What is SVA?
Shareholder Value Analysis (SVA) is one of a number of methods being explored as substitutes for traditional business measurements [10]. It is a financial analysis method used for the measurement of shareholder value. The core of this method is using the value of shares to divide the total net value estimation of a company. The company's value is calculated by considering returns which shareholders are given. Shareholders' wealth maximization, according to SVA, is the objective of the directors of the company.
Further, SVA rules that shareholders get value from a company only when equity returns exceed equity costs. When that value has been calculated, steps are taken by the company for enhancement of performance and targets; also using SVA for measuring the success of the steps or actions taken [10][15]
Performance is revealed in a company's stock price as executives hold the shareholder value approach. When investment to maximize the present value of long-term free cash flows, shareholder value is been created and its performance can be distilled into value drivers like operating profit margins, and sales [20].
Drivers of SVA
The drivers which distinguish the value approach from the traditional (the use of accounting measures such as return on assets) are as follows:
Sales in current year
Forecast period
Annual sales growth rate
Operating profit margin
Incremental fixed invest investment
Incremental working capital
Cash tax rate
Cost of capital
Sales in current year
The sales figure is the startup driver of SVA regarded as one of the important.
Forecast period
A firm's ability to exploit and maintain a competitive advantage over time, there is great tendency of its cash flow growing higher. In SVA, the period of this competitive advantage has a great impact on the sales growth rate estimation and profit margin of cash over time. This is an imperative driver as this period of competitive advantage is viable to generate cash flows and shareholder value through flexibility of setting higher selling prices leading to higher profit margin.
Annual sales growth rate
This is one of the drivers that have a direct link with the perspective of customers and the financial perspective. The sale growth rate can be much higher without causing cash deficit when there is an increase in financed assets by new debt or equity [21]. The sale growth rate value is gotten as a percentage increase or decrease in sales over a specific period of time, however, not essentially annually. It is also amount of increase that a specific variable has gained within a specific period and context. This is an essential driver in the SVA model because as sales growth rate gets higher, if everything else remains constant, the greater the projected cash flows.
Operating profit margin
This driver is imperative in the SVA model as it reveals managers' efficiency in profit generation using business operation. It accounts for cost of goods, administration and selling expenses. This value is gotten by removing the company's SG&A expenses from gross profit and exclude earned profit from investments made by firms as well as interest and taxes effects. Thus, increase in Operating Profit Margin is a plus for a company as it shows that cost is under control and fast sales increment than cost, meaning relative liquid position. It is important as a driver because it tells investors whether management has the ability to control cost. The higher the profit margin (sales - cash operating expenses), the greater the cash flows.
Incremental fixed investment
This is the annual investment of a company in long term operating assets less depreciation. This is an important driver in SVA since a large fixed capital investments are required by the business for expansion or sales growth.
Incremental working capital
This is a measure of the efficiency of a company and its financial health in its short-term. It refers to cash required for daily business operations, specifically, for financing raw materials conversion into processed good, which the company sells for payment. Working capital ratio is gotten by subtracting current liabilities from current assets. This driver is important as it provides investors an idea of a company's operational efficiency and also used in the analysis of the relationship between the money used to fund operations and the sales generated from these operations. Higher working capital means that the company is generating sales in comparison to the money invested in the sales. However, cash flow could suffer a decrease, if there is an increase in sales because greater investment will be required in working capital. This makes this driver more important in the SVA model.
Cash tax rate
The debt of a company influences the taxes it would pay to the government after operating profits. Cash taxes are calculated by subtracting interest payments on debt assuming the company is financed by 100% equity with no debt. This is an important SVA driver as the net cash flow gets lower as the tax rate gets higher.
Cost of capital
This is the necessary rate of return required to make capital budgeting project. It includes the cost of debt and the cost of equity. This determines the ability of a company can raise money through stock issuing or loan (debt issuing) or both [23]. This is an important SVA driver as actions taken by management affect the cost of capital of a firm, and if the cost of capital is low the greater the net present value of the firm. Thus, management can create shareholder value by capital structure financing with optimal debt proportion and by decreasing the systematic risk associated with the investments of a firm. Stakeholders' expectations are represented by the cost of capital; hence, shareholder value is created when the earnings of a firm on its assets are more than expected by shareholders
Calculation of Shareholder Value
This section explains the important of each steps involve in the calculation of shareholder value using the SVA model as well as the SVA drivers associated with each variables
Calculation of Weighted Average Cost of Capital (WACC)
This is an important step towards getting the shareholder value using SVA. It requires the cost of equity whose main driver is market return and cost of debt with main driver as cash tax rate as elucidated above. The cost of equity is the required return by stockholders from a company and is needed it is a representation of market compensation demanded in exchange for asset and risk ownership.
The cost of debt is the whole rate a firm pays when using debt as its source of finance. Investors also use it to measure how risky a company is in the industry, because the higher the cost of debt the riskier a company is. Its calculation involves the use of risk free rate, which is, for an investor, the interest expected over a specified period of time from a completely risk-free investment, and beta, which is a measure of the systematic risk or volatility of a portfolio in comparison to the market as a whole.
The WACC involves calculation of the cost of capital (cost of equity and cost if debt) of a firm in which each category of capital is weighted proportionately. Long-term debt and other sources of capital are included in the calculation of WACC. The value of WACC is gotten by multiplying the capital cost of each component by its proportional weight and then adding all [23].
WACC, in this regards, articulates an opportunity cost of currently used asset. WACC is very important because it is market driven [10]. The WACC relates to new investment returns rather than what happened in the past and it is a needed variable in SVA because when calculating shareholder value, it's a must to take into account the cost of equity meaning that after a company has repaid the cost of capital, then that's when real economic profit is been made [2]. It is also need as it allows managers to see if there is feasibility, economically, expansionary opportunities and mergers [23].
Calculation of Future Sales
A measure of future sales or turnover of a business is desired in the calculation of shareholder value as it shows, within a financial period, how many times an asset is been replaced. The main driver for this step is sales growth rate. A high sales growth is desirable by investor because it indicates that stock is been sold quickly, while a low sales growth indicates otherwise. Investors calculate this value to know if a company is growing since it is high and fast sales that build profit for the business. It is calculated by adding the total sales to the increased sale gotten through sales growth rate.
Calculation of After Tax Cash Inflow
After tax cash inflow is a measure of the ability of a company to generate cash flow using its operations. It is driven by the operating profit margin and cash tax rate. It is calculated by subtracting the tax paid from the operating profit. Investors calculate the after tax cash inflow because it shows the ability of a company to pay dividends. Payment of dividends is imperative to shareholders and this makes this value important in the SVA model. In completive market investors determine a company's health, performance, and how competitive it is by using the calculated value of after tax cash inflow. Thus, the higher the after tax cash inflow, the better a business is positioned to make distributions.
Calculation of Incremental Investment Needs
Calculation of Cumulative Present Value
Present value is the value or current worth of a future cash flow or free cash flow (FCF) given a set rate of return. Its major SVA driver is the cost of capital. The free cash flow (FCF) entails available cash for debt distribution and equity claimholders as well as the cash generated by a company after asset base maintenance expenses [23]. The cumulative present value of cash flow is calculated every year of the period of the forecast and the cost of capital is used as the discount value. The importance of FCF in SVA is that a company to stakeholders' relationship must be managed properly in order for FCF to be maximized in the long-term [20]. Thus, knowing the cumulative free cash flow is in imperative in SVA as it shows investors a company's available funds that cann be used to enhance shareholder value by pursuing investment opportunities, new product development, dividends payment, debt reduction, etc. [23]
Calculation of Residual Value
The cash flow arising after the period of normal planning or forecast period is the residual value. It is the present value of cash flow after the end of a competitive advantage, i.e., after competitors meet up with same level of differentiation in the market. This is an important step in SVA calculations as estimates show that the residual value account for about two third of the value of a business [10]. The residual value is calculated by dividing the free cash flow in the last year of the forecast period by the discount rate [24]. Investors see this value as essential because it gives an idea of the risk that may be associated with a company's fixed asset value.
Calculation of Business Value
This measure tells investors how much a business is worth including less debt. It is calculated by adding the residual value to the cumulative present value of free cash flow.
Calculation of Share Prices
The present value of future free cash flows, including a residual value, equals corporate value. 20 To get to shareholder value, you must reduce corporate value by debt and other liabilities (e.g., pension liabilities, employee stock options). [20]
SVA and other traditional accounting measures
Since the last decade, competitive market forces have increasingly subject businesses to do efficient commerce at a fair price acceptable by customers. In order to maintain this efficiency, value maximization is required of businesses and so every strategy and operations should be focus on adding value for the shareholder. The absence of this value was a part of the causes of the recent financial crises which has led to criticism of Shareholder Value Analysis (SVA) model. The question is why was there a need for SVA and what upper hand does SVA have over traditional accounting methods or GAAP?
Generally Accepted Accounting Principles (GAAP) or traditional accounting measurement has by some measures has survived the test of time been created in the 1930s as a response to the Great Depression to restore faith in the global financial system. These principles use historical company's performance as bases for providing information and measure traditional asset classes. However, over the decades, global economy has drastically changed as well as the measurement of corporate performance. That is, assets that are classified intangible and growth expectations have indispensably become imperative shareholder value drivers which traditional GAAP does not account for in their analysis [18].
GAAP hold that the key to business performance measure are net income and earnings per share. But [18] indicated that those measures do not correlate with share prices as the income statement of a company usually accounts for about 4% of market value for a stock with a typical price/earnings ratio of 25, while 25% is been covered by the balance sheet and the remaining 70% of market value consists of intangible assets (such as a company's brand or intellectual capital) and future growth expectations. Thus, a huge exposure, generally, is detected in GAAP's inability to account for a huge percentage of value meaning that imperative value creation assets that are not reported or managed become the company's leadership's responsibility.
In spite of this weakness, many companies still cites GAAP earnings per share as the most important measure to be reported much more than revenues or cash flow. Thus, linking earning and value will be fragile as many corporate decisions can decrease value while increasing earning. Earning were not intended to, and do not provide any approximation of a company's value. This is a problem and this is the core of the debate. Earning gives discernment about the riskiness of future cash flow and that is the extent of help earning can provide using the traditional accounting analysis or financial statements. Only little indication about the value an investment adds can be provided through Short-term earnings [20]. SVA is about value creation.
Nearly 80% of financial officer revealed that in order to deliver good earnings, value-creating projects might be waived. The motivation that could breed this choice is the fact that superficial enhancement in earning would lead to immediate stock price been higher that would a value-creating investment [20]. Corporate decisions founded on these GAAP methods of value, such as earnings per share, profit growth or return on equity, are progressively seen as being flawed for the above reason. In recent years, this short-term or measuring only what has happened in the past has been criticised. This anomaly is a cause for investors to seek new ways or methods to calculate value based on longer-term. SVA takes a longer-term view, and is about measuring and managing cash flows over time. The core concept behind shareholder value is that companies should only invest in strategies that generate returns in excess of the cost of capital. [10]. in order words, SVA is about the generated business profits above the minimum return by all capital providers. Hence, SVA incorporates financial statements of the business (profit and loss, balance sheet and cash flow) into one important measure [11].
Traditional accounting analyses based on accounting data are generally good for the management of a business than to the business' investor shareholders. Thus, accounting measures focus on residual profits after tax against total asset base, whereas value-based income statement focuses on the operating performance of the firm by adjusting net operating revenue. As such, SVA considers one significant variable, which is the capital being employed in the business, that is not considered by most traditional accounting methods. More so, SVA determine the excess returns available to all capital holders using a combination of financial statements. Additionally, risk and shareholder expectations are implicitly addresses by SVA through the use of a weighted average cost of capital (WACC) [11].
Thus, firm's value is not found in the financial or accounting statements which are relished by GAAP. Firm's value measurement, according to SVA, is based on expectations which are found in the future cash flows [5]. The present value of future cash flows is the value of a financial asset, which means that for a business to have value business owners must get returns in cash [20]. Further, GAAP concerns more on profits, but SVA considers cash flow as the business lifeblood not reported earnings. As SVA deals with the future, maximizing free cash flow is a major goal to be pursued over the life of the business as there tends to be an assurance in discounting implying that cash flow of the future are worth less than the present, thereby creating a balance between the short term and long term.
Many financial officers ignorantly flawed SVA even when its principles are been ignored. So the main issue seems to be what managing for shareholder value means. Maximizing the stock price has been understood as what SVA is about. By this, many firms have manipulated market prices in order to deliver high earnings per share [20]. But the term "value" is also crucial to the concept of creating shareholder value. The proposition is that prices of stock will grow higher if a company engages in building value. Building value is the objective while letting the price mirrors that value. Executives adhering to shareholder value principles manage for value, not price. [20]. Managing prices is a basis of traditional accounting methods.
Benefits/Advantages of SVA
SVA provides financial view based on long-term on which management can base strategic decisions and manage cash flow over time.
SVA forces firms to pay attention to future cash flow value and customer satisfaction
SVA provides management and investors basic comprehension of value creation in its business over time.
SVA is universal as it provides an approach not subjected to any account principle in particular. Hence, it is widely or globally applicable across many sectors [10],[15]
Drawbacks/Disadvantages of SVA
The estimation of cash flows can be hard to accurately complete. This can lead to strategic decisions using misleading figures.
System development and implementation can be complex and sometimes long
Difficulty could be experienced trying to get managers comprehend the SVA approach.
SVA is by nature an aggregate measure.
It does not take into account needs of a society [10][15]
Conclusion
The above elaboration on SVA and its calculations shows in deed that there are many variables and steps involved in arriving at the shareholder value related to a particular company. However, these variable and steps are highly required as seen in their importance relating to the model. SVA, in its highly flexible approach, is been employed in management decision making processes and performance evaluation. SVA has proved to be a methodology or concept useful enough to enable actual results and forecasts of whether value has been added in the past and/or whether value will be added in future following decisions on investment and financial forecast. More so, SVA provides basis for evaluating forecast on investment and capital projects of a company [11]. In a competitive market, the use of SVA provides insight into investment performance of the business.
However, many executives has flawed the approach of SVA as a major cause of the global financial crisis recently experienced, but it is shareholder value that was let down by management and not the other way round because the precepts of the concepts is not be followed, which is value creation [20]. SVA was flawed because the variables of the drivers of business value was either not comprehended or not followed. Thus, the principles associated with shareholder value and its execution remains the objective of management.
It is further worthy to remember that SVA is not only to be used as a sole measure of value in strategic decision making[11]. Lastly, SVA methodology is a superior technique in comparison to others because it derives valuation drivers of value that are identified, explicitly, in a strategic framework.
