Spotlight Quiz
July 2015
Value-based Management
Value-based management is the process of managing the organisation to increase value for
shareholders. The idea of maximising shareholder wealth is not new, but finding a way of measuring
corporate performance that can be used as a basis for management incentives has proved elusive.
Fairness to the managers requires that the measure should be independent of factors outside their
control, such as market volatility, but equally, fairness to shareholders requires a measure that
cannot be easily manipulated and really does reflect value creation.
The problems with focussing on earnings
For many years the holy grail of management performance was earnings - earnings growth meant
success. This focus led to an accounting focus on managing the earnings figure. Most often this
meant growing earnings per share, a measure that is still the basis of some management incentive
schemes.
However, the key difficulty with this approach is that accounting is designed to measure earnings
growth, based on a historic investment, but investors are looking for a return on the investment they
hold now. The underlying problem with earnings and earnings per share (eps) is that they ignore the
stock market and the value that it places on a company’s shares. Both risk and growth potential are
incorporated into share values by an efficient stock market.
If eps growth is perceived as real by the market, then shares will grow in value, because the market
buys anticipated, or future, growth. In contrast, eps growth that is seen as less than inspiring,
results in lower share prices. Risk is also ‘priced in’; riskier prospects are ‘cheaper’ stocks, while less
risk enhances value.
Question 1
Calculation of earnings per share.
Static PLC’s Income Statement shows the following:
£ million
Operating Profit
116
Finance Costs
6
Profit before Tax
110
Tax
25
Profit after tax
85
Dividends
20
Retained earnings
65
What is the earnings per share of Static PLC if their share capital is £140 million made up of 50 pence
shares?
(a)
(b)
(c)
(d)
(e)
41.4 pence per share
39.3 pence per share
30.4 pence per share
23.2 pence per share
Don’t know
Answer
The right answer is (c) 30.4 pence per share
Each possible answer above is derived from a different level of profit. For each of the answers the
same number of shares has been used, i.e. 140 million × 2 because each share is worth 50 pence or
£0.50. Answer (a) is based on Operating Profit and is therefore incorrect. Answer (b) is based on
Profit before Tax and is, again, therefore incorrect. Answer (c) is based on Profit after Tax – the
correct answer. Answer (d) is based on Retained Earnings for the year, also incorrect.
‘Earnings’ refers to the level of earnings that accrues to the shareholders. Operating Profit and Profit
before Tax are clearly not levels of profit that accrues to shareholders. Retained Earnings for the
year are part of the earnings accruing to shareholders, but so are dividends. Using Retained Earnings
is therefore incorrect.
Market Value Added (MVA®)
The concept of MVA® was developed by a consultancy, Stern Stewart, who trademarked the name
so that we now have to acknowledge that fact with an ®. The concept is simple: MVA® is the excess
of market value over the amount invested. So market value is the enterprise value of the firm
(market value of equity plus market value of debt) less the capital contributions to date (equity plus
debt). If the market value of debt is the same as its nominal value, then debt cancels out completely
and we are left with market value of equity less equity capital contributed. The latter would include
all of shareholders’ funds.
This measure has the benefit of incorporating an element of market value, so that share values are
no longer ignored. But we then rely on the market pricing shares efficiently. We also find that the
measure is exposed to swings in the market – general uncertainty would depress share prices and
therefore reduce a company’s MVA®. Alternatively, a market boom would exaggerate a company’s
performance by enhancing its MVA®.
The measure still suffers from the need to include accounting measures of capital invested and Stern
Stewart have refined the measure with many adjustments to take care of this problem. The
difficulties that remain though, are:
• We don’t know when the value was created in the life of the business
• We don’t know if the rate of value creation is high enough for the risk incurred, and
•
Being an absolute figure, the measure is distorted by size so that a big company will always
look better than a small company
Question 2
Performance Agogo PLC has an abbreviated Balance Sheet as follows
Balance Sheet
£ million
Current Assets
64
Non-current Assets
98
Total Assets
162
Current Liabilities
18
Long Term Loans
36
Equity:
Share Capital (25p shares)
60
Ret'd Earnings & Reserves
48
Total Liabilities & Equity
162
The long term loans are floating rate so that it is safe to assume their market value is the same as
their book value. The company’s shares are trading at 85 pence.
What is the company’s MVA®?
(a)
(b)
(c)
(d)
(e)
£96 million
£144 million
£180 million
£132 million
Don’t know
Answer
The right answer is (a) £96 million
The calculation is enterprise value of the company less all capital contributions.
Enterprise value is MV equity plus MV debt = (85 pence × 240 million shares) + £36 million loans =
£240 million.
Capital contributions = £60 million equity + £48 million ret’d earnings + £36 million loan = £144
million.
So MVA® = £240 - £144 = £96 million
Answer (b) omitted to include the £48 million retained earnings as a capital contribution.
Answer (c) included the loans in enterprise value but not in capital contributed and omitted to include
the retained earnings.
Answer (d) included the loans in enterprise value but not in capital contributed.
Market to Book Ratio (MBR)
The MBR addresses the last problem above associated with MVA®, i.e. that it is distorted by size so
that a big company will always look better than an equivalent smaller company. The principle is to
divide equity market value by equity book value to see the extent to which a company is trading
above or below its ‘book value’. This measure will be very familiar to companies that are
traditionally valued by comparing their market values and net asset values: investment trusts and
some property companies. Effectively the ratio is comparing a unit of invested capital with the
market value of that same unit of capital. So a successful company might invest £100 and the
market will value that £100 at £150. A less successful company might raise £100 to invest in a
project and the result might be that its market value increases by £50, i.e. less than the £100 raised!
Question 3
Using the same set of information as for Question 2, which of the following is the company’s MBR?
(a)
(b)
(c)
(d)
(e)
1.67
1.89
2.22
3.40
Don’t know
Answer
The right answer is (b) 1.89
Equity market value is 240 million shares * 85 pence per share = £204 million.
Equity book value is £108 million (£60m + £48m), so
MBR = 204/108 = 1.89.
Answer (a) included debt in both numerator and denominator. Answer (c) debt in market value but
not in book value. Answer (d) omitted to include retained earnings in book value of equity.
Total Shareholders Return (TSR)
Using the TSR measures the return from the shareholder’s perspective. It is based on the change in
the price of shares plus dividends received over a set period of time and is therefore slightly more
difficult to calculate.
A shareholder’s investment is the value of the shares purchased. The return on that investment
arises from dividends received plus the change in value of the shares, i.e. the capital gain (or loss)
over the period under review. Total shareholder return is the internal rate of return (IRR) of these
amounts (i.e. takes into consideration time value of money).
Approach
First, a time period is selected, say a holding period for a share. The methodology then takes the
initial investment - the share purchase - and includes all subsequent cash flows and the time they
were made or received, ending with the end-period value of the shares.
In a simple case of a share purchase and annual dividends, then the set of cash flows might look like:
Time
Cash Flow
(pence)
Time0
share purchase
-100
Time1
Time 2
Time 2
dividend received
dividend received
share value
+10
+10
+100
In this case, the cash flow looks exactly like a 2-year bond with an annual coupon of 10% being
issued at par. We can see that the annual return is 10%, but whatever the numbers, we can
calculate the return achieved in exactly the same way that we would calculate any IRR.
However, the return being delivered to shareholders is not always within the control of a company’s
management and so illustrates a problem if using this approach to decide whether a company’s
management is doing a good job on their behalf by focussing on share returns. What if the time
period starts with a peak in the stock market and ends with a 2008-style recession? Not many
companies kept stable share prices through that! Within any time period we might see big
variations in share value that are much more to do with market sentiment than company
performance.
Question 4
An investment manager bought shares in Racy PLC in June 2012 when they were 250 pence/share.
Since then, dividends have been received of 12 pence/share in June 2013, 15 pence /share in June
2014 and, most recently, 17 pence/share in June 2015, immediately after which the shares were
valued at 300 pence/share.
What is the Totals Shareholders’ Return over this period?
(a)
(b)
(c)
(d)
(e)
11.23%
11.74%
20.71%
37.60%
Don’t know
Answer
The right answer is (b) 11.74%
The Total Shareholders’ Return is the IRR of the investment. So we need to set out a table:
Time
Cash Flow
PV at 10%
PV at 12%
Year 0 (2012)
-250
-250
-250
Year 1
12
10.9
10.7
Year 2
15
12.4
12.0
Year 3 (2015)
300 + 17 = 317
238.2
225.6
NPV = 11.5
NPV = -1.7
We can then calculate the IRR as: 10% + 11.5/(11.5+1.7) ×(12% - 10%) = 11.74%
Choosing different rates to try, other than those above (10% and 12%) would give a slightly different
IRR, but this would only change the second decimal place – as long as the rates were not a long way
apart.
Answer (a) is the return calculated without including the time value of money, in other words total
received divided by total invested and then the cube root to allow for the three years.
Answer (c) has no basis whatsoever.
Answer (d) just takes the overall return, total received divided by total invested – regardless of the
time period.
The problem with trying to measure the performance delivered by a company’s management is that
we want to encourage managed risk-taking to generate growth in economic value. The tools that we
have are primarily the values determined by the stock market and accounting information. Both of
these can get us some way to our goal of measuring value delivered against risk exposure, but we
still seem to be falling short. Our next possible metric might be Economic Profit.
Economic Profit
This is a metric that relies on accounting information and on the stock market to a certain extent but
also on finance theory. At first this sounds as though we are going in the wrong direction – getting
less practical rather than more so. That may be true, but the concept of economic profit has gained
a lot of traction in the last few years. The idea is that we take a measure of profit before finance
costs, and then deduct a charge that reflects the full, risk-adjusted cost of capital. The logic is sound
in that any profit generated over and above the full cost of capital is a true return having
incorporated the cost of risk.
Economic profit can be measured in two ways. First:
Economic
Profit
(Entity)
Operating Profit
before finance costs
after notional tax deducted
=
=
Capital charge to cover returns
required by shareholders and debt
holders
=Invested capital × WACC
And second:
Economic
Profit
(Entity)
=
Performance spread
(ROCE (after tax) – WACC)
=
Invested capital
Both measures are equivalent and lead to the same Economic Profit.
‘Entity’ EP is based on profit after tax but before interest. This is to ensure that the figure is
comparable with weighted average cost of capital. WACC includes the cost of debt, so interest is
accounted for already, and is after tax because the investors’ required return can only be delivered
after the company has paid corporate taxes. The tax deduction should not be the figure quoted in
the income statement, it should be the notional figure calculated as the pre-interest profit times the
tax rate.
The benefit of using Economic Profit is that it tells us how much profit is adequate given the risk to
which the company is exposed, and it forces managers to consider the true costs of all the capital
they use. The major problem, though, is that is still uses ‘invested capital’ – a historic measure of
capital contribution rather than market values. But neither is perfect.
Question 5
Googoo Inc. has invested capital of USD 250 million, being USD 180 million equity and USD 70 million
debt. Operating profit, before any finance charges, is USD 50 million. Tax is charged at 21% and
post-tax WACC is 9%.
What is Googoo’s Economic Profit?
(a)
(b)
(c)
(d)
(e)
USD 14.5 million
USD 17 million
USD 21.5 million
USD 27.5 million
Don’t know
Answer
The right answer is (b) USD 17 million
The calculation starts with Operating profit and then deducts a notional tax charge of 21%:
Operating profit before finance cost but after tax = 50 × (1- 0.21) = USD 39.5 million
Economic profit is then USD 39.5 m – (Invested capital × WACC)
= USD 39.5 million – USD 250 million × 9%
= USD 17 million
The alternative calculation would be:
Economic Profit = Spread of (ROCE – WACC) × Invested Capital
= (39.5/250 – WACC) × Invested Capital
= (15.80% - 9.0%) × USD 250 million
= USD 17 million
Answer (d) was obtained if the pre-tax figure was taken for Operating Profit.
But nothing is perfect
All of the measures discussed have good points and bad points in trying to align the goals of
managers and shareholders. We started by detailing the problems with using earnings per share and
pointing out that earnings alone are not the same thing as value. We arrived at economic profit via
MVA®, MBR and TSR. But whether we look just at shareholder returns or a mix of market-based and
accounting-based measures we still do not have a perfect measure.
Question 6
When proposing a metric for a management incentive scheme, which of the following is cited as a
problem associated with economic profit?
(a) It still relies heavily on stock market values
(b) it is not within management’s control
(c) it could encourage pursuit of short term goals rather than longer-term value
(d) it could encourage management to pursue its goals rather than shareholders’ goals
(e) don’t know
Answer
The right answer is (c) it could encourage pursuit of short term goals rather than longer-term value.
This is because economic profit is a one-period measure – it evaluates performance over a single
period. But managers should make decisions on the basis of longer term performance, thereby
creating the growth in earnings that represents value. One of the bigger flaws in the measure is that
it is quite possible for a project to have a highly positive NPV but a negative economic profit in its
early years. The opposite can occur too, so that managers may choose projects that give positive
economic profits now rather than those that create long-term value for shareholders.
Nothing is perfect!