Shareholder Value Analysis Notes & Exercise
Shareholder Value Analysis (SVA) is one member of the family of techniques for determining the market value of a firm based on the drivers of its projected cash flows. Other cash-based techniques include Cash Flow Return on Investment (CFROI) and Total Shareholder Return (TSR). SVA is superior to other techniques because valuations are derived from explicitly identified drivers of value in a strategic framework.
SVA starts with fundamental financial theory: the value of an asset is the net present value of its cash flows over the life of the asset. In SVA, the firm is the asset to be valued/assessed. One then identifies the drivers of firm cash flows over the life of the firm and integrates the drivers into a model, which generates the estimated free cash flows on a year-by-year basis. Let's look at the drivers of cash/value.
1. Sales growth rate: Everything else being constant, the higher the sales growth rate, the greater the projected cash flows.
2. Operating profit margin: The higher the profit margin (sales - cash operating expenses), the greater the cash flows.
3. Tax rate: The higher the tax rate, the lower the net cash flow.
4. Working capital investment: Increased sales require greater investments in working capital (inventories, cash, receivables, offset by simultaneous financing provided by accounts payable and accruals), which decrease cash flows accordingly.
5. New Fixed capital investment: An expansion (growth in sales) of the business requires a larger base of fixed capital investments, which will decrease cash flows. This is equivalent to total projected capital investment for the year less depreciation.
6. Competitive advantage period: In a perfectly competitive market there are no superior profits to be had, given that all firms must price at marginal cost if they want to make sales. However, by making use of technology, positioning oneself in emerging or high growth industries, through superior customer service/relationship management and by developing a differentiated or niche product, firms will be able to set prices above marginal costs. Firms strive to achieve competitive advantage and thus the flexibility to sell at higher prices and realize higher profit margins. The more a firm is able to exploit a competitive advantage and maintain it over time, the more successful it will be and the higher its cash flows. The competitive advantage period affects the estimate of the sales growth rate and the cash profit margin over time. For example, an analysis of Microsoft's core competencies and its ability to develop and maintain competitive advantage over time could provide the basis estimation g at 20% per year for the next five years, 15% per year for years 6-10 and then leveling out after year 10. The cash profit margin would reflect the loss of superior competitive advantage over time accordingly, perhaps being estimated at 35% for years 1-5, 25% for years 6-10 and 10% after year 10. The greater the competitive advantage, the greater the cash flows and the calculated shareholder value.
7. Cost of capital: The cost of capital represents the expectations of stakeholders (stock and bondholders). When the firm earns more on its assets than expected/required by stakeholders, value is created for shareholders. The management actions taken by the firm have an effect on the firm's cost of capital and, the lower the cost of capital, the greater the (net present) value of the firm. Management would be able to decrease the firm's cost of capital and create shareholder value by financing the firm's capital structure with the optimal proportion of debt and by identifying ways to decrease the systematic risk of the firm's investments.
Model: Firm Value = PV free cash flows over the forecast period + residual value beyond the forecast period + firm's marketable securities.
1. PV free cash flows over the forecast (competitive advantage) period = Base sales * sales growth * cash profit margin * after-tax cash income rate - new capital investment - incremental working capital investment to support increased sales, over the period that the company is projected to maintain a competitive advantage. Expected cash flows are calculated for each year of the forecast (competitive advantage) period and discounted by the cost of capital. In the Microsoft example above, the forecast (competitive advantage) period of cash flows would be years 1-5 and years 6-10.
2. Residual value after the forecast (competitive advantage) period has expired and the firm's sales and earnings level out:
The present value of cash flows after expiration of competitive advantage (sales and earnings levels are constant, or no growth). After some period, the ability of the firm to achieve growing sales and high profit margins will dissipate, after competitors enter the market and provide the same level of differentiation. At this point no incremental capital investments or additional investments in working capital are required; only maintenance-level investments are required. The expected cash flows are the same each year after the competitive advantage period, or perpetuity. The present value of a perpetuity, you will recall, is just the expected cash flow divided by the discount rate/cost of capital for a no growth perpetuity, or by the cost of capital less the constant growth rate for a growth perpetuity.
3. The firm's marketable securities:
We add marketable securities because 1 & 2 above represent the value generated by investments in the business. Marketable securities guarantee liquidity in contingencies and are not considered an investment in the firm's income generating assets.
Work through the model to understand the relationships amongst the value drivers and how the model is used to derive the estimate for firm value. The model provides flexibility by allowing the analyst to 'tweak' the driver values to fit the specific situation for the firm being analyzed.
If we want to derive the value of equity, we can simply subtract the market value of the firm's debt from Firm Value, which is the sum of 1, 2, and 3 above (Equity value = Firm Value - Debt). We can then compare the 'fair value' of equity we derived using SVA with the market value equity (# shares outstanding * price per share) to obtain an indication of whether the firm is under- or over-valued.
The use of the SVA methodology developed by Rappaport extends far beyond a technique for estimating the value of the firm. It is the integration of SVA valuation methodology into a strategic context that makes it especially useful to managers. SVA can be used to evaluate strategic alternatives: Which ones add value? What can be done to create value? How can we extend the competitive advantage period and keep profit margins high? The same answers we arrive at in building a world class strategic plan are the same ones supporting the creation of shareholder wealth in the SVA model.
Do the following SVA Exercise:
The following information is given:
* Baseline (last year) sales: $200 million
* Sales growth rates: Base year = 15% with a fade rate of 1% a year for years 1-10: (increasing sales due to sustained competitive advantage and a differentiated product)[source: Strategic Plan]. Fade rate is the rate of decline per year from a base year.
* Sales growth rate in year 10 and forward: 5% (in year 11, the competition has caught up and the market has reached maturity) [source: Strategic Plan]
* Profit margin: Base year = 20%, with a fade rate of 1% a year for years 1-10: (during the period of competitive advantage, the firm can charge higher prices, but its profit margin slowly declines as competition increases) [source: Strategic Plan]
* Profit margin in year 10 and going forward: 10% [source: Strategic Plan]
* Fixed capital investment rate: 20% (for every dollar of new sales, we need an additional investment in fixed plant & equipment of $.20) [source: historical relationship]
* Working capital investment rate: 5% (for every dollar of new sales we need an additional investment in inventories & receivables of $.05) [source: historical relationship]
* Cash tax rate: 40% [source: historical relationship]
* Cost of capital: 11% [source: current yield on firm's debt & the cost of equity estimated using the Capital Asset Pricing Model, weighted average based on the target capital structure]
* Marketable securities: $15 million
* Market value of firm's debt: $50 million
* The firm has 5 million shares of common stock outstanding selling at:
**scenario 1 = $40/share and
**scenario 2 = $60/share.
As indicated, the values assigned to drivers link directly to the strategic plan and the associated strategic analysis. In arriving at these estimates strategic alternatives have been evaluated for their value creation potential, with the set of strategies selected that create the most shareholder wealth.
1. What is the PV of operating cash flows over the competitive advantage period?
2. What is the residual value of the firm after the period of competitive advantage?
3. What is the value of the firm's equity?
4. Compare the market value of equity ($40/share) with the estimate provided by SVA for scenario 1. What recommendations would you make to top management based on your analysis? Now compare the market value of equity ($60/share) with your SVA estimate. What would you recommend now?