Subject Paper No and Title Module No and Title Module Tag 4: Accounting Theory and Practice 34: Shareholder and Market COM_P4_M34 MODULE No. 34: Shareholder and Market
TABLE OF CONTENTS 1. Learning Outcomes 2. Introduction 3. Economic 4. Shareholder Value added 5. Comparison with other conventional performance measures 6. Market Value added 7. Calculation of MVA 8. Relationship between SVA and MVA 9. Characteristics of MVA 10. Summary MODULE No. 34: Shareholder and Market
1. Learning Outcomes After studying this module, you shall be able to Learn about the various value based performance measures Learn Shareholder Value added and its computation Identify the difference between SVA and other traditional performance measures Understand SVA with the help of examples Learn Market Evaluate the usefulness of EVA, SVA, and MVA in decision making purposes. MODULE No. 34: Shareholder and Market
2. Introduction Maximizing shareholders value has always been the ultimate aim of every company. Investors are very keen in assessing the corporate financial performance that correlate with shareholders wealth particularly the market price of a share. Traditional performance measures like return on investment, earnings per share, etc., have been used as the most important measure of shareholder value creation. But in the recent years, value based measures which measure performance in terms of change in value, have received a lot of attention. There are several value based measures such as Cash Flow Return on Investment (CFROI), Shareholder (SVA), Economic (EVA), Market (MVA) and Cash (CVA). The current module discusses EVA, SVA, and MVA. 3. Economic Economic value Added is an after-tax profit that exceeds the cost of capital or required minimum return on capital. It is computed by deducting the cost of capital from the aftertax profit. It is the best measure of the true profitability of an enterprise. Though EVA is relatively new to the financial press, its conceptual foundation is not. The term EVA was recently copyrighted by the consulting firm Stem Stewart & Company. Prominent US corporations such as IBM, Coca- Cola, Procter & Gamble, Johnson & Johnson, Microsoft, General Electric, Eli Lilly, Monsanto, Bausch & Lomb, AT & T and Indian companies such as Infosys, BPL, HLL, NIIT, TCS, Godrej Soaps, Ranbaxy laboratories, Samtel India Ltd have adopted EVA. Infosys Technologies is the first Indian company to report its EVA. The EVA framework developed by Stern Stewart & Company is gradually replacing the traditional measures of financial performance on account of its robustness and its immunity from creative accounting. It is an estimate of a firm's economic profit. It measures the value addition to an organization. EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital. Traditional performance measures such as NOPAT, EPS, ROI, ROE etc. have been criticized due to their inability to incorporate full cost of capital thereby accounting income is not a consistent predictor of firm value and cannot be used for measuring corporate performance. Operationally defined, EVA is the difference between the net operating profits after taxes (NOPAT) and capital charge i.e., cost of capital employed (COCE) or the product of capital employed with the difference between the Return on Capital Employed (ROCE) and the Cost of Capital Employed (COCE) i.e., EVA = net operating profits after taxes (NOPAT) Capital Charge (WACC x CE) MODULE No. 34: Shareholder and Market
Where WACC= weighted average cost of capital CE= Capital Employed NOPAT= Profits after depreciation and taxes but before interest cost OR EVA= Capital Employed (CE) X [Return on capital employed (ROCE)- Cost of Capital Employed (COCE)] Capital costs include both the cost of debt finance and the cost of equity finance. The cost of these sources of finance is reflected by the return required by the funds provider, be they a lender or a shareholder. This capital cost is referred to as the Weighted Average Cost of Capital (WACC) and is determined having regard to the relative capital structure of the business. WACC is used in SVA as the minimum hurdle rate of return the firm needs to exceed for value to be added. The formula for WACC is as follows: WACC = Cost of Debt X {Total Debt / (Total Debt + CMVE)} X (1 Tax) + [Cost of Equity X { (CMVE / (Total Debt+ CMVE))}] Where CMVE = Company s Share Price X Total Shares Outstanding 4. Shareholder Shareholder (SVA) is a metric which reflects a company's performance in a way that is meaningful to shareholders. At its most theoretical level, it implies that the primary goal of any company should be to increase the returns to shareholders, not necessarily to create value for the company as a whole. Those seeking ever-higher shareholder value added believe that management should make decisions for the company that caters to shareholder interests first and foremost. SVA is a value-based performance measure of a company's worth to shareholders. The basic calculation is net operating profit after tax (NOPAT) minus the cost of capital from the issuance of debt and equity, based on the company's weighted average cost of capital: SVA= NOPAT- Cost of Capital MODULE No. 34: Shareholder and Market
Figure 1: Sustainable Shareholder Value SVA represents the economic profits generated by a business above and beyond the minimum return required by all providers of capital. Value is added when the overall net economic cash flow of the business exceeds the economic cost of all the capital employed to produce the operating profit. Therefore, SVA integrates financial statements of the business (profit and loss, balance sheet and cash flow) into one meaningful measure. The SVA methodology is a highly flexible approach to assist management in the decision making process. Its applications include performance monitoring, capital budgeting, output pricing and market valuation of the entity. 5. Comparison with Conventional Performance Measures Conventional ratio analysis based on accounting data, has historically been regarded as more useful to the management of a business rather than to the investor shareholders of the business. Whereas accounting measures focus on residual profits after tax equivalents measured against the total asset base, the value-based income statement concentrates on the operating performance of the firm by adjusting net operating revenue (NOPAT) by the allocation of a capital charge incorporating the economic operations of the business. MODULE No. 34: Shareholder and Market
As such, SVA takes into consideration one important variable that most traditional accounting measures do not - how much capital is being employed in the business. SVA combines income statement and balance sheet data to determine the excess returns available to all capital holders. Additionally, through the use of a weighted average cost of capital (WACC), SVA implicitly addresses the concepts of risk and shareholder expectations. The comparison with the traditional accounting formats are broadly summarized in the following tables. Table 1.1 Traditional Operating Statement Revenues less: Cost of Goods Sold equals: Gross Profit less: Depreciation, Sales, Admin. & Other Expenses equals: Net Operating Profit Before Interest & Tax Equivalents less: Interest Expense equals: Profit Before Taxes less: Income Tax Equivalents equals: Net Profit After Taxes Table 1.2 Traditional Balance Sheet Current Assets plus: Non-Current Assets equals: Total Assets Current Liabilities plus: Non-Current Liabilities plus: Shareholder Funds equals: Total Liabilities + S/holder Funds Total Assets = Total Liabilities + S/holder Funds Value-Based Operating Statement Revenues less: Cost of Goods Sold equals: Gross Profit less: Depreciation, Sales, Admin. & Other Expenses equals: Net Operating Profit Before Interest & Tax Equivalents less: Adjusted Tax Equivalents equals: Net Operating Profit After Taxes (NOPAT) less: Capital Charge equals: Shareholder Value-Based Methodology Net Working Capital plus: Fixed Assets (excl FITB) equals: Net Operating Assets Bank OD less Cash and Investments plus: Short term Debt + Long Term Debt equals: Net Debt plus: Total Shareholder Funds plus: Current & Non-Current Provisions less: Future Income Tax Benefits (FITB) equals: Total Capital Employed Net Operating Assets = Total Capital Employed The value-based view explicitly recognises the capital charge associated with the use of capital. The bottom line under this format is, therefore, quite different from that under the traditional view. A positive bottom line (shareholder value added) signifies a superior MODULE No. 34: Shareholder and Market
performance because it accounts for all costs associated with the enterprise, including that associated with capital. It is important to recognize that SVA is not meant to be used in a vacuum as the sole measure of value, rather it is an additional measure which can be used in the decision making process. Worked Example on the use of SVA Following are the sample calculations for the SVA measures: Step 1: Calculation of NOPAT The first step in determining SVA is to calculate NOPAT from accounting-based data provided. In this example, we have assumed the corporate tax rate of 36% will apply to EBIT. Year 1 Year 2 Year 3 Year 4 Year 5 Revenue 743 630 578 548 544 Operating Expenses 242 163 154 146 142 Depreciation 51 51 55 59 62 Earnings Before Interest & 450 416 369 343 340 Taxes Income Tax Equivalents 162 150 133 124 122 NOPAT 288 266 236 220 217 Step 2: Calculation of Capital Employed From the Balance Sheet: Year 1 Year 2 Year 3 Year 4 Year 5 Current Assets (excl. Cash + 133 144 162 174 178 Investments) less Current Liabs (excl.std & 115 115 115 115 115 Provisions) equals Working Capital 18 29 47 59 63 add Non-Current Assets (excl FITB) 2600 2799 2994 3185 3373 equals Net Operating Assets 2618 2828 3041 3244 3436 Step 3: Calculation of Capital Charge Capital charge can be determined as follows: Year 1 Year 2 Year 3 Year 4 Year 5 Total Capital Employed 2618 2828 3041 3244 3436 WACC 8.24% 8.24% 8.24% 8.24% 8.24% Capital Charge 216 233 251 267 283 Step 4: Calculation of SVA MODULE No. 34: Shareholder and Market
SVA is calculated as NOPAT minus capital charge. Year 1 Year 2 Year 3 Year 4 Year 5 NOPAT 288 266 236 220 217 Less: Capital 216 233 251 267 283 Charge SVA 72 33-15 -47-66 The firm has shown positive earnings and positive SVA over the first two years of the planning period. However, from year three the negative value for SVA means that shareholder value is being destroyed. Key factors contributing to the decline in shareholder value over the period are the falling revenues and the increase in net operating assets. On the basis of the five years of data it appears that new investments are not earning the WACC. Comparison with Traditional Accounting Measures Year 1 Year 2 Year 3 Year 4 Year 5 SVA 72 33-15 -47-66 SVA as a % of Total Capital 2.76% 1.17% -0.47% -1.47% -1.92% Employed Traditional Accounting Measures Return on Assets 8.44% 7.03% 5.42% 4.43% 3.93% Return on Equity 16.81% 14.20% 11.15% 9.28% 8.38% Gearing 49.82% 50.51% 51.37% 52.28% 53.15% NPAT / Total Revenue 32.13% 34.45% 31.23% 28.73% 27.30% Current Ratio 0.82 1.08 1.27 1.44 1.60 Interest Times Cover 6.51 6.08 4.87 4.13 3.74 Traditional accounting measures do not recognize that equity capital has an economic cost that being the opportunity cost incurred by the shareholder when investing in the business, whereas the value based view explicitly recognizes the capital charge associated with the use of equity capital. Possible results of management not considering the opportunity cost of capital include a misallocation of resources and therefore divergence between business and shareholder goals. This is highlighted by the above table where traditional accounting measures (such as Return on Assets, profitability, liquidity and interest coverage) remain positive, although decline, over the five year period. Given this divergence between traditional accounting results and SVA outcomes, it would appear that the SVA framework has the potential to further assist management in its decision making processes and improve alignment between shareholder and business goals. MODULE No. 34: Shareholder and Market
6. Market Stewart (1991) defines MVA as the excess of market value of capital (both debt and equity) over the book value of capital. If the MVA is positive, the company has created wealth for its shareholders. To determine the market value, equity is taken at the market price on the date the calculation is made, and debt at book value. The total investment in the company since day one is then calculated as interest-bearing debt and equity, including retained earnings. Present market value is then compared with total investment. If the former amount is greater than the former, the company has created wealth. While EVA is an accounting-based measure for the corporate performance of one year, MVA is a market generated number. MVA is cumulative measure of the value created by the management in excess of the capital invested. Shareholder value creation is operationalized as Market Value-Added or MVA. MVA is a measure that captures the relative success of firms in maximizing shareholder value through efficient allocation and management of scarce resources. 7. Calculation of MVA Market value added represents the wealth generated by a company for its shareholders since inception. It equals the amount by which the market value of the company's stock exceeds the total capital invested in a company (including capital retained in the form of undistributed earnings). Since the main goal of a for-profit organization is to maximize shareholders' wealth, market value added is an important measure to analyze how much value a company has added to the wealth of its shareholders. Higher market value added is better. Formula Market value added in calculated in two flavors. 1. The most common calculation is from the perspective of common shareholders and it equals the excess of market capitalization over the total common shareholders' equity as shown below: Market (MVA) = Market Capitalization Total Common Shareholders' Equity = Total Shares Outstanding Current Market Price Total Common Equity 2. From the perspective of all investors (i.e. both shareholders and debt holders, and not just shareholders), market value added equals the market value of the company minus sum of the book value of equity and debt. MODULE No. 34: Shareholder and Market
Market for all Investors = Market Value of the Company (Book Value of Equity + Book Value of Debt) Market for all Investors = Market Value of Equity Total Shareholders' Equity + Market Value of Debt Book Value of Debt 8. Relationship between Shareholder and Market Value Added The firm's market value added, or MVA, is the discounted sum (present value) of all future expected economic value added: MVA = Present Value of a series of EVA values. The relationship between EVA and MVA has strong bearing on valuation shown in the formula below: MARKET VALUE OF EQUITY = BOOK VALUE OF EQUITY + PV OF ALL FUTURE EVA The MVA rate of return concept is similar to that of the yield on a bond. When a bond is issued with a yield greater than the current market rate then the bond will sell at a premium (there is positive EVA and so the bond will sell at positive MVA). If the yield of a bond is lower than the current market rate then the bond will sell at a discount (there is negative EVA and so the bond will sell at negative MVA). Since the valuation formula given above is always equal to DCF and NPV, and then the right estimate of value is always obtained regardless of what the original book value of equity is. 9. MVA and its characteristics Value based management and shareholder value analyses are well known concepts in the 1980 s, but there is now a renewed interest in them and also newer related concepts such as MVA. Market value added is the difference between the Company s market and book value of shares. According to Stern Stewart, if the total market value of a company is more than the amount of capital invested in it, the company has managed to create shareholder value. If the market value is less than capital invested, the company has destroyed shareholder value. Market = Company s total Market Value Capital Invested MODULE No. 34: Shareholder and Market
With the simplifying assumption that market and book value of debt are equal, this is the same as: Market = Market Value of equity Book value of equity Book value of equity refers to all equity equivalent items like reserves, retained earnings and provisions. In other words, in this context, all the items that are not debt (interest bearing or noninterest bearing) are classified as equity. Market value added (MVA TM ) is identical in meaning with the market to book ratio. The difference is only that MVA is an absolute measure and market to book ratio is a relative measure. If MVA is positive, that means that market to book ratio is less than one. According to Stewart, Market value added tells us how much value the company has added to, or subtracted from, its shareholders investment. Successful companies add their MVA and thus increase the value of capital invested in the company. Unsuccessful companies decrease the value of the capital originally invested in the company. Whether a company succeeds in creating MVA or not, depends on its rate of return. If a company s rate of return exceeds its cost of capital, the company will sell on the stock market with premium compared to the original capital. On the other hand, companies that have rate of return smaller than their cost of capital sell with discount compared to the original capital invested in company. Whether a company has positive or negative MVA depends on the rate of return compared to the cost of capital. Market value added can also be defined in relation to Economic (EVA TM ). EVA measures whether the operating profit is enough compared to the total cost of capital employed. Stewart defines the connection between EVA and MVA as: Market = Present Value of All future EVA By increasing EVA, a company increases its market value added or in other words increases the difference between Company s value and the amount of capital invested in it. The relationship of MVA with EVA has its implication on valuation. By rearranging the formula, market value of equity can be defined as : Market value of equity = Book value of equity + Present value of all future EVA. MVA is essentially the difference between the company s current market value, as determined by its stock price, and its economic book value. For example, in the case of General Electric, which was the top U.S. performer at the end of 1994, the total market value of GE s debt and equity at that time was $101 billion. And since the adjusted book value of that capital was only $46 billion, GE s MVA amounted to $55 billion. MVA is a far more revealing figure than a simple rise in market capitalisation, because the latter fails to consider the money investors put up. For example, if a company increased its market capitalization by Rs.500 crore over five years, but at the same time ploughed back Rs.600 crore in retained earnings, it actually has destroyed Rs.100 crore of shareholder wealth. MODULE No. 34: Shareholder and Market
For instance, the MVA of Infosys Technologies Ltd for the year ending 31st March 2010 to 2014 is given below: (Rs. In Crore) Year Shareholders Market Market Value funds Capitalization added 2010 22036 150,110 128074 2011 24501 186,100 161599 2012 29757 164,592 134835 2013 36059 165,917 129858 2014 42092 188,510 146418 From the above it could be observed that the MVA has increased tremendously and that is reflected in the increase of the share price of Infosys Technologies in the stock market. Thus, investors should focus on MVA instead of market capitalization, as market capitalization is a misleading indicator of success. For instance, the 2014 results of Company X and Y, as given below, indicate that on the basis of market capitalization Y may be perceived to be doing well and only $9 billion it is behind X. But MVA shows that it is far behind X as it has destroyed shareholders wealth to the tune of $17 billion. X Y Market Capitalization $61 billion $52 billion Investor s Capital $ 8 billion $69 billion MVA $53 billion $ 17 billion 10. Summary MODULE No. 34: Shareholder and Market
Value based management system has gained popularity in academic literature in last two decades. One such innovation in the field of internal and external performance measurement is EVA. Economic or EVA is an estimate of a firm's economic profit being the value created in excess of the required return of the company's investors (being shareholders and debt holders). EVA is popularized by and registered trademark of the US firm, Stern Stewart & Company. EVA is the profit earned by the firm, less the cost of financing the firm's capital. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital. EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the product of the cost of capital and the economic capital. The basic formula is: EVA = (r - c) * K = NOPAT - c * K Where r is the return on investment capital (ROIC); c is the weighted average of cost of capital (WACC); K is the economic capital employed; NOPAT is the net operating profit after tax. SVA represents the economic profits generated by the business over and above the minimum return required by all providers of capital, and is calculated by using the residual income method. Market (MVA) is the difference between the current market value of a firm and the capital contributed by investors. Economic or EVA is an estimate of a firm's economic profit being the value created in excess of the required return of the company's investors (being shareholders and debt holders). The firm's market value added, or MVA, is the discounted sum (present value) of all future expected economic value added: MVA = Present Value of a series of EVA values. The formula for MVA is: MVA= V- K MODULE No. 34: Shareholder and Market