Transcript Shareholder Value Creation & Value

Value Insight
Financial Management Consultants
Shareholder Value Creation
& Value-Based Management
The Presentation
• What drives international investment decisions …
• How is shareholder value created …
• How to measure value …
• How to manage value …
Ultimate Objective
• To align the conflicting interest between
management and shareholders
• To influence management to act and
behave like shareholders
International Competitiveness
Regardless of what you think about the merit of stakeholder
claims relative to each other, one thing is certain: if suppliers of
capital do not receive a fair return to compensate them for the
risk they are taking, they will move their capital across national
borders in search of better returns.
If they are prohibited by law from moving their capital, they will
consume more and invest less. Either way, nations who don't
provide global investors with adequate returns on invested
capital are doomed to fall further behind in the race for global
competitiveness and suffer a stagnating or decreasing
standard of living.
Tom Copeland et al. (McKinsey & Co) - VALUATION
Clem Sunter
Because one rule of the game has changed forever for South
Africa. We are now an open economy with all the opportunities
and threats that go with such status. If we don't nurture worldclass companies, we will remain at the bottom of the class.
Equally, with the relaxing of exchange controls and concurrent
widening of investment opportunities, a South African pension
fund or unit trust is increasingly going to compare South African
companies with the likes of General Electric in the US and
British Airways in the UK, i.e. world-class companies overseas.
The locals will therefore have to perform according to worldclass norms of performance to attract or retain their local as well
as their overseas shareholders.
What it Really takes to be World Class
Shareholder
Value Creation
Responsibility of Management
• Company mission statements proclaim
– Management will create shareholder value
• Creating shareholder value
– An accepted principle
– Uncertainty as to its definition
– Greater uncertainty on how to achieve it
Conflicting Interests
Shareholders
Management
Activity
Invest risk finance
in business
Manage business
for owners’ benefit
Rewards
Dividend and
capital growth
Salaries,
bonuses, etc.
Uncertain
Reasonably certain
Long term
(10 years plus)
Short term
(the next budget)
Certainty of
rewards
Focus horizon
Value Creation Defined
Value creation is the
• Sustained increase in dividend income
major driving force behind
• Sustained increase in share price
(capital gains)
investment decision-making !
• Combination of both
Only Cash Matters to Shareholders
Shareholders
Initial cash provided
to finance proposal
An expectancy that the
proposal will generate future cash
returns to shareholders
Business
Proposal
MAXIMISE
VALUE
It then becomes To
anmaximise value,
managers must know
ongoing process between
… how to manage value
how to measure value
measuring (valuing)
and managing value. and …
MEASURE
VALUE
MANAGE
VALUE
Measuring Value?
The Business Valuation
Valuation Defined
• A valuation is a process of arriving at a
value of an asset
• The value of an asset is the present
value of expected future benefits,
usually represented by cash flows
C. Correia et al. – Financial Management
Discounted Cash Flow (DCF) Valuations
The advantages of DCF valuations are:
• It is based on cash flow
DCF has become the industry
• Risk is accounted
for the
in the
discount
standard for
valuation
ofrate
going concern businesses.
• It recognises the time value of money
• Future capital requirements (both fixed and
working capital) are taken into account
By applying the DCF valuation method, the
value of a business equals:
Future free cash flow discounted to a present
value (PV) at a discount rate that equals the
weighted average cost of capital (WACC).
Business Value
• Future free cash flow
• Discounted to PV
• Discount rate = WACC
Free Cash Flow
A measure of financial performance calculated as
operating cash flow minus capital expenditures. Free
Calculated
as: the cash that a company
cash flow (FCF)
represents
is able to generate
after laying out the money
Net income
required to + maintain
or expand its asset
Non-cash items
+/- Working
capital changes
base. Free cash
flow is important
because it allows a
Capital expenditure
company to - pursue
opportunities that enhance
______________________
shareholder =value.
Without
cash, it's tough
Free cash
flow
to develop new products, make acquisitions, pay
dividends and reduce debt.
INVESTOPEDIA ©
WACC
is accepted
practice
to of
apply
a
The ItWeighted
Average
Cost
Capital
(WACC) Target
consists
of: Structure
Capital
• The in
cost
of equity the weights of
determining
(thecost
mostof
expensive
cost of
funding)
the
equity and
the
after tax cost
•ofThe
after
taxfinal
costcalculation
of debt
debt
in the
of WACC.
Cost of
Equity
After Tax
Cost of Debt
The Formula:
Shareholders make investments forCost of equity = RFR + (MRP x RI)
the long term
and
expect
to receive
The
cost
of equity
is theRFR
rate of= return
Risk free rate
risk premium
sustainedexpected
long-termbycash
returns.MRP
shareholders
in the= Market
form of
(Cost of owners’ funds)
RI
= Company beta
dividends and increase in share
price
for the
risk they are taking for making an investment.
Cost of Equity
Risk free rate
6%
(Government
bonds)
It consists
of a risk free rate plus
a risk premium.
Risk premium
+ 8%
The cost of equity is the most expensive cost
14%
*Cost
of
equity
of business finance and is not reflected as a
cost item in the income statement.
*An opportunity cost
Sources of Risk
• Economic
• Political / Social
• Market structure
• Firm’s position
+ 10%
+ 25%
+ 30%
SALES
PBIT
PAT
- 10%
- 25%
- 30%
Economic risk
Business risk
Operational risk
Financial risk
Hawawini & Viallet – Finance for Executives
Since interest is a tax
deductible expense, cost
to a company is the net
after tax cost of interest.
After Tax Cost of Debt
Interest rate
Tax shield @ 50%
After tax cost of debt
8%
- 4%
4%
Cost of Capital (WACC)
A Performance Measurement
The cost of capital is the minimum
acceptable return. It is an invisible
statement
thatgood
can no
dividingA line
between
and bad
longer
be ignoredaby
corporate
performance,
cut-off
management!
rate that must be earned in order to
create value.
G. Bennett Stewart (Stern Stewart & Co) – The Quest for Value
DestroysValue:
Creates
Maintains
Value:
Value:
Of importance is sustainable long-term
Shareholders are getting less
more
exactly
cash returns on invested capital.
what what
than
they have
they have
askedasked
for. for.
Business Performance
ROIC > WACC :
Creates value
ROIC = WACC :
Maintains value
ROIC < WACC :
Destroys value
ROIC = Long-term cash return on invested capital
The DCF Valuation Procedure
Step 1 : Analyse historical performance
Step 2 : Forecast financial performance
Step 3 : Quantify free cash flow (FCF)
Step 4 : Estimate WACC
Step 5 : Apply DCF valuation methodology
Step 6 : Reach a valuation conclusion
The slides that follow will illustrate
the basic steps in performing a DCF
business or strategy valuation.
Forecast Assumptions
• Inflation and growth = 0%
• Interest rate = 8%
• Tax rate = 50%
• Dividend paid = 25% of PAT
• Target capital structure:
50% equity and 50% debt
• Annual investment in assets = 10
Financial Forecast and FCF
Income Statement
Operating profit
Interest
PBT
Tax
PAT
0
50
10
40
20
20
1
50
9
41
21
20
2
50
8
42
21
21
3
50
8
42
21
21
OP
FCF
50
Tax
OCF
25
25
Invest
FCF
10
15
*Dividends not shown
Balance Sheet
Note:
Equity
70 85 101 117
1. Since interest forms part of the
Debt
110 105 99 93
discount rate (WACC), it is ignored in
Capital employed
180 190 200 210
theInvested
calculation
of FCF. 180 190 200 210
capital
2. Tax in FCF is calculated by applying
the actual “cash tax rate” to OP.
The target capital
structure for “weight”
purposes is 50:50
Cost of Capital (WACC)
Cost of equity
Risk free rate
Risk premium
Cost of equity
6%
+8%
14%
Cost of debt
Interest rate
Tax shield @ 50%
Cost of debt
WACC
Cost of equity
Cost of debt
WACC
8%
-4%
4%
1
14%
4%
2
.5
.5
1x2
7%
2%
9%
Business value consists of:
DCF Business Valuation
1 The value of the forecast period
Free cash flow
Discount factor
Present value
plus
the3forecast
0 2 The1 value after
2
Resperiod
(the residual value).
15
15
15
292
.92
.84
.77
.77
263
Business value
263
Debt
110
Equity value
153
Base equity value
Value creation
70
83
= 14
+ 13
+ 12
+ 224
This slide illustrates that
In terms
of the definition
of the
if the investment
is made
“cost
ofifequity”,
positive “value
and
the projections
are
creation”
means
accurate,also
equity
valuethat
of
shareholders
be getting
83 will bewill
created.
more than they have asked for.
Still a lot of “ifs”!!
Value must, however, still be created
through a process of management.
The next slide illustrates how value
creation can be broken down into future
value creation performance targets.
Value creation of 83 can be broken
Value-based
management
incentives
There
is novalue
correct
way to design
valuedown into future
annual
creation
comply
with
principles
of good
based
bonus
plans
and (refer
it remains
the should
performance
targets
(EP): the
Value-based
management
bonuses
VBM
later)
Yrbe
1 =based
9 corporate
governance
as recommended
on
the achievement
of future
EP targets.
prerogative
of business
owners
and
Yr 2 = 8 by managers
the King III
to Report.
develop a bonus plan that
YrWhen
3 = 7 designing a value-based bonus
lies in
1 plan,
2 the key
3 Res
will
provide
the the
bestEPsolution
forevery
them year that
embedding
into
the
plan
target of
[Residual
EP
(82)
is
the
expected
EP
Operational cash flow
25
25
25
and
their
business.
forms
part
of
the
strategic
plan.
that will be generated in the period
*Cost of capital
-16
-17
-18
after the
forecast]
Especially
in the case of capital intensive
businesses
must
EP
9
8
7 it 82
be Discount
noted that
be based
factorbonus plans should
.92not .84
.77 on
.77 the
achievement of EP targets of a single year, since it will
EP @ PV
83
= 8 + 7 + 5 + 63
motivate management to make short-term decisions with the
Future Performance Targets (EP)
sole objective of earning bigger bonuses. In the process they
EPreject
= Economic
profit
may
lucrative
investment opportunities and/or refrain
EP incurring
= Future value
creation
performance
targets
from
capital
expenses
that can
be vital for the
future existence of a business.
*Cost of capital = WACC X Opening capital
Managing Value?
VBM
Value-Based Management
VBM Defined
Value-based management is an integrative
process designed to improve strategic and
operational decision-making throughout an
organisation by focusing on the key drivers of
corporate value.
Tom Copeland et al.
MOST IMPORTANTLY !!
Commitment from top management,
especially from the CEO, is of vital
importance for VBM to be successful.
VBM
Management
processes must be
adjusted to
accommodate value
based activities and
decision-making.
Value Creation
Mindset
Management must first
of all develop a value
creation mindset for
VBM to be successful.
Management
Processes
Tom Copeland et al.
VALUE CREATION
MINDSET
Management must also
Management
mustmust
identify
Management
understand
whenisthere
A value driver
any is
and focus
on the key
understand
that value
conflict between
their
performance
variable
that
drivers
have the
biggest
valuethat
creation
is their
primary
their
drives
the objective
value of aand
business.
impact
on business
value.
primary
objective.
other objectives.
Primary
Objective
Other
Objectives
Understanding
Value Drivers
Tom Copeland et al.
Macro
Value Drivers
Revenue
Profit margin
Cash taxes
Fixed assets
Micro
* Volume
* Mix
* Market size
* Market share
* Pricing
* Wage rates
* Productivity
* Shrinkage
* Tax rate
* Structure
* Tax losses
* Allowances
* Asset life
* Technology
* Maintenance * Sub-contract
Working capital
* Debtor terms * Supplier terms
* Stock turn
* Supply chain
Cost of capital
* Gearing
* LT debt %
Competitive
advantage period
* Dividend policy
* SBU unique
* Risk mngmnt * Empl shares
* Incentivise
* Core strategy
STRATEGIC
PLANNING
BUDGETING
THE 4 KEY
MANAGEMENT
PROCESSES
FINANCIAL
REPORTING
MANAGEMENT
INCENTIVES
Strategic Planning
Budgeting
• Will the current strategy
create value?
• What is the Co’s expected
short-term performance?
• What is the value creation
potential based on
alternative strategies?
• How much capital is
expected to be invested
in each business unit?
Consistency?
The 4
key management
Consistency
processes must always be
Bonus Plans
Financial Reporting
aligned with value creation.
• Is the Co meeting its
performance goals?
• Are performance targets
aligned with SVC?
• Is the Co profitable and
creating value?
• What is the balance
between ST & LT bonuses?
James A. Knight – Value Based Management
VBM Implementation Process
Gaining
Commitment
Introducing
VBM
• Performance
measurement
• Value audit
• Generate senior
level commitment
• Value driver
assessment
• Broader buy-in
• Strategy valuation
• Value-based
incentives
• Education
Consensus on
need to change
Reinforcing
VBM
• VBM infrastructure
• Continuing education
Understanding of
how to change
Ensure that
change is sustained
Alfred Rappaport – Creating Shareholder Value
Management creates value by…
making investments…
in long-term business opportunities…
that generate cash returns…
higher than the cost of capital
Management also creates value by…
divesting from…
business units…
with cash returns…
consistently below the cost of capital…
destroying value in the process
Getting Out of Trouble
Identify value-destroying businesses
Assess improvement options
Identify resource needs
Obtain strategy approval
Sell
“as is”
Wind down
and closure
Short-term
performance
improvement
Value
regain plan
A. Black et al. – In Search of Shareholder Value
Value Recovery Options
Low Risk
Low Value
Sell now
“as is”
Wind down
and closure
Short-term
performance improvement
Full value
recovery plan
High Risk
High Value
A. Black et al.
Investment Appraisal Process
Identify strategic objectives
Search for investment opportunities
Initial screen
List possible outcomes
Quantify Value Creation
Select investment projects
Obtain authorisation
Review investment decisions
Kate Moran – Investment Appraisal
The Challenge
Value-creating growth is the strategic
challenge, and to succeed, companies
must be good at developing new,
potentially disruptive businesses.
Alfred Rappaport
The Advantages of VBM
• Decision-making supports value creation
• Focused decision-making
• Clear performance target setting
• Improved resource allocation
• Business units compete for capital
• Effective asset management
• Integrated financial management framework
• Early warning for poor performers (unemotional)
• Serves as a catalyst for change
• Promotes ownership mentality
KEY QUESTION:
Does your business
create or destroy value?
If you do not measure it,
you will never know.
When will VALUE become
the focus of your business?
Thank you for viewing
this presentation !
Value Insight
Fanie Swanepoel
B.Com. CA(SA)
Tel: 021 910 2715
Cell: 082 730 7662
E-mail: [email protected]
Website: www.valueinsight.co.za