Senior management’s most important job is to maximise shareholder value. This quest for value directs scarce resources to their most promising uses and most productive users, benefiting society at large. The more effectively resources can be deployed and managed, the more robust economic growth and the rate of improvement in society’s standard of living will be.
All business ventures must compete for and efficiently manage scarce capital resources to provide customer-valued products and services, thereby maximising the utility of their investment.
A performance measure called Economic Value Added, (“EVA” a registered term used by Stern Stewart) which also is known an Economic Profits (“EP”) has been developed to help managers operationalise their objective.
Modern corporate financial theory brings us three basic tenants that are the founding principles upon which the EP Financial Management System has been engineered:
· Management’s prime directive is to create shareholder value;
· Value is the net present value of discounted cash flow or EP;
· Performance is best measured by residual income, or EP.
Market Value Added (MVA)
To understand how EP drives the value of a company, we must first define the basis for considering the value of the company. An organisation’s market value added, or “MVA”, can be defined as its market value premium over its Operating Capital Employed.
Market Value Added = Market Value - Operating Capital Employed
MVA is the best measure of performance because it focuses on the cumulative value added or lost (quality) on the capital invested (quantity). It is a focus on wealth in dollars rather than rate of return in percent and therefore recognizes all value adding investments even if they dilute the rate of value creation.
To illustrate, imagine you purchased a grocery store last year for $100,000. During the last twelve months you rearranged the layout of the store, improved the quality of service offered by staff and shifted toward a broader and more desirable range of stock. The performance improved and now you are offered $150,000 to sell the store. Your MVA would be $150,000 (market value) less $100,000 (capital), or $50,000. That is, through effectively running the store you have created $50,000 of wealth in the form of MVA.
For a publicly listed company, we calculate market value as the number of shares outstanding times the share price plus the book value of debt. The capital is effectively the book value of the investment in the business, debt and equity, adjusted for certain accounting distortions.
As a measure of total wealth created, MVA is the single most important objective of company managers. Although MVA is the best indicator of total wealth creation, it is not particularly useful for internal financial management. The day-to-day share price movements would lead to employees focusing on the newspaper rather than their business. In fact, without an intermediate tool, it is difficult for managers to see how their actions affect MVA. Lastly, MVA can only be definitively measured at the consolidated level and is unusable for the business units within the company.
When organisations earn a rate of return higher than their cost of capital, EP is positive. In response, investors bid up share prices, increasing the value of the business and therefore MVA. Similarly, investors discount the value of businesses that earn a return below their cost of capital. Thus, intuitively, EP drives MVA.
More precisely, MVA is an estimate by shareholders of the net present value of all current and expected future investments in the business. That is MVA is NPV (Net Present Value). But it goes a step further. MVA or NPV can be calculated as the present value of all future EP, just as it can be the present value of cash flow. This is important in that EP can be used to evaluate strategies and new investments as well as to track performance over time.
We can also use this relationship to understand the market’s expectations for the company. Since we know MVA and EP today, and MVA is just the present value of investor expectations for EP, we can definitively estimate the average rate of EP improvement the market expects from a company.
If the company delivers on these expectations, we would expect the share price with all else being equal to grow at the cost of equity capital less the rate of dividends. The focus for EP measurement must be on generating improvements that exceed these expectations.
Economic Profits (EP)
EP is a measure of a firm’s true economic profit after subtracting the cost of all capital employed. EP is the one measure that properly accounts for all of the complex trade-offs involved in creating value. In addition, it is very easy to calculate. We take the spread between the rate of return on capital and the cost of that capital. This spread indicates the quality or efficiency with which we utilise our capital. Next, we multiply this spread by the quantity of economic capital used in the business:
Economic Profits = (Return on Capital - Cost of Capital) x Operating Capital Employed
Thus EP is the internal measure that best captures the quality and quantity of our capital utilisation. For example, assume we earn a 15% rate of return on our capital, our cost of capital is 10% and we have $1000 of capital. EP is simply $50.
$50 = (15% - 10%) x $1000
However, this definition of EP can be confusing for people who are not familiar with working in percentages, so EP can alternatively be thought of by multiplying through by capital on the right hand side of this equation:
Economic Profit = NOPAT - Capital Charge
Where NOPAT = Net Operating Profit After Taxes
Capital Charge = Cost of Capital x Economic Capital
Therefore EP can be expressed completely as:
Economic Profit = NOPAT - (Cost of Capital x Operating Capital Employed)
Operating Capital Employed is represented by “net assets” after adding back all debt and making certain adjustment discussed later in this document.
Although both of the equations are mathematically equivalent, it will be best understood by non-financial managers. EP is a residual income measure, or operating profits less a charge for the use of capital. With EP as a performance measure a company is, in effect, charged by its debt and equity investors for the use of capital through a line of credit that bears interest at a rate of the weighted average cost of capital. EP is the difference between the profits an organisation derives from its operations and the charge for economic capital used in its operations.
Again, to use our example, we earn $150 of NOPAT, our cost of capital is 10% and we have $1000 of capital. EP is again simply $50.
$50 = $150 - (10% x $1000)
Thus, the capital charge is just like any other cost that can be traded off in planning for improvements in performance. In fact, EP can even be improved by reducing as the capital charge declines more. This is the case when companies create value through downsizing or divestiture. Although growth is important to future value creation, some divisions can create the most value through downsizing and increasing focus.
EP allows the right blend of revenue, cost and capital to combine to achieve the best EP result in each business. EP doesn’t dictate the means, it just measures the end.
EP is perfectly consistent with modern corporate financial theory in that the present value of EP and free cash flow are equivalent. Many organisations use EP to establish clear, accountable links between strategic thinking, capital planning, daily operating decisions, performance measurement, and shareholder value.
The power of an EP financial management system is reinforced by its commonality across management processes. EP can readily be used for operating and capital budgets, acquisitions and divestitures, performance measurement and bench marking, and incentive compensation.
Figure 1: EVA or EP Drives MVA
Although EVA is a historical measure and markets are forward looking, generically calculated EVA explains approximately 50 percent of MVA. This represents an explanatory power that is nearly three times as effective as earnings per share growth, twice as good as cash flow growth, and one-and-a-half times as effective as return on equity. By definition, EVA is therefore the best internal measure of performance.
EP and Value
Discounted EP and discounted free cash flow are mathematical equivalents. A benefit of discounting EP versus free cash flow is the additional insight EP provides as a period to period measure. EP also imposes an added accountability for capital over the entire economic life of the investment, unlike free cash flow which only enforces capital discipline and accountability at the initial justification/approval of a capital expenditure.
Further benefit is derived from the power of commonality and focus in using EP as the single financial measure for budgeting, capital planning, performance evaluation and incentive compensation.
From the definition of MVA, the value of a firm can be expressed as:
Market Value = Capital + Market Value Added
However, MVA is the present value of all future EPs. Therefore, the value of an organisation can alternatively be expressed as the sum of its capital, current EP capitalised as perpetuity, and the present value of all expected future EP improvement:
Market Value = Capital + Value of Current EP as a Perpetuity +
Value of Expected EP Improvement
Because market value is dependent on market expectations of all future performance, market values are sensitive to changes in current EP as well as expected EP improvement. This leads to an interesting dilemma for management. How much effort should go into generating current results and how much should we devote to our investments in future prospects?
The answer is tough to resolve but the indication is clear. Management must be driven to produce the best results possible today while being very willing to commit significant effort and resources to future initiatives. It’s not a question of the short term or the long term, it should be the short term and the long term.
Managing EP
Although there are countless individual activities people can pursue to create value, ultimately they all fall into one of four categories measured by an increase in EP. EP will increase through operating directives such as enhancing operating efficiency, investing in value-creating projects and/or harvesting capital from uneconomic activities. EP will also increase through the financing directive of minimizing the cost of capital. To be more specific, EP can be increased by:
· Improving operating profits without tying up more capital in the business. This might be achieved through differentiated products and services that allow increased prices and volume, process initiatives to increase productivity and reduced costs, a greater attention to quality and service, and perhaps most importantly delivering customer satisfaction. As long as no new capital is invested, increases in profits flow directly through to EP.
· Investing capital where increased profits will more than cover the charge for additional capital. Investments in working capital, new equipment, facilities, research and development or marketing may be required to increase sales, develop new products and service new markets/customers. An investment in severance may be required to consolidate facilities or to improve operating efficiencies. As long as these investments generate a higher return than the cost of capital, EP will increase.
· Rationalising, liquidating, or curtailing investments in operations that can not generate returns greater than the cost of capital. This might be through divestitures, not renewing leases or withdrawing from unprofitable markets. As long as the proceeds after-tax are greater than the value of continuing the activity, EP will increase.
· Minimize the weighted average cost of capital. The cost of capital is primarily determined by the risks, both perceived and real, of the company’s operations. Strengthening the company’s competitive position and choice of industries in which it participates can reduce these risks. In addition, management can reduce its cost of capital through the prudent use of tax-deductible debt in the capital structure.
EP Financial Management System
A financial management system is the framework that defines the measures, incentives, tools and controls that support decision making. While a financial management system does not in itself create value, many financial management systems are quite adept at discouraging value creation. The EP Financial Management System has three major goals:
· Provide for and reinforce internal governance;
· Streamline, decentralize and focus the business;
· Make managers think and act like owners.
Typically, companies use a variety of conflicting measures such as earnings growth, earnings per share, return on equity, market share, gross and net margin, contribution dollars, cash flow, NPV and internal rate of return. Because these measures are not as closely correlated to MVA as is EP, they are much more likely to lead to decision-making which is incongruent with shareholder value and in conflict with each other.
Figure 2: EP and the Management System
The EP Financial Management System supports and motivates value-based decision-making for day-to-day operating decisions, budgeting and capital planning, and strategic initiatives. By using EP for all of these processes, as well as performance measurement and incentives, this will focus managers on the single goal of creating value.
EP Reporting
EP provides the proper balance between the pursuit of profitability and the costs of employing capital. EP is readily understood by operating managers. Frequent EP reporting provides timely feedback to positively influence organizational behavior and accommodate value-based decision making.
Eva reports should include a summary of the NOPAT and Operating Capital Employed as well as EP itself.
Definition of EP
In order to calculate EP, three essential elements, Net Operating Profit after Taxes (NOPAT), Operating Capital Employed, and the cost of capital, is needed.
Fundamentally, the calculation involves transforming the accounting financial statements to an economic basis for internal performance measurement.
In defining a measurement basis for EP, four broad categories of potential measurement distortions have been evaluated including Cash to Economic Basis, Accrual to Cash Basis, Non-Recurring Events, and Non-Operating Items.
The Cash to Economic adjustments address the way accounting treats some costs as period expenses while EP views them as investments in the future. While accounting writes this spending off, EP capitalises it and amortises it over an estimate of its useful life. Some examples might include: Research & Development, Marketing and Advertising, and Strategic Investments.
The Accrual to Cash adjustments seek to emphasise actual cash events and not accounting-only events. For example, accruing for a bad debt has no direct economic implication, yet writing off a specific receivable does. Accordingly, economic capital includes bad debt allowances but is reduced as actual write-offs are incurred, while economic operating profits disregard bad debt accruals and include actual write-offs instead. Similar examples would include Inventory provisions, among others.
Non-recurring events, like restructurings and asset sales, distort period performance and are capitalised for EP purposes. As an example, selling an asset for a book value gain would show the asset reduced to zero on the balance sheet, and a profit taken in the period. The EP treatment removes the after-tax profit from the income statement and makes it a permanent reduction to economic capital. In this way, the cash value of the events is captured, but without profit peaks and valleys distorting the period to period results.
Non-operating items involve amounts in capital and operating profit which are not involved in the normal course of business and for which either unusual or strategic circumstances would make measurement on an EP basis undesirable. This adjustment is infrequently made, but an example is the excess cash being held on the balance sheet which has no foreseen purpose. While EP treatment would require a return be charged on continuing to hold the cash, technically we would have to charge a reduced rate to reflect the lower risk of this asset and we expect the income earned on cash to be reasonably close to this level in most years. As a result, the calculated EP would be considered not meaningful and confusing, so we remove the excess cash from economic capital while interest income on the cash will not be included in operating profit.