From: Jurriaan Bendien (andromeda246@HETNET.NL)
Date: Wed May 19 2004 - 18:38:52 EDT
(Just when the post-Marxist economists have told us value theory is nonsense, corporate financial officers have taken it up. Value theory is necessary especially in large corporations, because as I mentioned in an earlier article, very large resources are being managed which are withdrawn from the market, i.e. they are held without being bought or sold, and consequently, they only have theoretical prices, i.e. prices which rely on a combination of internal price relativities and external price relativities. This would not be understood by Ian Steedman, who suggested once that Marx is logically committed to the idea that a product has two different prices depending on whether it is purchased, or whether it is sold, but corporate finance officers know quite well that there is something that happens in between purchase and sale. If M is the investment capital, and M' is that capital plus realised profit, then in between M and M' is something called P in which means of production (MP) and labor capacity (LP) are combined as (C) to create new value. The process can thus be described as M-C-P-C'-M' (see further Capital Vomume 2 by Karl Marx). I have edited excerpts of this article down for relevance - the complete article is available at: http://www.corporatefinancemag.com/ - JB). The value creation equation (Corporate Finance Magazine, March 2004) Mathematically MVA is the difference between market value - calculated as the sum of the market value of equity, debt and the market value of outstanding stock options - and the company's invested capital - the cash investors, both equity- and debt-holders, contributed to the company's operations. A high MVA indicates the company has created substantial wealth for shareholders. MVA is equivalent to the present value of all future expected EVAs. A positive MVA indicates that investors expect the company to generate significant amounts of EVA in the future. A company with a negative EVA but positive MVA can mean one of several things: the market expects it to turnaround; that it may be a potential takeover candidate; or that it is following a business cycle. Economic value added (EVA) is an estimate of true "economic" profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenders could get by investing in securities of comparable risk. In its simplest form it's a company's trading profit - net operating profit after taxes paid (NOPAT) minus a capital charge for both debt and equity. Stern Stewart has made changes in the caluculation of profit and capital to make the result more realistic. It capitalises investments in intangible assets placing them on the balance sheet where they belong. (...) Value Based Management, based on MVA/EVA, is a management approach that ensures corporations are run consistently on value - and normally on maximising shareholder value. It includes creating value, managing for value and measuring value. It uses simple transparent metrics that not only highlight where a company has added or destroyed shareholder value but gives investors a good indication of how capable the management team is. Nurturing the conditions to best create shareholder wealth is harder than you might think. Boards can often lack a shared perspective on how stock markets evaluates corporate performance. Equally, they may not fully understand the key strategic factors for creating value in today's market. That's where the CFO is meant to step in. (...) But what is shareholder value? "Shareholder value is why we come to work everyday," says Pat Mulva, head of IR at Exxon Mobil, the world's largest oil company (which does not have a CFO, by the way). "Everyday we compete for that investment dollar and it is our job to provide value to the people making that investment decision everyday." Mulva defines shareholder value as the appreciation of the share price and the long-term impact of dividends and share buy-backs. In 2002, Exxon distributed more than $10 billion to shareholders through dividends and share buybacks. In 2002, its dividend increased for the 20th consecutive year. (...) Ladislas Paszkiewicz, head of IR at oil company Total, agrees with Mulva's definition of shareholder value as the sum of a contribution of stock performance and yield through dividend. Likewise, a spokesman at Novartis, the Swiss-based pharmaceutical giant asserts that, "The ultimate measure [of shareholder value] is the development of the share price, dividend pay outs and value of spin offs." But Paszkiewicz also says that shareholder value is simply a by-product of how well (or badly) a company performs. "At Total, shareholder value is the result of our emphasis to improve company performance. We control what we deliver through the company's internal plans that focus on growth and productivity. This translates into shareholder value creation. The two are linked." Exxon's overriding objective is to create sustainable shareholder value by seeking high returns at low risk and focussing on the long-term, says Mulva. (...) An analysis of investments in the shares of Stern Stewart's publicly-owned US clients showed they produced 49% more wealth after five years than equal investments in shares of competitors with similar market capitalisations. How? As a company you are committed to shareholder value creation. But do you understand where and how value is being created and where opportunities for value creation lie? MVA, EVA and value-based management companies do, says Kondragunta, and that is why those US companies produce 49% wealth. Managers, and this essentially means the CFO, at value-based management companies believe that there are only three basic ways to increase and manage value. The first is to increase the returns from the assets already in the business by running the income statement more efficiently without investing new capital. The second is to invest additional capital and aggressively build the business so long as expected returns on new investments exceed the cost of capital. And the third is to release capital from existing operations, both by selling assets that are worth more to others and by increasing the efficiency of capital by such measures as turning working capital faster and speeding up cycle times. Total and Exxon do not subscribe to value-based management, but both firmly believe that the culture, strategy and financial controls of value-based management are firmly in place at their companies. "We have a global functional organisation operationally consistent throughout. It is this consistent approach that embraces the core principles at Exxon," says Mulva. (...) So how does Exxon measure the value its core principles bring? Through return on capital employed (ROCE - income before financial items relative to average capital employed). (...) It is a similar tale at Total. "We run the company from an industrial viewpoint. We allocate cash in an efficient manner and measure through return on average capital employed." (ROACE - operating profit before amortization of goodwill x 100/ average invested capital, accumulated amortization of goodwill). "It is a consistent measure of shareholder value in our industry and allows our investors to compare like with like." (...) Value-based management has been credited with many things: increased transparency, lower capital costs, more accurate forecasting and improved decision making. But Exxon Mobil's Mulva says that the real key to improving shareholder value is communicating with shareholders, investors, and the market. In fact just about everyone. (...) Royal Philips Electronics, the third largest global consumer electronics maker, has been using EVA as an instrument to measure financial performance since 1997. Philips recognized that the normal net income profit and loss account didn't account for a company's cost of capital, says group controller Gerard Ruizendaal. "We wanted to make it visible so we could understand this cost." EVA has since been ingrained in the company's standards and is based on the cost of capital that in each activity, reflects the risk related to the business, geography and effective tax rates. "The main idea is to improve our EVA every year so our return of capital is more than our cost of capital," says Ruizendaal. (...) "All the decision making tools must be consistent for driving value creation within the company, and with every year, with every process, it becomes a way of life. Philips also looks at how to integrate EVA into its staff incentive structure, with EVA accounting for approximately 50% of the criteria for yearly bonus incentives. "The amount of share options offered to employees depends on the share performance versus 24 benchmarked companies, and the incentives are less if we don't outperform against our benchmark peers." Over the last two years, Philips has systematically changed its portfolios to businesses with return of capital greater than the cost of capital. Gerard Kleisterlee, president, emphasized this in his message in the company's 2003 annual report, saying, that over the past year Philips had made considerable progress on its journey to create One Philips - a single, focused and clearly identifiable company geared to sustained value creation. Siemens introduced EVA in 1997. "It requires managers to radically rethink all business decisions and to forget ROI and measure profitability with an eye on the cost of capital," said Dr Karl Hermann Baumann, CFO back in 1997. (...) "Shareholder value is about a strong performance oriented culture and creating a sustainable economic value - not only on a day-to-day-level - but on a sustainable basis in the long term," says Sabine Kromer, corporate communications officer at Siemens. (...) "Global competitiveness to us means that we plan to expand our presence at lower cost locations. This means purchasing, manufacturing, software development and administrative services."
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