Financial Management Consultants Value Insight. Shareholder Value Creation & Value-Based Management.

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Transcript of Financial Management Consultants Value Insight. Shareholder Value Creation & Value-Based Management.

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Financial Management Consultants Value Insight Slide 2 Shareholder Value Creation & Value-Based Management Slide 3 The Presentation What drives international investment decisions How is shareholder value created How to measure value How to manage value Slide 4 Ultimate Objective To align the conflicting interest between management and shareholders To influence management to act and behave like shareholders Slide 5 International Competitiveness Regardless of what you think about the merit of stakeholder claims relative to each other, one thing is certain: if suppliers of capital do not receive a fair return to compensate them for the risk they are taking, they will move their capital across national borders in search of better returns. If they are prohibited by law from moving their capital, they will consume more and invest less. Either way, nations who don't provide global investors with adequate returns on invested capital are doomed to fall further behind in the race for global competitiveness and suffer a stagnating or decreasing standard of living. Tom Copeland et al. (McKinsey & Co) - VALUATION Slide 6 Clem Sunter Because one rule of the game has changed forever for South Africa. We are now an open economy with all the opportunities and threats that go with such status. If we don't nurture world- class companies, we will remain at the bottom of the class. Equally, with the relaxing of exchange controls and concurrent widening of investment opportunities, a South African pension fund or unit trust is increasingly going to compare South African companies with the likes of General Electric in the US and British Airways in the UK, i.e. world-class companies overseas. The locals will therefore have to perform according to world- class norms of performance to attract or retain their local as well as their overseas shareholders. What it Really takes to be World Class Slide 7 Shareholder Value Creation Slide 8 Responsibility of Management Company mission statements proclaim Management will create shareholder value Creating shareholder value An accepted principle Uncertainty as to its definition Greater uncertainty on how to achieve it Slide 9 Conflicting Interests Slide 10 Value Creation Defined Sustained increase in dividend income Sustained increase in share price (capital gains) Combination of both Value creation is the major driving force behind investment decision-making ! Slide 11 Only Cash Matters to Shareholders Shareholders Business Proposal Initial cash provided to finance proposal An expectancy that the proposal will generate future cash returns to shareholders Slide 12 MEASURE VALUE MAXIMISE VALUE MANAGE VALUE To maximise value, managers must know how to measure value and how to manage value It then becomes an ongoing process between measuring (valuing) and managing value. Slide 13 Measuring Value? The Business Valuation Slide 14 Valuation Defined A valuation is a process of arriving at a value of an asset The value of an asset is the present value of expected future benefits, usually represented by cash flows C. Correia et al. Financial Management Slide 15 Discounted Cash Flow (DCF) Valuations The advantages of DCF valuations are: It is based on cash flow Risk is accounted for in the discount rate It recognises the time value of money Future capital requirements (both fixed and working capital) are taken into account DCF has become the industry standard for the valuation of going concern businesses. Slide 16 Business Value Future free cash flow Discounted to PV Discount rate = WACC By applying the DCF valuation method, the value of a business equals: Future free cash flow discounted to a present value (PV) at a discount rate that equals the weighted average cost of capital (WACC). Slide 17 Free Cash Flow A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt. INVESTOPEDIA Calculated as: Net income + Non-cash items +/- Working capital changes - Capital expenditure ______________________ = Free cash flow Slide 18 Cost of Equity After Tax Cost of Debt WACC The Weighted Average Cost of Capital (WACC) consists of: The cost of equity (the most expensive cost of funding) The after tax cost of debt It is accepted practice to apply a Target Capital Structure in determining the weights of the cost of equity and the after tax cost of debt in the final calculation of WACC. Slide 19 Cost of Equity (Cost of owners funds) Shareholders make investments for the long term and expect to receive sustained long-term cash returns. *An opportunity cost The Formula: Cost of equity = RFR + (MRP x RI) RFR= Risk free rate MRP= Market risk premium RI= Company beta The cost of equity is the rate of return expected by shareholders in the form of dividends and increase in share price for the risk they are taking for making an investment. It consists of a risk free rate plus a risk premium. The cost of equity is the most expensive cost of business finance and is not reflected as a cost item in the income statement. Slide 20 PAT Economic Political / Social SALES Market structure Firms position PBIT + 10%+ 25%+ 30% - 10%- 25%- 30% Business riskFinancial risk Economic riskOperational risk Hawawini & Viallet Finance for Executives Sources of Risk Slide 21 After Tax Cost of Debt Since interest is a tax deductible expense, cost to a company is the net after tax cost of interest. Slide 22 Cost of Capital (WACC) A Performance Measurement The cost of capital is the minimum acceptable return. It is an invisible dividing line between good and bad corporate performance, a cut-off rate that must be earned in order to create value. G. Bennett Stewart (Stern Stewart & Co) The Quest for Value A statement that can no longer be ignored by management! Slide 23 Business Performance Creates Value: Shareholders are getting more than what they have asked for. Maintains Value: Shareholders are getting exactly what they have asked for. Destroys Value: Shareholders are getting less than what they have asked for. ROIC = Long-term cash return on invested capital Of importance is sustainable long-term cash returns on invested capital. Slide 24 The DCF Valuation Procedure Step 1 : Analyse historical performance Step 2 : Forecast financial performance Step 3 : Quantify free cash flow (FCF) Step 4 : Estimate WACC Step 5 : Apply DCF valuation methodology Step 6 : Reach a valuation conclusion Slide 25 The slides that follow will illustrate the basic steps in performing a DCF business or strategy valuation. Slide 26 Forecast Assumptions Inflation and growth = 0% Interest rate = 8% Tax rate = 50% Dividend paid = 25% of PAT Target capital structure: 50% equity and 50% debt Annual investment in assets = 10 Slide 27 Financial Forecast and FCF Note: 1. Since interest forms part of the discount rate (WACC), it is ignored in the calculation of FCF. 2. Tax in FCF is calculated by applying the actual cash tax rate to OP. Slide 28 Cost of Capital (WACC) The target capital structure for weight purposes is 50:50 Slide 29 DCF Business Valuation Business value consists of: 1 The value of the forecast period plus 2 The value after the forecast period (the residual value). In terms of the definition of the cost of equity, positive value creation also means that shareholders will be getting more than they have asked for. This slide illustrates that if the investment is made and if the projections are accurate, equity value of 83 will be created. Still a lot of ifs!! Slide 30 Value must, however, still be created through a process of management. The next slide illustrates how value creation can be broken down into future value creation performance targets. Slide 31 Future Performance Targets (EP) *Cost of capital = WACC X Opening capital Value-based management bonuses (refer VBM later) should be based on the achievement of future EP targets. When designing a value-based bonus plan, the key lies in embedding into the plan the EP target of every year that forms part of the strategic plan. Especially in the case of capital intensive businesses it must be noted that bonus plans should not be based on the achievement of EP targets of a single year, since it will motivate management to make short-term decisions with the sole objective of earning bigger bonuses. In the process they may reject lucrative investment opportunities and/or refrain from incurring capital expenses that can be vital for the future existence of a business. Value creation of 83 can be broken down into future annual value creation performance targets (EP): Yr 1 = 9 Yr 2 = 8 Yr 3 = 7 [Residual EP (82) is the expected EP that will be generated in the period after the forecast] There is no correct way to design value- based bonus plans and it remains the prerogative of business owners and managers to develop a bonus plan that will provide the best solution for them and their business. Value-based management incentives comply with the principles of good corporate governance as recommended by the King III Report. Slide 32 Managing Value? VBM Value-Based Management Slide 33 VBM Defined Value-based management is an integrative process designed to improve strategic and operational decision-making throughout an organisation by focusing on the key drivers of corporate value. Tom Copeland et al. Slide 34 MOST IMPORTANTLY !! Commitment from top management, especially from the CEO, is of vital importance for VBM to be successful. Slide 35 VBM Management Processes Value Creation Mindset Management processes must be adjusted to accommodate value ba