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Valuation Perspectives … Economic Profit (EP) and Market Value Added (MVA)

Part two of a six part series


by Roy E. Johnson, Vice President, Healthcare Capital & Mergers, LLC


A simple, yet powerful, phrase sets a tone for the second article in our series. Analyzing shareholder value is mainly about determining what management has done, or is expected to do, with the capital they have been entrusted with. An important element of the analysis is to measure the “value impact” of past and present financial performance, along with strategies and future investment programs. Exhibit 1 establishes a framework that, through three companies (‘A’, ‘B’ and ‘C’), provides a basis for determining first, a key indicator of shareholder value (Economic Profit) and then, two of the most important expressions of value creation (Market Value Added and the “Magnifier”).

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Economic Profit (EP) is a concept right out of basic economics – the course most people took in college. EP is what any business owner (shareholder) should be concerned with, since it takes into account the cost of all the capital invested in the business. EP is the “residual” (what’s left over) after all the costs of running a business have been accounted for and the suppliers of capital have been provided with a fair return on their investment. A problem with Accounting Profit – most commonly expressed as Net Income or Earnings per Share (EPS) – is that it only includes a charge for debt financing; thus, missing a cost for “equity” capital, the most expensive and prevalent form of capital for a typical industrial company. The cost of equity capital is what a common shareholder expects to earn annually as a rate of return on investment. The cost of equity capital formula adds a premium to the current return on a long-term risk-free security – presently the 10-year U. S. government bond.

Because of this condition and another important one – the gap between accounting profit and cash flow, there is virtually no correlation between Net Income and/or EPS Growth and key stock market indicators – e.g., market-to-book ratios.

As stated above, Economic Profit (EP) is a “residual” – the amount of profit available after all suppliers of capital have been given a fair return for their investment. The example in Exhibit 1 shows how three companies, all with the same Accounting Profit, can have significantly different Economic Profit.

If we start with the upper portion of Exhibit 1, we have the essence of the Accounting Profit model, reflecting the traditional “profit & loss” summary.

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Historically, this is what “Wall Street” has published and what most companies have geared themselves to. The question to ask is … what is different about these companies and can you make any type of investment decision based on this information?

Two critical factors are missing, from a financial perspective, to begin to make shareholder value judgments. These two factors get at the heart of the shortcomings of using the traditional Accounting Profit model, based on Net Income or Earnings per Share as the key determinant for stock prices. Using “earnings” (alone) as a proxy for “value” misses the following:


Economic Profit begins the same as Accounting Profit – that is, with Revenue (or Sales). All the operating related expenses and taxes are then subtracted to arrive at Net Operating Profit (NOP). The EP model, in its unending quest to get close to the “economics” of the business, makes some adjustments to the typical “accounting” P&L, as follows:


The rule for making adjustments is very straightforward and is based on the concept of “simplicity with integrity”. If an adjustment is needed to maintain the economic integrity of the performance measure, then make it. If not, use information as reported.

A major enhancement in the EP model is the explicit recognition of balance sheet investment. The major categories are working capital (receivables, inventory, payables, etc.) and fixed capital (property, plant and equipment). In some companies, goodwill and intangibles are important investments and, obviously, are included in the invested capital. Another important item, ignored in the “accounting” model, is one found in the footnotes – “operating” leases. This “off balance sheet” item accounts for assets leased – thus, a financial obligation similar to other secured debt – but falling below an arbitrary hurdle defined by a Generally Accepted Accounting Principles (GAAP) formula to determine whether or not an asset should appear on the balance sheet. In some companies, operating leases represent a significant portion of assets and debt. A “rule of thumb” is if the present value of operating leases comprise more than 10% of invested capital, then they should be included. If less than 10%, they are not material and can be left out of the calculation of EP – again, “simplicity with integrity”.

Charging a cost for the capital invested in a business approximates the desires of investors. What this means is that the Capital Charge (CCAP) – 12% in our example – is the minimum annual return that investors, in the aggregate, expect from each of these three companies. Thus, the closest we can come to replicating the capital market perspective is to assess profitability after “charging” for this (minimum) return on capital requirement. The term “hurdle rate” is one used widely with respect to the analysis of capital investments. CCAP is the “hurdle” for these three firms. In this case, it is expressed as a dollar amount, but can also be a percentage. While not perfect, this approach captures the expectations of the financial markets.

As seen in Exhibit 1, all the firms are not profitable from an economic, or rate of return, perspective. In fact, only Company ‘A’ is truly profitable with an EP of $28 million. Note the EP of $4 million (just above break-even) under the Co. ‘B’ column and the negative EP of $(20) million under the Co. ‘C’ column. A variation on this format, in which the minimum return is expressed as a percentage, rather than a dollar amount, and the comparison is to a percentage CCAP – can be illustrated as follows:

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The point for now is that, conceptually, virtually all economic measures are based on the notion of ascribing a cost (minimum rate of return) to the capital invested in a business. While companies produce a balance sheet when the books are closed, most people don’t evaluate it thoroughly, nor do they make the balance sheet a focus of their analysis.

The EP status of a business positions it as a value “creator” (‘A’) or “destroyer” (‘C’) – or, as with Co. ‘B’, being value “neutral”. This has major implications for what growth will produce in terms of shareholder value. If we apply a growth scenario, with a very limited number of assumptions, to the three firms (‘A’, ‘B’ and ‘C’) we can begin to get an appreciation of why EP is so important in the value creation process.

Market Value Added
Exhibit 2 provides the foundation of looking into the future for a business.

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The assumptions in Exhibit 2, while simple and few in number, are representative of a forward-looking financial model, which investors use to value companies and businesses within companies. It’s also indicative of the type of thinking necessary to value strategies. The “value” we’re describing here – Market Value Added (MVA) – is what the market is adding or subtracting to what has been invested in the company, based on their evaluation of past/present financial performance and their perception as to where the company is going in the future. A goal of any for-profit business is to increase the “spread” between what has been invested and what the market feels is warranted based on performance. So, both EP and MVA are “spreads” … or “residuals”.

We could expand these assumptions into a more robust scenario, but the ones above will suffice to illustrate the concept. A numeric expression of these assumptions for our three companies – ‘A’, ‘B’ and ‘C’ – in the next Exhibit (3) provides an illustration.

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Co. ‘A’ increases its EP throughout the forecast period – in this case, four years. If you think about the consistency of performance implied in the assumptions (which, again, are probably over-simplified) you should understand the EP forecast results for Co. ‘A’ – EP increases each year at the 10% growth rate for revenue – $31 million in future year #1 to $41 million in future year #4. The “Years 5 on Residual” is a typical way that the years after the forecast horizon are treated, which “capitalizes” the year 4 EP at the CCAP rate (in this case, 12%). This assumes that the plan can produce no incremental EP even if the business continues to grow, which is equivalent to saying that, after year 4, the company will just earn its cost of capital on new investment. The MVA for this growth scenario is the sum of the EP’s for the four-year growth period plus the residual value.

The example is over-simplified, at this point, in that it doesn’t (yet) account for discounting of the future values. However, it does show that Co. ‘A’ is creating shareholder value with its growth plan. Therefore, the total “warranted” market value of Co. ‘A’ (again, before discounting the future year EP’s) is the “base” period IC of $600 million (from Exhibit 1) plus the above MVA of $485 – for a total of nearly $1.1 billion. Obviously, the “real” MVA and total warranted value for Co. ‘A’ will be less when we apply the 12% discount rate to future year EP and residual values, but for now we can see that Co. ‘A’ should command a premium over its invested capital when valued in the financial markets. Why? Because management is earning more than the cost of capital and is growing the business. You should be able to visualize that if Co. ‘A’ can increase its revenue growth, then it will generate more MVA – and, thus, should experience a greater “warranted” total market value.

One of the interesting features of this analysis is that we get approximately the same MVA result as we would with the traditional Free Cash Flow (FCF) approach. Once we factor in an appropriate discount rate – which we will do after we get through with this non-discounted example – MVA (under the EP approach) is about the same as the Net Present Value (NPV) calculated using the Free Cash Flow (FCF) technique. One reason that the EP model is receiving wide-spread application in corporations and the financial institutions that invest large sums in the equity markets is that it is the conceptual equivalent to the FCF approach, with the result (MVA) equal or very close to the NPV. Further, with the EP approach, we can determine meaningful period-by-period financial results – indicative of value creation, destruction or neutrality – which is usually not possible with the free cash flow technique. The FCF model provides a credible value-based “end result”, but is typically not very useful in assessing value creation “progress along the way”.

Company ‘B’ presents a somewhat different scenario. Even though it grows and maintains its 10% after tax profit margin, the company does not produce any significant future year EP’s. By now, this should be apparent, since Co. ‘B’ just earns its CCAP. Co. ‘B’ may get bigger, but it doesn’t get much better, at least in terms of shareholder value creation. Notice the very modest $70 million MVA, which is less than 10% of its $800 million invested capital. This is noteworthy, because it indicates that ‘B’-type companies should be valued (in the financial markets) fairly close to their “economic book” value. They simply don’t return much more to the shareholders than what was invested in the first place – and are not expected to do much more with new investment.

Company ‘C’ is truly a problem. It cannot grow out of its dilemma of earning a return below the cost of capital, without radically changing the way it conducts its business. Yet, the business world is littered with ‘C’-type companies and businesses, thinking that they can grow and be successful without changing their fundamental structure. This is a very serious situation in Corporate America since a significant percentage (20% or more according to some research) of publicly traded companies in the United States fall into the ‘C’ category. Whatever assumptions we may make, the impact is clear – growth “destroys” shareholder value for ‘C’-types – and, more growth means more destruction!

Our next article will present an example to illustrate the value creating potential for ‘A’-type companies and businesses, along with how ‘C’-types destroy shareholder value.

Call Healthcare Capital & Mergers, LLC if you would like to learn more about our business valuations services. We provide simple business valuations such as a partner buy in or buyout valuation, fairness opinions on an offer to buy or sell a company, valuations to raise capital and valuations of early stage companies or technologies. We also offer more complex certified business valuations involving litigation or feasibility studies. In addition, we provide expert witness services to defend a business valuation.

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