 1.5 (high risk), with the value 1.0 indicating that its risk profile is identical to that of the total market. For our example we have chosen a high-risk value of 1.25.

These four values are used to derive an appropriate cost of equity for a specific company. See section D of figure 17.10. The formula is:

Cost of equity (company k) = Risk-free rate + [Market premium × beta-k] 13.6% = 8% + [4.5% × 1.25]

It is not the purpose of this book to go into further detail of this complex subject.

Figure 17.10 Capital asset pricing model

How added value is created

The cost of equity as calculated above is, as we have seen, combined with the cost of non-equity funds to give an overall weighted cost of capital. This WACC figure is of crucial importance. It represents the long-term hurdle rate that a company must exceed for sustainable achievement.

We will here introduce the term ROIC (return on invested capital). (For a full description refer to appendix 1.)

This is another means of measuring performance that is similiar to ROTA. We use a new measure here because we must adopt a definition of assets that corresponds to the funds base used for calculating the cost of capital.

If we were to look at a company that had a WACC of 10 per cent and an ROIC of 12 per cent we would know that value is being created. This excess value should be reflected in the company’s market capitalization.

With a zero growth expectation we could expect to see the market value of the company at 20 per cent above its book value. However if we add growth to the equation this value increases rapidly (see figure 17.11).

The reason for the upward curve is as follows. Where there is zero growth, earnings are constant and each year they can be paid out in full. So the return is similiar to that of a high-yielding fixed interest bond. The price of such a bond is determined by its return relative to its required yield. There is a premium of 20 per cent in this situation.

However where some of the earnings are not paid out but in order to achieve growth are re-invested at the premium rate the effect on value is compounded. The funds that are re-invested earn a higher rate of return than they would if they had been paid out. The higher the rate of retention and re-investment the greater will be the effect on value.

But all this assumes that the company can re-invest at the premium ROIC. For these conditions to apply, the company must have a strong strategic position in a high-growth market.

Figure 17.11 How value is affected when return on invested capital (ROIC) is greater than weighted average cost of capital (WACC)

Alternative growth/value scenarios

In figure 17.12 three scenarios are depicted.

In section A the chart, repeated from figure 17.11, shows the interaction of growth with a high rate of return. We can see that the really successful company is one of high growth and an ROIC in excess of WACC.

A relatively small number of companies occupy this position for more than a short period of time. Such companies attract strong competition which almost invariably erodes their competitive advantage. There are economic laws that tend to push companies into a position where ROIC almost exactly equals WACC.

In section B we see the dramatic negative impact that growth has on the value of low profit companies. There are not many companies that persist with overall high growth and with low profitability, but within individual companies there are nearly always divisions, business units or single products that have these characteristics. They reduce the value of the total company. Very often this factor is not easily seen from the figures presented to management. The real worth of shareholder value analysis lies in the light that it throws on these situations.

In section C we have a situation where ROIC is exactly equal to WACC. Here growth has no effect on value. Intuitively it can be difficult to accept this concept.

The reason for this phenomenon is that growth almost always requires extra investment. The funds for this extra investment will have to be paid for at the WACC rate. Extra profits will be earned at the ROIC rate. Where these are exactly equal, they cancel one another out. Therefore no extra benefit accrues to the existing shareholders. Growth has not added value.

In economics we are taught that extra increments of investment will continue to be made so long as the extra returns exceed the extra costs, but the return will be less with each increment. Equilibrium is reached only when the extra returns and costs are equal. We will use this concept to put a value on a company at a specific future time.

Figure 17.12 Alternative scenarios: creating and destroying value

Terminal (continuing) value

The second important issue we did not fully deal with is the question of terminal value. We simply assumed this to be ten times the amount of profit in the final year.

We need a more soundly based approach than this. We will use the ROIC – WACC relationship to direct us towards a logical solution.

Management’s objective is to implement strategies that will give their company a competitive advantage that will allow it to earn a return greater than WACC. Where they achieve this premium return they add value for the shareholders.

However this premium return will inevitably attract competition that will whittle away its advantage over time. Without some competitive advantage a company will not continue to earn premium profits, so its ROIC will fall back to the level of WACC. Of course, good management will continuously seek to put in place new strategies that will restore the advantage.

In shareholder value analysis we assess the number of years forward for which current strategies will continue to add value. At the end of that ‘horizon period’ there will be equality between ROIC and WACC. Further growth beyond that date will not add value. We make this the point where we assess the continuing or terminal value of the company.

To calculate the terminal value we simply take the cash flow in that final year and assess it as we would value an annuity. That is we divide the cash flow by the cost of capital. When we use this more logically sound approach in our example we produce a value somewhat in excess of the earlier shortcut approach. See figure 17.13.

See appendix 1 for futher discussion of terminal value calculations.

Figure 17.13 Calculating terminal value

Complete model

Therefore, to carry out a full total value appraisal on a company, it is necessary to:

• Decide on the ‘horizon period’, i.e., the number of years for which current strategies will continue to add value to the company. In practice this number tends to be between six and ten years.
• For each of these years forecast operating and investment cash flows in detail. Discount each year back to the present using a discount factor based on WACC.
• Capitalize the final year’s cash flow using the long-term cost of capital. This gives the terminal value at the end of the horizon period. Discount this value back to the present again using WACC.

Figure 17.14 shows the complete calculation for the SVA Sample Company.

Figure 17.14 SVA Sample Company Inc. total appraisal

* Dr Alfred Rappaport (author of Creating Shareholder Value) is one of the founders of the movement and the ideas in this chapter owe much to his initiatives.

* Observant readers will have noted that there are no short-term loans included in current liabilities. These loans are treated as part of the funding of the business for reasons to be seen shortly.