1. EF506 Corporate Treasury Management – Cian Twomey
1/12/10
Value-Based Management (VBM) &
Economic Value Added (EVA)

2. 1. VBM Explained
Aligning people, processes and systems to continuously increase shareholder value.
Focusing management decision making on key drivers of value
Difference between performance— historical — and valuation, which is always about the potential and the promise to keep increasing total return

3. Shareholder Value (SV)
SV part of a larger stakeholder management issue which includes managing relationships with customers, employees and suppliers as well are shareholders.
In financial terms, SV can be thought of as market capitalisation (current share price * number of shares outstanding)
Koller (moodle): 2 dimensions (exhibit #2): long-term view & managing capital.
 Multiyear DCF valuation handles both well.

4. Koller, exhibit 2

5. Value Creation & Destruction
Capital budgeting: objective of shareholder wealth maximisation & acceptance or otherwise of proposed projects.
Time value of money; required rate of return
Value creation (destruction) = + (-) NPV

6. VBM’s Approach VBM extends this analysis to entire firm:
Value creation: if returns on invested capital (ROIC) > cost of capital
Apply to past performance or future plans; particular product line or division etc.
More than a performance metric & decision-making tool
 strategy, processes, & and culture also affected
Koller: “A precise and unambiguous metric - value - upon which an entire organisation can be built.”

7. What about Strategic Objectives?
Managers may use proxies, e.g. low-cost production; market leadership etc.
May be a trade-off between SV and proxy goals.
E.g.: May over-invest in plant capacity, marketing etc.

8. Problems with Earnings-Based Management
May focus on earnings per share (eps) growth.
 Misleading measure of value creation.
Accounting figures can be manipulated, e.g. depreciation; goodwill; R&D
Ignores investment required to generate profits – example
Can  eps by, say,  dividends. If return on retained earnings < investors’ required return (e.g. CAPM-based)  share price  (ignoring time value of money
Could  eps by taking on riskier projects  should  discount rate. Crude eps figures do not adjust for risk; DCF measures do

9. Other Potential Problems?
Different accounting standards:
UK/Irish: ‘true and fair view’
US: conformity with GAAP
Move towards IAS
Size factors
Inflation: market vs. book values
Cash flows: survival; hedging motives
Accounting scandals: Enron/Andersen, WorldCom

10. How a Business Creates Value
Koller:
1. VBM provides decision-makers at all levels with the right information & incentives to make value-creating decisions.
What information is relevant?
How are incentives set?
2. Marriage between value creation mindset and processes & systems necessary to translate that mindset into action.
establishing a culture driven by value creation demands a wide-reaching organisational transformation
Alone, either is insufficient. Why?

11. Value Creation in Action
i) Know ultimate objective.
‘More than words’  translate mission statement into active management for SV
Koller: ‘Objectives should be tailored to the different levels within an organisation.’
ii) If, and when, other objectives (examples?) take priority.
Non-financial goals (innovation, employee welfare) may add value if they do not compromise a firm’s financial stability
iii) Understand the firm’s key value drivers, i.e. performance variables that actually create value for the firm.

12. Value Drivers
‘Any variable that affects the value of a company’ (Koller)
Recall: Value is created when investment produces a rate of return > required for risk class of that investment.
Using Value Drivers
Koller: Firm cannot act directly on value
 Acts instead on things it can influence: cost, capital investments, etc.
Prioritise & assign responsibility
Defined at a level of detail consistent with decision-maker’s level of responsibility.
e.g. Sales growth levels not influenced by 1 line manager
At all levels, good growth  positive performance spread  affect decision to expand or not

13. 3 levels i) Generic (Firm-level) 3 categories (growth; return; risk)
Long-term value creation depends on ability to create sustainable competitive advantage; maintain barriers to entry
ii) Strategic Business Unit (SBU):
Allocate capital to SBUs according to how well each is creating value.
Factors include productivity & customer mix.
iii) Operational (‘Grass roots level’)
Particular managers have responsibilities for revenue, cost, and capital items.
Drivers are precisely defined & tied to specific decisions

14. Koller, exhibit #3:

15. Koller – Key Value Drivers
Based on company’s free cash flow and key value drivers
Value of a business = sum of the value of assets in place and the value of growth opportunities (link to real options) – diagram in class…
Value of assets in place is determined by the level of net operating profit less adjusted taxes (NOPAT) as well as WACC
Value of growth opportunities determined by key value drivers of ROIC, amount of net new investment, the period of competitive advantage, the investment rate and WACC.
Period of competitive advantage (CAP) shows the length of time over which the expected ROIC will > company’s WACC (shows the sustainability of return)

16. Sources of Competitive Advantage
Corporate strategy: creating & exploiting imperfections in product and factor markets
 Generate economic rents, i.e. excess returns leading to +ve NPVs
Competition & Economic Rents
Competitive market: actual return = required return  no +ve NPV projects
New projects must have competitive advantages that are difficult to replicate: low cost or value-added.

17. Barriers to Entry & Positive NPVs
Successful investments: ‘creating, preserving, and even enhancing competitive advantages that serve as barriers to entry.’
Time & cost constraints: useful to identify projects with the potential for +ve NPV
5 sources of barriers to entry:
 Investments that exploit the following 5 sources are more likely to generate +ve NPVs…

18. 5 Sources a. Economies of scale:
1 large plant may be superior to 3 smaller ones
b. Product differentiation:
Focus on investments in R&D, advertising, quality control
c. Cost advantages
Monopoly control of low-cost materials; locations (McDonalds)

19. 5 Sources d. Access to distribution channels
Shelf space in supermarkets; Dell (direct sales)
Foreign venture capital projects: no current NPV gain; goal = access for future investments
e. Government policy
Invest in projects protected from competition by government regulation
Barriers to entry generally eroded  investment strategy must evolve  seek out new opportunities and fend off new rivals (e.g. Xerox)
Institutionalise strategy of cost  and/or product differentiation.

20. Identifying Value Drivers
Existing reporting systems should be linked to valuation process.
Cannot consider value drivers in isolation.
Note: Value drivers for 2 types of firms:
Telecoms company (Koller, exhibit 4)
Hard goods retailer (Koller, exhibit 5)
Note: Can compare market-derived estimates with internal SV
 Is market more ‘bullish’ or ‘bearish’ than management?

21. Koller, exh. 5
Improved scale economies
Reduced from 1.5 to 1.2

22. Example: Koller [moodle]

23. Value Action Pentagon
Internal and external restructuring activities needed to create value in a business.
Restructuring framework - diagram
In the process of analysing the value of a company, first the “as is” DCF valuation is compared with the current market value of the company. Any difference between these values is a perception gap.
If the market determined SV < “as is value”, then management needs to do a better job of communicating with the analysts of the financial market so that the market value of the company might increase

24. Value Action Pentagon Model

25. Final Thoughts on VBM
Value creation models generally aim at creating value for shareholders / owners.
Alternative: focus on stakeholders rather than shareholders (e.g. ‘Balanced Scorecard’).
determining the aims, benefits and value generators for each stakeholder is difficult
Advocates of SV argue it does not ignore other stakeholders – e.g. if company ignores to assess the interests of its employees, they will leave

26. 2. ECONOMIC VALUE ADDED (EVATM )
1990s: new approaches of value based financial management systems addressed perceived problems of existing financial management systems.
Economic Value Added (EVA), Cash Flow Return on Investment (CFROI) and Economic Margin are measures of corporate performance that have a strong correlation with improvements in share price.
Stern & Stewart and Co. introduced the EVA™ financial management system.
EVA is not new  Alfred Marshall had the basic idea back in the 1880s.
Internet sites on EVA: &

27. Linking EVA & SV approaches
EVA based on the broader notion of economic profit (return less a capital charge),
 attempt to remove accounting distortions and factor in company’s use of capital.
More conventional measures of performance such as earnings per share (EPS) and Price/Earnings ratios are by definition limited and have virtually no correlation with significant long-term share value.
Use of EVA + other metrics linked to growing demands for firms to deliver SV

28. What Exactly is EVA?
EVA™: net operating profits after tax less a company’s cost of capital (including the costs of both equity and debt) subject to a number of adjustments to data reported in financial statements.
EVA = NOPAT - (WACC x Invested Capital) (*)
EVA = (ROIC - WACC) x Invested Capital (**)
where ROIC = return on invested capital
i.e. +ve EVA  return > cost of capital
Simple numerical example…
SAB Miller example - handout

29. Case Study: FedEx. Vs. UPS
Read the case – ed…
Questions:
1. Why did FedEx’s stock price decline at J.C. Penney’s announcement? Assuming a perfectly efficient stock market, how might one interpret this loss of $85 million in FedEx’s market value of equity?

30. FedEx. Vs. UPS
2. How have Federal Express and United Parcel Service performed since the mid-1980s?
Which firm is doing better? Use insights derived from the two firms’ financial statements, financial ratios, stock price performance, and economic profit (or EVA)
Growth & ratios: exhibits 4 & 9
Eps & returns to investors: exhibit 14
EVA / MVA : exhibits 19 & 20

31. EVA vs. EPS
Transforms DCF concept (longer-term investment appraisal) into a simple measure of annual corporate operating performance.
Work from traditional accounting statements.
Overcomes problems with EPS: adjusts for risk (WACC); not as easy to manipulate; TVM; capital.
Stewart: “Generating accounting profits is like playing volleyball with the net down. EVA puts it back up.”
Stern Stewart profiles case studies on website

32. NB: Link between managerial performance, compensation and organisational control and responsibilities - ref. Koller, exhibit 6

33. EVA and Firm Value
Problem with EVA: historical  need to assess how current strategies are likely to affect future values.
 Stern Stewart developed a forward-looking, though related concept, Market Value Added (MVA).
MVA: whether a firm has created or destroyed value.
MVA = Market Value - Invested Capital
Market Value = current value of a firm’s debt & shares
Invested Capital = all the cash raised from finance providers (book value of debt and equity) and retained from profits to finance new investments since the company was founded.

34. MVA
Stern Stewart: MVA is superior to ‘market value’ as a yardstick: MV can be  simply by investing more capital; e.g. Japanese banks have high MV, but most have negative MVAs.
MVA uses stock market to take a snapshot of a firm’s cumulative performance & likelihood that a firm will invest its capital wisely
‘Market’ assesses a firm’s past track record, its current investment opportunities, and its future growth prospects.
MVA implicitly assumes stock market’s efficiency as a discount mechanism  Controversial!

35. MVA: Example
Rival plc was founded 5 years ago with €50M of equity finance; no other capital; retained profits = €10M.
Shares traded on the Dublin Stock Exchange are currently worth €90M.
MVA = MV - Capital = €90M - (50M + 10M) = €30M
If the firm raises €30M by issuing more shares  MV must  to €120M to maintain SV.
If, say, the shares rose to only €115M because shareholders are doubtful about the returns to be earned when the issue money is invested in the firm (i.e. expect a negative NPV project), SV  by €5M.

36. Building up MVA
How to build MVA: generate consistently +ve & growing EVA
 Trend, not the level, of EVA drives share prices
Theoretical link: MVA = PV (Future EVAs)
 MVA = market premium based on an assessment of a firm’s value creating potential
 Market pays = discounted value added = PV (Future EVAs)
Evidence:
 Stock market is quite volatile: EVA & MVA may change abruptly in the short-run;
 Long-run: companies that out-perform their peers will generate +ve MVAs
EVA has highest correlation with share prices (& thus SV)

37. EVA & Time Horizons
Encourages analysts, investors & managers to adopt a longer-term perspective.
EVA valuation: Value = Value of Current Operations + Value of the Forward Plan
Value of the Forward Plan depends on 2 things:
ROIC - WACC = spread
Competitive advantage period (CAP): period of time ROIC > WACC on new investments
depends on franchise value; patents; other barriers to entry
Links strategy & finance  key issue in Value Based Management (VBM)

38. Summary of EVA’s Advantages – Buckley (handout)
Makes cost of capital visible to managers
Can be applied to all sections & departments in a business
Consistent with objective of maximising shareholder value
Can act as the basis for incentive schemes

39. The Economist: ‘A Star to Sail By’?
EVA: “a useful tool, not a complete answer.”
Danger of reduced growth if managers ‘milk’ a business by slashing capital expenditure.
May not be very appropriate for firms with significant intangible assets (e.g. brand names) or where the CAP is very short.
Should not lose sight of strategy & innovation, especially for newer firms.
Newer measures available, e.g. ‘balanced scorecard’

40. Case Study: Coke vs. Pepsi
Read the case (handout)…
Questions:
1. Examine the historical performances of Coca-Cola and PepsiCo in terms of EVA (Exhibit 1). What trends do you observe? What are the factors behind these trends? What do you think are the key drivers of EVA?

41. Coke vs. Pepsi case
2. Calculate and interpret the Weighted Average Cost of Capital (WACC) for both Coca-Cola and PepsiCo. Assume a tax rate of 35 percent.
a. After-tax cost of debt (Kd): the rate of return required by creditors in exchange for providing debt capital to the firm. Yields on publicly traded debt issuances of Coca-Cola Co. and PepsiCo are not given, but can be computed from data in case Exhibit 8.
b. Cost of equity (Ke), beta, and the market risk premium: can use CAPM, dividend discount model (DDM) etc. For this case, use CAPM with year 2000 betas. For the market risk premium, use geometric average of market returns over Treasury bonds from 1926 to 1998 and for the risk-free rate, use the yield on 20-year T-bonds as a proxy (Exhibit 8).
c. Weights of debt and equity capital: normally calculated using market, not book, values. The case does not give any information on current debt outstanding for Coca-Cola and PepsiCo, but we can use the forecast amounts for 2001 in Exhibit 6 for (i) loans and notes payable; (ii) current portion of long-term debt; and (iii) long-term debt.

42. Coke vs. Pepsi case
3. Calculate EVAs for both companies for 2001 to 2003 using the forecasts given in the case, the WACCs just calculated, and following the guidelines for NOPAT and ROIC given in case Exhibit 9. You will need to make the following adjustments:
• Cash taxes are deducted from operating profit.
• Goodwill is added back to operating profit & accumulated goodwill amortisation is added back to invested capital. (See Exhibit 9.)
• Cumulative losses added back to invested capital. (See Exhibit 9.)
• Deferred tax liabilities are added back to invested capital. (Stern Stewart suggest making this adjustment).
• Marketable securities are deducted from invested capital. In the case of PepsiCo, assume that cash in excess of $2 billion was not necessary for operations and was closer in function to marketable securities.
4. Plot the ROIC-WACC spreads for 1994 to 2003 (estimated). Together with the forecasted EVA figures, what information do these numbers give to investors? If you had to choose between Coca-Cola Co. and PepsiCo, which one would you choose, and why?