Shareholder value and Economic Profit

Shareholders invest in a company to make a profit.  This can come from an increase in the share price and/or the dividends the company pays.

The challenge is to find a measure of business performance that correlates with share price movements.  Then, if we plan our business to raise this measure, we should raise the share price, and hence create value for our shareholders.



EBITDA

Earnings before interest, tax, depreciation and amortisation (EBITDA)

Profit is not a good measure of the value a business is generating for its shareholders.  Ultimately, a shareholder is interested in the amount of cash generated, rather than profit (which is after all only an accounting calculation). It is cash which enables the business to expand and develop, and pay dividends.  And it is the expectation of future cash flows that drives the share price up, and creates values for shareholders.

In calculating profit, depreciation is included as a cost.

Depreciation and amortisation are not cash transactions but an accounting exercise to balance the reducing value of assets over time.  We can measure earnings before interest, tax, depreciation and amortisation - EBITDA!  This is the amount of operating profit that will eventually be turned into cash.  But EBITDA alone doesn't tell us if we are creating value.


Economic profit or Economic Value Added (EVA)

Economic profit (EP) takes account of the fact that investors have choices.  They can invest in your company, or your competitor; in art; in another industry; or put their money in the bank.  Every investment has a certain amount of risk, and a level of reward.

If your company generates more cash for each pound invested than other investments with a similar level of risk, it is making an 'economic profit'.  

• Studies of real companies show clearly that an increase in EP correlates strongly with an increase in share price, and the creation of shareholder value.  
• A fall in EP goes with a reduction in share price, and destruction of shareholder value.

Economic profit is calculated by taking the cash flow generated by the business (EBITDA) and subtracting a 'charge' for the 'cost of capital'.  The cost of capital is the profit the business must make, simply to meet the expectations of investors who take this level of risk.

If the company was financed only by shareholders' funds, the cost of capital would be the average return of investments after tax with the same level of risk; for example, a group of companies of similar size in the same industry.  This is the 'cost of equity'.

Most companies are financed partly by shareholders' funds, and partly by bank loans.  So, their cost of capital is not simply the cost of equity, but takes into account the interest paid on loans as well.  This is known as the 'weighted average cost of capital', or the WACC rate.

Economic profit is calculated by

• subtracting a capital charge (the net asset value of a business multiplied by the WACC rate) from EBITDA.  
• Tax is also deducted because this is paid out of cash flow.  
• Interest is not deducted, as the capital charge has already taken this into account.

Economic profit = Profit (Earnings) - Tax - Capital charge

Capital charge = Net Asset Value of a business X WACC rate


Example of application of Economic Profit
http://spreadsheets.google.com/pub?key=t7BiKoYpNh8QNDvzcZoN8xA&output=html

Shareholders' equity: the retained earnings portion is often the largest component.

Shareholders' Equity

 

What Does Shareholders' Equity Mean?

 

A firm's total assets minus its total liabilities. Equivalently, it is share capital plus retained earnings minus treasury shares. Shareholders' equity represents the amount by which a company is financed through common and preferred shares.

 

Also known as "share capital", "net worth" or "stockholders' equity".

Shareholders' equity comes from two main sources.

• The first and original source is the money that was originally invested in the company, along with any additional investments made thereafter.
• The second comes from retained earnings which the company is able to accumulate over time through its operations. In most cases, the retained earnings portion is the largest component.

Sources of Shareholder Value

Sources of Shareholder Value

For the equity holder, the source of future cash flows is the earnings of firms.

Earnings create value for shareholders by the :

• Payment of cash dividends
• Repurchase of shares
• Retirement of debt
• Investment in securities, capital projects, or other firms.

If a firm repurchases its shares, it reduces the number of shares outstanding and thus increases future per-share earnings.

If a firm retires its debt, it reduces its interest expense and therefore increases the cash flow available to the shareholders.

Finally, earnings that are not used for dividends, share repurchases, or debt retirement are retained earnings. These may increase future cash flows to shareholders if they are invested productively in securities, capital projects, or other firms.

Which creates more value?

Cash dividends: Some argue that shareholders most value stocks' cash dividends. But this is not necessarily true. In fact, from a tax standpoint, share repurchases are superior to dividends. Cash dividends are taxed at the highest marginal tax rate to the investor; share repurchases, however, generate capital gains that can be realized at the shareholder's discretion and at a lower capital gains tax rate.

Share repurchases: Recently, there have been an increasing number of firms who engage in share repurchases. The shift from dividends to share repurchases is one factor that has raised the valuation of some equities.

Debt repayment: Others might argue that debt repayment lowers shareholder value because the interest saved on the debt retired generally is less than the rate of return earned on equity capital. They also might claim that by retiring debt, they lose the ability to deduct the interest paid as an expense. However, debt entails a fixed commitment that must be met in good or bad times and, as such, increases the volatility of earnings that go to the shareholder. Reducing debt therefore lowers the volatility of future earnings and may not diminish shareholder value.

Reinvestment of earnings: Many investors claim that this is the most important source of value, but this is not always the case. If retained earnings are reinvested profitably, value surely will be created. However, retained earnings may tempt managers to pursue other goals, such as overbidding to acquire other firms or spending on perquisites that do not increase the value to shareholders. Therefore, the market often views the buildup of cash reserves and marketable securities with suspicion and frequently discounts their value.

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Fear of misusing retained earnings

If the fear of misusing retained earnings is particularly strong, it is possible that the market will value the firm at less than the value of its reserves. Great investors, such as Benjamin Graham, made some of their most profitable trades by purchasing shares in such companies and then convincing management (sometimes tactfully, sometimes with a threat of takeover) to disgorge their liquid assets.

Why management would not employ assets in a way to maximise shareholder value, since managers often hold a large equity stake in the firm? The reason is that there may exist a conflict between the goal of the shareholders, and the goals of the management, which may include prestige, control of markets, and other objectives. Economists recognise the conflict between the goals of managers and shareholders as AGENCY COST, and these costs are inherent in every corporate structure where ownership is separated from management.

Payment of cash dividends or committed share repurchases often lowers management's temptation to pursue goals that do not maximise shareholder value.

In recent years, dividend yields have fallen to 1.5%, less than one-third of their historic average. The major reasons for this are the tax disadvantage of dividends and the increase in employee stock options, where capital gains and not dividends figure into option value. Nevertheless, dividends historically have served the function of showing investor that the firms' earnings were indeed real.

Recent concerns about aggressive accounting policies and the integrity of earnings following the Enron debacle may bring back this once-favoured way of delivering investor value.

Ref: Stocks for the Long Run, Jeremy Siegel