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Ideas Taking Off

The Future of Value-Based Planning



There’s an unsettling vogue in shareholder value consulting. Rather than responding to the distinct performance measurement, valuation, capital formation, and capital structure questions posed by increasingly sophisticated and, at times, lop-sided securities markets, the quest for value has become an excuse for studying anything and everything else — from the client’s goal-setting procedures to its communication networks to its compensation practices — all with the alleged promise of revolutionizing the way the company plans for value.

Unfortunately, in many instances, the practitioners have the basics all wrong.  The incentives are so skewed toward the big study — usually incentive compensation — that the nuts-and-bolts issues like terminal cash flow, the cost of capital, depreciation, and forecast smoothing have become issues to finesse rather than comprehend, at the unwitting expense of your shareholders.

Need examples? Try these brain-teasers out on your corporate development or financial planning department. Then read on to see if they shared the same consternation we did.

  • Why do so many shareholder value consultants exhort you to project cash flow in nominal terms, but value the terminal period as a constant — as if the company’s productive assets wither with inflation?
  • Why do they prescribe a risk premium for equities of 5-to-6 percent, based on the long-term historical difference between geometric means in the stock market and government bond market, when you’d in fact need 7-to-8 percent each year to replicate that differential?
  • Why do they assert that a cost of capital based on the external price and dividend behavior of your stock is appropriate for evaluating internal accounting-based returns, despite widely divergent internal and external return variance?
  • Why do they encourage you to develop a most likely case for valuing projected cash flows, but don’t adjust for the inevitably greater volatility of actual results around that case, biasing the valuations upward — even though the projections are themselves unbiased?
  • Why does their return on capital measure swoon every time you replace a large fully-depreciated asset, despite presumably anticipating replacement cost through depreciation expense?

Unfortunately, there is no satisfactory defense of these practices:

  • In today’s environment, treating terminal cash flow as a constant, unadjusted by inflation, probably understates your company’s perpetuity value by at least 30 percent, your company’s total value by 15 percent.  Depending on leverage, the error can bias your estimated equity value by as much as 15 to 55 percent.  That’s value that’s too often made up by padding projections during the earlier forecast period.  Or worse, simply lost through squandered investment opportunities.  Wittingly or not, treating terminal cash flow as a constant skews the balance of short- and long-term values, encouraging the same shortsighted investment policy that consultants so often deride.

  • Many consultants advise using the geometric risk premium (historically 5-to-6 percent) because it’s an unbiased long-term measure of the market’s incremental return over government bonds.  But it’s unlikely that you’ve ever tied anyone’s pay to cumulative performance over 65 years on a compound basis. If you’re like most companies, you set targets for one, two or three years, and hope your cost of capital for long-term purposes will suffice for shorter intervals. Wishful thinking. As long as there’s uncertainty about hitting your long-term target exactly each and every year, the annual target must be raised if you want an unbiased opportunity to compound to your long-term goal. For most companies, the adjustment is on the order of 150-to-250 basis points.

  • You’ve probably also been advised to measure capital costs on a business-by-business basis, but to find guidance from such external indicators as stock betas.  Unless your business portfolio consists exclusively of stock certificates marked annually to market, you’ve again been misinformed. True, properly measured internal returns on capital should compound, over time, to the same return experienced externally by your investors. But the volatility of those two return streams will most certainly diverge — usually by a gaping margin — necessitating a wholly difference cost of capital if you truly want to satisfy your investors’ expectations.

  • And how about those forecasts your analysts slaved over?  Ever ask your consultants what would happen if your actual experience turned out to be more volatile — albeit on track? The truth is, unless they’ve fudged elsewhere (like the cost of capital), you’re projections aren’t worth what your consultants claim they are, because a volatile actual path around an artificially smooth forecast will almost always compound to a smaller value. In fact, it wouldn’t surprise us if your valuations were off by 15 to 25 percent.

  • Finally, you may have been sold a software package that calculates taxes on a cash basis, subtracting the change in your deferred tax balance, but reducing net PP&E by only a portion of the depreciation that gave rise to it — the GAAP portion. This creates the impression that even if your return on capital always equals its cost, the net present value of cash flows will be positive — a fatal contradiction.  Worse, even if you treat deferred taxes consistently on an accrual basis, replacement of a significant, aging asset will cause your return on capital to plunge, even though its replacement cost was presumably anticipated by prior depreciation expense.

    The truth is, an asset’s performance should be measured separately from its financing.  In the case of deferred taxes, the tax effects of depreciation that are distinctive to purchasing versus, say, leasing the asset should be filtered out of year-to-year operating measures.  Failure to do so can deter necessary overhauls to the point where, far from creating shareholder value, you are destroying it.

Should you be concerned?  We think so.

We’re the first to admit that the issues we’ve raised are technical and less glamorous than the executive compensation assignments other shareholder value consultants have chosen exclusively to peddle.  But if they haven’t got the fundamental finance questions right, how can you trust them with extensions — especially those affecting the morale and performance of your key executives, or the mix and structure of your business portfolio?

We have found it hard enough to get line managers and engineers to participate enthusiastically in the financial reporting and capital planning process; it is nigh impossible if your credibility’s blown by conceptual blunders that any engineer with a background in statistics may uncover.  The building blocks of finance matter a lot, and dismissing them with the cavalier impatience that has become trademark with the usual names in shareholder value, is to dismiss the possibility of their clients ever having a compensation, capital budgeting, performance measurement and valuation process upon which their shareholders can rely.  It’s no surprise that leading academics like Gregg Jarrell have, seemingly out of frustration with the present generation of shareholder value measures, recommended returning to traditional measures like reported earnings.

It’s not that the calcification of our profession is intentional.  It’s just that many firms began publishing their thoughts 10-to-20 years ago, entombed themselves within them with definitive manifestos and computer programs, belittled competing approaches, and are now bound by a decade of inertia and identification to defend their age-old prescriptions — no matter how wrong.

Unlike Jarrell, we do not believe the search for accurate performance measures is a lost cause.  We believe its benefits are real and obtainable — but elusive because of the many worn and allegedly proprietary formulations that have stultified creative thinking in our profession.

Over the years, we have worked with scores of companies in evaluating operating performance; developing and evaluating long-range business plans; improving internal control mechanisms; assessing long- and short-term capital needs; accessing public and private markets for debt and equity; screening, pricing and structuring acquisitions; and identifying and consummating value-adding restructurings.  Clients have ranged from the CEO’s and CFO’s of the very largest corporations in the United States and Europe to many of this country’s most respected private and mid-sized companies.

If you require substantive assistance in valuation and financial planning, we’re confident we’re the firm for you.  To learn more about our financial advisory capabilities, click on Obtain Information on the sidebar.

Illustrations: Warren Gebert
Photography: Wayne Takenaka

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