In corporate circles, there is always talk about creating “value.” Managements are forever striving to “add value” and to undertake “value enhancing” or “value accretive” activities. But ask a typical senior manager what this “value” is and you will not get a convincing answer. It is important to understand this concept because it goes to the heart of a company’s “market value”!
All businesses are pools of debt and equity capital that have been entrusted to the management to deliver returns, taking into account the inherent risks of the business. While the ultimate objective of any enterprise is to maximise returns for its owners, i.e., the shareholders, the reality is that the shareholder/owner stands right at the end of a long line of other stakeholders. This includes customers, employees, suppliers, credit providers and the government. And unless other stakeholders are first satisfied in terms of their expectations either in the form of a good product, salaries and wages, debt servicing, payments of taxes or following rules and regulations—an equity holder cannot expect to generate a fair return on a sustainable basis.
This fact is also reflected in the profit and loss statement where the top line is based on sales to consumers, operating costs which consist of salaries and wages to employees and raw material costs to suppliers. Then come interest costs to debt providers followed by taxes to the government. The profit after tax that is left over is what finally belongs to the shareholders. The interesting fact in this entire chain is that while all other stakeholders receive their minimum return expectation, it is unclear whether the poor shareholder gets his due or not. Whatever remains, whether adequate or not, goes to the shareholders.
We now come closer to the definition of value. Based on the risk that equity holders take in an enterprise, we can calculate a minimum equity rate of return as well. When the profit after tax exceeds this hurdle rate, an organisation is deemed to have satisfied all of its stakeholders and the residual profit left over is the value creation in that time period.
However, is that truly value? The answer is both yes and no—we have to dig one level deeper to get the full picture. Every pool of capital when employed in a business generates a stream of cash. This cash needs to be discounted over time at a rate which accounts for the return expectation of all its capital providers, including equity holders. The sum left over, i.e. the net present value (NPV), is the value that a business generates. Every business needs to maximise this excess value created because this NPV belongs to the equity holders as the owners of the business. The book value of equity and the business’ NPV when added give the market value of the equity. Therefore, the “value” of any activity or business is its NPV.
Business managers can maximise the market value of their companies in different ways. Increasing the cash flow, all else being equal, is the most obvious. Second, managers can deploy additional capital in NPV positive ventures. Third, the market is constantly assessing the value of each company by estimating future cash flows and the risk attached to them. This is reflected in the discount rate, which is also impacted by the business model.
• The ‘value’ of any business or activity is effectively its net present value (NPV)
• There are many ways in which managers can maximise their firm’s market value
Managers, while striving to de-risk their business models, can enhance their firm’s market value by providing a better understanding of the future of their business to the marketplace, and constantly delivering against expectations. In addition, just like managers spend long hours doing discounted cash flow models for new investment proposals, the same must be done for investments that have already been made.
Often, managers discriminate between capital that they want, and capital that they already have. This artificial distinction needs to be removed, and value creation for all capital must be calculated using similar principles. Managers should construct DCF models to determine NPVs for future investment decisions and their existing businesses to understand its true “value”, and to provide appropriate guidance to the market if so required.
Source: The Financial Express