An assessment on managing and measuring Shareholder Value

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Shareholder Value Added differ from value based management as it is a performance measure of a company's worth to shareholders compared to the weighted average cost of capital invested (WACC). It started to become popular in the 1980s largely thanks to Jack Welch, former CEO of General Electric.

SVA is the economic profits made by a business above and beyond the minimum return required by all providers of capital. "Value" is put in when the overall net economic cash flow of the business surpasses the economic cost of all the capital employed to produce the operating profit. As a result, SVA integrates financial statements of the business (profit and loss, balance sheet and cash flow) into one meaningful measure.

The SVA approach is a methodology which acknowledges that equity holders as well as debt financiers need to be compensated for the bearing of investment risk in particular businesses.

Usually, it can be seen that debt financiers have been clearly compensated; on the other hand, this has not been the case for providers of equity capital. This type of inequality can lead to inefficiencies in the allocation and utilization of capital.

The SVA methodology is a very open approach to help management in the decision making process. Its functions include performance monitoring, capital budgeting, output pricing and market valuation of the entity.

Advantages of SVA

Traditionally accounting equations focus more on net profits after tax equivalents measured as a percentage of the total asset base. On the other hand the value based management approach, like SVA, concentrates more on the operating performance of the firm by altering net operating revenue (NOPAT) by the allocation of a capital charge along with the economic operations of the business. The SVA method takes into account one really important variable that many traditional accounting measures do not which is how much capital is being used in the business. SVA combines income statement and balance sheet data to decide the excess returns available to all capital holders.

Criticism

The main importance of maximizing shareholder value has been commonly criticized. Shareholder value does benefit the owners of a corporation financially but it does not give a clear assessment of corporate social responsibility and environmental issues like employment and ethical business practices. A management decision can maximize shareholder value but lowers the welfare of the local communities, the workers in the company and the environment. Another point to ponder is short term focus on shareholder value can be harmful to long term shareholder value. The expense of tricks that temporarily increase a stocks value can have negative impacts on its long term value. The concentration on shareholder value has come high critics especially after the 2009 financial meltdown.

Calculation of SVA

The basic calculation is net operating profit after tax (NOPAT) minus the cost of capital from the issuance of debt and equity, based on the company's weighted average cost of capital:

NOPAT is the net profit after tax.

Cost of capital is capital x WACC.

SVA in Malaysia

This is the top 10 companies who gives the best service to their shareholders according to The edge in the year 2008.

1. British American Tobacco

2. Digi.com

3. Amway (M) Holdings

4. Berjaya Sports Toto

5. Nestle (M)

6. Hai-O Enterprise

7. Jobstreet Corp

8. Uchi Technologies

9. KNM Group

10. Guiness Anchor

This shows that SVA is an important strategy for big companies be it a local company or a foreign company. We can see this from the fact that BAT is 1st on the list while on the second place we can find Digi, a local telecommunications brand. A company that really aims to maximize the shareholders wealth will attract more investors as they want to be provided the services provided in companies that have a high share holder value, like the ten companies above.

Economic Value Added

The EVA is developed by Stern Stewart & Co. Economic Value Added or EVA in short is a calculation of true economic profit that is determined by making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital and other methods. It measures a company's financial performance established on the residual wealth calculated by deducting cost of capital from its operating profit.

EVA helps in erasing questionable accounting adjustments. In could have caught Enron who reported false profits in their financial statements. EVA is comparable to Residual Income or (RI) in short although there might be some differences. Another term EVA can be called is Residual Cash Flow (RCF). In all three methods (EVA, RI, RCF), money cost of capital refers to the amount of money rather than the percentage of cost of capital. The amortization of goodwill or capitalization of brand advertising and other similar alterations are the conversions that can be made to Economic Profit to make it EVA.

EVA has been argued not to be appropriate for high technology companies where R&D expenditures have long expected payoff periods or for mature heavy-manufacturing industries.

Calculating EVA:

The basic formula of EVA is:

Where:

 , called the Return on Invested Capital (ROIC).

r is the firm's return on capital

 NOPAT is the Net Operating Profit After Tax

c is the Weighted Average Cost of Capital (WACC)

K is capital employed.

Investors of the company will gain a positive value added when the return from the capital employed in the business operations exceeds the cost of that capital. The value gained by employees of the company or by product users is not included in the calculations.

EVA Applications in Malaysia

Creating value is a big aspect of a firm's strategy. Firms want to use their resources fully. To calculate this we need to calculate the performance result. EVA is used in measuring the performances of stocks trading in Bursa Malaysia.

EVA is used in Malaysia by corporations to:

Measure performance

Capital budgeting

Setting the corporations goals

Motivating managers

Estimate the value of the firm

Examining securities

Communication with stockholders

As a determinant of bonuses

EVA is a useful tool for assessing company performance. It combines factors, such as economy, accounting and market information in its assessment. A research done in Malaysia found that larger size companies were found to have lower EVA values. Companies which have the characteristics of both large in size and government owned have lower EVA.

Return on Capital Employed

Return on Capital Employed (ROCE) is a ratio that is applied in finance to measure the returns that a company is achieving from its capital employed. The return on capital employed (ROCE) ratio completes the return on equity (ROE) ratio by adding a company's debt liabilities to equity to reflect a company's total "capital employed".

ROCE limits the focus to gain a better understanding of a company's ability to generate returns from its available capital base. ROCE is utilized as a measure for comparing the performance between businesses and also to assess whether a business makes enough returns to pay for its cost of capital. By comparing net income to the sum of a company's debt and equity capital, investors will get a better picture on how the use of leverage impacts a company's profitability. Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it estimates management's ability to generate earnings from a company's total pool of capital.

ROCE is similar to ROE but there are differences. ROCE ignores borrowings, shareholders equity funds and interest paid on borrowing whereas ROE uses them.

Formula of ROCE:

EBIT is the Earning before Interest and tax.

Capital employed is Net Assets or the capital investments that is necessary to operate.

Drawbacks of ROCE

The major drawback of ROCE is that it measures return against the book value of assets in the business. As these are depreciated the ROCE will keep on increasing even if cash flow has stayed the normal value. This means, older businesses with depreciated assets will usually have a higher ROCE rate than newer, businesses. Also while cash flow is influenced by inflation, the book value of assets is not. Therefore revenues increase with inflation while capital employed generally does not (as the book value of assets is not affected by inflation).

The return on capital employed is an important measure of a company's profitability. Many investment analysts think that factoring debt into a company's total capital provides a more comprehensive evaluation of how well management is using the debt and equity it has at its disposal.

Investors would be well served by focusing on ROCE as a key, if not the key, factor to gauge a company's profitability. An ROCE ratio, as a very general rule of thumb, should be at or above a company's average borrowing rate.  ROCE is sometimes confused with return on common equity which is ROE in short.

Applications in Malaysia

ROCE is a good indicator was to how well a company's management is using its business assets to generate earnings.

An example of ROCE in Financial Statement is Petronas:

PETDAG's earnings for the year ending 31-Mar-07 were reported as follows:

As per the above, its Average Capital Employed

(2641+3004.2) / 2= RM2, 822.6 million

ROCE = 711.2 / 2822.6 = 25.2%

This means that the company is achieving a return of 25.2% on its business assets

ROCE is an important strategy that must be taken into account by small companies as well as big companies. Some people questions if the use of ROCE is applicable, but companies around Malaysia still uses it as ROCE is a good indicator as to how a company has been using its assets t generate profit.

Value Based Management

Value based management is an approach that makes sure corporations are consistently aiming to maximize their shareholders wealth. The primary purpose is shareholder wealth maximization. Value-based management is a management philosophy that uses analytical tools and processes to focus an organization on the single objective of creating shareholder value. It includes an alignment of corporate strategy, performance reporting and incentive compensation, and aids to bring all staff together to act like shareholders, making decisions that maximize value. These decisions should ultimately lead to improvements in stock market performance over the long run.

Value Based Management includes three of these followings:

1. Creating Value

2. Managing for Value

3. Measuring Value

Value is created because creation of value is the primary goal of managers in leading companies. A firm exists to create and maximize their shareholders wealth. They also have to take into account the other stakeholders in the company such as customers, managers, employees, suppliers and the society. The organization will then determine which of the stakeholders are to be prioritized.

This management principle states that management should first and foremost bear in mind the interests of shareholders in its business decisions. Even though this is built into the legal premise of a publicly traded company, this method is usually highlighted in opposition to assumed examples of CEO's and other management actions which enrich themselves at the expense of shareholders. Examples of this is acquisitions which are dilutive to shareholders, where, they may cause the company to have twice the profits for example but these could then have to be split amongst three times the shareholders.

As value based management is difficult to influence precisely by any manager, it is regularly broken down in components, so called value drivers. A popular model comprises 7 drivers of shareholder value giving some guidance to managers:

Revenue

Operating Margin

Cash Tax Rate

Incremental Capital Expenditure

Investment in Working Capital

Cost of Capital

Competitive Advantage Period

There are many different value-based methods of measuring value creation in a company, the most popular are:

Discounted Cash Flow (DCF): This method was made popular by LEK/Alcar Consulting Group. It says that the value of an asset is the present value of the expected cash flows resulting from the use of the asset, discounted by the company's cost of capital.

Cash Flow Return on Investment (CFROI): This method was popularized by Boston Consulting Group (BCG) and HOLT Value Associates. CFROI is the cash flow a company generates in a given period, expressed as a percentage of the amount of investment in the company's assets. This ratio is then converted to an internal rate of return measure that estimates return over the normal economic life of the assets.

Return on Invested Capital (ROIC): This method was popularized by McKinsey and Co. ROIC indicates how much return a company is generating on the amount invested in the operations of a company. It is a ratio of a company's net operating profits less adjusted taxes (NOPLAT) to its invested capital. Invested capital includes working capital, fixed assets, and other operating assets.

Economic Value Added (EVA): This method was popularized by Stern Stewart & Co. It is a residual income approach, measuring whether the operating profit after tax (adjusted for such things as amortization and R & D expenditures) is enough compared to the total cost of capital employed (the company's adjusted book value of capital multiplied by its cost of capital). The idea behind EVA is that shareholders must earn a return that compensates them for the risk taken.

Value Based management in Malaysia

VM was first introduced in Malaysia in 1986. Unfortunately, VM has not yet become widely practiced in Malaysia. It was observed that due to some successful applications of VM in the Malaysian construction industry, further actions should now be taken to exert its full potential to improve value for money for the clients of the industry.

The philosophy and techniques of VM are founded on a technique and process which provides a structured approach to the examination and development of a project that will increase the likelihood of achieving the predetermined requirements at optimum value for money.

By having the concept of VM installed, it can identify the option which gives the best value for money in accordance with set criteria. It has been recognized that VM is a factor that is critical to the success of projects, by providing the basis of improving value for money. This is a strong statement, which if it is well researched, will be able to help the Malaysian companies to be more competitive, to provide greater client satisfaction and be able to cushion the impact of globalization in the near future.

Blue Ocean Strategy

Blue Ocean Strategy is a practice to create value that is based on a book written by W.Chan Kim and Renee Maubirgne. The book explains on a strategy on how to attain high growth and profits for your corporation by producing a new demand in a market that is not yet contested. The theory suggests it is better than competing with other suppliers for customers that are already there in an existing industry which is called the Red Ocean Strategy. The authors have researched on this method for 15 years. The book explains the strategic moves that can be done to implement the strategy.

There are three parts to the book. The first part explains the key concepts that are found in this strategy. One concept is the Value Innovation concept.  Value innovation is a strategic move that allows a company to form a blue ocean. Companies in the red ocean aim for incremental improvements for customers through either low cost or differentiation. On the other hand Value innovation helps companies make giant leaps in the value provided to customers through the simultaneous pursuit of differentiation and low cost. Blue Ocean Strategy believes that both are important and inseparable. Other key concepts include; the strategy canvas, the four actions framework and the eliminate-reduce-raise-create grid. On the second part of the book the authors continues by describing the four principles of blue ocean strategy formulation. These are: how to create uncontested market space by reconstructing market boundaries, focusing on the big picture, reaching beyond existing demand and getting the strategic sequence right. The four formulations guides firms on how to create blue oceans by reviewing the six conventional boundaries of competition, overcoming adoption hurdles, reduce the planning risk by following the four steps and to create new demand by launching a possible blue ocean idea and using strategic pricing and target costing. The final part illustrates the two key implementation of the strategy that includes tipping point leadership and fair process. These principles are an integral part to overcome 4 key hurdles that are the cognitive, resource, motivational and political hurdles.

The authors have presented the following primary tools; Strategy Canvas, the Four Actions Framework, the Eliminate-Reduce-Raise-Create Grid, and the Three Characteristics of Good Strategy.

STRATEGY CANVAS

It is a diagnostic and action framework for building a compelling Blue Ocean Strategy, it consists of an X-Y canvas where x-axis represents the many factors organizations compete on (price, image, support, speed, etc.) and the y-axis illustrates where each company is positioned for each factor. Identical or similar strategy curves are a clear indication that everyone is trying to outdo the other on the same factors and no organization stands out from the crowd.

FOUR ACTIONS FRAMEWORK / GRID

ELIMINATE factors that the industry has long competed on and no longer add value for the customer; this will eliminate unnecessary costs. REDUCE factors that were over designed or features that were added for the sake of competition; reduces unnecessary costs. RAISE factors important to the customer that have been compromised; utilize some of the cost savings from the first two actions. CREATE factors that have never been offered (a new value proposition).

THREE CHARACTERISTICS OF GOOD STRATEGY

Focus, Divergence, and a Tagline - The new strategy FOCUSES on the important areas and not on every single factor, DIVERGES away from the competitors offerings, and has a simple easy to communicate TAGLINE. To create a Blue Ocean strategy, the organization's curve on the strategy canvas must move away from the competition.

Example in Malaysia: Air Asia

An example of a company that applies the Blue Ocean Strategy that we can find in Malaysia is Air Asia. They applied the blue ocean strategy and avoided competing head on with other airlines such as MAS and Tiger Air. By following the framework in Blue Ocean Strategy Air Asia has done to achieve a high profit.

They used the Four actions Framework by:

Delete:

* Over the counter booking system

* Free Food / Beverage on air

* Seat reservation by class

: Reduce

* "Luxury" facilities in the airport lounge

* Attendance service

* Seat Quality

Raise:

* Key different destinations

* Frequency of flights

Make:

* Online Booking System

* Point to point travel system

By using this strategy, Air Asia focuses on factors that customers value more such as easy reservation and frequency of flights. This will increase their value in the eyes of the customers (Value innovation).

Air Asia also focused to sell their tickets more to people who cannot afford high ticket prices such as students and also normal government employees. Most airlines in the area targets well off businessmen and people who can afford high ticket price.

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