Value creation is a corporation’s raison d’être, the ultimate measure by which it is judged. Debate has focused on what is the most appropriate type of value for the corporation to create. Is it:
- the value that the stockmarket gives the company (its market value);
- the value shown in its balance sheet (the accounting or book value of its assets minus its liabilities);
- something based on its expected future performance - profits or cash; or
- none of these?
In the 1990s, the main emphasis of executives was on creating value for shareholders - a value that was reflected in movements of the company’s stock price. But measures based on stockmarket values are subject to the same wild fluctuations as the market itself. In a rising tide, all boats get raised. But when macroeconomic changes force up markets generally, it does not mean that the value of each individual company in that market has changed similarly. Markets are moved by sentiment that has little to do with the underlying value of individual corporations.
The dotcom frenzy at the end of the 1990s was proof of this. Small new internet firms were suddenly lifted into the stratosphere by investors’ enthusiasm for their stocks. But their underlying value throughout the frenzy remained more or less unchanged - for many of them, that value was ultimately measured by a liquidator.
However, any measure based on book value has to get over the fact that accounting measures are not carved in stone. They can (and do) differ from country to country. It is also stymied by the fact that book values fail to take full account of intangible assets - things you cannot kick, like brands, patents or partnerships. These have come to assume a growing proportion of many companies’ value, particularly in the high-tech sector where the most valuable assets walk in and out of the front door every day. At the start of this century, it was estimated that intangible assets could account for as much as half of the value of the entire American economy.
Measures that attempt to value a company based on its future prospects are no easy alternative. They soon run into the difficulty of quantifying what those prospects are. The popular idea that a company is no more than the net present value of its future cash flow depends on guessing first what that cash flow is going to be, and then what future interest rates are going to be. Interest rates are used to discount those cash flows and calculate their present value. However, these measures do have the advantage of being independent of accounting rules, so they can be used to compare companies in different industries and countries.
A measure developed to overcome these problems is called EVA (economic value added). This is the measure of output (taken as operating profit after tax and some other adjustments) less input (taken as the annual rental charge on the total capital employed, both debt and equity). Managers have all the elements of this equation (costs, revenues, debt and capital expenditure) in their hands. So when it increases or decreases they have no one to praise or blame other than themselves. This makes it (in theory) a good benchmark against which to measure their bonuses and other perks.