BASIC ASSUMPTIONS REVIEW
EVA, and the related concept of economic profit, suggests that maximizing the differential between a firm’s incremental investments and its cost of capital will maximize shareholder wealth. Mathematically, we will show that this boils down to maximizing its return on equity.
Some readers are certainly thinking at this point that the author must delight in pointing out the obvious. The implication that maximizing $EVA and $MVA boil down to maximizing a firm’s return on equity was not obvious – we had to look at the underlying concepts. But the thought that maximizing return on equity (i.e., the shareholders’ investment) is the path to maximizing shareholder value should be intuitively obvious. What is not obvious is what happens when companies do not follow value maximizing strategies.
The following assumptions are implicit in any valuation of expected future cash flows to the equity owners of a business:
Business appraisers have known for years that suboptimal reinvestment policies have a depressing impact on the value of a company’s illiquid minority shares. Reinvestment at less than a company’s required rate of return, assuming no leakage of assets from the company through dividends or excess compensation to owners/managers, reduces a company’s expected growth rate of value (relative to the optimal reinvestment outlook), and therefore tends to lower the value of minority shares. We attempt to capture the impact of expected growth in value lower than the required return using the Quantitative Marketability Discount Model ("QMDM"). This impact is captured as a component of the marketability discount applied to marketable minority interest value indications. Other appraisers using benchmark analysis have made more subjective judgments to attempt to account for this potential.
THE VALUE OF A BUSINESS
In working on this E-Law, I had what can only be described as a "BGO" – a Blinding Glimpse of the Obvious. The penalty of lower expected future value resulting from less than optimal reinvestment plans has an impact on controlling shareholders, as well! Having made this "discovery," two questions came immediately to mind:
An example is sometimes worth a thousand or more words. Consider the following valuation situation:
This "valuation" is a straightforward application of the Gordon Growth Model. A company’s normalized, expected net earnings for next year are capitalized at its discount rate less its expected growth rate in earnings (18% – 8% = 10% which is the capitalization rate. The inverse of the capitalization rate, or 1/10% , is the multiple, or 10x). Expected net earnings of $1.0 million are worth $10.0 million at the marketable minority interest level. No controversy thus far.
The text in the assumptions box suggests that this marketable minority interest value of $10.0 million is a reasonable proxy for a controlling interest value indication. The rationale is straightforward. By assumption, salaries and any other owner-related expenses, as well as any non-recurring items of income or expense have been normalized to a theoretical "public equivalent" level. Unless a buyer of the company can expect to realize increases in cash flows through better management (financial buyers) or changing the cash flows (strategic buyers), no (or very little) premium will be paid to the marketable minority interest value. Under these assumptions, there is no difference in the present value of the business today ($10.0 million), or if it is run according to the above assumptions and sold in 10 years. The importance of this issue will be clarified momentarily.
THE VALUE OF THE BUSINESS PLAN
It should be clear that the business is worth $10.0 million. Now, let’s look at the expected business plan of the company which has just been valued at $10.0 million. Consider that our company is run by its 100% shareholder (to eliminate minority shareholder issues). Consider further that no excess compensation will be paid to the owner or his relatives, and that there will be no dividends. The only differences between the expected business plan of the owner and the assumptions of the $10.0 valuation are the following:
Just as we valued the business (in the context of the market place of willing buyers and sellers), we can value the business plan of this owner. In other words, what is the present value of the expected cash flows, given that we are expecting a suboptimal reinvestment plan? Compare the two situations:
The table above has two columns. The first, Reinvest at Required Rate of Return, provides the valuation of the business we first described. The second, Suboptimal Reinvestment Policy, indicates the value of the assumed business plan. This plan provides for reinvestment of cash flows for the next ten years at 5%, rather than 18%, and then a sale of the business at the end of the tenth year (valued at that time under the assumption of optimal reinvestment of cash flows!)
The value of the business plan, as described above, is $7.5 million, which is $2.5 million lower than the value of the business. What happened to the missing $2.5 million? We can see this by examining the results of the forecasts at the end of ten years, when the business will be sold.
IMPLICATIONS FOR BUSINESS APPRAISERS
By examining the components of value in the table below, we see that the value of the business plan of $7.5 million is lower than the value of the business because there will be some $13.1 million fewer future dollars at the end of ten years. This is the result of suboptimal expected reinvestments in the business rather than reinvestments at the discount rate.
Is the business worth any less because the current owner plans to reinvest at less than the discount rate? No. Because there are buyers in the market for businesses who will pay for the company based on the assumptions outlined above, which includes optimal reinvestment policy. This is a confusing point for many business appraisers. They seem to want to adjust the discount rate to reflect the expectation of future suboptimality, but this is a circular process that is never-ending and is not based the way that markets work.
Why shouldn’t we adjust the discount rate to account for suboptimal expected reinvestment? Because, today, tomorrow, or at any time in the future, the current owner can:
A corollary question is: Why would we adjust the discount rate for minority shareholders of this very same company? Because they cannot change the policies or the business plans.
The missing $2.5 million represents an opportunity cost to the business owner above. If there were minority shareholders, it would certainly represent an opportunity cost to them, as well.
Since the $2.5 million is an opportunity cost, it is not one that is paid with a check. It is realized year-by-year as a result of suboptimal reinvestments. This phenomenon is likely responsible for the notion among some business appraisers that there should be a marketability discount applicable to controlling interests of companies. The math and the logic above, I believe, suggest otherwise. It does not seem appropriate to create a "marketability discount" to account for the opportunity cost of suboptimal business plans on the value of a business today.
IMPLICATIONS FOR BUSINESS OWNERS AND THEIR ADVISERS
We chose the example above intentionally. In Mercer Capital’s valuation practice, we see many examples of mature companies experiencing relatively slow growth that consistently accumulate assets that are deployed in excess of non-operating assets. The example suggests that there is an economic penalty to this strategy that is not felt by a controlling shareholder today.
Many slower growing, mature, privately owned companies fit the general description of our example company. The economic, opportunity cost of less than optimal reinvestment or dividend policies can be substantial. And few business owners recognize this very real cost as they continue to accumulate excess and nonoperating assets in their companies. If they think about it, they may believe that whatever opportunity cost that is being incurred is borne by minority shareholders, but this invisible opportunity cost is borne by all shareholders.
What does our example have to do with EVA and MVA? MVA, or market value added, is the differential in the book value of a firm’s equity and the market value of its equity. As we saw in the previous issue of E-Law, Equation 14:
The %MVA is determined by the market’s (or the appraiser’s) price/earnings multiple multiplied by a firm’s ROE, or return on equity. If a firm increases its ROE, other things being equal, value (and %MVA) will rise. If the increase in ROE translates into more rapid growth prospects for an enterprise, the price/earnings multiple may also be increased by the market (or the appraiser).
Business owners need to be aware of the opportunity costs of their incremental reinvestment decisions. From a policy standpoint, more than a few private businesses avoid paying dividends to shareholders in order to avoid the personal income tax consequences of the dividends. Instead, they engage in a practice of accumulating excess assets. The example above shows that the shareholders of companies that do this are paying a considerable "tax" in the form of opportunity losses.
Business appraisers and other advisers to business owners who understand these EVA, economic profit, market value added, and return on equity concepts are in a position to assist their clients in the process of maximizing shareholder wealth.
Business owners, their advisers, and yes, business appraisers, should take an important lesson from this brief analysis of EVA and MVA.
A firm maximizes value by maximizing its return on equity.
As a result, there should clearly be a focus on ROE in valuation reports of private companies. Low ROEs, other things being equal, yield relatively low price/book multiples, and therefore, relatively low values of $MVA. Alternatively, high ROEs, other things being equal, yield relatively high price/book multiples, and therefore, relatively high values of $MVA.
The overall point of this review of Economic Value Added (remember, economic profit is the same thing), and Market Value Added (which is, effectively, the premium to a firm’s book value that is reflected by the value of its capitalized earnings) is that shareholder value added is the result of a consistent focus on maximizing the return on equity of a firm. We will explore these concepts further in future E-Laws.
For now, it should be clear that suboptimal reinvestment policies (i.e., investing at less than a firm’s cost of capital) and suboptimal dividend policies (i.e., policies that facilitate the build-up of excess or non-operating assets in an operating business) have very real and substantial economic opportunity costs for shareholders of private companies.