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“I am a better investor because I am a businessman, and I am a better businessman because I am an investor.” — Warren Buffet
I have been working in the financial industry for a few years now, and only recently have I asked this very fundamental question — When does a company create value for its shareholders?
There is a clear difference between the value of a firm and value creation. Both concepts are however, still rooted in economic theory but the distinction between the two is important to understand. Many investors and even some financial professionals have challenges in answering this question.
Corporate Finance can be thought of as “the acquisition and allocation of a corporation’s funds, or resources, with the objective of maximising shareholder wealth (i.e. stock value). In the financial management of a corporation, funds are generated from various sources (i.e., from equities and liabilities) and are allocated (invested) for desirable assets [1].” It is therefore important for any investor or business executive to have a high level understanding of Corporate Finance to determine if a business is actually creating value for its shareholders. As it turns out, there are four core corporate finance principles in examining value creation [2].
Value creation occurs when a company generates a return on invested capital [3] that is higher than its cost of capital [4]. To illustrate, imagine a one year project funded only with $100 million in debt at an interest rate of 8 percent to purchase fixed assets, other core operating assets and to provide working capital. After the year has ended, the project provides $35 million in revenues. Once all expenses and taxes are considered, the project leaves a net operating profit of $20 million. The project would therefore have provided a return on invested capital of 20 percent relative to its cost of capital of 8 percent. Said in this way, it is easy to see that the project would not be worthwhile if it yields less than $8 million. Shareholder value is eroded whenever return on invested capital is less than cost of capital.
Sometimes a company will issue debt to repurchase shares from shareholders or substitute equity for debt financing. The management team will erroneously make the claim that by repurchasing shares with debt, they are returning value to shareholders or that using capital from debt rather than equity is better for the company as it is a cheaper source of capital [5]. The reality is that value is only created when a firm generates higher cash flows [6] whether it be from increasing revenues (growth) or a higher return on invested capital, not by rearranging investor’s claims on cash flows. Whenever a company changes ownership on the claims to its cash flows (i.e. from equity investors to debt investors) without increasing the total available cash flows, value is not created. This principle aligns perfectly with the Modigliani-Miller Theorem [7] which states that the capital structure of a company is irrelevant and its value is independent of this capital structure.
The market value of a company should be seen as the expectations investors have about the company’s future performance and not just the company’s actual cash flow performance. Therefore as a company’s stock price rises, the company is forced to perform better by providing higher returns on capital relative to its cost of capital and/or growing revenues at a faster rate. This principle implies that investors can rephrase the question of “Is this company undervalued?” to “Can this company achieve the required cash flow going forward at its current share price?”. Business executives who are armed with more information as company insiders are able to answer more precise questions such as “What return on invested capital is the stock market expecting?” or “How much faster should my company grow revenues to meet the expectations of the market?” These questions can be answered using financial models (e.g. the Discounted Cash Flow model [8]).
The value of a company is a function of the management team and its shareholders. Management will execute strategies and develop a culture among other staff members that will increase the company’s competitive advantages. This creates value going forward and increases the valuation of the firm for shareholders. The value of a company is therefore not absolute as different managers bring their own strengths and weakness to the company. Additionally, different shareholders may be able to bring their own expertise as a consultant to the company or provide synergies with other businesses they may own. As a result different managers and shareholders will provide different amounts of cash flows depending on their capability to add value.
These principles should be the guiding force for business executives when managing a company. Managing for shareholder value, an idea coined by Alfred Rappaport, is taking the long term view of a company and ignoring short term fluctuations in profits. Unfortunately, most investors and shareholders alike are preoccupied with net profits and fail to realise that the profit and loss statement is not rooted in economic theory. There is a saying that goes “Profit is a matter of opinion, cash is a fact” and the calculation of earnings can distort the perceived cash flows from the revenue source due to various accounting standards. Over-emphasising profits without understanding the balance sheet and cash flow statements will put shareholder value and shareholder interests at risk. Creating value for shareholders is not the same as maximising short-term profits [9].
