Value-based management
l Is a managerial approach, its primary purpose is long-run shareholder wealth maximization.
l All the decision making of the company is in order to increase value of the company.
l The total market value of company = Total market value of equity + Total market value of bond
Earning-based management
Problem:
1. accounting profit of a company is high effected by accounting system and accounting standard of the company;
2. Accounting profit does not mention investors’ expect;
3. Ignore time value of money. Sometime the company cannot receive money immediately after sell the good, because of credit;
4. Ignore risk.
Performance spread = Actual rate of return – Required rate of return
How a business create value
Corporate value
= Present value of cash flows within planning horizon + Present value of cash flows with after planning horizon
² Normally “within planning horizon” can increase corporate value
² Normally “after planning horizon” cannot increase corporate value; therefore the “present value of cash flow after planning horizon” is 0.
To expand or not expand?
² Estimate whether expand or not expand the project base on the performance spread.
² Positive performance spread means NPV = +
² Negative performance spread means NPV = -
² Grow = invest
Value creation and SBU performance spreads
A = reject, use the resource here to other project
B = spent more time to monitor this business. The company will close down this in future because it can not increase so much value for the company.
E = the investment is low, the value creation is low, the company can try to allocate resource from A to E.
The value action pentagon (the action can consider to use to create value)
1. Increase the return on existing capital
- Increase actual rate of return on capital.
- Calculation in page 329.
2. Raise investment in positive spread units
- Calculation in page 330.
3. Divest assets (剥离资产)
- They cancel the business A (like clothing business) and invest in business B (like toy business).
- Calculation in page 330.
4. Extend the planning horizon
- If the company can increase planning horizon, the company can increase value creation every years.
- Calculation in page 330.
5. Lower the required rate of return
- Lower the cost of capital of company.
- Calculation in page 331.
The role of the corporate centre in a value-based company
l Portfolio planning, the prefer way to allocate resource to those SBUs, to create great value for company.
l Managing strategic value drivers shared by two or more SBUs. Share certain resource with certain unit / department.
l Provide the pervading philosophy and governing objective
l The overall structure of the organization. Need to consider the culture, vision and mission and etc of company.
Value-creation metrics (The method to make decision)
1. Cash flow
l Corporate value
= present value of free cash flows from operations + the value of non-operating assets
l Shareholder value from operations
= present value of free cash flows from operations - debt
l Total shareholder value
= shareholder value from operation + value of non-operating assets
² Value of non-operating asset = the asset which is own by company no use in the moment.
-------------------------------------------------------------------------------------------------------
2. Shareholder value analysis (SVA) : Rappaport's value drivers
l Shareholder value analysis is forward looking.
l Use to evaluating the inherent value of the equity invested in a firm.
l Company should focus on the key value driver. The 7 terms of company should focus on estimate are:
i. Sales growth rate
ii. Operating profit margin
iii. Tax rate
iv. Fixed capital investment
v. Working capital investment
vi. The planning horizon (forecast period)
vii. The required rate of return
l Assumption:
i. A business is worth the NPV of its future cash flows, discounted at the appropriate cost of capital.
ii. Sales of company will increase constant growth rate.
iii. The operating profit margin is a constant percentage of sales.
iv. Profit means profit before deduction of interest and tax.
v. The tax rate is a constant percentage of the operating profit.
vi. Fixed capital and working capital investment are related to the increase in sales.
Corporate value
= Present value of operating cash flows within the planning horizon (‘forecast period’)
+ Present value of operating cash flows after the planning horizon
+ The current value of marketable securities and other non-operating investments, e.g. government bonds
Advantage | Disadvantage |
It helps managers focus on value-creating activities. - Acquisition and divestment strategies, - capital structure and dividend policies, - performance measures, - transfer pricing and - executive compensation are seen in a new light | Constant percentage increases in value drivers lack realism in some circumstances. - No necessary that the sales, investment in fixed capital, investment is working capital, operating profit will increase constant. |
It can be misused in target setting. | |
Data availability, because many firms’ accounting systems are not equipped to provide the necessary input data. |
-------------------------------------------------------------------------------------------------------
3. Economic profit (EP)
(i.) Entity approach
Economic Profit (Entity approach)
= Performance spread x Invested capital
= (Return in capital - WACC) x Invested capital
= (Return in capital x Invested capital) – (WACC x Invested capital)
= Operating profit before interest after tax – Capital charges
² Return of capital
= Actual Return on capita
= Equity capital + Debt capital
(ii.) Equity approach
Economic Profit (Equity approach)
= Operation profit after deduction of tax – (Invested equity capital x Required return on equity)
= (Operation profit before interest deduction and after tax deduction - Interest paid) – (Invested equity capital x Required return on equity)
Economic Profit (Equity approach)
= (Return on equity – Required return on equity) x Invested equity capital
Advantage | Disadvantage |
- Every manager is rewarded for paying close attention to the cost associated with using capital. (每个经理奖励，密切关注与使用资金有关的费用) | - The balance sheet does not reflect invested capital. |
- It can be used to evaluate strategic options that produce returns over a number of years. (它可以被用于评估在一定数量的岁月期间导致回归的战略选择) | - Economic profit depends on balance sheet, easy affect by accounting standard and accounting system. - Because different company have different accounting standard and accounting system. |
- It can be used to look back at how the unit has performed relative to the amount of capital used each year as well as creating future targets in terms of Economic profit. (可以被用于看单位怎样执行了相对相当数量资本每年使用并且创造未来目标根据EP) | - High economic profit and negative NPV can go together. - Because accounting profit base on historical value; NPV base on actual market value. |
- Economic Profit per unit can be calculated. | - Difficult to count some resource which is share to more than one unit. |
4. Economic value added (EVA)
l Economic value analysis = backward looking, a measure of performance.
l Economic value analysis evaluating how much value a firm actually has created
EVA = Adjusted invested capital x (Adjusted return on capital – WACC)
EVA = Adjusted operating profits after tax – (Adjusted invested capital return x WACC)
-------------------------------------------------------------------------------------------------------
5. Total shareholder return
= (Total return / Initial share price) x 100
= [(Dividend per share + Change in share price) / Initial share price] x 100
= {[Dividend per share + (Share price at end of period – Initial share price)] / Initial share price} x 100
² Total return = Dividend per share + (Change in share price)
-------------------------------------------------------------------------------------------------------
6. Market value added
MVA = Market value − Invested capital
l Positive MVA = value has been created
l Negative MVA = value has been destroyed.
² Market value = Current value of debt, preference shares and ordinary shares
² Invested capital = All the cash raised from finance providers or retained from earnings to finance new investment in the business, since the company was founded
