Archive for the 'Measuring Equity Value' Category

Introduction

Management’s job is to create equity value for the owners of the business at a pace that exceeds the owners’ cost of capital.   Though the goal is clear and crisp, the measurement is evasive.   Nonetheless, if creating equity value is the goal, the ability to measure equity value creation is paramount.   When management discusses the company’s performance with its board, the equity value calculation should be the focal point of the dialogue.

Equity Value Created

The equation for calculating how much equity value is created in a given period is:

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The equation is applicable for companies that are in an industry where using an EBITDA Multiple is an acceptable approximation for valuing businesses.

The result of the equation is the absolute amount of equity value that was created during the period for which the measurement is being made.   A few examples will be used to illustrate.  For all examples, assume the following:

  • Gross debt (e.g., bank loans, revolver) is unchanged
  • No additional equity is invested and no dividends are paid
  • 10X is an acceptable EBITDA multiple for the company

Example 1: In a quarter, EBITDA increases by $2M.   Cash increases by $10M.   Equity Value Created = [(2 * 4) * 10] + 10 = $90M

Example 2: Over the past 6 months, EBITDA increases by $6M.   Cash declines by $20M.   Equity Value Created = [(6* 2) * 10] -20 = $100M

Example 3: Over the past 12 months, EBITDA decrease by $5M.   Cash increases by $75M.   Equity Value Created = [-5 * 10] + 75 = $25M

In the examples, we assumed Gross Debt and Equity were unchanged.  Note, however, that the change in cash might instead have been a change in gross debt or equity, and the calculation would have yielded the same result.   For example, the $10M in Example 1 could have been a dividend to equity holders.  Cash in net indebtedness would have been zero, but change in equity investment would have been negative $10M.   Or, in Example 2, the $20M of cash decline might have been funded through an increase in gross debt or an additional equity investment.  If so, cash would be unchanged during the six months, but either net indebtedness or equity would have been $20.   In Example 3, the $100M could have been used to buy back equity or reduce debt.

Further notice that no assumptions were made as to whether the change in EBITDA was the result of organic growth or an acquisition of another business.  In Example 2, where cash flow is a negative $20M, it might have been that a $10M acquisition occurred during the period and that this acquisition contributed $2M to the gain in EBITDA.   The methodology captures value that is created through the combination of organic and inorganic activities.

Also note, no assumptions were made on how much capital was invested; how much interest and tax payments were made; or how much working capital changed.  All of these are important—but all are implicitly considered in the calculation.    The change in net indebtedness and the change in equity investment would have captured how much cash was needed to fund capital expenditures and working capital, to pay interest and taxes.   A management team that uses the equation will realize how each of sources and use of cash affects the calculation of equity value created.

Hopefully, the power of the equation is becoming clear.  The calculation itself is simple.  The comprehensive nature of the measurement captures the broad range of variables that affect equity value generation.   The result is a singular measurement of how management performed against its primary responsibility of creating equity value for its owner.  It doesn’t get much better than this.

EQUITY IRR

Let’s return to the full statement of management’s job of creating equity value for the owners of the business at a pace that exceeds the owners’ cost of capital.   The prior equation calculated how much equity value was created.  It did not grapple with how the pace compared to the owner’s cost of capital.  To complete the performance measurement, the internal rate of return (“IRR”) of equity value creation must be calculated.  This Equity IRR can then be compared to return expectation of the equity owners.  The comparison spotlights whether investors should be disappointed, satisfied, or thrilled with the performance over the period being measured.

The following equation can be used for calculating Equity IRR:

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Returning to the early examples, let’s assume each company had an Equity Value at the Beginning of the Period of $1B.   For Example 1, Equity IRR = ($90M / $1B) x 4 = 36%.   Example 2: Equity IRR = ($100M / $1B) x 2 = 20%.   Example 3: ($25M / $1B) x 1 = 2.5%.

If the equity owners have a cost of capital of 20%, they would be thrilled with Example 1, satisfied with Example 2, and certainly disappointed with Example 3.

Instead of assuming all three companies had an beginning Equity Value of $1B, let’s assume Example 1 was $4B, Example 2 was $500M, and Example 3 was $125M.

Equity IRR for #1 = ($90M / $4B) x 4 = 9%.   Example 2: Equity IRR = ($100M / $500M) x 2 = 40%.   Example 3: ($25M / $125M) x 1 = 20%.

If cost of capital remains at 20%, now owners would be disappointed in #1, thrilled in #2, and satisfied in #3.

Equity Value at Beginning of the Period

In the prior section, the equation for calculating Equity IRR was discussed.  The IRR equation requires “Equity Value at Beginning of Period” as an input.  To derive equity value, follow three simple equations:

  • Equity Value = Enterprise Value – Net Indebtedness
  • Enterprise Value = Annualized EBITDA X EBITDA Multiple
  • Net Indebtedness = Debt less Cash Balance

In the following examples, assume the appropriate EBITDA multiple is 10X.

Example 4:  A company had $50M EBITDA the prior quarter.  It owed $550M of debt and had $50M of cash on the balance sheet.    Net Indebtedness = $550M minus $50M = $500M.  Enterprise Value = $50M * 4 * 10 = $2B.   Equity Value = $2B – $500M = $1.5B.

Discussion of EBITDA Multiple

Central to this methodology is the use of EBITDA multiple as an indicator of value.   The true value of a company is its Intrinsic Value (see Intrinsic Value posts).   A management team cannot become overly reliant on EBITDA multiple to estimate Intrinsic Value.  Instead, the management team must be on a never-ending quest to improve its determination of Intrinsic Value based on ever-improving understanding of what its cash flows will really be.   As Intrinsic Value is better understood, it will lead to fine tuning what EBITDA Multiple should be used in the methodology above.

Methodology Self-Corrects for Incorrect EBITDA Multiples

What if the EBITDA Multiple is a poor placeholder for estimating Intrinsic Value?  The methodology will reveal this, leading to adjustments.  It is best to use examples to illustrate this.

A management team is able to make a reliable estimate of their cost of equity.  A large cap public company with low leverage and highly predictable cash flow might have a cost of equity of 12%.   A 18% might be a more appropriate estimate for a smaller company with less certain cash flows and lots of debt.  The 6% premium is necessary due to the higher risk profile.

Let’s assume a particular company has a 15% cost of equity.  Further, assume this company uses an 8x EBITDA multiple and, using this multiple, calculates that it is consistently delivering a 30% IRR to its equity holders.  What can be deduced?  The 8x EBITDA multiple is understated because the price of the company is too low.  The buyer, who has a 15% cost of equity, is buying at a price that will lead to a 30% return.  The seller is leaving a lot of money on the table.

Now, let’s consider a company that also has a 15% cost of equity and also assumes an 8x EBITDA multiple.  This company, however, calculates that it delivering only 5% IRR to its equity holders.  The 8x is overstated.  Sellers are right to sell at this price.  Buyers beware.

Of course, Intrinsic Value is based on forward looking cash flows, not past results.  Therefore, judgment must be applied as to how prior importance will inform future results.

Application of Equity Value Methodology to Business Units

Many companies are sub-divided into Business Units defined around some combination of Products and/or Geographies.  General Management positions are created and their charter is to maximum the value of their Business Units.   The shorthand “P&L responsibility” suggests these managers have comprehensive financial responsibility for their sector of the company.

The Value Creation methodology could (and should!) be applied to General Management positions.  Each business unit or product group should know how much equity value it is creating each quarter and what Equity IRR it is achieving.  This requires a more comprehensive tabulation of financial results, as capital and cash flow are integral to the calculation.  The benefits: are better decision making within each unit or group, an improved understanding of the sources of value creation, and a more appropriate way of measuring performance of business unit leaders.

Public Company Applicability

The ultimate measure for public companies is stock price.   Nonetheless, the ability to measure equity value creation independent of stock price remains is important.

Stock price can be thought of as shareholders’ consensus view at a particular moment of Intrinsic Value.   The stock market is volatile, which means shareholders’ view is prone to material swings.  Often, the variability is driven by macro-economic factors instead of company performance.   The unavoidable conclusion is that stock price, though an important indicator, is neither a precise nor reliable measure of Intrinsic Value.

In some quarters, a stock price will increase.  In others, a stock price will decline.  The correlation to the company’s performance in the particular quarter is modest.  An executive team that relies on stock price as the primary measure of its quarterly performance will be overly dependent on the ebbs and flows of the market.  If stock price is up, they will attribute to their performance.  If down, it is too easily written off to externalities.

With this as backdrop, the Value Creation methodology has clear applicability for a public company.  The management team is required to consider its Enterprise Value without simply resorting to the then-current stock price.  Moreover, it is able to measure its progress in advancing equity value over shorter (e.g., quarterly) periods of time.  Finally, the methodology allows a company to describe to its shareholders how it sets value creation goals and how it measures achievement.

Industry Analysts and Prospective Investors

A further feature of the methodology is that external interested parties can perform the measurement using only publically available information.  The external party can apply a range of EBITDA multiples when performing the calculation.   The remainder of the input should come directly from data published by the company.

An industry analyst can determine the relative Equity IRR performance of companies in the industry.  A prospective investor can tabulate the track record of a company in creating equity value over multiple periods.

Consider the power of this.  A company that generates Equity IRR at a 40% pace must be viewed differently than a peer who is performing at a 20% Equity IRR.   Revenue growth or EBITDA versus expectations are far less powerful indicators than the Equity IRR calculation.

Evaluating Forecasts

Management, or an external analyst, typically can develop a highly reliable forecast extending 3 or 4 quarters.  Assuming the forecast is achieved, what does it imply about the Equity IRR that was achieved in each of these quarters?  Using the industry norm EBITDA multiple, would the IRR be high (e.g., 30%) or low (e.g., 5%)?

This analysis can reveal whether stock price is likely to rise or fall if results are achieved.  If used internal to a company, it could reveal whether the company should be thrilled, ho-hum, or upset if the forecast is achieved.  A sandbagger is not rewarded for barely beating a 5% IRR forecast.   A manager who barely misses a 30% IRR is the hero.

Summary

If the job of management is to create equity value for its owners at a pace that exceeds the owners’ cost of capital, management should measure how well it performs against the goal.   Likewise, if a general manager has “P&L Responsibility”, she should know the pace in which her group creates equity value.

The value creation methodology provides the ability to measure equity value created and equity IRR.  This drives better decision-making within the organization and a frame of reference for resource allocation.  When applied to individual business units, high-performing areas are spotlighted, and value-destroying parts are exposed.   External analysts have a more comprehensive tool to assess performance both on an absolute basis and when comparing a company to its peer group.   Prospective investors can assess a company’s historical track record of creating equity value.