On completion of this course you will understand:

• Project evaluation & discounted cash flow techniques
• Net present value, internal rate of return, and total shareholder return
• Market values and book values
• What traditional accounting misses out
• Shareholders and other stakeholders

1. Profits aren’t enough – Servicing capital providers

Sustainable businesses need to earn consistent and predictable profits. But accounting profits alone are not enough. Let’s say you’re in the happy position of owning a profitable business outright, and your business managers are generating and reporting $1 million of annual profits and cash flows for you, the 100% owner. So far so good?

Well, depending how much of your capital is tied up in the business, $1m annual profits might not seem so good after all. What if the net business assets were worth $1 billion – 1,000 times as much as the annual profits? This business is using, and tying up, $1bn of your capital, that you can’t deploy elsewhere. Your managers are only achieving a rate of return on your capital of $1m / $1bn = 0.1% per annum. You could probably achieve a greater rate of return – for a similar level of risk – by deploying the capital elsewhere.

So – as the business owner – you’ll want to monitor your investment and your managers by the rates of return they’re achieving on your capital, as well as the $ amounts of profits. As business managers and project managers, we need, in turn, to understand our capital providers, and the rates of return our capital providers are – quite reasonably – requiring from their capital investments in the business we’re employed in.

2. Future value, Present value & Net present value

The amounts of reported profits and cash flows are fundamentally important. But so is their timing. $1m receivable tomorrow is better than $1m receivable in 10 years’ time. If we get $1m tomorrow, we might be able to use it a number of different useful ways. For example, we might be able to repay some borrowings earlier, and save interest expense. Or we might be able to deploy the $1m into another attractive investment opportunity.

On the other hand, if we have to wait another 10 years to get our $1m, we won’t have any of those attractive options open to us. So we’d clearly prefer to collect our money earlier, assuming no difference in the amounts. This preference reflects the time value of money. But what if we had to choose between getting a smaller amount of $0.8m tomorrow, or the full $1m in 10 years’ time?

Tools for making that evaluation include Future value, Present value, and Net present value. These project evaluaton tools are all Discounted Cash Flow (DCF) techniques, giving results in money terms. They factor in the timing of forecast cash flows as well as their amounts. And they also take account of the rates of return required by our capital providers.

3. Internal rate of return, Yield & Total shareholder return

Another group of Discounted Cash Flow (DCF) project evaluation techniques includes Internal rate of return (IRR). IRR summarises a set of cash flows as a single percentage figure. The IRR measure is independent of any investor’s required rate of return. The greater the positive percentage IRR figure, and all other things being equal, the more attractive the proposal for an investor. IRR can also be used to evaluate the cost of different financing proposals. The lower the IRR, the more cost effective the financing appears to be on this measure.

Yield is one of the many words in finance with a number of different meanings. In the context of borrowing and financing, yield is the internal rate of return (IRR) of the borrowing – or other financing – cash flows. Yield is also a measure of the rate of return on an investment in tradeable debt, for example a corporate bond.

Total shareholder return (TSR) is a measure of the rate of return enjoyed by investors in equity shares (shareholders). TSR takes account of the capital value of the shares over time, together with any dividends on the shares over the same period, and any other relevant cash flows for the shareholder. TSR is calculated as the IRR of these relevant cash flows. Many companies whose shares are listed on an exchange use TSR as a key performance measure for their senior managers.

4. Valuation, Market & Book values

Values and valuations are fundamentally important, but not always straightforward to quantify. Appropriate valuation techniques, and the values themselves, can depend on the circumstances, as well as the nature of the asset. One valuation method for a business is a DCF analysis of the entire enterprise.

When a company’s shares are listed on an exchange, the latest traded price per share is quoted continuously during trading hours. The total current market value of the (equity) shares is simply the share price multiplied by the number of shares. This total figure is sometimes known as the market capitalisation, to emphasise the perspective that the current market price of the shares might represent an overvaluation – or an undervaluation – by the market.

Multiples valuation means comparing values, or estimating values, based on a mutiple of a relevant financial measure. Examples include PE ratios for a company’s equity, and EBITDA multiples for the whole enterprise (the total of the company’s equity and its debt). Market values imply a sale and purchase transaction, or a potential sale and purchase transaction, in the market. Book values, in this context, mean amounts reported in a company’s financial statements. Book values and market values can differ substantially, with market values of successful companies often greatly exceeding their book values. Reasons for the differences include valuable intangible corporate assets, that are not recorded in traditional financial statements. Book values for large organisations are audited, adding to the credibility of the reported book values.

5. Growing and Safeguarding stakeholder value

Growth enhances corporate value, while risk destroys value. Accordingly, managers can grow corporate value by appropriate sustainable growth of the future net positive cash flows of the business. In turn, this might flow from revenue growth, cost control – or both – assuming no change in related risk. Similarly, all other things being equal, applying risk management techniques to reduce the risk of future cash flows will increase their value, via a reduction in the required rate of return for the (now) lower-risk cash flows. In practice however, there will more often be a trade-off between improving – or worsening – forecast cash flows and related levels of risk. For example, discontinuing insurance cover will save insurance expenses, but increases the risk of suffering uninsured losses. The sustainability of the entire business, including its environmental sustainability, is increasing a key dimension of its stakeholder risk management. Stakeholders include shareholders.

A more subtle way to enhance shareholder value is to reduce the amount of capital that the company needs in order to operate. For example, by better working capital management. An example would be improving trade credit terms negotiated with and applied to customers and suppliers. In a simple case, this might enable the company to return capital to its shareholders for them to deploy elsewhere, while continuing to generate profits in the company.

The stakeholders in a business include its shareholders, but also an increasing wide group of other poeple, organisations and potentially other entities. For example, one life sciences business mentions its stakeholders as including customers, employees, suppliers, industry organisations, local and central governments, those who live and work where the business operates, and society as a whole. Companies are increasingly - and explicitly - taking account of the interests and capital value of all of these other stakeholders, and professional management of the company’s relationships with them, and not just the company’s own shareholders as in the past.