Abstract
The purpose of this chapter is to make explicit some important truths – particularly in relation to listed company performance measurement and how performance in the market for a company’s products and services, can be aligned with the capital market outcomes experienced by shareholders.
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Notes
- 1.
Kontes, Peter, The CEO, Strategy and Shareholder Value, John Wiley & Sons, NJ, 2010, p. 23.
- 2.
Economic Profit = Earnings of $10m less Equity Capital of $100m multiplied by the cost of equity of 10 percent.
- 3.
The increase in value was estimated using the Market to Book formula M:B = (ROE-g)/(Ke-g).
For Company A in Year 5, ROE is $20m/$161m = 12.5 percent and assumed to be sustainable at this level, g is assumed to be sustainable at 5 percent, and Ke is 10 percent. This gives a M:B ratio of 1.5×. Book Equity for Company A is $161m in Year 5. So the value is 1.5 × $161m = $241m, which is a 141 percent increase over the value of $100m in the base year, and represents a 19.2 percent annual growth in value.
For Company C, in Year 5 ROE is $20m/$249m = 8.1 percent and assumed to be sustainable at this level, g is assumed to be sustainable at 5 percent and Ke is 10 percent. This gives a M:B ratio of 0.62×. Book Equity for Company C is $249m in Year 5. So the value is 0.62 × $249m = $153m. This is a 53 percent increase in value over five years, and represents an 8.8 percent annual growth in value (which is less than the 10 percent per year required to preserve shareholder wealth).
- 4.
Carsales.com Limited 2013 Annual Report, p. 25.
- 5.
Kontes, Peter, op. cit., p. 4. In the US study, the criteria by which companies were defined as EPS dominant or EP dominant was based on EPS being 5 percent per annum higher than EP per share, and vice versa.
- 6.
Under the equity capital approach, we can express intrinsic value as…
Intrinsic Value = PV of [Equity Cash Flows]
= PV of [Economic Profits] + Opening Equity
= PV of [(Return on Equity − Ke) × Opening Equity] + Opening Equity
The equity capital approach can be easier to use at group level and in particular when seeking to compare performance to that of other companies. This is because the information required is generally more readily available. The equity capital approach is also more appropriate in the case of banks and other financial institutions.
Under the total capital approach, we can express intrinsic enterprise value as…
Intrinsic Value = PV of [Operating Cash Flows]
= PV of [Economic Profits] + Opening Capital
= PV of [(Return on Capital − WACC) × Opening Capital] + Opening Capital
This approach is often preferred at a business unit level since managers at that level generally find it easier to think about the economics of their business in terms of ROC rather than ROE.
- 7.
Together, these two attributes mean it can be disaggregated meaningfully to a business unit, product or segment level – something that we will speak more about in the chapters to come.
- 8.
We use the term Market to Book (M:B) in this context, even though we are using intrinsic value, which is really management’s view of what it thinks the market value should be, given what it knows about the likely future economic profit outcomes under the strategy currently being pursued.
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Kilroy, D., Schneider, M. (2017). Some Important Truths. In: Customer Value, Shareholder Wealth, Community Wellbeing. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-54774-9_2
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DOI: https://doi.org/10.1007/978-3-319-54774-9_2
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