Chapter 10

Reporting to the Masters: Shareholder and Value-Added KPIs

In This Chapter

arrow Understanding value from a shareholders perspective

arrow Appreciating the importance of opportunity cost

arrow Measuring shareholder return

Profit, revenue, cash flow and liquidity KPIs are important to all companies regardless of sector, industry or whether the business is privately or publicly owned.

Once a company becomes publicly listed, however, investors and analysts will use certain KPIs to decide how strong your business is. Their interpretation of these metrics will influence whether shareholders decide to buy, sell or hold your stock.

In a public company, shareholders wear the trousers. Everything a business does, every strategy it embarks on, every decision it makes is focused on delivering shareholder value, and the KPIs detailed in this chapter help the leadership team know how well they are doing against that objective.

The Ultimate Value Metric: EVA

In the past, profit-based KPIs were considered the best and only real way to measure corporate performance and therefore shareholder value.

But looking at profit and revenue can be misleading for two reasons.

  • Profit calculations ignore the costs of capital and can therefore distort performance.
  • Profits can easily be manipulated through legal – albeit creative – accounting practices.

In an effort to draw a meaningful distinction between value and profit that would help investors make a more accurate interpretation, New York based consultancy Stern Stewart created the ultimate value metric – Economic Value Added (EVA), also known as economic profit.

Basically EVA estimates the profit of a business when the cost of financing the company’s capital has been removed, because value is only really created when the return on the capital employed is more than the cost of that capital.

Why profitable companies might not create value

EVA is an important metric for investors and analysts because it allows the investor to pull back the veil of numbers to establish whether value is actually being created in the business or not.

Many businesses view capital, which is any cash that has been deposited in a company over its lifetime, as ‘free’. By ignoring costs associated with capital, irrespective of how this was financed, a company can get a better picture of whether it has actually generated value relative to the economy as a whole.

Understanding opportunity cost

The central premise of EVA is that capital is not free. As well as incurring a real financial cost there is also the opportunity cost of capital to consider.

If an investor has $20,000 to invest in your business they could easily invest that money into any other type of investment such as property, gold, government bonds or another company. If he decides to invest in your business, then the investor is effectively charging you a rent to tie up his cash so that you can use that money to support operations. The investor is therefore compensated for choosing to invest in your business as opposed to making an investment elsewhere, and EVA is the only KPI that takes this cost into account.

example.eps Say Company A (a start up in mobile phone apps) earned $100,000 on their capital base of $1 million thanks to strong early sales of their mobile apps. Return on Capital Employed (ROCE) – which I explore in Chapter 11 – is 10 per cent, a good result, especially as the business has only been operating for a couple of years.

To get off the ground Company A borrowed some money and also sold shares to investors who agreed on a required return in exchange for their investment. Obviously if the investor bought shares in Company A then their money was tied up and they couldn’t use it elsewhere. Investing money into start ups of this nature carries some significant risks and investors therefore expect a higher return. If therefore shareholder expectations and obligations to service debt add up to an investment costs of capital of 15 per cent, then it means Company A may be enjoying an ‘accounting profit’ of 10 per cent but the business actually lost 5 per cent for its shareholders.

Conversely if Company A had $100 million in capital, including debt and equity finance and the cost of that capital (including interest in the debt and cost of underwriting the equity) is $15 million Company A would only add genuine value to its shareholders when profits exceeded $15 million a year. Traditional profit metrics don’t factor in the cost of capital and can present an overly flattering picture as a result. If Company A generates an income of $30 million, EVA would only be $15 million.

Measuring opportunity cost in practice

The key performance question EVA helps to answer is: ‘How well are we delivering value to our shareholders?’ This metric is usually reported on a monthly basis. Use this formula:

Economic Value Added (EVA) = Net Operating Profit After Tax (NOPAT) – (Weighted Average Costs of Capital (WACC) × Economic Capital Employed)

tip.eps Calculating EVA in practice is a notoriously thorny and complex matter so if it’s one you want to use I suggest you get some help from a qualified accountant to do it.

Normally, the equity cost of capital for an organization is calculated through the Capital Asset Pricing Model (CAPM). A firm’s nominal equity cost of capital is calculated as a base risk-free rate plus ‘beta’ – the latter being a general equity risk premium adjusted for a firm-specific risk measure. In short, therefore, the equity rate is the return investors are seeking to achieve when buying a company’s common shares. This is expressed as:

the firm’s equity investors’ expected return (future) = risk-free return (future) + the firm’s beta (a relative measure of volatility) × general equity risk premium (history)

The equity risk premium represents the excess return above the risk-free rate that investors demand for holding risky securities. So, with a risk-free rate of 7 per cent, a beta of 1.1 and an assumed equity risk premium of 4 per cent, a company would have the following cost of equity:

Cost of equity = 7 per cent + (1.1 × 4 per cent) = 11.4 per cent.

The cost of debt is the rate of return that debt-holders require in order to hold debt. To determine this rate it stated that the yield had to be calculated. This is typically worked out using discounted cash flow analysis, i.e., the internal rate of return. The cost of tax should be calculated after tax as follows:

Cost of debt after tax = cost of tax before tax × (100 – marginal tax rate)

You can find the data you need to calculate EVA in the profit and loss statement. The component parts needed to calculate EVA require a bit more work to establish than many of the other financial indicators. However you only need to calculate WACC every year. How costly this metric will be to initiate will depend on how readily you can get your hands on the necessary data. If it already exists and just needs to be extracted then it will just require the addition of a new formula in your accounting system. If some of the information is missing it could be a costly measure to establish so you will need to be very sure you need it.

Keeping an Eye on Your Share Price

Investors decide to buy, hold or sell their shares based largely on the movement of your share price. Understanding how attractive your shares are to existing and potential investors is therefore important.

If your share price drops because your business didn’t do as well as expected, or because a negative news story affects your business then millions, sometimes billions, can be wiped off the value of the shares almost overnight.

truestory.eps Who can forget the catastrophic collapse of one of the UK’s most successful jewellery business following the then CEO’s careless remark at an Institute of Directors dinner. Gerard Ratner thought he’d add a few jokes to his speech at the last minute and proceeded to tell the audience about the earrings his store sold adding, they were, ‘Cheaper than an M&S [Marks & Spencer] prawn sandwich but probably wouldn’t last as long.’ Another clanger he felt compelled to share was, ‘We also do cut-glass sherry decanters complete with six glasses on a silver-plated tray that your butler can serve drinks on – all for £4.95. People say, ‘How can you sell this for such a low price’? I say, ‘Because it’s total crap’’.

Unbeknown to Ratner there was a journalist in the room and the story ended up in the press. Even though he’d only been joking, the remarks made it look like he was mocking his own customers, and they stopped buying. His ‘jokes’ wiped an estimated £500 million of the share value of the business, he was forced to resign and the business under his name did not survive for long.

It’s all relative: comparing businesses

Ultimately share price is relative and investors will not make their decisions in isolation – they will compare your share price to other businesses in your sector and beyond.

Not only does this comparison help investors compare different businesses accurately but it also provides managers with insights into how easy or otherwise it’s going to be to attract investment capital, and whether or not the business is ripe for a takeover bid. If the share price of a business is trading lower than it should be, then that business can make an attractive takeover target, so keeping a close eye on share price is critical to your on-going strategy.

The KPI most often used to make this comparison is the Price/Earnings ratio, usually known as the P/E ratio. This metric looks at the relationships between the share price and the company’s earnings.

Looking at historic performance the P/E ratio measures the price an investor is paying for $1 of the company’s earnings. Or it can be expressed as the time it will take for the investor to recoup their initial investment assuming it maintains the same earnings as the year before. A higher P/E ratio therefore means that the investor is paying more for each $1 of net income or has to wait longer for their return on investment so the stock is often more expensive compared to one with a lower P/E ratio.

Measuring P/E ratio in practice

The key performance question P/E ratio helps answer is: ‘To what extent is the current share price attractive to investors?’ The data required to calculate P/E ratio is available from your company accounts and the current share price. This metric is usually measured on a quarterly or annual basis.

P/E Ratio = Current price per share/Earnings per share

For example if Company X is reporting earnings per share of $4 and the share price is $40 per share then:

P/E Ratio = 40/4 = 10

Compare that to Company Y that reported earnings per share of $10 and a share price of $40 per share then:

P/E Ratio = 40/10 = 4

Company X has a P/E ratio of 10 and Company Y has a P/E ratio of 4 which means that Company Y is a much better investment because it will take just 4 years to recoup the investment as opposed to 10 years with Company X.

warning.eps The biggest problem with P/E ratio is that it uses past earnings to arrive at current value. And yet the mantra of stock investing is that ‘past performance does not guarantee future performance’ – as evidenced by Ratners Jewellery chain.

tip.eps Increasingly investors are looking at the forward P/E ratio – share price divided by the expected earnings for the next year. This revised metric can be particularly useful when profits from the previous year have been distorted by a divestment, corporate write-down or one off windfall.

Tracking Total Shareholder Return (TSR)

Ultimately investors want to know how much money is going to be returned to them either through in increase in share value or through dividends. The metric that they use to measure this is called total shareholder return (TSR), and it is useful to investors in analysing the best companies to invest in, or the ones they believe will deliver the best return on investment.

TSR is a measure often used for evaluating current performance.

Competition is stiff on the stock market

In any sector in any industry competition is fierce and businesses are not only competing for customers they are competing for investors. TSR is often used as a key measure to determine senior executive compensation because it puts stock performance in direct comparison to other companies in their sector.

This puts additional performance pressure on senior executives because it’s not enough to deliver high performance – that performance must be comparable or better than competitors or other organizations with a similar profile, otherwise they risk losing the investor to a competitor.

Investors will use TSR to decide whether to stay invested in the business or to sell the shareholding and invest elsewhere.

Measuring TSR in practice

The key performance question TSR helps to answer is: To what extent are we delivering value to shareholders? This metric is usually reported annually or twice yearly. Assessing TSR across the year is preferable because it allows for seasonal or other market fluctuations and therefore gives a more accurate picture of share performance.

Total Shareholder Value = (Net Share Price for the period + Dividend)/Share price at the start of the period × 100

Say for example you wanted to assess the TSR for Company C over a year. To calculate the net share price you need to know the share price at the start of the period in question and the price at the end. So Company C’s share price was $30 on the 1st of January 2013 and $35 on the 31st December 2013, making the net share price $5. The company also paid $12 in dividends which is added to the $5 to make $17. The TSR for Company C is 56.66 per cent ($17/$30 x 100).

The TSV is always expressed as a percentage, which makes it very easy to compare across business and allows for benchmarking against industry or market returns.

Obviously TSR is only relevant to publicly listed companies and is not applicable to privately owned enterprises. Although useful it can’t be calculated at a divisional or business unit level and as a metric it is ‘backward-looking’. TRS only reflects the past overall return to shareholders and offers minimal insight into likely future returns.