CHAPTER 12 MANAGING FOR SHAREHOLDER VALUE We now return to the primary concept we established at the beginning of this book, namely, that the basic obligation of the management of any company is to make investment, operating, and financing decisions that will enhance share- holder value over the long term. Our discussion of valuing business cash flows in Chapter 11 strongly suggested that management should periodically reexamine the company’s policies and strategies to test whether its basic obligation of creat- ing shareholder value is in fact being met. We recall that increasing shareholder value depends on making new investments that exceed the cost of capital—an ex- pression of investor expectations—as well as managing all existing investments for cash flow results that similarly exceed investor expectations. The most beneficial aspect of the growing emphasis on shareholder value creation over the past decade has been the widespread rediscovery of management fundamentals—even if at times under threat of dismissal by hostile raiders. De- spite the periodic lapses of economic discipline exemplified in the recent dot.com bubble, which we discussed in Chapter 1, there has been real progress made with the prospect of more to come. Growing numbers of corporate managers, in the U.S. and in other parts of the world, are tackling the critical task of creating value for their shareholders. They are doing this by reexamining the structure and func- tioning of their company as a whole and by placing greater emphasis on making their decisions, large and small, on the basis of sound economic trade-offs. The basic imperative of requiring all investments to earn above the cost of capital has been rediscovered as a practical—even if difficult to achieve—goal. Vast efforts at restructuring, increasing cost-effectiveness, making disinvestments and acqui- sitions, and developing value-based processes, data flows, measures, and incen- tives are being carried out in the name of shareholder value creation. In fact, testing the efficiency with which all resources are employed and defining the relative contribution from various business segments with an objective “outside” orientation has become commonplace in many companies. One could argue that 391 hel78340_ch12.qxd 9/27/01 11:32 AM Page 391 Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use. 392 Financial Analysis: Tools and Techniques this approach should really have been commonplace all along, because of the long-established fact that all business decisions have an economic basis—whether this is recognized or not. A number of specialized measures and valuation method- ologies have emerged in support of value-based management principles, which we’ll discuss later in this chapter. Shareholder Value Creation in Perspective Before we turn to a detailed discussion of value-based measurement techniques, it’ll be useful to revisit the business system as shown in Figure 12–1 to provide an overall perspective for the various analytical processes presented in this book, and to review their relationship to shareholder value creation. Two additional FIGURE 12–1 Shareholder Value Creation in a Business System Context Dis- investment Depreciation effect Interest (tax-adjusted) Dividends paid New investment Leverage VolumePrice Costs (fixed & variable) Investment base Shareholders' equity Long-term debt Operating profit after taxes Earnings retained in company Funds available for growth Managing all new business investments as well as all existing investments for a targeted economic return above the cost of capital Managing all operations for competitive advantage and cost-effectiveness Managing the trade-off between dividends, debt service, and reinvestment Managing the capital structure for proper leverage, acceptable risk, and future flexibility Funding of company growth, given attractive opportunities suitable for the portfolio Exceed cost of capital Meet return goals Meet key success measures Cost/benefit analysis Risk/reward analysis Opportunity analysis hel78340_ch12.qxd 9/27/01 11:32 AM Page 392 CHAPTER 12 Managing for Shareholder Value 393 overview perspectives in Figures 12–2 and 12–3 also will help set the stage for this chapter. As the upper part of the diagram shows, companies focusing on share- holder value will tailor their analytical processes and physical implementation to achieve economic (cash flow) returns above the cost of capital on new in- vestments as well as on existing investments, making sure that return goals are set at appropriate levels and in the proper economic context. We recall the dis- cussion of Chapters 7, 8, and 9 in which the principles and the measures sup- porting this approach were presented. One of the key issues to be faced in this area, however, is the dichotomy between the economic analysis of new invest- ments, where expected cash flow patterns can be judged in an incremental fash- ion, and the analysis of the existing investment base, where normal accounting data and recorded values are the main source of information. It is here where much of the development of value-based methodologies has taken place, in an effort to close the conceptual gap between cash flow economics and ratio-based conventional analysis. The midsection of the diagram reflects our familiar set of operational trade- offs, which in a value creation context, should be made with long-term cash flow generation in mind. Excellent product and service offerings, competitive advan- tage, and cost-effectiveness are the underlying driving forces, but the many deci- sions supporting daily activities require not only an analytical understanding of their cash flow impact, but also measures and incentives that reinforce economic decision making. Again, the increasing emphasis on value-based management is fueling a shift away from accounting-based methodology toward cash flow frame- works. We encountered some of this trend in our discussion of the analytical approaches of earlier chapters, and we’ll expand on the measures and their impli- cations later in this chapter. The bottom part of the diagram deals with the financing aspects of value creation, where we recognize the many trade-offs we’ve encountered in Chap- ters 6, 9, and 10. Companies with a value orientation consciously manage these trade-offs for long-term cash flow generation, and view the disposition of profits and the target dimensions of the capital structure as critical supportive elements in their strategic planning. Choices that affect dividend payout, changes in leverage, repurchase of shares, and funding of future opportunities are made against the criterion of value creation. The trade-offs chosen here can at times significantly affect the direction of the company’s strategy. Another overview of the integration of financial, strategic, and operational activities supporting shareholder value creation is provided in Figure 12–2. Here we see the core concept of earning in excess of the cost of capital surrounded by the key management activities, starting at the top with the evaluation and selection of sound strategies, leading to broad resource allocation and the analysis of spe- cific business investments. In this area the analytical tools of Chapters 7 and 8 come into play. This is followed by the identification of those elements and vari- ables that drive value creation, which form the basis for operational targets and the hel78340_ch12.qxd 9/27/01 11:32 AM Page 393 394 Financial Analysis: Tools and Techniques measures by which performance is gauged. Here the materials of Chapters 3, 4, and 5 have relevance. Next is the critical area of designing incentives for man- agers to act in an economic fashion, and to support a long-term view of decision making. We’ve not focused on such incentive programs because they are beyond the scope of this book. However, financial and other measures selected for the purpose must reinforce the economic (cash flow) orientation we have stressed throughout. Finally, there’s the broad strategic issue of the portfolio of activities carried on by the company, which is intimately connected with the capital structure proportions and trade-offs. Here the materials in Chapters 6, 9, 10, and 11 are the appropriate background. Let’s now turn to a final summary overview of the major elements of share- holder value creation and their relationship to the three areas of management decisions: investments, operations, and financing. The diagram in Figure 12–3 will be useful in tying together the various concepts we’ve discussed. It’s de- signed to assist the reader in visualizing the linkage between management deci- sions and shareholder value. The diagram shows the three basic types of decisions on the left and identifies their key impacts on the cash flows that are the drivers for creating value. The combination of investment and operating decisions gener- ates cash flow from operations after taxes, or free cash flow, while the financing decisions influence the capital structure and the level of the weighted cost of cap- ital of the company. Applying the cost of capital—which of course reflects ex- pected investor returns—as a discount rate to the free cash flow and ongoing value determines the total shareholder value, as discussed in Chapter 11. At the same time, product life cycles, competition, and many other influences affect the FIGURE 12–2 Shareholder Value Creation in a Management Context 1. Achieve cash returns above the cost of capital 2. Make sound new investments Seek and evaluate sound strategies Allocate resources to strategies selected Define and set operating targets and implementations Evaluate results consistently with appropriate measures Identify and evaluate specific new investments within strategic context Identify and test key value drivers Manage capital structure proportions Achieve economic behavior with relevant incentives Manage business portfolio balance and size Balance short- versus long-term viewpoints hel78340_ch12.qxd 9/27/01 11:33 AM Page 394 CHAPTER 12 Managing for Shareholder Value 395 size and variability of these projected cash flows. In turn, the capital markets in- fluence the investor’s return expectation. Alternatively, the right side of the diagram shows that shareholder value also can be viewed in the form of total shareholder return (TSR), which we know to be the combination of cash dividends and realized capital gains, when seen through the eyes of the shareholder. This investor viewpoint is inseparable from the basic driving force of the business—cash flow patterns—for it is positive free cash flow that will permit the company to pay dividends in the first place, and also will boost the market value of the shares, enabling the investor to realize capital gains. Naturally, it’s possible to create value by minimizing dividends and rein- vesting all funds in soundly based opportunities. The value increase would then come from capital appreciation, assuming successful implementation and ex- pected growth in cash flow performance. Conversely, under conditions where sound new opportunities are not available, it might be best for the shareholders that the company repurchase shares rather than invest in mediocre business pro- jects to avoid destroying value. What are the implications of the three overviews we’ve just presented? Note that we’ve once more returned to a systems view of the corporation, driven by the same three basic management decisions, but stressing even more the cash flow pat- terns that are the economic underpinning of performance and value. All financial analysis techniques and methodologies discussed in this book are ultimately related to the business system and its strategic context as viewed here and in Chapter 2, FIGURE 12–3 Shareholder Value Creation in a Cash Flow Context Operating decisions The manager Dividends Capital gains Share- holder value Free cash flow from activities; ongoing value Financing decisions Investment decisions Expectations Capital markets Competition; life cycles; economic environment Price/volume/ cost trade- offs; cost effective- ness Debt; equity; leverage; payout repurchase Working capital; facilities; programs Discount rate Cost of capital The investor hel78340_ch12.qxd 9/27/01 11:33 AM Page 395 396 Financial Analysis: Tools and Techniques and it’s important that the analytical use of any measure, or a combination of mea- sures, be judged in this sense. The basic message of managing for shareholder value is nothing more than management’s obligation to base all of its investment, operating, and financing decisions on an economic—cash flow—rationale, and to manage all resources en- trusted to its care for superior economic returns. Over time, consistency in this ap- proach will generate growing shareholder value, and relative growth in share price performance. If this sounds fundamental, it’s intended to be, since the challenge for the 21st century is competitive survival through managing better in a world arena—where economic fundamentals are gaining dominance over ideology. Financial analysis in its many forms, as introduced in Chapter 2 and specifically explained in the remainder of this book, is an essential toolkit for analytically ori- ented persons of any viewpoint, as they judge the financial/economic performance and outlook of any business. Evolution of Value-Based Methodologies Over the last two decades, a number of value-based methodologies have evolved and are gaining increasing acceptance. Their basic aim is to link performance ex- pressed in past and expected cash flow patterns or their surrogates to the market value of a company as a whole and to the relative price level of its common shares. They have become popular within the context of value-based management processes, and various consulting firms use these approaches to establish a firm connection between management actions and shareholder value results. More- over, such programs relate cash flow thinking and results to management in- centive pay. They are designed to provide a coherent set of economic principles that should guide a company’s planning processes, investment policies, financing choices, operational decisions, and management incentives toward increasing shareholder value, as displayed earlier in our overviews. The change in thinking underlying these processes is exemplified in the simple diagram of Figure 12–4, which displays the significant shift in emphasis as reflected in the way corporate performance is being measured. Prior to the 1980s, management emphasis in the majority of situations tended to be on achieving consistently high profit margins. The asset base neces- sary to support operations was of secondary importance, almost an afterthought, as indicated by the separation border. The idea was that if margins were high enough, asset recovery and returns would take care of themselves, as would fund- ing of new investment needs for rapid growth. Needless to say, companies apply- ing this way of thinking did not make the best use of invested funds, and asset effectiveness was problematic. In the ’80s the emphasis shifted toward growth of profits in absolute terms, again with a focus on the operating statement and less at- tention paid to asset effectiveness. With some luck, sufficient profit growth would support existing and new investments, but this mindset still left asset effectiveness open to real questions. hel78340_ch12.qxd 9/27/01 11:33 AM Page 396 TEAMFLY Team-Fly ® CHAPTER 12 Managing for Shareholder Value 397 It wasn’t until the ’90s that formal closure began between the asset base and operating profits, usually in the form of a percent return of profits on assets, ex- pressed in a variety of ways. While recorded values and accounting-based profit could introduce distortions, and while using short-term returns as a goal could lead to less than optimal new investment actions, combining assets and profitabil- ity was a significant step toward a more integrated way of judging results and making new decisions. As more economic and integrated measures began to be used in practice, growing efforts were made to deal with the shortcomings of accounting-based thinking, and to provide more meaningful signals to managers at all levels. Shareholder value creation was introduced and was based on a vari- ety of adjusted data representing the asset base and operating results. One key element was the rediscovery of the cost of capital (which first ap- peared in economic literature around 1890!) as a key criterion for judging per- formance. The concept of economic profit was defined as the excess of adjusted earnings over the cost of the adjusted resources supporting them. Another key ele- ment was the rediscovery of cash flow as the driver of value, whether in the form of free cash flow for judging a whole company, or net cash flows for investment proposals. Various cash flow measures gained importance, among them cash flow return on investment (CFROI) in a variety of forms. The common theme during this evolution was the belated recognition that any business entity is in fact an economic system which has to be judged over a reasonable time horizon with FIGURE 12–4 The Changing Emphasis in Corporate Performance Measures "History" The 80s The 90s Emerging Practice "Profit Margin" ¥ High growth environment ¥ Any growth environment ¥ Any growth environment ¥ Valuation and strategy tools *EVA is a registered trademark of Stern Stewart & Co. ¥ Lower and inconsistent growth conditions; acquisitions % $$ "Operating Profit $$" "Profit Growth" "Return on Assets" "Shareholder Value Creation over Time" Asset base Asset base Asset base Changes Cost of capital Adjust- ments Profit Profit % $$ EVA* $$ Free cash flow Profit Profit Sales Costs Current asset values Cash flow % CFROI hel78340_ch12.qxd 9/27/01 11:33 AM Page 397 398 Financial Analysis: Tools and Techniques performance and value criteria that reflect and encourage the cash flow trade-offs underlying management decisions, incentives, execution, and results. A Review of Key Measures At this point we should review in broad terms the key performance and value measures encountered in current business practice, and to comment in more detail on several of the emerging tools that support shareholder value creation. We’ve grouped the measures into earnings, cash flow, and value categories, and will take up each area in sequence. Earnings Measures The five measures in this area are the traditional ways of stating earnings or relat- ing earnings to different expressions of invested capital, which we discussed in Chapter 4. They are being supplanted increasingly by cash flow and value-based measures, especially for internal planning, analysis, and evaluation purposes. We list them here more for completeness than for their current relevance. • Earnings per share (EPS) is accounting net income after taxes divided by the number of shares outstanding. • Return on investment (ROI) is accounting profit divided by the book value of the investment supporting the operations, both defined in a variety of ways. • Return on net assets (RONA), or return on capitalization, is after-tax accounting operating profit (NOPAT) divided by the book value of total assets less current liabilities. • Return on capital employed (ROCE) is accounting operating profit (NOPAT) over the book value of assets supporting the operations. • Return on equity (ROE) is accounting net income after taxes divided by the book value of shareholders’ equity. EPS, one of the most commonly quoted indices of performance, which we discussed in several places in this book, has declined from its former pre- eminence. While still tracked by security analysts as an indicator of near-term per- formance, and used in simple valuation situations via the earnings multiple, EPS expresses only the income side of the accounting spectrum. Moreover, it is subject to the many rules of accounting that have moved performance data further and further away from cash flow. In addition, the number of shares outstanding will fluctuate even more in these days of share buybacks, and will affect the level and trend of this measure. ROI is the simplest way of expressing the profitability of asset use, and in its unadjusted form remains a basic accounting measure, not an expression of eco- nomic performance. The accounting earnings reflect many noncash charges and hel78340_ch12.qxd 9/27/01 11:33 AM Page 398 CHAPTER 12 Managing for Shareholder Value 399 additions, while the book value of the investment is a recorded value, not a cur- rent economic value. It might be useful as an approximation, but can often be un- reliable because of the nature of accounting data, as we mentioned in Chapter 4. RONA has become fairly popular, using a more focused operating profit related to the net assets, or capitalization, as recorded on the balance sheet. It still suffers from some of the same accounting issues as ROI, especially in the valua- tion of the asset base. ROCE is a further modification, focusing on operating profit and operating assets, but with similar accounting issues remaining. Mostly applied to internal goal setting, it helps to make asset utilization a performance issue, at least near- term. It does not, however, relate well to economic measures used in judging new investments, nor does it assist in making day-to-day decisions on an economic basis. ROE is the relationship of accounting net profit to the recorded residual ownership claim of the common shareholders, a recorded value buffeted by a whole host of set-asides, reserves, and reclassifications. Still widely quoted and at times used in goal setting, the measure by its very nature cannot reflect the eco- nomic performance of a company. Apart from the usual accounting issues it’s also affected by the financial leverage employed by a company. Beside the measure’s shortcomings for internal use, the leverage distortion makes peer comparisons more difficult, when capital structures vary. Cash Flow Measures The more recent approaches to performance and value measurement are in- variably based on cash flow analysis, with much emphasis placed on removing accounting allocations and noncash adjustments to arrive at cash provided by op- erations and cash invested to support the operations. They relate closely to com- monly used economic criteria like net present value and internal rate of return, thus linking the economic approach to new investments with the assessment of ongoing operations. We’ve discussed many of these already in earlier chapters, and will take up the most current ones later in this section. • Free cash flow is operating cash flow (net income after taxes plus depreciation and amortization, but often adjusted to remove interest expense), less new business investments (including changes in working capital) plus dispositions of assets. • Cash flow return on gross investment (ROGI) is operating cash flow (net income after taxes plus depreciation and amortization) divided by gross assets (before accumulated depreciation). • Cash flow return on investment (CFROI) is the internal rate of return over the life of the investment, based on operating cash inflows, cash investment outflows, and cash recoveries. It involves a variety of adjustments to arrive at operating cash flows and the cash value of the asset base involved, as we’ll demonstrate. hel78340_ch12.qxd 9/27/01 11:33 AM Page 399 400 Financial Analysis: Tools and Techniques • Total shareholder return (TSR) is the yield to the investor from shares held over one or several periods, calculated from the combination of dividends and change in share value. • Total business return (TBR) is the internal rate of return from a business unit or unlisted company over one or several periods, from the combination of cash flows and change in capital value. It involves a variety of adjustments to develop beginning and ending values of the business. Free cash flow has become a commonly accepted concept, useful as an eco- nomic criterion for periodic results, but, even more importantly, representing a key element in the valuation of companies and their parts, as well as in strategic planning analyses. ROGI at times serves as a simple substitute for a periodic economic return, relating operating cash flows to recorded operating assets—which have been “grossed up” by adding back accumulated depreciation to provide a surrogate for current values of the asset base. It can be a useful approximation to a more rigor- ous cash flow analysis in many situations, but could introduce some distortions because in effect it relies on the original cost of assets of different ages as a broad surrogate for current value. CFROI, in its most sophisticated form, is an economic return developed for the company or its parts, representing an internal rate of return over the average life of the operating assets involved. It’s directly comparable to the cost of capital, and to the results from cash-flow-based new investment analyses. The methodol- ogy requires a series of adjustments and several conceptual constructs, as we’ll discuss later. TSR has become a popular concept, used and published widely, because it expresses the annual return achieved by an investor from holding a company’s shares over a specified period of time, based on dividends and change in market value. It links to a company’s cost of capital calculation as an expression of the shareholder expectations to be considered in establishing the cost of equity capital. TBR is a parallel measure to CFROI, designed to measure the internal rate of return of business units or other entities, based on free cash flow and estimates of the beginning and ending values of the entity, much like the analysis of an in- vestment project as presented in Chapter 8. Value Measures The seven value measures listed here similarly reflect the evolution from simple multiples to present value cash flow concepts. Again we’ve discussed several of the basic measures in earlier chapters, but later we’ll go into more detail about the most important ones for current value-based management practice. • Earnings multiples are based on total income after taxes or EPS multiplied by a judgmental factor. They are related to the price/earnings ratio, which is often employed as a guide for the factor used. hel78340_ch12.qxd 9/27/01 11:33 AM Page 400 [...]... generated — 2,075 2,075 2,075 2,075 2,075 2,075 2,075 2,075 12, 000 — — — — 12, 000 10% 1,200 875 0 12, 000 10% 1,200 875 0 12, 000 10% 1,200 875 0 12, 000 10% 1,200 875 0 12, 000 10% 1,200 875 0 12, 000 10% 1,200 875 0 12, 000 10% 1,200 875 0 12, 000 10% 1,200 875 2,000 Total cash flow required $ 12, 000 Present value of future cash flows Net present value @ 10%... value gap is the difference between the present value of the company’s projected cash flows under existing conditions, and the present value of a different and usually higher cash flow pattern expected from hel78340_ch12.qxd 412 9/27/01 11:33 AM Page 412 Financial Analysis: Tools and Techniques the restructured company The attraction for the acquirer in a corporate takeover is to realize the potential... investment analysis, operational effectiveness, financial management, and evaluation and compensation—a systems approach to sound management hel78340_ch12.qxd 422 9/27/01 11:33 AM Page 422 Financial Analysis: Tools and Techniques 2 The challenge of shareholder value creation can be stated simply: consistently exceeding the cost of capital in the performance of existing and new investments However, bringing... business as described in Chapter 11, based on Figure 11–5 on 384, which can be hel78340_ch12.qxd 9/27/01 11:33 AM 424 Page 424 Financial Analysis: Tools and Techniques used to calculate present values and the equity valuation for any pattern of inputs and discount rates Another interactive template allows the user to view the impact of changes in key assumptions on various accounting and cash flow measures... the more difficult areas of financial analysis that must be practiced with complex integrative situations Such detailed case examples go beyond the scope of this book, but they can be readily found in more extensive finance texts and case books, such as we’ve listed at the end of each chapter hel78340_ch12.qxd 9/27/01 11:33 AM Page 418 418 Financial Analysis: Tools and Techniques To round out our... separation of the two approaches, F I G U R E 12 7 The Divergence of Accounting and Cash Flow Measures Rate of return Project/business internal rate of return Cost of capital Positive net present value over the economic life Accounting return on assets 0 Time n hel78340_ch12.qxd 9/27/01 11:33 AM Page 410 410 Financial Analysis: Tools and Techniques F I G U R E 12 8 Another View of Accounting vs Cash Flow... well-established company acquires a new and fast-growing company, the market value assessment of the acquirer’s stock is likely to be more reliable than that of the candidate, whose stock might be thinly traded and unproved, or it might reflect excessive speculation But even if they had comparable market hel78340_ch12.qxd 9/27/01 11:33 AM Page 416 416 Financial Analysis: Tools and Techniques exposure, the inherent... adjustments to both operating profit and the asset base, this approach can be used to track changes in value creation from period to period, and to establish a valuation of the company Economic profit is not a new principle, because in its basic form it *EVA is a registered trademark of Stern Stewart & Co hel78340_ch12.qxd 9/27/01 11:33 AM 402 Page 402 Financial Analysis: Tools and Techniques simply states that... the ongoing operations of the company or business hel78340_ch12.qxd 9/27/01 420 11:33 AM Page 420 Financial Analysis: Tools and Techniques unit, but also be adjusted for planned strategic investments, divestments, potential synergies from combinations, major research outlays, and planned restructuring In other words, the pattern of inflows and outflows should represent, as closely as possible, a strategic... referred to as adding back the change in the LIFO reserve Deferred income taxes, as we discussed in earlier chapters, arise from timing differences between taxes due on corporate tax returns and those reflected on hel78340_ch12.qxd 404 9/27/01 11:33 AM Page 404 Financial Analysis: Tools and Techniques the books In an effort to represent the cash taxes actually paid during a period, the change in deferred . investment and a hel78340_ch12.qxd 9/27/01 11:33 AM Page 407 408 Financial Analysis: Tools and Techniques FIGURE 12 6 An Illustration of Economic Profit, CFROI, and Earnings Measures (thousands of. 2,075 Initial investment . . . . . . . . . . . . . . . . . . . . . . . . . . . 12, 000 12, 000 12, 000 12, 000 12, 000 12, 000 12, 000 12, 000 12, 000 Cost of capital . . . . . . . . . . . . . . . . . . . . . . earlier chapters, arise from tim- ing differences between taxes due on corporate tax returns and those reflected on hel78340_ch12.qxd 9/27/01 11:33 AM Page 403 404 Financial Analysis: Tools and Techniques the