Summary by Kent Jones
Master of Accountancy Program
University of South Florida, Summer 2002
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This article provides an overview of shareholder value analysis (SVA) also called discounted cash flow (DCF) or net present value (NPV) and how this economic measurement technique is better than accrual based accounting measures (e.g. EPS, ROE…) as a tool for management decision making.
SVA enables management to measure the economic impact of individual strategy decisions on the business. For example, management can use SVA to determine the value of mergers and acquisitions, new product development, asset sales, capital expenditures, etc.
Measuring shareholder value requires the combination of three elements:
Cash flow
Cash flow over a given period of time (value growth duration)
Risk (cost of capital)
Creating Value
Corporate value is the net present value of all future cash flows to all investor types (both debt and equity). Shareholder value is the corporate value net of future claims to cash flow. Future claims include short and long term debt, capital leases, contingent liabilities, etc.
Corporate Value = NPV of Cash Flows + Market Value of Nonoperating Assets
Shareholder Value = Corporate Value – Market Value of all Debts
Measuring and Calculating Cash Flow
| Formula | Example | Value Drivers |
| Sales | $1,000 | Sales Growth |
| Operating Expenses | (600) | Margin |
| Pre-tax Profit | 400 | |
| Cash Taxes | (100) | Tax Rate |
| Net Operating Profit after Taxes (NOPAT) | 300 | |
| Depreciation Expense | 75 | |
| Capital Expenditures | (125) | Fixed Capital Investment |
| Incremental Working Capital | (50) | Working Capital Investment |
| Free Cash Flow | 200 |
Forecasting free cash flow usually begins by using price, volume, GNP and other micro and macro economic factors to forecast revenues and expenses. These forecasts are usually done at the business unit, product or value chain level then consolidated. Planning in this manner brings the exercise to the operational level and beyond the confines of the boardroom.
Cash Flow over Time
The length of the forecast period (value growth duration) is determined based on the time expected for investments to yield internal rates of return (IRR) greater than the weighted average cost of capital (WACC). Typically management plans for three to five years. But, this does not consider cash flow fluctuations throughout the growth period. To determine the forecast period, several factors should be considered:
Map the company and its competition based on various factors such as distribution channels, brand names, R&D… For example, in the pharmaceutical industry, value growth duration is long due to patent rights, R&D and high barriers to entry.
Utilize public information on the competition as a benchmark to assess the market’s expectation of the company’s value growth duration.
Residual (Terminal) Value
Cash Flows beyond the forecast period must also be valued. Fixed capital and working capital is assumed to yield returns equal to the cost of capital making the NPV of these investments equal to zero. Therefore, the residual is based entirely on NOPAT. NOPAT may be adjusted for maintenance spending to reflect higher costs associated with aging equipment. NOPAT discounted as a perpetuity (NOPAT / WACC) at the end of the value growth duration period then discounted back to the current period (beginning of value growth duration).
Risk Defined
The risk of a company is measured with WACC. WACC is the after tax cost of debt plus the cost of equity. It is important to note that the cost of debt is based on the current yield of the company’s debt (marginal cost of debt). Using the capital asset pricing model (CAPM) the cost of equity can be computed as follows:
Cost of Equity = Risk Free Rate + Beta * (Market Risk Premium)
The risk free rate is based on the 30 year US treasury bonds primarily because these bonds are viewed as having the least amount of risk (risk that the US government would default on the bonds) over a long period of time. The market risk premium (MRP) is the premium that investors require for investing in a portfolio of investments that is of higher risk than the US government. Merrill Lynch publishes 12 month expected market returns based on the S&P 500. Netting out the risk free rate, a market risk premium can be computed. Beta is a measure of the relative riskiness of an individual company as compared to the market. A beta of 1.0 means that the risk premium associated with an individual company equals that of the market in general. Beta estimates are computed for publicly traded companies by various sources such as Merrill Lynch or Value Line.
The WACC can now be computed as follows:
WACC = % of debt * Cost of Debt + % of Equity * Cost of Equity
Following is an example of a US manufacturing company:
Market Capitalization = $550 million
Outstanding Debt = $250 million
Marginal Borrowing Rate = 8.5%
Risk Free Rate = 7%
Expected Market Return = 12%
Beta = 0.90
Tax Rate = 28%
MRP = 12% - 7% = 5%
Cost of Debt = 8.5% * (1-28%) = 6.12%
Cost of Equity = 7% + .90 * 5% = 11.5%
WACC = 250 / 800 * 6.12% + 550 / 800 * 11.5% = 9.8%
Conclusion
Shareholder value analysis should be implemented at the operational level to better align the interests of managers with that of the stockholders. Additionally, managers compensated on accrual based measures will optimize their performance based on these measures. Accrual based measurements are occasionally in conflict with cash flow based measures. As a result, management may not consistently make decisions to maximize return on investment.
Difficulties moving SVA throughout the management levels include:
Ability to identify key drivers (e.g. production yield, waste, cycle time, etc.),
Managers are entrenched in the accrual based measures,
Managers are not familiar with SVA and require education,
Ability to monitor performance once implemented (e.g. are the systems in place to accommodate the new measures of performance).
Planning is becoming more than just an annual event, but an ongoing, regularly used strategic exercise that enables a firm to quickly adjust to evolving market forces.
Summary of Various Measurement Methodologies
Economic Principles
Shareholder Value Analysis (SVA) - also known as discounted cash flow analysis (DCF) or Net Present Value (NPV)
Evaluates the net cash inflows and cash outflows on a risk adjusted basis.
Most widely accepted.
Economic Value Analysis (EVA)
Primarily used as a performance measurement tool to calculate period to period performance.
Helps a firm focus on value creation or increased cash flow.
Changes in EVA can be used as a financial measurement tool.
Cash Flow Return on Investment (CFROI)
Derived from market data to determine cash flow growth and discount rate.
Helps a firm focus on value creation or increased cash flow.
Viewed as a complex financial measurement tool.
Accounting Principles
Return on Capital (ROC)
Return on Invested Capital (ROIC)
Return on Equity (ROE)
Earnings per Share (EPS)
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Related summaries:
Bacidore, J. M., J. A. Boquist, T. T. Milbourn and A. V. Thakor. 1997. The search for the best financial performance measure. Financial Analysts Journal (May/June): 11-20. (Summary).
Clinton, B. D. and S. Chen. 1998. Do new performance measures measure up? Management Accounting (October): 38, 40-43. (Summary).
Dierks, P. A. and A. Patel. 1997. What is EVA, and how can it help your company? Management Accounting (November): 52-58. (Summary).
Epstein, M. J. and S. D. Young. 1999. Greening with EVA. Management Accounting (January): 45-49. (Summary).
Ittner, C. D. and D. F. Larcker. 1998. Innovations in performance measurement: Trends and research implications. Journal of Management Accounting Research (10): 205-238. (Summary).
Jalbert, T. and S. P. Landry. 2003. Which performance measurement is best for your company? Management Accounting Quarterly (Spring): 32-41. (Discussion of EVA, tracking stock and balanced scorecard). (Summary).
Martin, J. R. Not dated. Relationship between the internal rate of return (IRR), cost of capital, and net present value (NPV). Management And Accounting Web. IRR NPV and Cost of Capital
Martin, J. R. Not dated. What is a business valuation? Management And Accounting Web. Business Valuation
Wallace, J. S. 1998. EVA® Financial systems: Management perspectives. Advances in Management Accounting (6): 1-15. (Summary).