4. Operational Definitions

Transcription

1 4. Operational Definitions 4.1 Introduction In this chapter we shall formalise the operational definitions of various concepts and variables which have been used in the research. These variables have been used by various researchers in their earlier research, though, not all together. Various researchers who have used them in their research earlier have been mentioned in the literature review chapter. The variable definitions are different for different authors. We have picked up the definitions that are most logically appropriately suitable to our research. 4.2 Shareholder Value Creation There are a lot of authors like Marshall, Rappaport, Stern, Stewart, Chen, Fernandez, etc. who have defined shareholder value creation as "an excess return over the cost of capital". What differs between the authors is the definition of the words "return" and "cost of capital". Alfred Marshall in his theory of "residual income" defines return as "profit after tax" and cost of capital to be "cost of equity". Rapport in his theory of "Shareholder Value Added" considers "increase in market value" as shareholder value added and does not consider cost of equity at all. Stern, Stewart & company that own the trademarks "EVA" consider "net operating profit after tax" as return and "weighted average cost of capital" as cost of capital. Pablo Fernandez has considered Rappaport's theory of "shareholder value added" with minor modifications as return and considered "cost of equity" as the cost of capital. 61

2 Since EVA and PFM consider all the possible definitions of "return" and "cost of capital" given by various authors, these have been considered to be our definitions of shareholder value creation for the purposes of research. For instance (Maddin, 1996) used Market Value Added (MVA) as the difference in index at two points of time. Whereas (Alfred Rappaport) in his book "Creating - Shareholder Value" has defined MVA as excess of Market Value to Book Value. We found the definition of Rappaport to be more convincing and thus, we have used this as a definition for the research. Some variables have also been tweaked. So this difference in interpretation of various authors and our adoption of the same and tweaking of a few variables is explained wherever it is done while giving operational definitions below. 4.3 Pablo Fernandez Model PFM is a model of measuring Shareholder Value Creation as proposed by a famous Lain American economist Pablo Fernandez. He professed on calculating Shareholder Value base on the market price. According to Pablo the market price reflects all the information and the information is available to all at the same time. His model is as follow: Figure 4.1: PFM Model Oncrease.,of4 Equity Ki-rk.ef L> I. Equity Market Value: Equity Market Value is a price of the company stock on the bourses. In our study we have taken NSE; 62

3 II. Increase in Market Value : Increase in Market Value is calculated as: Imv = (Pt Pt-i) Pt-i Where; liviv = Increased Market Value Pt = Price of the stock today; Pt-i = Price of the stock one year before III. Shareholder Value Added (SVA): Shareholder Value is calculated as SVA =IIMV + DIV + Bonus + OP Outlays Cony t-i SVA = Shareholder Value Added IMV = Increased Market Value; DIV = Dividend paid by the company in the year; Bonus = Bonus shares issued OP = Other payments to Shareholders such as Sharebuybacks, discount on issue of share, Outlays = Outlays by Shareholders like increase in capital, exercise of options, warrants, etc. Cony. = Conversion of convertible debentures, etc IV. Shareholder Return (SR) = Shareholder Return is calculated as under: SVA SR = n t-1 SR = Shareholder Return; SVA = Shareholder Value Added; 63

4 Pt_l= Market Price at the beginning of the year V. Required return on Equity = Required Return on Equity is calculated using Capital Asset Pricing Model (CAPM) Ke= rf + (rn, rf) Ke= Cost of Equity; rf=risk free rate of return; /3 = Beta of the stock rn, = Market Return i.e. return that is given by the Index; Market Return is calculated as: MR = (It It_i)± (It_i) Where It= Index today; It_i = Index one year back VI. Created Shareholder Value = Created Shareholder Value is the excess of Shareholder Return over the Required Rate of Return on the equity. It is calculated as follows: SVC = EMV X (SR Ke) or SVC = SVA (EMV X Ke) SVC = Shareholder Value Created; EMV = Equity Market Value. Equity Market Value is calculated as: EMV = MP X OS MP = Market Price of a stock; 64

5 OS = Outstanding Shares If = Cost of Equity; The following points need to be noted here: 1. The market price is the closing price on the NSE. The rationale for taking NIFTY and NSE is because as Index N11-1Y is more broad based and NSE has higher turnover in comparison to other markets in the country; 2. Outstanding shares are the shares outstanding in that particular company as on 31st March of that particular year; 3. For the purposes of calculating risk free rate of return we have taken a weighted average yield of 364 day treasury bill of that particular year; 4. Market return is the return on NLI. I Y; 5. (3 values are a covariance of the individual stock returns with NIFTY return Economic Value Added (EVA) EVATm is an improvement over the concept of "Residual Income" by noted economist Alfred Marshall. This is concept which is popularized and copyrighted by Stern, Stewart & co. It is excess of Operating Profit after Tax over the Weighted Average Cost of Capital. It is, thus, calculated as follows: EVA = NOPAT WACC EVA = Economic Value Added; NOPAT = Net Operating Profit after Tax. Though, Stern and Stewart have recommended about 160 manipulations to the accounting figures, practically there are not more than 5 manipulations practiced in real life (Weaver, 2001). These are: 65

6 1. Other Income is not included; 2. Depreciation and non cash expenses are added back; 3. Non operating expenses are excluded; 4. Interest is not considered; 5. Tax (Tax and Fringe Benefit Tax is deducted but deferred tax is not considered) WACC = Weighted Average Cost of Capital is calculated by calculating total cost of capital and taking a weighted average. WACC = (D X I) (K p X P) (K e X E) (D+P+E) WACC = Weighted Average Cost of Capital; D = Total Debt; I = Interest; Kp = Preference Dividend; P = Preference Capital; E = Total Shareholder's Funds calculated as Paid up Equity Capital plus Reserves and Surplus; K,= Cost of Equity as calculated by using CAPM. Following points may be noted here: 1. A lot of researchers have not considered financial institutions, banks, non banking finance companies (NBFC) while conducting research on EVA. We have, however, included all the finance sector companies which were a part of NIFTY.; 66

7 2. While calculating EVA for these companies we have used our rationales as actual calculation of EVA for finance companies is not available in the any of the publicly available research; 3. Our rationale while calculating was that money was a commodity and interest expended and interest spent is a part of finance company operations specially banks and thus, we have considered interest earned and interest expended while calculating Net operating profit after tax; 4. For Indian companies we need to make only 5 manipulations is again not a part of any literature earlier but from our understanding of accounting and as per Indian Accounting Standards. 4.5 Net Operating Profit after Tax (NPAT) Net profit after tax is a traditional accounting measure calculated as: NPAT = (Revenue + Non operating Income) (Operating Expenses + Non operating Expense + Tax) This is taken straight from the company records on Capitaline a financial statements database by capital markets. 4.6 Earnings per Share (EPS) EPS is again a traditional accounting method and taken straight from the company records on Capitaline a financial statements database by capital markets. It is calculated as: EPS = NPAT OS Where; EPS = Earnings per share; NPAT = Net Profit after Tax; OS = Outstanding shares 67

8 4.7 Earnings before Interest, Depreciation & Tax Margin (EBIDTAM) This is again a traditional accounting method and taken straight from the company records on Capitaline a financial statements database by capital markets. It is calculated as: EBIDTAM = (EBIDTA ± Sales) x 100 Where: EBIDTAM = Earnings before Interest, Depreciation and Tax Margin; EBIDTA = Earnings before Interest, Depreciation and Tax 4.8 Earnings before Interest and Tax Margin (EBITM) A few researcher such as (weaver, 2001); (Maddin, 1996) used this variable along with EBIDTAM as absence of depreciation in their opinion made a significant impact on the final analysis. We have, therefore, considered this. It is calculated as: EBITM = (EBIT Sales) x 100 EBITM = Earnings before Interest and Tax Margin; EBIT = Earnings before Interest & Tax 4.9 Earnings before Depreciation and Tax Margin (EBDTM) There was a paper by (Mishra and Goyal, 2005) who felt that interest was a financial charge and should be considered while considering traditional accounting measures. We have, thus, considered this. This is nothing but Earnings after interest but before depreciation and tax. It is calculated as follows: EBDTM = (EBDT ± Sales) x 100 EBDTM = Earnings before Depreciation and Tax Margin; EBDT = Earnings before Depreciation and Tax 68

9 4.10 Return on Capital Employed (RoCE) Return on capital employed is again a regular traditional accounting method which we picked up straight from the company records. It is calculated as follows: ROCE = (NPAT CE) x 100 Where: ROCE = Return on Capital Employed; CE = Capital Employed which is equal to Debt plus Equity capital 4.11 Return on Net Worth (RoNW) Return on Networth is yet another traditional accounting measure which is taken from the company records. It is calculated as follows: RONW = (NPAT TNW) x 100 Where: RONVV = Return on Networth; NPAT = Net Profit after Tax; TNVV = Tangible Networth which is calculated as follows: TNW = GNW IA Where: o o TNVV = Tangible Networth; GNVV = Gross Networth calculated as Capital (Preference + Equity) plus reserves and surplus; o IA = Intangible Assets like Goodwill, Patents, etc Return on Equity (RoE) Return on Equity is a traditional accounting variable used by almost all the researchers. It has also been taken from the records of the company. It is calculated as: 69

10 RoE = (PAT NW) x 100 RoE = Return on Equity; PAT = Profit after Tax; NW = Net Worth 4.13 Net Profit after Tax Margin (NPM) It is net profit margin. It is calculated as: NPM = (NPAT Sales) x Reported Net Profit after Tax This is the absolute figure of Net Profit after Tax. We have taken it from the profit and loss account of the companies Book Value (BV) Book Value of the share is a most important variable as it is important from the point of view of calculating MVA. Also BV by itself is used as a dependent variable to ascertain if it explains the Market Value Added better than others. This figure is also taken from the financial details of the company. It is calculated as: BV = TNW OS Where; BV = Book Value; TNW = Tangible Net Worth; OS = Outstanding number of Equity Shares 4.16 Market Value (MV) Market Value is the price at which the share is traded on the NSE. This is important variable for us to calculate PFM and MVA. We have taken closing prices of the shares on the NSE web site. 70

11 4.17 Debt Equity Ratio Also called as leverage ratio (Pandey, 2010) is used as a proxy for Capital Structure. Debt Equity Ratio is taken from the financial statement of the company (Balance Sheet). It is calculated as: DER = TOL NW Where; DER = Debt Equity Ratio; TOL = Total Outside Liabilities; NW = Net Worth 4.18 Managerial Remuneration This variable is a very interesting study used by researchers such as (Riceman, Cahan and Lal, 2002 and Dimitris, Kyriazis and Anastassis, 2005). Managerial Remuneration is defined by them as the remuneration paid to Board of Directors. We have taken this figure form the company profit and loss account Dividend Dividend has been a debatable issue for antiquity. Right from the era of Modigliani & Miller and Walter and Gordon, relevance of Dividend is debated. The importance of Dividend is also pointed out in the literature review chapter. The dividend is a figure taken from financial statements of the companies Market Value Added (MVA) Increase in Market Value or Market Value Added (MVA): Market Value Added is calculated as excess of Market Value over Book Value. The rationale is if a share is trading above the book value then what is the factor that explains the premium. Thus, it is calculated as: MVA = MV BV 7 1

12 MVA = Market Value Added; MV = Market Value; BV = Book Value 4.21 EVA Is a Performance Metric To understand economic profit, it helps to distinguish between a performance metric and a wealth metric. A performance metric refers to a measure under company control, such as earnings or return on capital. A wealth metric, on the other hand, is a measure of value that - such as equity market capitalization or the price-to-earnings (P/E) multiple -depends on the stock market's collective and forward-looking view. Now, although these two types of metrics are distinct, they are related. Every performance metric has a corresponding wealth metric. In theory, over the long run, a performance metric can be expected to impact its corresponding wealth metric. For example, consider the matching pair of earnings per share (EPS), a fundamental performance metric, and the P/E multiple, its corresponding wealth metric. The variables that determine EPS - earnings and shares outstanding - are numbers affected only by the company's actions and decisions. On the other hand, the P/E multiple, which is determined by the company's stock price, depends on the value of these actions and decisions assigned by the stock market. The company therefore influences the P/E ratio but cannot fully control it. Here is another way to think about the difference between the two: EPS is a current (or historical) fact but P/E is a forwardlooking and collective opinion. The key criterion for the pairing of a performance and wealth metric is consistency: each half of the pair should reference the same group of capital hdders and their respective claims' on company assets. For example, EPS by definition concerns the 72

13 allocation of earnings to common shareholders; the P/E multiple refers to equity market capitalization, which is the value held by shareholders. Consider another example: return on capital (ROC) is a performance metric that represents the return both to debt and stockholders, and its corresponding wealth metric is the EBITDA multiple - the value of total debt, plus equity market capitalization (also known as the "enterprise value" or "entity value"), divided by earnings before interest, taxes, depreciation and amortization (EBITDA). This is also called the "price-to-ebidta multiple", or "the enterprise multiple". Note how ROC and the EBITDA multiple meet the consistency test. Like ROC, EBITDA captures earnings that accrue to both holders of stock and debt. The EBITDA multiple, therefore, reveals how the market values the company in light of earnings to stockholders and debt-holders. Below is a chart listing a few performance metrics and their corresponding wealth metrics. Note that economic profit's corresponding wealth metric is market value added (MVA). We explore this relationship below as we come to understand specifically what economic value is and how works: Table 4.1: Performance and wealth metrics: Performance metric. Wealth metric Return on Equity (ROE), EPS growth P/E Ratio Return on Capital (ROC or ROIC), Operating Income Growth Economic Profit (For us it is EVA) Free Cash Flow Cash Flow Return on Investment (CFROI) Ratio of: Entity value EBITDA Market Value Added (MVA) Equity Market Capitalization (price x common shares outstanding) Total Shareholder Return (TSR) 73

14 (Rappaport, 1960, Stern, and Stewart, 1991) used this as a wealth metrics, which is followed in the research as well as there was no evidence to think contrary. The wealth metrics typically becomes the dependent variable and all the other variables are independent variables. It must also be noted that as per the established finance literature market whether _ satisfies Efficient Market Hypothesis "Strong" or "Semi strong" form does reflect almost all the information in the market price. Only the "weak" form of efficient market hypothesis says that "all the possible information is not reflected in the market price". It has been stated in the literature review Indian markets project "semi strong" theory efficient market hypothesis. Therefore, we found MVA to be a suitable dependent variable to relate all the independent variables and test the hypothesis listed out in the research methodology chapter. 74