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GENERATION 21x SPEAK: WEALTH CREATION Baby, You're a Rich Man By S. Gupta & K. Sahani
A company is deemed to have created value for its investors if it generates returns in excess of its opportunity costs of capital, and destroyed value if it does not. A good measure of judging the ability of a company to add value is to use Economic Value Added (EVA) and, to a lesser extent, the Return on Net Worth (RONW) as assessment tools. EVA represents the value added to shareholders by generating operating profits in excess of the cost of capital employed. A company's EVA can increase in 3 ways:
In this millennium, EVA is likely to emerge as more than just an accounting tool or metric. The better companies will use it as a performance management tool. Indeed, companies can, if they so wish, use EVA as a metric that helps them in the process of strategy evolution. There is a simple logic underlying the enhanced use that companies will find for EVA this century. The basis of EVA is the principle that a company should be able to generate returns higher than the investments made. This investment is the cost of capital, or, specifically, the Weighted Average Cost of Capital (WACC) which is, in effect, the cost of equity-funds and the cost of debt-funds. Given that, the role of EVA as a performance measure is evident. Departments, even individual employees, can now be appraised on the basis of how their actions have contributed to the EVA of the company and consequently, to shareholder value. No longer will it be necessary to expend time and effort in aligning individual and departmental goals with the larger organisational goal. The discipline of EVA will ensure that this happens spontaneously. The link between EVA and strategy isn't that evident. Strategy, simply put, is nothing but a set of choices. Managers have evolved, over a period of time, techniques that help them make the right decisions every time. Although the process is likely to be elaborate, it will be possible for companies and managers to assess the impact of a decision in terms of its impact on the EVA of the company. The actual process may involve some element of simulation, but advanced computing techniques will render it fairly easy-to-use. Thus, managers can choose between options on the basis of the impact each option will have on the company's EVA. The number of companies doing this will increase this millennium; soon, EVA is likely to become part of the strategy process. At the beginning of the 21st century, companies are realising that they need to view assets not just from the perspective of investment, but also from that of returns. These situations, typically, rise in mature industries-and apart from the software and the pharma sector, most Indian companies find themselves in this stage today. Most organisations that find themselves at this stage of the lifecycle are stuck in a vicious cycle. Their margins are low, but their cashflows are positive. This cashflow is either distributed as dividend or held back as retained earnings, which are then ploughed back either in the same or similar businesses. The results are almost always the same: these investments, expectedly, earn below-average returns. And shareholder value gets destroyed. Having realised this, companies-especially those that have good corporate governance norms-will either try to adopt a different business model that causes a significant increase in the quantum of returns, or they will distribute the most part of their positive cashflow as dividend. This, however, is at the numerical level. The typical company has many types of shareholders. In the first part of this millennium, for instance, mutual funds are likely to become vociferous shareholders. So-if there are any reforms on the pension-funds front-such companies will have to learn the science and art of managing different types of shareholders with vastly different expectations. The software boom on the stockmarkets in the last decade of the 20th century holds a lesson for millennial managers: greenfield sectors like software, biotech, and life-sciences will always boast higher returns. But the risks too are commensurate. Companies using EVA as a performance measure and a tool in the strategy evolution process would do well to compare themselves to companies either in the same or related businesses. A company in the software business, for instance, will, almost always, have a higher EVA than another which is in the business of manufacturing electric motors. The reasons? Returns are higher, and capital requirements, lower in the software business. Thus, in the American context, it is difficult to say which the better company is: GE, Microsoft, or Coca-Cola? Microsoft requires less capital than the other two. Yet, for most part of the 1990s GE and Coca-Cola kept pace with the software major's MVA (Market Value Added) although, in terms of EVA, Microsoft outscored them. Understanding this difference between industries and dealing with it in a mature fashion is one of the things managers need to do. As India Inc. begins its march into this millennium, it should not wait for shareholder-pressure or government intervention to start focusing on shareholder value. In the wired economy, a company either enhances shareholder value, or perishes. S. Gupta & K. Sahani are
second-year MBA student at the ICFAI Business School |
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There
is a widespread belief that Indian stockmarkets react on the basis of sentiments and
rumours rather than the fundamental strength of companies and the economy. A study of
markets over the last 4 years reveals that they rewarded only companies that created
shareholder value, and punished those that destroyed it. 