| 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. | | 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.  |
