Forget earnings per share, return on investment, return on equity, internal rate of return - these are all outdated measures of performance and don't measure wealth generation.
Far beyond the traditional measurements to evaluate the overall management or performance of an organization, there is the measurement of the generation or destruction of VALUE: economic / social value and / or economic / financial / private value.
The first measurement estimates the economic contribution of an organization or a project to society. The second explicitly measures the economic contribution of a company to the enrichment of its public and / or private SHAREHOLDERS.
Both are important. The ideal would be for every public or private company to generate both values, although this is not always possible or intended…
In our environment there has been a certain delay in the generalized incorporation of value management, planning and control of value creation, due to different circumstances. Among others is resistance to change, with and without reasons.
One of the understandable reasons given - in relation to the economic / social value - is the difficulty that exists in Venezuela, to have access to complete and updated data on social prices or shadow prices.
One of the reasons that cannot be addressed - in relation to the economic / financial / private VALUE - is how complex the risk calculation is and consequently the discount rate or opportunity cost of risk-adjusted capital.
This leads many people in Venezuela to use an update rate -for all circumstances- of 10%, even if it is real or nominal cash flows, in Bs. Or US $, and company projects of a completely different nature and variability.
Does this create problems? Yes, two and very serious:
- If 10% is used and the correct rate is higher, this can lead to accepting projects that will not generate value; in the case of valuation of a company, this would imply overvaluing it, in proportion to the difference between the correct and incorrect rate. If 10% is used and the correct rate is lower, this can lead to rejecting projects that could generate value; in the case of a company, this would imply undervaluing it, in proportion to the difference between the correct and incorrect rate.
Those people or companies that - consciously or unconsciously - use these wrong criteria, are not precisely contributing to increase the value, or generable wealth: in fact, a previously profitable company can collapse if it is abruptly or progressively filled with value-destroying projects Even more so if at the same time it rejects precisely the projects that could generate value. The same is valid in terms of mergers or acquisitions, since acquiring overvalued companies or selling undervalued companies is a terrible business, in which the main losers are the SHAREHOLDERS, but consequently so are the workers, customers and other stakeholders.
Cash flow
The Free Cash Flow (FDCL) or Non-Financial Cash Flow is calculated from the Net Operating Income After Taxes (UONDI), assuming –initially- that the assets are financed exclusively with Equity.
The Financial Cash Flow -equal in amount to the FDCL- is calculated from the cash flow corresponding to the handling of dividends, marketable securities and debt service, due consideration of the tax savings that debt entails, and dissaving tax that imply the gains generated by the management of negotiable securities (or savings if they generate losses).
Now, is it really very complex to determine the cash flow to be discounted, to value the assets, or the financial flow to value the debt?
Absolutely no! The algorithms, or step-by-step calculation rules, are extremely simple.
The important thing is to make sure you use the correct data: historical and budgeted.
The risk
Is it really very complex to determine the risk? No. There are different methodologies to use to get closer to the value to use, even in countries with comparatively small, imperfect and inefficient capital markets, such as Venezuela. Many people speak without basis -that is, without having done any calculation or study- about the imperfections and the statistical non-significance of the Venezuelan market due to the disastrous action of stock market speculators: curiously, speculators are neither stupid nor crazy nor bandits, and by speculating with the expectations of winning they and others, contribute precisely to improve the balance between supply and demand, and increase statistical significance.
It is important to distinguish between the calculation of risk from accounting data and the calculation from stock market data.
In accounting terms, operational risk measures the possibility of not winning, and financial risk measures the possibility of not being able to pay: global risk measures - jointly - the possibility of not winning and not being able to pay at the same time.
Another measurement of accounting risk is provided by the Venezuelan Altman Z, which measures the possibility of bankruptcy or, more moderately, the possibility of having difficulties or arrears with payments, allowing the timely identification of the determinants of such situation.
From refined stock market data, it is possible to calculate, for stocks with sufficient presence and volatility, the total market risk, the total risk of the stock, the non-diversifiable risk of the stock, and the diversifiable risk of the stock: information that It is not directly obtainable from the accounting information, but it is possible to estimate indirectly, using different techniques (accounting b's). All these calculations are very simple (averages, standard deviations, variances, covariances, etc.).
In addition, it is possible to resort to criteria and tables published periodically, on the range of variation of the b of different sectors in different countries (eg IESA, Value Line, etc.).
In good accounts there are various risk calculation methods that can lead to different values, but in the light of systematic analysis criteria it is possible to filter and correlate, to determine the most appropriate value to use in each case: even in relation to risk country.
Discount rate
Something very curious has happened in Venezuela that has also happened in other countries with underdeveloped capital markets.
Many people who superficially know the methodology of calculating the Financial Value from discounting the Free Cash Flow to the Opportunity Cost of Capital that - taking into account the risk - should be used by the rational shareholder, prefer to calculate the Economic Value Added (EVA®).
This is because the calculation looks much simpler: it avoids the Free Cash Flow calculation (it is true) and it seems that it allows using 10% in any case (it is not true).
However - especially in the state business sector, including oil - there are no updated guidelines regarding the adequacy of the appropriate discount rate and despite the sophisticated and very expensive computer systems developed or acquired for this purpose, all projects and companies 10% are still being evaluated, and traditional management control continues to ignore systematic measurement of value, using the appropriate opportunity cost.
Perhaps the powers that the new law assigns to the Office of the Comptroller General of the Republic in terms of Management Control, contribute to change this situation: A situation that is also of interest to the Venezuelan Investment Fund, and by the way it is for PDVSA and the Ministry of Energy and Mines.
Whichever method is used to calculate the EVA of a process, project or division, the discount rate must be derived from the criteria on which the CAPM (Capital Asset Pricing Model) or the Capital Asset Valuation Model is based. WACC (Weighted-Average Cost of Capital: Weighted Average Cost of Capital), and everything related to the interactions between investment and financing decisions.
EVA®
The expression “EVA” in English is the abbreviation for “Economic Value Added”, a specific and widely spread methodology in the world for calculating the Economic Value Added by a company, project or process, it measures the contribution to the increase in wealth of the SHAREHOLDERS, and therefore their satisfaction.
The EVA® is a financial tool - created and patented by Stern Stewart (USA) - that tells you by how much you are exceeding the total cost of capital and suggests what to do if you are not: it induces a new financial discipline that promotes Managers to act like entrepreneurs, by providing them with the real key to measuring and creating wealth.
EVA® is operating income net of taxes less the total cost of capital used to produce those profits: not only the cost of equity of debt but also of equity.
EVA = UONDI - AONE x R
UONDI = Net Operating Income After Tax (equivalent to Gross Operating Cash Flow)
AONE = Net Operating Assets Employed (does not correspond to total accounting assets)
R = Opportunity Cost of Capital, adjusted for risk, or financial rate of return required by a rational shareholder (the same one that should be used to discount the FDCL)
Note for specialists only:
If we discount a successive series of EVAs at the opportunity cost of capital, we can obtain the NPV of future EVAs (VANEVA), just as we can obtain the NPV of future FDCLs (VANFDCL): in general, both will not be the same.
Since FDCL = UONDI - incr AONE, the economic NPV and the financial NPV will match only if the initial AONE minus the NPV of the AONE increments (increases in working capital and fixed assets) is zero:
MVA = VAN EVA = VAN FDCL - (AONE - VAN INCR aone)
From this formula it is possible to determine how to maximize shareholder value, and how to incorporate the relevant criteria into corporate culture, orienting it to create wealth.
Note that in the case of Microsoft, the Market Value Added (MVA) reaches 45 billion US $ of BV (Book Value) giving a MV (Market Value) of 50 billion US $ (a multiplier greater than 10): similar It is the case of Coca Cola that with 7 billion BV adds 70 billion MVA, totaling a MV of 77 billion (a multiplier of 10). What is it that creates this tremendous value? The Human and Intellectual Capital, duly led and rewarded in proportion to the EVA generated and the generable
Objections
There are those who object to the EVA as a correct measurement of global performance. Here are the most common objections along with the usual counter-arguments:
- It only measures the financial: it is not true, since –due to the value chain- and broken down into its components, it allows us to separately appreciate the incidence of commercial, operational, human management, etc., and even simulate the impact of each a. It depends on non-controllable exogenous variables: true, but this does not mean any problem, to the same extent that by disaggregating it into its components we can perfectly separate the effect from the exogenous, and even simulate its impact. Only measure the short term: false, since when calculating the NPV of the future EVAs that the business plans and projects to be developed can create, it is avoided to evaluate or compensate only the past management, allowing -on the contrary- to proactively encourage the design and construction of the future (Hamel & Prahalad).
Attributes of EVA®
One of the best attributes of EVA is the ease with which it allows the contribution to the economic value of a corporation to be broken down into its component parts. The EVA can be calculated at the level of a division, a company and / or a function, and thus determine which unit is the one that is contributing the most to the creation of corporate value: hence the widespread use that is being made of EVA, by linking it to periodic managerial incentives that reward better performance (variable compensation): looking forward and looking back.
Thus, for example, the EVA calculation methodology allows elegantly solving the problem of determining - separately and fairly - the contribution to corporate value from the areas of marketing and sales, supply and purchases, or production / maintenance: this implies changing - justifiably- the metric and overcome some accounting and budgeting biases, which make it difficult to correctly appreciate functional management from an economic / financial perspective that correctly measures the contribution to the generation of wealth. Even though this is not essential, the complementary use of BSC, ABC and SAP systems makes things easier.
The EVA®, by not requiring calculations related to the cash flow itself, facilitates its application to any functional area to which you want to calculate its contribution: this does not mean that the EVA® does not take into account the management of working capital, or that it does not definitively resolve matters related to transfer prices, but quite the opposite: it simply does it in a different way.
Outdated management control
Many Venezuelans, specialists in corporate and financial planning, and / or financial evaluation, are perfectly familiar with the subject and are in a position to calculate, plan and control -very well- the economic and financial value: in fact, the EVA joined the BSC. widely disseminated in our environment as a management instrument, associated with the creation of value for the shareholder.
If the representative algorithm of the EVA® is progressively disaggregated into its component parts and plotted in the form of a tree - linking the different variables together - we can easily visualize the means / ends interrelationships that guide the generation of the value: this allows us to appreciate very clearly, the branches of the generators of financial value from commercial activity, and clearly separate them from those from operational activities, showing at the same time their relationship with the variables that account for human management: diagrams conceptual and tabular data of the Balanced ScoreCard's (Kaplan & Norton BSC's).
Practice shows that this representation is very useful for both planning and management assurance purposes, as it facilitates both the a priori operationalization of the value-generating strategy and the a posteriori analysis of eventual deviations, facilitating double loop learning. characteristic of new approaches that have made traditional management control (Argyris) obsolete.
Epilogue
The value of anything is not what you pay for it, or what it costs to produce it, but what you get for it… (Lyon).
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