Managing for value creation was the undisputed mantra of the 1990s. Faced with the realisation that so-called ‘earnings-enhancing’ acquisitions were little more than a mathematical trick while ‘profitable’ companies failed for lack of cashflow, the ascendancy of a system that seemed to offer a real link between financial management and share-price performance was irresistible. The leading system of this type, EVA, or Economic Value Added, was developed by New York consultancy Stern Stewart in the 1980s as a way of measuring past performance, evaluating investment projects and rewarding managers in a way that aligns their interests with those of shareholders.
But some have argued that the steam has gone out of the value-based management bandwagon: companies that are renowned for implementing EVA and similar systems have seen their share prices slide recently, while high-tech ‘growth’ stocks have soared. That view, however, completely misunderstands how EVA works.
In fact, not only does EVA help promote growth – real, not ephemeral growth – the methodology also helps identify just how much growth the markets expect any one company to deliver. This makes EVA a powerful tool, and just as relevant in the 21st century as it was when it first appeared.
Obviously, markets expect growth: that’s what investment is all about, and markets exist to direct scarce capital to higher growth opportunities. But what isn’t always very clear is how much growth is expected. As we’ll see, EVA provides some answers.
Stern Stewart Europe has examined the accounts of the 152 mid-market UK companies – those with an enterprise value of between £200m and £1bn – and ranked them according to their success at creating wealth for shareholders. It shows how these companies – which have typically suffered by being neither big enough to play the global stage like BP Amoco nor niche enough to be dot.commed – have created value. The best 25 companies from this ranking are reproduced exclusively on the opposite page [please refer to page 27 of the April issue of Financial Director, paper version only], along with the bottom 10.
The first point to make is that fully 73% of these 152 companies have created value, defined as having a market valuation greater than the book value of the assets – so they have succeeded so far in generating value for shareholders over and above the value of the operating assets. That’s called MVA – Market Value Added.
Of course, that value represents not so much the companies’ success to date, but rather, the performance that is expected of them in the future. Success is determined by generating profits that more than cover the weighted average cost of debt and equity capital. That’s EVA – economic value added. So, MVA represents the present value of all future EVAs that the company is expected to generate each year.
Until recently, that has been where the analysis stopped. Now, the components of MVA are being re-examined to show how much of a company’s share price reflects the current performance of the group, and how much reflects expectations of growth.
There are two bits to consider: the first is to take the latest available EVA figure – the actual financial performance of the company – and to assume that that performance continues in perpetuity. (While one may be tempted to dismiss this as an unrealistic assumption, it serves as a base case for evaluating growth expectations.) Hence, it’s capitalised using the company’s own cost of capital. Say that a business generated EVA of £4m: if its cost of capital is 10%, then the present value of that current EVA stream is £40m (£4m / 0.10).
Now for the second bit. If the MVA – the present value of all future EVAs – is, say, £100m, then the share price is currently expecting aggregate EVA of £60m over and above what the company is currently producing. That £60m is, of course, the present value of increases in EVA. It’s called the Future Growth Value – FGV.
Mich Bergesen, managing director of the UK and Benelux for Stern Stewart Europe, explains, ‘If you take the present value of current EVA plus the book value [the operating capital], that is what we call the current operations value of the business. So, in other words, if this business had absolutely no future growth prospects whatsoever, that is what I would pay for the business as a going concern. The fact that it has this extra Future Growth Value means I will pay a premium.’
Exactly when those increases – the Future Growth Value – are expected to be delivered is not something that the model can determine. But it is useful to look at the FGV and compare it with the total market value. That helps serve as a benchmark that enables companies to see how much growth the market is expecting of the other companies in the industry sector or the market as a whole.
‘FGV as a percentage of market value shows how much of the value of this company is forward-looking and how much of it is in current operations,’ Bergesen says. He adds that care must be exercised when a company has had an unusually bad year.
However, looking at the FGV is a valuable exercise, for two reasons: first of all, by getting a clearer insight into just how much growth the markets are expecting of a company, it is possible to consider whether the current strategy is likely to deliver the goods: if not, then expect the share price to weaken as the company disappoints the markets.
Alternatively, if the markets appear to have low expectations, then perhaps an investor relations exercise is called for: the market may well be failing to value a business as a high-growth concern. Either way, the formula helps interpret what it is that the share price is trying to tell you about its hunger for growth.
The examples on this page [please refer to page 28 of the April issue of Financial Director, paper version only] are worth working through, but the case of Express Dairies is notable: it is an example of a company that is valued highly in relation to its assets, hence it has a significant MVA of £279m. No wonder, given that it generates more than £27m over and above its cost of capital. But the growth expectations in this company are essentially zero: the Future Growth Value is minus £2m. It has plateaued, but at a broadly acceptable level of financial performance. Perhaps this gives the lie to the notion promoted by EVA critics that the methodology is overly demanding of growth. It’s perfectly acceptable to be a cash cow – as long as the cash isn’t retained and squandered in low-yield projects. Or to use the classic textbook example, there are still good returns to be made out of buggy whips.
So far, we’ve discussed how to interpret a company’s share price to determine the growth expectations of the market. But the same EVA methodology is also invaluable at helping businesses deliver that growth. As the examples on page 30 reveal, the system works by providing an intellectual rigour to investment decision-making, reinforcing that with a remuneration system that aligns the interests of managers and employees with those of shareholders.
Patrick Dunne of venture capital group 3i puts it this way: ‘EVA is all about where you put your chips. What’s the best use of capital? Do you stick it on buildings or humans or technology?’ It can certainly work even in the new e-conomy. ‘You could have argued that for some of the e-tail businesses it may have been better to invest capital in logistics. Advertising might actually have made things worse,’ Dunne suggests.
Ron Petersen, chief executive of engineering group Brunel Holdings, sets out how EVA has helped not just to reduce costs and eliminate wastage, but to grow the business as well. One business unit manufactures cheese-making equipment. ‘Today, instead of a sleepy little business that thought, ‘If it’s not in the West Country then it can’t be good,’ we’re now competing around the world and building plants in New Mexico and Oregon and so on,’ he says.
Ironically, one of the things that is most controversial about EVA is the one thing that its practitioners worry least about: the cost of capital, and in particular, the cost of equity. While academics can worry about exactly how the cost of equity is calculated, in the real world it is more important to be approximately right than exactly wrong. ‘If a decision is dependent upon a small difference in cost of capital then there’s probably something wrong,’ says Dunne. ‘I think you could probably spend your time better on other things than being precise about that.’
Petersen believes strongly that, if it’s true that the markets have turned their backs on value management, then it won’t continue forever. ‘If you consistently outperform your cost of capital and you improve upon its performance, by definition somebody is going to figure out that you’re doing something right,’ he says. You will, in other words, be feeding your share price with the growth it demands. ‘That, in the long term, is going to over-ride the flight from industrials into dot.coms. At the end of the day, the market will come back to earnings capability.’