Process Value less True Capital Cost equals True Value
Our emphasis on the importance of developing reasonably accurate estimates of the amount of capital tied up in major processes and the cost of that capital is grounded in the concept of EVA: economic value added as the measure of long-term prosperity of a firm. It is neither the soft benefits of processes nor simply the earnings or apparent profits they generate that indicate if a process is an asset or a liability. These measures do not indicate whether it contributes to or threatens the success of a firm. We repeat that a process can be considered an asset only if it increases the value of a firm by generating a positive cash flow after the cost of the capital has been deducted. A negative cash flow makes a process a liability, regardless of the benefits it seems to provide.
Kinds of Asset Processes
This cash-flow approach to determining whether processes are assets or liabilities needs a little qualification, however. There are in fact three kinds of processes that should be considered assets, even though only one of them directly generates economic value.
-
Value-generating: These are the processes that clearly provide something of value to customers or that generate value for the firm itself by reducing costs and improving margins. Marketing, manufacturing, and pricing are examples of value-generating processes. If you answer "yes" to the question, Does this process directly contribute to our after-tax cash flow after the cost of the capital tied up in it is subtracted? then the process is a value-generating asset.
-
Option-enabling: Option-enabling processes provide a firm with an advantage in dealing with uncertainty and change. While they may not be directly value-generating, they put the firm in a position to exploit new value-generating opportunities. They enhance corporate flexibility, speed of response, speed of learning, focus, and shared commitment. R&D, education, team-building, and planning processes are examples of option-enabling processes. For instance, Shell's development of scenario-planning processes is widely seen as an importance source of the firm's ability to respond quickly and effectively to political, social, economic, and industry change. If you answer "yes" to the question, Does this process help make sure we keep ahead? then the process is an option-enabling asset.
-
Value-preserving: Neglecting these processes reduce the company's ability to compete and to continue to generate economic value. Such processes may not create economic value directly, but not having them would result in value loss. Many advertising and customer support processes fall in this category. Over time, some value-generating processes become value-preserving processes. For instance, ATMs in banks generated value when only a few banks had them and they provided a competitive advantage. Now that they are universal, they are required to preserve value. If you answer "yes" to the question, Is this process intrinsic, not peripheral, to supporting our value-generating processes? then the process is a value-preserving asset. In many cases, improving these processes will result in more value being generated by the processes they support.
All three kinds of asset processes are assets because they generate economic value, either directly or indirectly. In EVA terms, they create or lead to the creation of more value than they cost. Because EVA is at the heart of successful business process investment, we will discuss it in some detail.
EVA, Not Profits
Discussing salience in the previous chapter, we said that investors' valuations of a process are the ones that count most. It is virtually impossible to overestimate the importance of the investor's view of company value. Alfred Rappaport says, "Those who criticize the goal of value maximization are forgetting that stockholders are not merely the beneficiaries of the corporation's financial success, but also the referees who determine management's financial power. Any management-no matter how powerful and independent-that flouts the financial objective of maximizing shareholder value does so at its own peril." Whether or not they happen to be aware of the details of a process, investors judge its effects by the performance of a company-its ability to create rather than consume wealth. EVA is based on this concept of shareholder value as the real measure of the worth of a company and the processes that company carries out.
Peter Drucker neatly articulates the connections among capital, profits, EVA, and shareholder value:
- EVA is based on something we have known for a long time: what we generally call profits, the money left to service equity, is usually not profit at all. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources. It does not cover its full cost unless the reported profit exceeds the cost of capital. Until then, it does not create wealth; it destroys it. By that measurement, incidentally, few U.S. businesses have been profitable since World War II.
This description suggests that firms can report profits and pay taxes on those profits while the real value of the company is decreasing. If we assume that that profits equal wealth, this will seems paradoxical. But the paradox disappears as soon as we understand that profits do not represent real value if the cost of generating them is too high. Some examples drawn from Bennett Stewart's The Quest for Value illustrate the point.
In 1992, Spiegel, the catalog retailer, reported an operating profit of $188 million. After paying $69 million in taxes, the firm had a net profit of $119 million, a respectable 7.5% return on assets. But the total capital Spiegel employed to generate this return was $1.6 billion. Its weighted average cost of capital, a combination of interest rates for debt and the cost of equity, was 11.1% in 1992, or $178 million. The firm was profitable but suffered a net loss of value of $59 million.
IBM's performance in 1988 tells a similar story. The firm's return on assets was around 10%, but its weighted average cost of capital was close to 13%. IBM's loss of value was $1.7 billion dollars in that year. Investors were not blind to the problem. They valued the company at $80 billion, Although this represents a market value added (MVA) of $20 billion over IBM's capital base of $60 billion, that is a $26 billion drop in MVA from the 1983 figure. By 1993, MVA had plunged $75 billion from its earlier high. By contrast, Wal-Mart, which had essentially the same cost of capital as IBM, generated a 25% return on that capital in 1988. Its MVA on a capital base of $5 billion was $20 billion, a $9 billion increase since 1983.
A fundamental EVA axiom is that cash is the only real basis of value. Free cash flow is what is left after all investments have been financed. It is operating profits less the cost of all the capital employed to generate them. One of the corollaries of this axiom is that the value of a firm and the valuation of its stock can actually increase when reported profits are reduced. How is this possible? Let's start with an example from personal rather than corporate finances.
Say that we buy an item costing $10,000. We have to pay $10,000 for it whether or not that item is deductible, but our after-tax cash flow-the real measure of our added wealth-looks very different at the end of the year in the two cases. Being able to deduct the $10,000 reduces gross adjusted income, the individual equivalent of a corporation's before-tax profits, and increases after-tax cash flow, the free cash flow that is real money in the sense that you have it available to spend or save as you wish. Assuming for the sake of convenience a 30% marginal tax rate and an adjusted gross income of $40,000, here is the difference between not deducting and deducting that $10,000 purchase: [Note: Peter's figures showed 31,000 after-tax cash for the deduction and 28,000 for no deduction, which didn't add up, so I modified the chart to more clearly reflect his point]
|
No Deduction: |
Deduction: |
| Adjusted Gross Income |
$40,000 |
$40,000 |
| Deductions |
$0 |
$10,000 |
| Pre-Tax Earnings |
$40,000 |
$30,000 |
| Tax |
$12,000 |
$9,000 |
| Non-deductible expense |
$10,000 |
$0 |
| After-Tax cash flow |
$18,000 |
$21,000 |
Without the deduction, earnings on paper are more than 30% higher but real added wealth is 14% less. Although the numbers used in this example are simple, they illustrate a valid truth: that lower reported profits can increased value.
The same phenomenon has been observed when companies changed their inventory accounting method from "first in first out" (FIFO) to "last in first out" (LIFO). FIFO assumes that the item it has just sold is the oldest in its inventory and therefore usually the cheapest. LIFO assumes that the item is the most recent-typically the most expensive. The shift from FIFO to LIFO has no impact on what the firm paid for its inventory. If it paid $800 for an item in 1994 and $1,200 for the same item in 1995, it spent $2,000 on the two items, regardless of which it expenses first when it makes a sale. But expensing the $1,200 item first decreases the margin between cost and selling price and reduces reported profits. As in the personal finances example above, this reduces the company's tax liability and increases its cash flow and hence its shareholder value.
The market reacted similarly to RJR when the company's managers went on an earnings binge in the late 80s. The tobacco firm offered incentives to distributors to stock up on cigarette inventory near the end of 1988, boosting reported sales and profits. When RJR was preparing to introduce its semi-annual price increase in 1989, there were more than 18 billion cigarettes in stock that had been sold to distributors at a lower price and on which the company had already paid excise tax. Add the fact that cigarettes go stale after a time, and the inefficacy of RJR's earnings strategy is beyond dispute. The company soon paid the price: shipments dropped 29% in the third quarter, compared to the previous year, and 19% in the fourth quarter. RJR's stock went up, not down, when these results became known, however. Investors saw the company taking actions to restore the real economic value of the firm rather than generate paper profits that actually increased its liabilities.
|
