| EXECUTIVE SUMMARY
| |
 To maximize the
long-term financial performance and
value of a business, CPAs
should help management focus on two key
components of value creation: revenue
growth and achieving a return on invested
capital (ROIC) in excess of the weighted
average cost of capital (WACC).
A lower WACC creates
higher value because of the
resulting increased spread between it and
the ROIC.
CPAs can use three
tools to measure and monitor a
company’s performance: •
DCF. A discounted
cash flow analysis quantifies the present
value of expected future net cash flow
using the WACC. •
EVA. An economic
value added analysis reveals the return in
excess of the company’s cost of capital by
subtracting a capital charge (invested
capital x WACC) from the company’s net
operating profit after taxes (NOPAT).
•
Performance-based compensation
plans. Such plans motivate
employees and align their interests with
those of the owners.
W. James Lloyd, CPA/ABV,
ASA, is the managing director and
Lauren E. Davis, MBA,
is an analyst with ValuePoint Consulting
Group, Knoxville, Tenn. ValuePoint
provides valuation, value improvement and
litigation consulting services, www.valuepointconsulting.com. |
P
rivately held companies are often their
owners’ most significant asset. But when resources
are diverted from profitable products to
concentrate on short-term revenue, a company’s
future value may be at stake. This article
explains how CPA/ABVs and other valuation
professionals can help their business clients stay
focused on long-term value creation.
CREATING SHAREHOLDER VALUE
Value creation relies on two
critical components: (1) revenue growth and (2)
return on invested capital (“ROIC”) in excess of
the cost of capital. The cost of capital, which is
generally referred to as the weighted average cost
of capital (“WACC”), is determined by weighting
the company’s after-tax cost of debt with its cost
of equity. ROIC is calculated by dividing the
company’s after-tax net operating profits by the
sum of working capital and fixed assets. Since
earning a return in excess of the company’s WACC
is necessary to increase value, management should
understand and use it as a benchmark for strategic
decision making. WACC is a combination of
the company’s cost of debt and cost of equity. The
cost of debt is the interest rate the company pays
on its long-term debt. Banks and other lending
institutions charge an interest rate that reflects
the risk of nonpayment. The cost of equity is the
rate of return necessary to compensate
shareholders for their investment in the company.
Unfortunately, many business owners often overlook
the cost of equity. This is a big mistake from an
individual wealth-accumulation perspective.
Business owners, just like other investors, have a
choice—they can either keep their capital in the
company or move it to an alternative investment.
If the capital stays invested, its return should
reflect the risk of doing so. Since equity
returns from investments in privately held
companies are not readily observable, valuation
practitioners generally use return data from
similar publicly traded companies as a proxy. If
investors in similar public companies are earning
an average annual return of 15%, investors in the
privately owned company should probably be earning
at least that much or they would be better off
investing in the public company. In reality, the
proxy rate derived from public company data must
be adjusted up or down to reflect the private
company’s actual risk profile. The
following formula is used to calculate the WACC:
WACC = [(Dc x (1 – t)) x Wd] + [Ec x We]
Where:
| Dc | = | Cost of debt
| | t | = |
Marginal tax rate | | Wd
| = | Weight of debt
(percentage of the capital structure
represented by long-term debt) |
| Ec | = | Cost of
equity | | We | =
| Weight of equity (percentage of the
capital structure represented by equity)
| For illustration
purposes, assume a capital structure of 60% equity
and 40% debt (at market weights) and the following
costs:
Using the above inputs, the company’s WACC is
calculated as follows: WACC = [6% x (1 –
40%) x 40%] + [18% x 60%] WACC = 12.24%
For decision-making purposes, management
should view 12.24% as a minimum return threshold.
To increase the company’s value, revenues must
grow and produce a net return greater than 12.24%.
Returns below the threshold will diminish the
company’s value.
| |
Tools for Creating and Measuring
Value The following
tools are often used by consultants to
measure, monitor and enhance a company’s
value-creation progress:
Discounted cash flow (DCF) analysis
. A DCF analysis measures a
company’s value by quantifying the present
value of its expected future net cash flow
using WACC as the discount rate. For this
purpose, net cash flow is defined as
after-tax cash flow from operations on an
invested capital basis (excluding the
impact of debt service) less the sum of
net changes in working capital and new
investments in capital assets. The
DCF formula is as follows: | Value = | CF1
| + | CF2
| + …+ | CFn
| | (1+ r) 1
| (1+ r) 2
| (1+ r) n
| Where:
CF1 =
net cash flow in year 1
CF2 = net
cash flow in year 2
CFn = net cash
flow in year n
r = discount rate
(WACC) The company’s net cash
flows are projected for a number of years
and then discounted to present value using
the WACC. The expected cash flows earned
beyond the projection period are
capitalized into a terminal value and
added to the value of the projected cash
flows for a total value indication.
The DCF model relies upon cash flow
assumptions such as revenue growth rates,
operating margins, working capital needs
and new investments in fixed assets for
purposes of estimating future cash flows.
After establishing the current (baseline)
value, the DCF model can be used to
measure the value-creation impact of
various assumption changes. Performing
these “what-if” scenarios with management
is an effective way to motivate the
implementation of needed changes.
For example, if the baseline model
assumed a revenue growth rate of 10% and a
gross profit margin of 40% for the next
five years, management can easily see the
benefit of increasing the revenue growth
rate to 15% and improving the gross profit
margin to 45%. Finding the best
opportunities for making these
improvements requires analysis (see
above), but the benefits are worth the
effort.
Economic value added
(EVA). Based on the premise
that shareholder value is created by
earning a return in excess of the
company’s cost of capital, EVA is
calculated by subtracting a capital charge
(invested capital x WACC) from the
company’s net operating profit after taxes
(NOPAT). If the EVA is positive,
shareholder value has increased.
Therefore, increasing the company’s future
EVA is key to creating shareholder value.
An EVA model normally includes an
analysis of the company’s historical EVA
performance and projected future EVA under
various assumptions. By changing the
assumptions, such as for revenue growth
and operating margins, management can see
the effects of certain value improvement
initiatives. For illustration
purposes, assume the following simplified
facts: NOPAT =
$15,000
Invested capital = $50,000
WACC = 12%
| EVA | = NOPAT –
(Invested capital x WACC) |
| | = $15,000 –
($50,000 x 12%) |
| | = $9,000
| The example
above indicates that both operating and
capital charges have been covered and
shareholder value has increased by $9,000.
Performance-based
compensation. This effective
tool for motivating employees aligns their
interests with the shareholders. For
example, establish a base level of
compensation plus a bonus pool tied to
certain EVA targets. A minimum level of
EVA is required for any bonus to apply,
and the pool increases based on how much
actual EVA exceeds the minimum threshold.
By tying compensation to certain
performance metrics, such as EVA or EVA
improvement, employees have a sense of
ownership and strong incentives to help
achieve the company’s value-creation
goals. Numerous criteria and performance
metrics can be used in setting up a
performance-based compensation plan.
However, to be effective, the performance
criteria must be achievable, measurable
and clearly communicated to the
employee(s) intended to be impacted by it.
Regular feedback and information reporting
procedures should be established that will
help employees monitor their progress for
meeting the performance goals throughout
the year. |
REDUCING WACC
From a
value-creation standpoint, the lower the company’s
WACC, the better. More value is created by a lower
WACC because of the resulting increased spread
between it and the ROIC. The most effective ways
to reduce the WACC are to: (1) lower the cost of
equity or (2) change the capital structure to
include more debt. Since the cost of
equity reflects the risk associated with
generating future net cash flow, lowering the
company’s risk characteristics will also lower
this cost. If the company depends upon a small
number of customers for a significant percentage
of its revenues, better diversification of the
customer base would lower that risk factor.
Likewise, if the company is highly dependent upon
one or a few key employees, transferring
responsibilities to additional qualified personnel
will help reduce that risk. Many business
owners try their best to avoid long-term debt.
This no or ultra-low debt policy can hamper the
company’s growth and value-creation potential.
Since the after-tax cost of debt is generally much
less than the cost of equity, changing the capital
structure to include more debt will also reduce
the WACC. Using the same inputs as above,
the following illustrates how the WACC can be
reduced substantially by changing the capital
structure from 40% to 60% debt: WACC = [6%
x (1 – 40%) x 60%] + [18% x 40%] WACC =
9.36% The reduced WACC creates more spread
between it and the ROIC. This will help the
company’s value grow much faster. However, adding
debt to the capital structure to reduce the WACC
only works to a certain point, since too much debt
can actually increase risk and constrain the
company’s ability to generate net cash flow. When
determining the optimum level of debt for a
private company, good proxies to consider are the
capital structures of similar public companies.
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Tapping a Fresh Stream of Profits
Our firm was engaged to
analyze a wholesale drink distributor’s
financial performance and assist with
formulating a plan to grow revenue and
shareholder value. The company was a small
family-owned business that had suffered
from low profitability over the previous
several years. Using a DCF model, we
quantified the potential impact of our
recommendations. Our financial
analysis started with a year-to-year
comparison of the company’s historical
financial statement data. We also
benchmarked the historical data against
industry peers. This type of comparison is
generally useful for identifying potential
problem areas and narrowing the initial
focus. Our analysis indicated the
following issues: - Revenue
growth was very low at approximately 5%
per year over the previous five years.
- Gross profit as a percentage of sales
was stable and in line with the industry
peer group.
- Operating expenses as a percentage of
sales were substantially greater than
the industry peer group—primarily due to
a high level of fixed expenses.
- Working capital was substantially
above the industry peer group—primarily
due to low inventory turnover.
After entering the historical
financials into our DCF model, we
estimated the company’s future net cash
flows and value based on its current level
of performance. The value indication, much
lower than the owner expected, was then
used as a benchmark for measuring the
impact of our improvement recommendations.
After analyzing the company’s
operations and revenues by product line
and customer, we identified several
opportunities for improving revenue growth
and profitability:
 Increase sales and marketing
efforts in two nearby cities with
excellent growth potential where the
competition was less vibrant. As an
initial step, hire a new sales manager
dedicated to this effort.
Eliminate several slow-moving
product lines with low upside potential.
The upside potential of the lines was
insufficient relative to the sales
resources being utilized.
Increase inventory turnover
by reducing the level of slow-moving
products and improving the purchasing and
inventory management systems.
Develop a formal marketing
plan and update the company Web site to
allow customers the convenience of placing
orders online.
Change the compensation terms
for all management-level employees to a
base-plus-bonus plan with the bonus tied
to predetermined profitability targets.
Reduce operating expenses as
a percentage of sales from 25% to 20% over
the next five years as revenues increase.
Based on our discussions with
management and research regarding the
company’s competitors and industry, we
concluded that revenue growth of 15% to
20% per year over the next five years
should be achievable. By updating
the assumptions in our DCF model to
reflect the above changes, we were able to
illustrate the potential impact to
management. If management could
successfully accomplish the above goals,
the net result would be an increase in
value at the end of five years of
approximately three times the non-improved
value. The company is currently in the
seventh month of implementation and
appears well on track to meeting the
targets. |
KEY ISSUES
Growth in
revenues and cash flows as well as achieving a
ROIC that exceeds the WACC are critical
ingredients for increasing shareholder value.
Top-Line Revenue Growth.
Although a company may improve its cash flow in
the short term through cost reductions, this
strategy has obvious long-term limitations.
Therefore, top-line revenue growth is necessary to
increase shareholder value. The 80/20 rule
of thumb applies to most companies. This means
that 80% of gross profit is generated by 20% of
the products and services and 20% of the customers
produce 80% of the revenues. Analyzing the
business with this rule in mind often uncovers
opportunities to increase the company’s growth and
profitability. It helps management focus on areas
most likely to optimize cash flow.
Determining which products/services and
customers have the most potential for helping the
company achieve its growth and profitability goals
requires:
Analyzing historical sales and gross
profit by product/service line.
Determining which customers or types
of customers are the most profitable (net of
selling and service-related costs).
Assessing industry trends including
current and future substitute products and
services.
Determining the impact on working
capital for each of the significant product lines
and customers.
Cash Flow. Positive cash flow is
necessary to fund daily operating expenses, future
growth initiatives and distributions to investors.
Therefore, the ability to generate positive cash
flow, on a long-term, sustainable basis, is
critically important to a business’s value.
To assess the sustainability of future cash
flows, examine how the company reinvests into the
business. Companies that consistently reinvest a
significant portion of operating cash flow into
recruiting and training high-quality employees,
acquiring new technologies, and funding research
and development initiatives will most likely have
higher growth rates and be more profitable on a
long-term, sustainable basis than those that do
not. A company’s reinvestment efforts are
illustrated through the ratio of annual
investments in new operating assets to available
operating cash flow. Available operating cash flow
equals after-tax net cash flow from operations
before reinvestments. The higher the ratio, the
better the investments are paying off. If the
ratio is trending down from year to year,
management should re-evaluate its investment
decisions. One of the best ways to grow
cash flow on a long-term, sustainable basis is by
increasing the volume of units sold and decreasing
the related cost per unit. Higher volumes result
in lower unit costs due to improved operating
efficiencies and better utilization of resources
(that is, spreading fixed costs over more units).
To achieve higher unit sales volumes, a company
can narrow its product/service offerings and focus
on what it does best—that is, it should not try to
be all things to all potential customers.  |
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