Measuring Value Creation

The metrics that measure «value» or «value creation» were originally based on DCF techniques and these are most commonly applied to individual project evaluations. The first step in measuring the value created from any investment project is to calculate the net present value (NPV). The NPV represents:

– The sum of the «present values» of future cash flows resulting from an investment that is discounted at a given rate of interest, the «cost of capital». This gives a sum for the future receipts from the investment expressed in today’s monetary values.

– Less the cost of the investment. This determines whether, again in today’s money, there is a surplus or deficit from the investment.

The NPV that results simply represents the «present value» of the future cash flows less the original cost of the investment. If the NPV is positive then the return from the investment has exceeded the cost of capital and the value of the company should increase by the amount of value created. If, however, the NPV is negative the company’s value should theoretically decrease.

In reality there are many complications to this simple scenario. Companies represent a composite portfolio of numerous investment projects that have been made at different points of time and they do not convey all the information investors need to adjust values accordingly. Complex investment project scenarios can be extremely difficult to analyze and there are many arguments about the correct discount rates to use.

In spite of the difficulties, and although investors cannot always delve into the results of individual projects, it is possible for them to study the accounts of companies and to infer from them whether value has been added or destroyed. Investors can also extend this approach further by analyzing the forecast for companies to determine whether they are likely to add value in the future. This can help with their investment decisions and will, in turn, affect share prices.

Strictly speaking, companies wishing to deliver and maximize shareholder value creation need to focus on two things:

– Maximizing the stream of future cash flows;

– Minimizing the interest charged against that stream by reducing the «cost of capital».

Some would argue that influencing the cost of capital charge significantly is almost impossible and that the sole focus therefore should be on cash flow maximization. At its most basic level, then, a successful VBM approach means achieving a positive stream of future cash flows to give shareholders a return on capital in excess of its cost.

There are many ways of measuring this value but two are the most well known. The first is total shareholder returnand the second is economic profit.

From an investor’s perspective, when measuring the value that has been created the most important measure to use is total shareholder return. It is the sum of two components, which represent the benefits to the shareholder from owning the share:

– The percentage share price appreciation over the period being measured;

– The dividend yield during the period, expressed as a percentage of the share price.

Internally, companies that adopted VBM often use the second most popular measure of value. This is known as «economic profit». It measures the return earned by the company in a period after deducting a charge for the cost of capital employed within the business. Economic profit is often considered as the internal VBM measure that acts as a proxy for the shareholder value measured externally by the total shareholder return.