Finance needs to move beyond its traditional, and essential, core accounting role to include being the custodian of organisational value, according to the 2018 CGMA report The Changing Role and Mandate of Finance.
However, there is a vast gap between meeting the demands of this extended mandate and the reality on the ground. How many businesses have a finance function that has the expertise and capability to identify, understand, measure, and manage the various sources of value in their business? It should not be assumed finance will automatically be made the custodians of value; they will need to earn the right to gain this responsibility. Currently, it seems that this is a role that many finance senior management teams do not recognise or understand, let alone champion.
This is the first in a series of articles that looks at how value is created, the way it is measured, and the cost of capital. The second article will build on the first to look at improving forecasting capability. This enables finance to develop in-house expertise to be effective custodians of organisational value.
This is not a matter the profession can ignore, as the potential for significant rewards or losses is enormous — successful businesses are those that understand what drives value and what diminishes it. There needs to be a significant investment in research and skills development to improve all these capabilities in finance professionals so they can take a lead role and partner the business in the protection and growth of organisational value.
Finance isn't currently leading on calculating that value; instead, external parties like market analysts, providers of funding, and external mergers and acquisitions advisers are taking the lead. The use of valuation techniques by in-house finance teams in ongoing business management is extremely limited, despite them having access to the richest sources of data on the actual and potential performance of the business. However, it is within the business itself where there is the greatest opportunity to create or destroy value.
To be the custodians of organisational value, finance teams must have expertise in both financial and intellectual capital. Various approaches, such as Kaplan and Norton's balanced scorecard, have been proposed to bring the consideration of intellectual capital into business management, but we are not seeing any significant level of recognition, consensus, or adoption of any approaches by finance teams. Approaches for bringing it into the quantitative measurement of value have made even less impact. Consequently, expenditure on intellectual capital is still largely treated, both in financial reporting and in the minds of business managers, as a cost to be controlled rather than an investment in business assets.
Over my many years of enabling organisations to understand, manage, and optimise their value, I have seen limited development in the tools and techniques used by finance professionals. This has been accompanied by a general lack within finance of recognition, prioritisation, and investment in this activity.
There is no off-the-shelf, instant solution to calculate a precise, robust company valuation nor any tool to enable effective value management. However, incremental improvements in this area can deliver significant benefits even whilst the capability is being developed. Improved understanding can lead to both improved actual performance and increased certainty about future performance, both factors leading to increased business value.
Value creation — a technical perspective
Value is created by employing both the financial and intellectual capital of a business to generate a combination of earnings growth and a return on invested capital (ROIC) exceeding the weighted average cost of capital (WACC) that is funding that business. Funding of this invested capital is provided by debt and equity capital (see the chart "Funding Providers' Value Creation," below).
Funding providers’ value creation
Invested financial capital represents the retained value created from the business's historic performance and comprises net working capital and tangible fixed assets. Intellectual capital encompasses the intangible, nonphysical assets represented by customer relationships, product/service propositions, processes, innovations, supplier relationships, employees, and digital capability, which are employed in combination by the business to create synergies that drive future value creation.
Value creation is dependent on the growth rate (g), ROIC, and WACC in combination with the net operating profit after tax (NOPAT). Value is always created when ROIC is improved. However, growth will only lead to value creation when ROIC exceeds WACC. With simplifying assumptions of a constant growth and ROIC rates, according to McKinsey & Co's guide, Valuation: Measuring and Managing the Value of Companies (Seventh Edition), this relationship can be represented by the "value driver formula" as follows:
This is commonly used by analysts to calculate a continuing or terminal value for a business to be used at the end of the explicit forecast horizon in a discounted cash flow valuation.
The value created can then be employed to:
- Fund future organic or inorganic growth in the financial capital required to build the business.
- Invest in maintaining or increasing internally developed intellectual capital (not reported on the balance sheet).
- Acquire externally generated intellectual capital (reported on the balance sheet as goodwill or intangible assets).
- Repay debt capital (short- and long-term interest-bearing debt and debt equivalents) or build holdings of cash excess to operational needs.
- Repurchase equity capital (stock).
The decision as to which is the best course of action will depend on a range of factors, but, principally, whether the perceived returns from identified potential investments exceed the company's WACC.
Value measurement challenges
Most theory focuses on the derivation of valuations from information held in the financial accounts. However, these accounts do not capture all shareholder value, as shown by price-to-book ratios, and the situation is getting worse. The ratio between S&P 500 price and book values is about 4.5 and has more than doubled over the last decade. Some of this may be due to factors such as the valuation given to financial capital or irrational exuberance of the market, but a key cause will be the nonreporting of all the other value hidden away in intellectual capital.
Finance professionals need to be competent in the financial reporting and management of intellectual capital. In the 1970s the ratio of financial capital to intellectual capital was on average about four times. Since then, the proportional relationship between financial and intellectual capital has reversed. This means that now most value is not a recognition of historical financial performance, but the financial performance that is expected to be achieved in the future.
Approaches to value measurement
The significance of intellectual capital in a business's value means that it must be a major consideration when completing a valuation. However, directly measuring the value of intellectual capital is extremely difficult, and there is no best practice or regulatory requirements as to how it should be completed. Several characteristics of intellectual capital make it difficult to determine a fair value:
- Most is not legally owned by the business; for instance, the business does not have legal ownership of its clients or employees.
- It is only of value when combined with other intellectual capital; an excellent product proposition is only of value if you have access to a market with customer demand.
- It is esoteric in nature, having different value for different parties; the expertise of a brain surgeon has massive value for a hospital but significantly less to a car dealership.
Valuations are completed using various methods, including component valuations, multiples from precedent transactions or public company comparables, and discounted cash flow. All methods have their strengths and weaknesses (see the table, "Weighing Up Alternative Valuation Techniques," below), and the best one to use will often be a matter of judgement.
Weighing up alternative valuation techniques
A key consideration will be why the valuation is being completed. In the situation of a sale event, the key focus may be on calculating a number to guide negotiations. However, to manage organisational value on an ongoing basis, it will also be necessary to have detailed justification as to why the value is at the level it is and how it could change subject to defined actions and under various scenarios.
The general principle that intellectual capital is only of value when it is part of a system rules out component valuations as a valid method for many businesses with a high proportion of intellectual capital.
Precedent transactions and public company comparable multiples may be based on the historic or forecast values of various financial profit (net income or EBITDA) or cash flow (free cash flow for firm (FCFF), free cash flow for equity (FCFE), or cash from operations) measures (see the chart "Profit and Cash Flow Measures Used in Multiples," below).
Profit and cash flow measures used in multiples
Valuations based on each of these financial measures will derive significantly different valuations. The multiples will also vary significantly over time due to factors including premiums or discounts resulting from market conditions, a listing, or a takeover. The approach seems weak for valuing businesses where most value is held in financial capital, but even worse when it is mainly represented by intellectual capital. There is no practical insight provided on the underlying drivers of future financial performance, which drive the value represented in intellectual capital.
This leaves one remaining approach: discounted cash flow. This uses future unlevered free cash flows discounted at the business's WACC to create a business valuation. It is more complex to prepare but can provide the most justification and potentially the most accurate valuation. Having prepared a base case valuation, this can then be flexed to provide scenario modelling. The detail provided within the valuation can uncover immensely powerful insights to guide the realisation of opportunities to enhance value and avoid value destruction. This is subject to two critical success factors: determination of the appropriate discount rate to apply to future financial performance values and the provision of robust long-term financial forecasts. Initially, we will look at establishing the appropriate discount rate to apply to the business or divisional forecast.
Any future values should be discounted at the appropriate WACC. It may be necessary to use different WACC values on various parts of the business to reflect varying levels of risk on those different areas.
In summary, WACC is derived from the company's cost of equity and after-tax cost of debt weighted in proportion to the target mix of funding from equity and debt.
The cost of debt can be identified relatively easily from the actual interest rate paid or that would be paid on any borrowings. However, the cost of equity is far more complex to determine, as, effectively, it is the return a company must provide shareholders to maintain a steady stock price. Technical guidance is to use a method like the capital asset pricing model (CAPM) to risk-adjust the expected market return, but the reality of actually doing this can be difficult (see the chart "Example Derivation of Weighted Average Cost of Capital Using Capital Asset Pricing Model (CAPM)," below).
Example derivation of weighted average cost of capital using capital asset pricing model (CAPM)
Difficult as it may be, it is essential to have a view on your company's WACC. So long as this is in the right ballpark, then it can be used as a benchmark for comparison of returns from potential investments. In the event of a merger or acquisition, the precise WACC employed is more critical, but at that time there will also be various other factors, such as a takeover premium, which come into play and influence the valuation given to the business.
In the next article we will look at the second critical success factor — the creation of robust forecasts, which can then be discounted to provide a discounted-cash-flow valuation.
Time for action
Business valuation is a complex area, but a "do nothing" option is not sustainable. Realistically, it is not possible to create a definitive business valuation because so many factors are subjective and people will assign value differently. However, incremental improvements in this area can deliver significant benefits even whilst the capability is still being developed.
Some initial actions to take are:
- Design an in-house centre of expertise in value measurement and management.
- Improve understanding of intellectual capital and its impact on financial performance.
- Identify your industry growth rates.
- Establish an agreed view of the business's WACC.
- Start reviewing investments in intellectual capital alongside other investments.
The sooner the process is started, the greater the value opportunity or loss avoidance.
This article is the first in a series looking at the role of the management accountant in understanding, measuring, and managing value.
Paul Ashworth, FCMA, CGMA, is a Jersey, British Isles-based practising management accountant providing strategic insight and enabling business intelligence systems in financial and business services, and public-sector organisations. To comment on this article or to suggest an idea for another article, contact Oliver Rowe at Oliver.Rowe@aicpa-cima.com.