Introducing Value-Based Finance
[A Transition from 'Accounting' to 'Economics']
Part one of a six part series
by Roy E. Johnson, Vice President, Healthcare Capital & Mergers, LLC
The movement from 'accounting' to 'economic' metrics is at the 'core' of value-based finance (VBF) – driven by the fact that the 'real' profitability of a business is not always reflected in the traditional accounting measures that focus on net earnings. An example using a hypothetical firm – Growthstar Inc. – will illustrate the dilemma. The company has a 'CORE' business, expanded three years ago by the acquisition of 'NEWCO'. The purchase price was $55 million, financed with excess cash and new debt. 'Off balance sheet' leases of $15 million were assumed. Thus, the total investment was $70 million, none of which impacted the 'book' value of Growthstar Inc. stockholders' equity. Financial highlights of the three most recent historical years plus the current year will be presented, to provide a comparison of the 'accounting' versus 'economic' framework.
Exhibit 1 gives a tabular summary for the 'accounting' scenario, noting that year #3 is the most distant and year #1 is the most recent historical period. The 'NEWCO' deal was closed at the end of year #3. Thus, it had no effect on the company's 'operations' for year #3.
Has this acquisition benefited Growthstar's shareholders? Based on the 'accounting' scenario, the answer would seem to be a resounding 'yes'! Revenue has doubled and Net Income has grown nearly fourfold – using year #3 as a 'base' – through the current year. Return on Equity has almost doubled, from 12% to 22%, during this time period.
Under an 'economic' framework, however, the key indicators paint a somewhat different picture. The 'economic' scenario entails some important adjustments:
- Interest expense is eliminated from the P&L – and is factored into a weighted average cost of capital. Thus, the P&L is focused on 'operating' profit.
- The acquisition reserve in year #3 (accounting write-off of 'purchased R&D' portion of goodwill) is reversed – added back to both the P&L and balance sheet – reflecting the 'sunk cost' nature of acquisition investments. Write-offs reduce acquisition prices on the 'books'.
- All capital invested in the company – not just equity capital – becomes the basis for 'return' measures. This includes working and fixed capital, goodwill and assets financed by operating leases. A 'capital charge' will be assessed to the total invested capital. Deferred taxes are analyzed, to calculate an 'effective' tax rate based on taxes paid.
Exhibit 2 gives a tabular summary for the 'economic' scenario.
The highlights of Exhibit 2 are:
- Net Operating Profit is up about 240% – during the analysis period – versus a 380% increase of Net Income in the 'accounting' scenario. NOP growth is higher than Revenue growth, as 'operating profit' margins have increased to 9% from their year #3 level of 8%. The 'accounting' reserve – related to the acquisition – distorts the 'real' profit in year #3, and affects the comparative indicators for subsequent years in the 'accounting' scenario.
- Return on Capital is the same in the current year as it was in year #3 – the most distant year. In year #2, this return decreases – to below the cost of capital level – as the total acquisition investment is absorbed into company operations. Year #1 indicates progress toward getting back to the year #3 return. The 'message' here is that the company is now no better or worse off – on a 'relative' basis – than it was before it made the acquisition. This is quite a contrast to the Return on Equity results from Exhibit 1, influenced by 'accounting' entries and only the 'Equity' portion of Invested Capital incorporated into the return metric.
- Economic Profit goes from positive in year #3 to 'negative' in year #2, and then rebounds as the firm moves through year #1 and the current year. As with NOP, the current year is a bit more than double the year #3 level, versus a fourfold increase of Net Income.
Whether the shareholders will benefit long-term from this acquisition will depend on the strategy and future profitability of 'NEWCO'. This year's economic profit is a good sign.
To conclude, 'accounting' metrics often do not provide good 'shareholder value' indicators. Thus, much of the business world is turning to 'economics' for 'value analysis'. Exhibit 3 gives a graphic portrayal of first – profit growth rates, and second – returns versus cost of capital. In the Returns versus Cost of Capital graph, the left bar (black) is distant year #3 return, the middle bar (striped) is current year return, and the right bar (gray) is cost of capital.
As future articles will discuss, accountings earnings and their growth have little correlation with stock market returns. One of the reasons is that 'accounting' has its origins in credit and liquidation analysis, not in valuation. Most valuation techniques are founded in cash flow based measures, and many successful investors use accounting-based results as a starting, not an ending, point. Thus, we introduce value-based finance with a transition from 'accounting' to 'economics' – to set the stage for critical valuation perspectives and the proper application of VBF concepts and techniques.
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.
Article © 2009 Healthcare Capital and Mergers, LLC
contact@capitalandmergers.com
1-866-603-4142