1. Economic profit or EVA

Economic profit is less ambitious than net present value. It only seeks to measure the wealth created by the company in each financial year. EVA does not just factor in the cost of debt, such as in calculating net profit, but also accounts for the cost of equity.

Economic profit or EVA first measures the excess of ROCE over the weighted average cost of capital. Then, to determine the value created during the period, the ratio is multiplied by the book value of the capital employed at the start of the reporting period. Thus, a company that had an opening book value of capital employed of 100 and an after-tax return on capital employed of 12% with a WACC of only 10% will have earned 2% more than the required rate. It will have created a value of 2 on funds of 100 during the period.

Economic profit is related to net present value, because NPV is the sum of the economic profits discounted at the weighted average cost of capital:

The table shows EVA for some European firms.

To calculate EVA, it is necessary to switch from an accounting to an economic reading of the company. This is done by restating certain items of capital employed as follows:

• The exceptional losses of previous years must be restated and added to capital employed insofar as they artificially reduce the company’s capital.
• The goodwill recorded in the balance sheet must be taken as gross, i.e. corrected for cumulative amortisation or impairment, the badwill must be deducted from equity and assets.
• Other major restatements are for deferred tax liabilities and for depreciation (so as to be consistent with capital employed obtained through previously mentioned restatements).

Of course, the profit and loss account (operating profit/loss and taxes) must be restated to ensure consistency with the capital employed calculated previously.

The firms that develop economic profit tools for companies generally have a long list of accounting adjustments that attest to their expertise. Such accounting expertise typically represents a barrier to entry for others seeking to perform the same analyses.

EVA’s novelty also lies in its scope of application, since it enables a company to measure performance at all levels by applying an individual required rate of return to various units. It is a decentralised financial management tool.

A firm may be tempted to maximise short-term EVA, which may be detrimental to future EVAs (underinvestment, artificial reduction of working capital). In general, it is very complex to pick annual criteria that will make it possible to measure value creation for a firm properly. Only the NPV of future cash flows allows us to take into account the long-term capacity to create value.

2. Cash flow return on investment

The original version of cash flow return on investment (CFROI) corresponds to the average of the internal rates of return on the company’s existing investments. It measures the IRR earned by a firm’s existing projects.

CFROI is the internal rate of return that equals the company’s gross capital employed (GCE), i.e. before depreciation and adjusted for inflation, and the series of after-tax EBITDA computed over the lifetime of existing fixed assets (estimated by dividing the gross value of fixed assets by the depreciation). CFROI is then compared with the weighted average cost of capital. If CFROI is higher than WACC, then the company is creating value; if it is lower, then the firm is destroying value.

As with EVA, computing CFROI requires a number of restatements, which seem to exist mainly to convince their users to hire the founder of the concept (Holt) to implement it. It is sometimes used in a very simplified manner, which makes it very close to a mere accounting criterion (see Section 27.5).

1. Creating stock market value (market value added)

For listed companies, market value added (MVA) is equal to:

In most cases, if no other information is available, we assume that net debt corresponds to its book value. Thus, the equation becomes simpler:

So, market value added is frequently considered to be the difference between market capitalisation and the book value of equity. This is the equivalent of the price-to-book ratio (PBR) discussed in Chapter 22.³ The table shows MVA for some large listed European companies as of May 2017.

MVA, and particularly any change in MVA, constitutes a more relevant measure of value than just developments in share price. MVA assesses the increase in value with regard to the capital invested.

Inversely, MVA can raise measurement problems due to the use of accounting data.

It is easy to demonstrate the relationship between market value added and intrinsic value creation in equilibrium markets, since:

Economic profit being equal to capital employed × (ROCE − WACC). This is also equivalent to:

However, those who do not believe in market efficiency contend that MVA is flawed because it is based on market values that are often volatile and out of the management’s control. Yet this volatility is an inescapable fact for all, as that is how the markets function.

2. Total shareholder return (TSR)

TSR is the return received by the shareholder who bought the share at the beginning of a period, earned dividends (which are generally assumed to have been reinvested in new shares) and values his portfolio with the last share price at the end of the period. In other words, TSR equals (share appreciation + dividends)/price at the beginning of the period.

In order for it to be meaningful, the TSR ratio is calculated on a yearly basis over a fairly long period of, say, five to 10 years. This smooths out the impact of erratic market movements, e.g. the tech, media and telecom stock bubble of 2000 or the 2007–2010 crisis.

As an example, this is how the TSR of Investor AB, the Swedish industrial holding company controlled by the Wallenberg family, is explained by dividends paid and share price appreciation over different time periods:

1. Earnings per share

Notwithstanding the comments just made about earnings per share, many financial managers continue to favour using it, especially with regard to financial communication. Despite its limitations, it is still the most widespread multiple because it is directly connected to the share price via the price/earnings ratio. EPS’s popularity is rooted in three misconceptions:

• the belief that earnings per share factors in the cost of equity and, therefore, the cost of risk;
• the belief that accounting data influence the value of the company. Changing accounting methods (for inventories, depreciation, goodwill, etc.) will not modify the company’s value, even if it does change earnings per share; and
• the belief that any financial decision that lifts EPS will change value as well. This would imply that the P/E ratio⁴ remains the same before and after the financial decision, which is frequently not the case. Thus, value is not a direct multiple of earnings per share, because the decision may affect investors’ assessment of the company’s risks and growth potential.

Consider Company A, which, based upon its risks and growth and profitability prospects, has a P/E ratio of 20. Its net profit is 50. Company B has equity of 450 with net profit of 30, giving it a P/E of 15. Company A decides to acquire a controlling interest in Company B, paying a premium of 33% on B’s value, i.e. a total of 600. Company A finances the acquisition entirely by taking on debt at an after-tax cost of 3%. Both Companies A and B are fairly valued with regards to their risk exposure. There are no industrial or commercial synergies that could increase the new group’s earnings, and no goodwill.

Company A’s net profit is thus:

Since A financed its acquisition of B entirely through debt, it still has the same number of shares. The increase in earnings per share is therefore equal to that in net profit; that is, 24%. This certainly seems like an extraordinary result! But has A really created value by buying B? The answer is no, since there are no synergies to speak of between A and B. Keep in mind that A paid 33% more than B’s equilibrium price. In fact, Company A has destroyed value in proportion to this premium, i.e. 150, because it cannot be offset by synergies.

In fact, the explanation for the – apparent – paradox of a 24% rise in earnings per share matched by a destruction of value is that the buyer’s EPS has increased, because the P/E of the company bought by means of debt is higher than the after-tax cost of the debt. Here, B has a P/E of 20 given the 33% premium paid by A on the acquisition. The inverse of 20 (5%) is much higher than the 3% after-tax cost of the debt for A.

Consider now Company C, which has equity of 1400 with net profit of 140, i.e. a P/E of 10. It merges with Company D, which has the same risk exposure, equity of 990 and a P/E of 18 (net profit of 55), with no control premium. Thanks to very strong industrial synergies, C is able to boost D’s net profit by 50%. Without doubt, value has been created. And yet, it is not difficult to prove (see Exercise 1) that C’s EPS dropped 7% after the merger. This is a mechanical effect due simply to the fact that D’s P/E of 18 is higher than C’s P/E of 10, because D has better earnings prospects than C.

So, what was the net result of Company C’s acquisition of Company D? The question is not whether Company C’s EPS has been enhanced or diluted, but whether it paid too much for D. In fact, it did not, since there was no control premium paid and industrial synergies were created. After the operation, C’s share will trade at a higher P/E, as it should enjoy greater earnings growth thanks to the contribution from D’s higher-growth businesses. In the end, C’s higher P/E ratio should more than compensate for C’s diluted EPS, lifting the share price. This is only logical considering that the industrial synergies created value.

• the risk on capital employed remains the same from one period to the next, or before and after operations such as mergers, capital increases or share buy-backs, investments, etc.;
• earnings growth remains the same before and after any given operation; and
• the company’s financial structure remains the same from one period to the next, or before and after a given operation.

If these three conditions are met, we can assume that EPS growth reflects the creation of value, and EPS dilution the destruction of value.

If just one of these conditions is lacking, then there is no way to effectively evaluate EPS. It is not possible to infer that any increase in EPS reflects the creation of value, nor that a decrease is a destruction of value. In our example of a combination between A and B financed by debt, although A’s EPS rose 24%, its risk increased sharply. Its position is no longer directly comparable with that before the acquisition of B.

Similarly, C’s post-merger EPS cannot be compared with its EPS prior to the merger. While the merger did not change its financial structure, C’s growth rate after the merger with D is different from what it was beforehand.

2. Accounting rates of return

Accounting rates of return comprise:

• return on equity (ROE);
• return on capital employed (ROCE), which was described in Chapter 13; and
• cash flow return on investment (CFROI), the simplified version of which compares EBITDA with gross capital employed, i.e. before amortisation and depreciation of fixed assets.

This ratio is used particularly in business sectors wherein charges to depreciation do not necessarily reflect the normal deterioration of fixed assets, e.g. in the hotel business.

The main drawback of accounting rates of return on equity or capital employed is precisely that they are accounting measures. As shall be demonstrated below, these have their dangers.

Consider⁶ Company X, which produces a single product and generates a return of 20% on capital employed amounting to 100. X operates in a highly profitable sector and is considering diversifying. Should it expect the present 20% rate of return to be generated on other possible projects? If it does, X will never diversify because it is unlikely that any other investments will meet these criteria.

How can this problem be rationally approached? The company generates an accounting return of 20%. Suppose its shareholders and investors require a 10% return. Its market value is thus 20/10%, or 200.

The proposed investment amounts to 100 and generates a return of 15% on identical risks. The required rate of return is constant at 10%. We see that:

This yields an enterprise value of 35/10% = 350 (+150), with a return on capital employed of 35/200 = 17.5%.

The value of the capital employed has increased by more than the amount invested (150 vs. 100), because the profitability of Company X’s investment (15%) is higher than the rate required by its shareholders and investors (10%). Value has been created, and X was right to invest. And yet, the return on capital employed fell by 20% to 17.5%, demonstrating that this criterion is not relevant.

The inverse example is Company Y, which has a return of 5% on capital employed 
of 100. Assuming the shareholders and investors require a 10% return as well, the value of Y’s capital employed is 5/10% = 50.

The proposed investment amounts to 25 and yields a return of 8%. Since we have the same 10% required return, we get:

This results in capital employed being valued at 7/10% = 70 (+20), with a return of 7/125 = 5.6%.

The value of Y’s capital employed has indeed increased by 20, but this is still less than the increase of 25 in capital invested. Value has been destroyed. The return on the investment is just 8%, whereas the required rate is 10%. The company has lost money and should not have made the investment. And yet the return on capital employed rose from 5% to 5.6%.

Similarly, one could demonstrate that ROE increases after an acquisition funded by a share issue, when the target company’s reverse 1/(P/E) is higher than the buyer’s current ROE.

Setting aside all these accounting concepts, what are the implications for the financial concept (k)?

Unfortunately, some corporate managers continue to view decision-making in terms of the impact on accounting measures (EPS and accounting profitability), even though it has just been demonstrated that these criteria have little to say about the creation of value. True, accounting systems are a company’s main source of information. However, financial managers need to focus first and foremost on how financial decisions affect value.

Let’s discuss synergy effects before mentioning EPS accretion!

1. Strengths and weaknesses of financial indicators

As long as performance measures and their implementation remain so diversified, it is vital to have a good understanding of their respective flaws. By choosing one or another measure, companies can present their results in a more or less flattering light. Financial managers typically choose those measures that will demonstrate the creation, rather than the destruction, of value.

2. Creating value or values?

Over the past 20 years, the concept of value creation has spread rapidly, to the point where no corporate communication can afford to disregard it. Increasingly, value is assessed not just as it pertains to shareholders, but to all the stakeholders in the company: shareholders, employees and clients alike.

Managers now talk of stakeholder value, customer capital and human capital just as they do of financial capital.

While these concepts are certainly very appealing, we believe they are rooted in two misconceptions:

1. The creation of value is sometimes rather hastily accused of leading to layoffs, plant closures, drastic cost reductions or disregard for environmental protection, labour law and human dignity. In fact, the opposite is true! A look at groups that have created sustainable value for their shareholders, frequently over long periods, shows that these same companies are at the forefront of innovation, constantly creating new markets, meeting new needs, hiring and training employees and inspiring loyalty and strong customer relationships. Just a few examples are L’Oréal, 
Johnson & Johnson, Singapore Airlines, Apple and BMW. Cost-cutting strategies can only be temporary and they cannot durably create shareholder value. Cost-cutting only works in the short term and only if it gives rise to a strategy of profitable growth.
2. Shareholders entrust their money to managers whose task is to multiply it. Financial directors must operate within the framework of a given corporate mission and with the shareholders’ best interests in mind. When managers pursue other objectives, they betray the basic tenet upon which this pact is founded. More importantly, they are sure to fall short of all their objectives.

Only by creating sustainable value can a company ensure that it has the means to finance growth, train and pay its employees properly, produce quality goods or services and respect the environment.

Summary

Questions

Exercises

Answers

Notes

Bibliography