Companies have reverted to traditional ways of measuring their intrinsic
value. Jane Lewis offers a guide to the many ways that financial performance
can be measured.
Ever since the so-called father of accounting Luca Pacioli published the
first accounting guide in 1494, theorists have debated how to measure financial
performance and assess the true value of companies. No-one has yet come up with
a universally acceptable answer.
Here, we outline just some of the thousands of different methodologies that
have been employed over the ages.
At the height of the recent stock market bubble, the force of ‘momentum
investing’ ensured that the share prices of loss-making dotcoms overtook those
of reliably profitable blue chips. It became clear that on this rare occasion,
the distinction between value and price had been widely ignored.
Now that conventional ‘value investment’ is back in style – which aims to
seek out stocks that are cheap compared to their intrinsic value – the rules of
measurement have changed yet again.
But a key legacy of the new economy era is a greater emphasis on the value
of intangible assets, most notably those pertaining to the performance of
people.
For the first time in its history, HR could become a key influence in the
formal valuation of companies. Make the most of it.
1. VALUATION BY FINANCIAL OUTCOME
In the sober aftermath of burst bubble of the new economy, many investors
saw the return of old-style business appraisal techniques, which concentrate on
what is actually happening to the bottom line, as a welcome return to sanity.
Measures such as dividend yield and price/earnings ratio, which both major on
financial outcomes, are tried and tested ways of providing a snapshot of how a
company is performing. The downside is that taken alone, they provide little in
the way of future assessment, offering a very narrow view of a company’s
prospects.
Dividend Yield
What is it? Dividend yield is the cash income paid to shareholders, normally
twice yearly. It is the oldest and most basic foundation of business valuation.
What does it tell you about a company’s value? In theory, a good dividend
provides strong evidence that a company has performed well in the previous
year. Because dividend yield is a lagging rather than a leading indicator
(reflecting what has happened in the past rather than what may happen in the
future), it tends to have little impact on the share price, which usually
reflects the market’s expectation of future prospects. An attractive yield one
year may largely be an illusion if the next payment is cut. Predicting what the
next dividend will be, is more important than assessing the amount actually
paid in the past year.
What are the downsides? Because dividend payments say little about a
company’s growth prospects, they were dismissed as irrelevant during the 1990s
boom by many hot-growth companies. However, they are also fallible as a
reflection of current profitability: ailing capital-rich companies often resort
to dividend payments to sweeten the impact of poor annual results. It is quite
possible to declare a loss and still issue a meaty dividend.
What is its standing now? The recent collapse of so many growth stocks
caused general jubilation among yield aficionados, who had been frequently
taunted for being ‘dinosaurs’. In the new climate of temperance, companies that
have doggedly issued a steady stream of respectable dividends suddenly look
very attractive.
Nonetheless, many influential players still avoid them altogether. Microsoft
has never issued a dividend payment throughout its highly profitable history,
arguing that shareholders are better served by its focus on keeping the stock
price high. If they want to realise their investment, they need only sell their
shares. In the UK, the appeal for substantial investors such as pension funds
has also waned following Gordon Brown’s 1997 decision to abolish tax relief on
dividend payments. Companies are therefore increasingly preoccupied with
finding alternative, more tax-efficient ways of returning cash to shareholders.
Price/earnings ratio
What is it? Traditionally the favoured way of taking a snapshot value
appraisal, a company’s price/earnings ratio is calculated by dividing its share
price by its earnings per share – the definition of ‘earnings’ is profits,
after tax and other charges.
What does it tell you about a company’s value? Ostensibly, a high p/e ratio
– historically around the 20-22 mark in the UK – signifies strong performance.
But a low p/e ratio is not necessarily indicative of poor performance: it could
just be that the market has overlooked and undervalued a company. Thus the Holy
Grail for ‘value investors’ – bargain-hunters looking to snap up cheap stocks –
are firms with low p/e ratios, whose prospects when examined closely are
nonetheless good.
What are the downsides? The growth of so-called ‘aggressive’ accounting
techniques have badly damaged the credibility of p/e ratios. As Enron
demonstrated so spectacularly, a company’s stated ‘earnings’ can be highly
deceptive when it comes to assessing its real state of health. Too many companies
still artificially boost their profits in order to keep their p/e ratios high.
What is its standing now? In the current climate soaring p/e ratios have
become harder than ever to justify and many critics perceive them to be the
sign of a still over-valued market. Even in the weeks following 11 September,
the average US p/e ratio, at 28, was high by historical standards. In Japan,
currently in the grip of economic meltdown, ratios in some companies are still
as a high as 60. This has convinced many critics that p/e ratios are a better
indicator of ‘barmy stock markets’ than of actual value.
2. MEASURING VALUE BY ASSETS
Proponents of this school subscribe to Oscar Wilde’s dictum that only a
cynic "knows the price of everything and the value of nothing". Real
value, they argue, can only be assessed if a company’s full assets and
liabilities (as well as its earnings and growth prospects) are taken into
account. In recent years, the distinction between value and price has rarely
been so widely ignored.
Asset analysis is most useful when companies possess unexploited assets that
could be sold or put to other uses – real estate or stakes in other companies,
for example. The decline of the manufacturing industry and the rise of the
service economy have muddied the issue of asset identification. Intangible
assets – brand names, goodwill, royalty rights and the skills of the workforce
– are clearly critical to the ultimate value of companies, but are notoriously
difficult to measure satisfactorily on the balance sheet. Many of the following
metrics represent an att-empt to do just that.
Tobin’s Q
What is it? Invented by the US economist and 1981 Nobel laureate James
Tobin, who died in March aged 84, the Q ratio compares a company’s market value
to the replacement cost of its assets. It is commonly aggregated across the
market as a whole.
What does it tell you about a company’s value? A low Q ratio suggests a
company may be going cheap. Conversely, a high one indicates its share price
could be overvalued. During the 1990s, stock markets in the US and Europe
became very expensive measured by this benchmark, consequently it fell out of
favour. It has recently regained popularity among bearish investors who regard
it as a touchstone metric due to its ability to cut through market hype.
What are the downsides? In its purest incarnation, Tobin’s Q has been
criticised as being too blunt an instrument as it lacks the subtlety to
incorporate the true value of intangible assets that fuel growth into its
calculations. Its most vehement critics dismiss it as an archaic measure that
should be scrapped.
What is its standing now? Growing evidence that Tobin’s Q can be tailored to
incorporate new metrics which measure intangibles, has restored its
credibility. These include those metrics dealing with HR performance (see
below). The Q ratio’s resurgence as a key benchmark looks set to grow. It was
recently championed by UK economists Andrew Smithers and Stephen Wright in
their book Value on Wall Street. Meanwhile, no less an authority than Alan
Greenspan, chairman of the Federal Reserve, has remarked that a high Q value
often reflects good HR practice.
The Balanced Scorecard
What is it? Developed by Robert Kaplan and David Norton, the Balanced
Scorecard aims to present a rounded picture of corporate health by monitoring
performance across all areas of a company’s activity via a series of key
performance indicators (KPIs).
What does it tell you about a company’s value? Arguably, the metric offers
the most holistic snapshot of a company’s standing, both within its market and
internally. As well as measuring financial performance and company growth, it
assesses the value of business processes, customer relationships and employee
investment programmes. As such, it measures value for all a company’s
stakeholders – not just those with share certificates.
What are the downsides? During the years of the boom, when shareholder value
assumed pivotal importance to the exclusion of everything else, the Balanced
Scorecard was frequently dismissed as irrelevant. Critics claim it can also be
difficult to implement and monitor efficiently.
What is its standing now? Because of its emphasis on measuring intangible as
well as tangible values, the Balanced Scorecard has long been a favoured metric
in HR. It has also spawned many imitators, notably the Skandia Navigator created
in 1993. This identifies and evaluates customer capital, structural capital and
human capital. With growing evidence that ‘soft’ issues such as staff and
customer satisfaction do have an impact on the bottom line, the Balanced
Scorecard and its ilk look set to enjoy a well-earned revival in the boardroom.
The Human Capital Index (HCI)
What is it? Developed by consultants Watson Wyatt, the Human Capital Index
is arguably the leading metric for identifying correlations between people
management and financial performance.
What does it tell you about a company’s value? Quite a lot, say HCI’s
developers. They claim the index has identified a ‘significant’ link between
effective people management, profitability and, ultimately, market value. In a
pioneering US study in 1999, the index showed that improvements in key HR
practices among participating companies sparked a 30 per cent increase in
market value.
What are the downsides? Critics say there are problems with cause and
effect. Rather than HCI driving the positive financial results, it could be
argued that successful companies simply have more resources to invest in HR
programmes. As such, human capital management could be a lagging, rather than a
leading indicator, of financial success.
What is its standing now? Watson Wyatt human capital consultant Mary
Southwell, claims that further studies conducted in 2001 demonstrated
conclusively that HR practice does influence and create business outcomes and
is not merely a side effect of them. Thanks to indices such as HCI and its
close relative the Intellectual Capital Index, developed by Goran and Johan
Roos, human capital management is now at the forefront of modern management
preoccupations. Indeed, just about every consultancy you can think of, from PricewaterhouseCoopers
to the beleaguered Andersen, has leapt onto the bandwagon by developing their
own benchmarks.
3. MEASURING VALUE BY CAPITAL PERFORMANCE
The old investment saying that ‘assets are only worth what they can earn’
was taken up with a vengeance in the 1990s when a new breed of performance
metrics stormed into existence. Thanks to sustained marketing efforts, the sway
of benchmarks such as Stern Stewart’s Economic Value Added (EVA) and its
arch-rival Holt Associates’ Cash-flow Return on Investment (CFROI) became so
powerful that before long, no public company could safely afford to ignore
them. Indeed, many of those who took an aloof attitude were swiftly penalised
by analysts and powerful institutional investors.
The cultural impact of these performance metrics on companies was equally
pronounced. Soon every activity, however humble, was judged by its ability to
‘add value’ to the share price. With hindsight, it is clear that much of the
brouhaha was driven by hype and that many companies were merely paying lip
service to a ubiquitous mantra. Nonetheless, benchmarks such as Eva provided an
important reminder to managers that capital has a cost. They could no longer
coast along on the idea that making a good profit was enough to sustain long-term
growth.
Economic Value Added (Eva)
What is it? Eva is a cash flow-based measure that aims to discover whether
business activity creates real value, or merely consumes core capital. Although
this concept has been around for decades, it was refashioned, repackaged and
marketed as a methodology by Joel Stern and Bennett Stewart in the early 1990s.
Eva works by taking the company’s net operating profit after tax and then
subtracting the cost of capital used to generate that profit. If the company is
still in the black following this calculation it is judged to have a ‘positive
Eva’; the converse is a ‘negative Eva’.
What does it tell you about a company’s value? Stern Stewart & Co was so
adamant that Eva was a far more accurate gauge of value than conventional
accounting techniques that it urged companies to drop ‘fuddy-duddy’ processes
such as profit & loss. In the mid-1990s, when the hype surrounding Eva was
at its peak, it had a huge influence over a company’s market value. The mere
whisper of a negative Eva could wipe millions off a company’s share price.
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What are the downsides? In order to achieve a strong Eva score, companies
must commit themselves entirely to a Value-Based Management (VBM) programme. In
theory, this is "seductively simple", states the Harvard Business
Review: choose your metric, tie salaries to agreed improvement targets and
"voilà , managers and employees will start making all sorts of
value-creating decisions." In practice, almost half the companies it
surveyed had met with mediocre success, mainly because of difficulties altering
corporate culture. After AT&T consistently failed to boost its share price
with its Eva programme, it returned to traditional performance measures such as
earnings per share. "The only people who got any value out of the
programme were the consultants", adds the Harvard Business Review. Eva is
continually criticised for creating tunnel-visioned managers who saw it as a
silver bullet and relied on it far too heavily in decision-making.
What is its standing now? Eva first began to lose ground as the metric of
choice during the dotcom boom, when its emphasis on profit, as opposed to
growth, was clearly out of step with the times. Stern Stewart moved quickly to
update the methodology by widening its definition of ‘capital’ to incorporate
new economy totems such as market growth potential, exclusive partnerships and
the lifetime value of customers. However, this had the affect of alienating
traditionalists. The benchmark’s star was further damaged when a Merrill Lynch
study found little evidence that a strong Eva correlated with superior stock
performance. Nonetheless, the main legacy of the Eva craze – value-based
management – continues to live on and has paid dividends for some companies.
Senior executives at Cadbury Schweppes, Dow Chemical and Siemens have been
lavish in their praise and Lloyds TSB chairman, Brian Pitman, dubbed it
"the driving force behind our success."
