Value-based Management (VBM)
aligns a company’s overall aspirations, analytical techniques and management processes with the key drivers of value
characteristics VBM
- determined by DCFs
- value is created when companies invest capital at returns which exceed the cost of capital
- focused on better decision-making throughout the organization
working capital..
current assets - current liabilities
cost of capital
- required return necessary to make a capital budgeting project worthwhile
- refers to the cost of equity or cost of debt
four essential management processes that govern the adoption of VBM
- develop strategy to maximize value
- translate strategy into short-term and long-term performance targets determined by key value drives
- develop action plans and budgets to define steps
- put performance measurement and incentive systems in place
VBM target setting
- base targets on key value drivers
- include both financial and non-financial targets
- tailor targets to different levels within the organization
2 limitations of earnings
- companies manage earnings because they have considerable latitude in estimating the amount and timing of accruals
- accruals deal with only a small fraction of the cash flow investors should value stocks with
informational efficient market
stock prices reflect all relevant information, preventing investors from making certain decisions
fundamental efficient market
- prices are just right
- future prices are based on revised information
allocating efficient market
- depends on skills of informed buyers and sellers
- DCF values
- early bird specials
non-DCF approach
- short-term relative performance focus
- near-term investor sentiment or earnings-expectations game
- P/E multiples of companies in the same industry
2 basic factors shape the returns from a stock mispriced on a DCF basis
- the greater the estimated mispricing relative to current stock price, the greater the potential return
- the time it takes the stock price to converge toward what you believe to be right; the shorter the time the greater the return
managing for short-term earnings comprises shareholder value in 2 ways
- companies delay/forgo value-creating investments
- focus on short-term earnings comprises shareholder value
3 fears to overcome before believing in the effectiveness of DCF analysis in boosting performance
- others in the investment community will not follow
- short-term earnings will continue to sig. influence stock prices
- forecasting high uncertainty cash flows is impractical
open-end fund
collective investment scheme that can issue and redeem shares at any time
closed-end fund
collective investment model based on issuing fixed number of shares which are not redeemable from the fund.
long-term investment horizons would reduce the value relevance of short-term earnings and the earnings obsession by…
- reducing agency costs of delegated investment
- reducing earnings
- increase allocating efficiency
conclusion Rappaport (1995)
- sig. cause of corporate scandals is the obsession with short-term performance
- all the discounted cash flows together is the value of the firm created for the shareholders
Firm value consists of 2 components
- physical assets in place
- NPV of current and future investment opportunities
stock volatility
the degree of variation in a stock price over time
- reflects idiosyncratic risk
moderate myopic management
only cutting costs in either M&A or R&D
- mostly R&D budget
Results study Bacidore et al (1997). High stock returns lead to…
- increase marketing budget
- decrease R&D budget
EVA use and measure
- go from accounting number to a cash flow number
- expected earnings of investment, what is needed for the investment and what you want as a ROI
- adjusts net operaring profit after tax
EVA calculation
NOPAT - (WACC*capital invested)
NOPAT = net operating profit after tax
WACC = weighted average cost of capital
Capital invested = book value net capital at beginning of period
