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Value creation

SHAREHOLDER value is created by companies earning a rate of return on the total capital employed by the company in excess of the cost of that capital. The cost of capital used is generally taken to be the Weighted Average Cost of Capital – WACC. WACC is a function of a number of variables: the level of debt and equity capital employed; interest rates; taxation rates; and the perceived equity risk of the individual company securities. A company’s WACC is affected both by decisions taken within the company and external macro-economic events.

Value reflects the relationship over time between operating performance of a company, as measured by the Net Operating Profit after Tax (NOPAT) margin and the Total Capital Employed (TCE). These two drivers determine the return on capital, the measure that should be compared to WACC. Companies will have varying operating margin and capital turn performance depending on the nature of the industry and operating structure.

Figure 1 (below) shows the relationship between NOPAT margin and Capital Turn, (Sales divided by TCE). The company at A is failing to earn returns which exceed the cost of capital (that is, below the WACC curve). From this position the company has three options. Improved operating performance, assuming sales and total capital employed remain constant, would result in the company moving to B, with Return on Capital in excess of WACC. This strategy represents the harvesting of the “low hanging fruit”. In most companies there are few, if any, opportunities for this type of performance improvement.

The second approach to increasing value involves investing additional capital which earns a rate of return in excess of the cost of capital. This is illustrated by the company moving from A to C. Initial investment may result in a deterioration in capital turn as the capital employed grows. However, as sales grow margin performance improves and the company should emerge as a larger entity at C.

The third strategy involves the divestment of assets that do not earn a positive rate of return. Divestment should improve the capital turn of the business and also margin performance. This strategy is illustrated by movement from A to D. The company may be smaller but it now earns a positive rate of return on a smaller capital base.

While these three strategies are simplified, observed share prices include investor expectations regarding future earnings and capital expenditure requirements. Companies need to be able to show that they are able to earn a return on capital in excess of the cost of capital over the medium to long term. Short-term attempts to influence share prices following investor sentiment are unlikely to lead to sustainable increase in market value.

Ultimately the reward for a greater understanding of the mechanics of value creation should be superior shareholder TSR performance over time. Trudo

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