Chapter 13 - Managing for Shareholder Value

Top Creators of Shareholder Value for 2001 ($ Millions) invested cost of invested cost of MVA capital return capital MVA capital return capital Gen Elect 339,200 82, %9.4% Gen Elect 339,200 82, %9.4% Microsoft 325,872 26, % 13.7% Microsoft 325,872 26, % 13.7% Wal-Mart 221,166 65, % 8.9% Wal-Mart 221,166 65, % 8.9% Intel 169,980 41, % 16.2% Intel 169,980 41, % 16.2% Citigroup 155, , % 12.0% Citigroup 155, , % 12.0%

Market Value Added MVA = Firm Value - Invested Capital Firm value = market value of the firm’s outstanding debt and equity securities. Invested Capital = the sum total of the funds that have been invested in the firm.

Value Creation  The combination of opportunity and execution.  Opportunities must be recognized.  Employees must be ready, willing, and able to take advantage of the opportunities.

Business Valuation: The Accounting Model  Using the P/E ratio:  If a firm’s P/E ratio is 20, then a dollar increase in earnings per share will create $20 in additional equity value per share.  Problem: ignores R&D, which would reduce earnings per share, but should increase future earnings!

Business Valuation: Free Cash Flow Valuation Model  Value = the PV of the firm’s projected free cash flows for all future years.

Business Valuation: Free Cash Flow Valuation Model  Value = the PV of the firm’s projected free cash flows for all future years. Value = FCF + FCF + FCF + … + Terminal value ( 1+k) 1 (1+k) 2 (1+k) 3 (1+k) n ( 1+k) 1 (1+k) 2 (1+k) 3 (1+k) n

Value Drivers Variables that managers can tweak to increase firm value. Examples:  sales growth  operating profit margin  net working capital-to-sales ratio  property, plant and equipment-to-sales ratio  cost of capital

Economic Value Added

Net operating weighted average invested Net operating weighted average invested EVA t = profit after - cost of x capital t-1 tax (NOPAT) t capital (k wacc ) tax (NOPAT) t capital (k wacc )

Economic Value Added Net operating weighted average invested Net operating weighted average invested EVA t = profit after - cost of x capital t-1 tax (NOPAT) t capital (k wacc ) tax (NOPAT) t capital (k wacc ) alternative definition: Return on weighted average invested Return on weighted average invested EVA t = invested - cost of x capital t-1 capital (ROIC) t capital (k wacc ) capital (ROIC) t capital (k wacc )

Paying for Performance Shareholder and manager interests are aligned when:  contributions of individuals and groups toward creation of shareholder value are measured using EVA, and  rewards are structured accordingly.

Components of a Firm’s Compensation Policy  base pay  bonus: quarterly, semi-annual, or annual  long-term compensation: options, grants

Designing a Compensation Program 1) How much to pay? 2) Base pay versus at-risk or incentive compensation 3) Linking incentive compensation to performance 4) Paying with a cash bonus versus equity