Financial Management Consultants

Value Insight

Shareholder Value Creation

& Value-Based Management

The Presentation

• What drives international investment decisions …

• How is shareholder value created …

• How to measure value …

• How to manage value …

Ultimate Objective

• To align the conflicting interest between management and shareholders

• To influence management to act and behave like shareholders

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

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

ShareholderValue Creation

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

Conflicting Interests

Shareholders Management

Activity Invest risk finance

in business Manage business for owners’ benefit

Rewards Dividend and capital growth

Salaries, bonuses, etc.

Certainty of rewards

Uncertain Reasonably certain

Focus horizon Long term

(10 years plus) Short term

(the next budget)

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 !

Only Cash Matters to Shareholders

ShareholdersBusinessProposal

Initial cash provided

to finance proposal

An expectancy that the

proposal will generate future cash

returns to shareholders

MEASUREVALUE

MAXIMISEVALUE

MANAGEVALUE

To maximise value,managers must knowhow to measure value

and …

… how to manage value

It then becomes anongoing process between

measuring (valuing)and managing value.

Measuring Value?

The Business Valuation

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

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.

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).

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

Cost ofEquity

After TaxCost 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.

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 rateMRP = Market risk premiumRI = Company beta

Risk free rate (Government bonds)

6%

Risk premium + 8% *Cost of equity 14%

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 plusa 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.

PAT

• Economic• Political / Social

SALES

• Market structure• Firm’s position

PBIT

+ 10% + 25% + 30%

- 10% - 25% - 30%

Business risk Financial risk

Economic risk Operational risk

Hawawini & Viallet – Finance for Executives

Sources of Risk

After Tax Cost of Debt

Interest rate 8% Tax shield @ 50% - 4% After tax cost of debt 4%

Since interest is a tax deductible expense, cost to a company is the net after

tax cost of interest.

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!

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 > WACC : Creates value

ROIC = WACC : Maintains value

ROIC < WACC : Destroys value

ROIC = Long-term cash return on invested capital

Of importance is sustainable long-term cash returns on invested capital.

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

The slides that follow will illustrate

the basic steps in performing a DCF

business or strategy valuation.

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

Financial Forecast and FCF

Income Statement 0 1 2 3 FCF Operating profit 50 50 50 50 OP 50 Interest 10 9 8 8 PBT 40 41 42 42 Tax 20 21 21 21 Tax 25 PAT 20 20 21 21 OCF 25 *Dividends not shown Balance Sheet Equity 70 85 101 117 Debt 110 105 99 93 Capital employed 180 190 200 210 Invested capital 180 190 200 210 Invest 10 FCF 15

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.

Cost of Capital (WACC)

Cost of equity Risk free rate 6% Risk premium +8% Cost of equity 14%

Cost of debt Interest rate 8% Tax shield @ 50% -4% Cost of debt 4%

WACC 1 2 1x2 Cost of equity 14% .5 7% Cost of debt 4% .5 2% WACC 9%

The target capital structure for “weight”

purposes is 50:50

DCF Business Valuation

0 1 2 3 Res

Free cash flow 15 15 15 292

Discount factor .92 .84 .77 .77

Present value 263 = 14 + 13 + 12 + 224

Business value 263

Debt 110

Equity value 153

Base equity value 70

Value creation 83

Business value consists of:

1 The value of the forecast period plus2 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”!!

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.

Future Performance Targets (EP)

*Cost of capital = WACC X Opening capital

1 2 3 Res

Operational cash flow 25 25 25

*Cost of capital -16 -17 -18

EP 9 8 7 82

Discount factor .92 .84 .77 .77

EP @ PV 83 = 8 + 7 + 5 + 63

EP = Economic profit EP = Future value creation performance targets

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 = 9Yr 2 = 8Yr 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.

Managing Value?

VBMValue-Based Management

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.

MOST IMPORTANTLY !!

Commitment from top management,

especially from the CEO, is of vital

importance for VBM to be successful.

VBM

ManagementProcesses

Value CreationMindset

Management processes must be

adjusted to accommodate value based activities and

decision-making.

Management must first of all develop a value creation mindset for

VBM to be successful.

Tom Copeland et al.

PrimaryObjective

OtherObjectives

UnderstandingValue Drivers

VALUE CREATIONMINDSET

A value driver is any performance variable that

drives the value of a business.

Management must also understand when there is

conflict between their primary objective and their

other objectives.

Management must understand that

value creation is their primary objective.

Management must identify and focus on the key value

drivers that have the biggest impact on business value.

Tom Copeland et al.

Val

ue

Dri

vers

Revenue

Profit margin

Cash taxes

Fixed assets

Working capital

Cost of capital

Competitiveadvantage period

Macro

* Volume * Market size* Mix * Market share

* Pricing * Productivity* Wage rates * Shrinkage

* Tax rate * Tax losses* Structure * Allowances

Micro

* Asset life * Technology* Maintenance * Sub-contract

* Debtor terms * Supplier terms* Stock turn * Supply chain

* Gearing * Dividend policy* LT debt % * SBU unique

* Risk mngmnt * Empl shares* Incentivise * Core strategy

MANAGEMENTINCENTIVES

FINANCIALREPORTING

BUDGETINGSTRATEGICPLANNING

THE 4 KEYMANAGEMENTPROCESSES

• Will the current strategy create value?

• What is the value creation potential based on alternative strategies?

Strategic Planning

• What is the Co’s expected short-term performance?

• How much capital is expected to be invested in each business unit?

Budgeting

• Is the Co meeting its performance goals?

• Is the Co profitable and creating value?

Financial Reporting

• Are performance targets aligned with SVC?

• What is the balance between ST & LT bonuses?

Bonus Plans

Consistency

James A. Knight – Value Based Management

Consistency?

The 4 key management processes must always be aligned with value creation.

VBM Implementation Process

• Generate senior level commitment

• Broader buy-in

Consensus on

need to change

• Value audit

• Value driver assessment

• Strategy valuation

• Education

Understanding of

how to change

• Performance measurement

• Value-based incentives

• VBM infrastructure

• Continuing education

Ensure that

change is sustained

GainingCommitment

IntroducingVBM

ReinforcingVBM

Alfred Rappaport – Creating Shareholder Value

Management creates value by…

making investments…

in long-term business opportunities…

that generate cash returns…

higher than the cost of capital

Management also creates value by…

divesting from…

business units…

with cash returns…

consistently below the cost of capital…

destroying value in the process

Identify value-destroying businesses

Assess improvement options

Identify resource needs

Obtain strategy approval

Sell“as is”

Wind downand closure

Short-termperformanceimprovement

Valueregain plan

Getting Out of Trouble

A. Black et al. – In Search of Shareholder Value

Wind downand closure

Sell now“as is”

Short-termperformance improvement

Full valuerecovery plan

Value Recovery Options

A. Black et al.

Low Risk

High Risk

Low Value

High Value

List possible outcomes

Inv

es

tme

nt

Ap

pra

isa

l Pro

ce

ss

Quantify Value Creation

Review investment decisions

Identify strategic objectives

Search for investment opportunities

Initial screen

Select investment projects

Obtain authorisation

Kate Moran – Investment Appraisal

The Challenge

Value-creating growth is the strategic

challenge, and to succeed, companies

must be good at developing new,

potentially disruptive businesses.

Alfred Rappaport

The Advantages of VBM

• Decision-making supports value creation

• Focused decision-making

• Clear performance target setting

• Improved resource allocation

• Business units compete for capital

• Effective asset management

• Integrated financial management framework

• Early warning for poor performers (unemotional)

• Serves as a catalyst for change

• Promotes ownership mentality

KEY QUESTION:

Does your business

create or destroy value?

If you do not measure it,

you will never know.

When will VALUE become

the focus of your business?

Thank you for viewing

this presentation !

Value Insight

Fanie SwanepoelB.Com. CA(SA)

Tel: 021 910 2715

Cell: 082 730 7662

E-mail: office@valueinsight.co.za

Website: www.valueinsight.co.za