A firm’s performance is measured in a myriad of ways. However, the ultimate measurement objective, that of value creation, is the one measure that is extremely difficult achieve. Financial reporting centres around the income statement which fails to reflect risk, cash, historic cost accounting and inflation. Even cash flow data is usually reported in terms of conversion of profit to cash, but again this not a measure of value unless there is an understanding of what the conversion rate should be.
Conversion rates are influenced by many things, not least the rate at which the firm is growing. In defence of financial statements, they must address many different stakeholder requirements.
However, as a guide to measuring value creation financial statements have limitations reflecting as they do the past just as much as the present and doing little to guide toward the future. In summary they do not really address whether the firm and its management are creating value.
There are of course complex techniques such as “Economic Value Added” aimed at arriving at a version of value measurement. Although these may be effective, they come at a price usually involving a shadow reporting framework and a large consultancy bill.
A simple process
What we will discuss is a simple and transparent process of measuring value creation from existing data with no complicated accounting adjustments.
The first step in this process is to isolate the incremental (year-on-year change) operating result. There are several reasons for this but primarily it is because the change year-on-year reflects current management’s influence on the business. Incremental results also handily exclude the effects of inflation and historic accounting adjustments and of course they are very easy to arrive at.
Once the incremental operating result is known the next step is to convert this into a present value using MWACC as the appropriate discount rate. This is achieved through a little bit of magic involving an annuity calculation the tenor of which should be to the average useful economic life of the capital the firm has invested over the same period. Value has been created if the present value of the incremental result exceeds the capital the firm has consumed in achieving it. It really is as simple as that.
As well as being extremely simple and straight forward to apply, this technique is incredibly powerful. It can be used to set budgets when looking at the incremental result forecast for next year and it can appraise performance by looking at the result for the year just finished.
It can be broken down into its component parts so that all functions within the organisation can be set value enhancing targets relevant to them. For instance, the sales team can be set a revenue growth target, operations with a margin target, and management with a capital allocation budget. Every part of the firm is now working in alignment toward creating value.
However, the advantages do not stop there: the target is dynamic. Management are free to invest more capital if the appropriate business opportunities arise. Management are not constrained by the capital spend budgeted as long as the return from this investment beats MWACC.
This gives management flexibility and discretion within a dynamic value-based framework. All their decisions count over the course of the period being assessed from the terms granted to new customers to big-ticket M&A. Management cannot afford to let any asset sit idle; CAPEX budgets must be focused, appropriate and suddenly choices around working capital count. They all influence the capital consumed and return generated.
The power of MWACC
MWACC is a dynamic technique that encourages and rewards an entrepreneurial spirit and holistic management of the firm’s capital usage and profitability.
It may be a cliché but you do get what you reward, and you can only reward what you can measure. By aligning easily understandable and accepted existing KPI’s to levels at which value is created, the firm is now directly driving management across all functional areas toward the common goal of value creation.
Of course, external economic conditions fluctuate and the value of the firm is at the mercy of these. This technique though is immune to these external influences and reflects the returns management have generated from the capital they have consumed.
Financial management is the strategic partner to the business and it should be used to drive value and strategy. Finance is not about keeping a score, it is about shaping the future.
Modified Weighted Average Cost of Capital is copyright.