Value metrics

Sreenivas Kamma
Kelley School of Business
1

Agenda
− Value metrics
− Market value added
− Linking operations to value

2

Assessing your firm
Performance:

How much economic value has your firm created? Health:

How well positioned is it to create additional value in the future and what risks may prevent this?

Expectations:

Are the company’s capabilities and performance in line with the market’s expectations? 3

Look at a typical income statement
− ACCOUNTS FOR:
− Cost of Raw
Materials
− Cost of Production
Labor
− Cost of Management
Time

What is missing?
4

What is missing from traditional measures? −
− What happens if you treat something as “free”?
− Why should this cost be considered?

5

How do investors think?
− Suppliers of capital - stockholders and bondholders have several alternatives. − Consider Warren Buffet:
“I am in the capital allocation business. My job is to figure out which businesses to invest in, with whom and at what price. I am not a steel executive who can think only about how best to invest in steel.” − With investors like Buffet, how do you win the competition for capital? 6

Think like an investor
Today

?
$

$

Give $1.5 m to the manager for corporate investment in the project. In One Year

To get $ 2m

Same Risk
Investor

Which would the investor want?

Do-it-yourself:
How much do I need to invest in a similar risk financial market portfolio earning
R = 8%

To get $ 2m

2m/1.08 = 1.85  Value created by manager = 1.85-1.5
= 0.35 m

7

Need for a metric
− The best opportunities draw the most capital.
− These alternatives help establish the “opportunity set” by which your firm’s activities are measured.
− If you want capital, have to offer at least a return that investors could earn elsewhere in investments of equivalent risk - their opportunity cost of capital.
− You create wealth for investors only if you earn more than this benchmark rate of return.
− Need a yardstick which tells us whether we are doing this.

8

Economic Value Added
EVA = [Price of steel-Cost of steel] - [C * Space used]

Net
NetOperating
OperatingProfit
Profit
After
AfterTaxes
Taxes

Rental
Rentalcharge
chargefor foroffice officespace spaceused used

Rental
Rentalrate/square
rate/square meter meter
Payments
Paymentsto: to: --landlord
--landlord

Total
Totalsquare
square meters metersoccupied occupied ----Office
Office
----Warehouse
Warehouse

--municipality
--municipality
9

Economic Value Added
EVA = NOPAT - [C * Invested capital]

Net
NetOperating
OperatingProfit
Profit
After
AfterTaxes
Taxes

Rental
Rentalcharge
chargefor forcapital capitalprovided providedby by investors investors
Rental
Rentalrate rate Payments
Paymentsto:
to:
--banks
--banks
--bondholders
--bondholders
--stockholders
--stockholders

Amount
Amountofof
capital capitaltied tiedup upinin business business --Inventories
--Inventories
--Receivables
--Receivables
--Plant
--Plant&&
equipment equipment 10

Capital charge is not special
Revenues
- Material costs
- Labor costs

100
60
20

Revenues

- Taxes
10
Positive earnings 10
- Charge for capital 30

- Charge for capital
- Labor costs
- Taxes
Positive earnings
- Material costs

= negative EVA

= negative EVA

100
30
20
10
40
60

11

Charge for capital
− Rental rate * Amount of capital used
− rental rate for capital obtained from shareholders − rental rate for capital obtained from bondholders − blended average of rental rates: weighted average cost of capital

12

EVA formulations
1

EVA = NOPAT - [WACC x Invested capital]
Divide expression (1) by Invested Capital and multiply expression (1) by Invested Capital

2

EVA = [ROIC - WACC] x Invested capital
ROIC is return on invested capital; also known as
RONA = Return onNet Assets = Net Operating Profit after taxes/Net Assets

=

13

Key Value Drivers
− Value creation depends on
− Spread
− Volume of investment
− Duration of spread
14

Some examples
− Boeing Co.: ‘Sources of value’ study 2/99.
Assess how much each line of