Adding Value: April 1993

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There are four perspectives on corporate performance and four ways of measuring capital costs. But in the long run, all these ways of measuring financial performance are equivalent. The different vantage points differ only in their timing.

Adding Value (Financial Director, April 1993 – reprinted in The Business of Economics, Oxford, 1996)

The object of business is to create, maximize and defend economic rent. It is difficult to overestimate how much damage has been done to the use of economics in business by this inappropriate term. Rent is what is left over after all the factors of production employed in a business or activity – including the providers of equity capital – have been paid. The term ‘profit’ includes both the cost of equity and the added value which the firm creates. That is responsible for many of the ways in which profit is a misleading indicator of company performance – as, for example, when firms increase profit but subtract value by reinvesting at less than the cost of capital, or enhance earnings per share without adding value by acquiring firms on less elevated PE multiples.

Economists talk about rent because the central analytic concept dates from David Ricardo, existing almost two centuries ago is an environment in which the cultivation of agricultural land was the principal commercial activity The analogue between Ricardo’s approach and the assessment of the competitive advantage of firms remains an instructive one. (Figure 2.2).

Some economic texts use the phrase ‘super-normal profit’ to describe economic rent, but this, if anything, aggravates the terminological problem: what business readily admits to making ‘super-normal profits’ still less to having them as its objective? I have preferred the phrase added value. This essay describes the limits between competitive advantage, added value and various conventional measures of firm performance. Coincidentally, it establishes lists between the resource-based theory of strategy and my own earlier work on the relationship between economic concepts and accounting profitability (Kay, 1976: Edwards, Kay and Mayer, 1987).

In measuring the financial health of a business, different people focus on different things – earnings, profits, cash flow or competitive advantage . However, these signs do not point in different directions. Underlying all of them is the ability to sustain a positive margin between input costs and output value.

In the long run, the marginal firm in an industry will be one for which £1 of output costs exactly £l. A company that does worse than this will not survive indefinitely while if £1 can be earned for less than £1, new businesses will be attracted to the industry. When a competitive market is in equilibrium in this way, the added value created by any firm will be exactly equal to the size of its competitive advantage over the marginal, or weakest, firm in the same industry.

That proposition establishes a fundamental link. It is competitive advantage, moderated by market conditions, that creates added value. In a market with over-capacity, where marginal firms are losing money, even companies with a competitive advantage may not succeed in adding much value. On the other hand, in industries where entry is difficult – perhaps because of regulation, perhaps because demand has grown more rapidly than expected – firms may seem to add value even if they hold no advantage.

But there is an ambiguity that needs to be resolved if added value is to be an operational concept for the corporate strategist or the finance director. Added value is calculated after comprehensive accounting for the costs of inputs. In particular, it differs from operating margin or profit because it includes a full allowance for the capital costs of operating assets. But how are these capital costs to be calculated?

There are four different ways of measuring them, and each relates to a different perspective on corporate behaviour and a different view of the measuring of corporate success (Table 2.4). The economic perspective, based on cash flow, and the accounting perspective, which emphasises historic cost, are both familiar. The strategic perspective is less so. Why is current cost accounting the most relevant way of assessing competitive advantage? The answer is that the replacement cost of assets tells you what it would cost for a new firm to set up in that industry now. A company that cannot add value relative to this benchmark has low competitive advantage in that market and should not be in it in the long term. A firm that does add value relative to the benchmark has correctly identified a market in which it has competitive advantage.

Table 2.4: Four Perspectives on Corporate Success

Whose perspectives?

How they measure capital cost

What they measure Economist/Banker Accountant Strategist Investor Expensing Historic cost Current cost Market value Cash flow Historic cost earnings Current cost earnings Shareholder value

The fourth perspective is that of the investor. Here the concern is with shareholder value, that fashionable concept of the 1980s. In this approach, the capital resources used in the business are measured by reference to their market value, and the assets of the firm have depreciated when the value of the firm has increased by less than the magnitude of its retained profits.

Figure 2.3 shows how these relate to each other for a typical investment project. The cash-flow impact occurs at the beginning; historic cost accounting spreads expenditure over the useful life of the asset. Under current cost principles, asset depreciation in the early years is largely offset by holding gains. But as asset life increases, these holding gains diminish and the depreciation charge itself rises. The market value measure sometimes lags cash flow, sometimes anticipates benefits yet to come.

There are four perspectives on corporate performance and four ways of measuring capital costs. But over time, the area under each of these curves is the same. In the long nun, all these ways of measuring financial performance are equivalent. The different vantage points differ only in their timing.

That result can be proved mathematically. but the clearest way of demonstrating the equivalence is by example.

Eurotunnel is an unusual company. It was formed to undertake a single activity – the building of a tunnel between Britain and France. The estimates of costs, revenues and other operating data used here are drawn from the prospectus issued when the company was floated on the London Stock Exchange and the Paris Bourse in November 1987. Estimates of the market value of Eurotunnel at various dates are based on estimates made contemporaneously by Warburg Securities. All these have been overtaken by events, but since updated information and estimates are not available in equally comprehensive form, I use the 1987 figures.

Table 2.5 shows the anticipated cash flow from the tunnel in various years. It follows broadly the pattern of Figure 2.3. During the construction phase, cash flows arc negative. It turns around when the tunnel comes into operation. There are some subsequent capital expenditures, but these arc small and cash flow grows (in money terms) until the expiry of the firm’s concession in 2042, when ownership of the tunnel is due to revert to the French and British governments.

Table 2.5: Cash Flows: Eurotunnel (£m)

Operating revenue Capital expenditure

19901995200320202040 06429202,5988,186 728010800 -7286428122,5988,186

Source: Derived from Eurotunnel plc prospectus

Table 2.6 looks at the added value created by Eurotunnel in historic cost terms. As capital employed in the tunnel diminishes (because depreciation charges have repaid most of the initial construction costs), added value rises.

Table 2.6:Added Value: Eurotunnel (£m)

Operating revenue Capital expenditure

19901995200320202040 06429202,5988,186 3,1703,9362,755-494-4,510 244554438184-123 -244884712,4138,309

Source: Own calculations based on prospectus estimate

Table 2.7 shows the evolution of shareholder returns. Excess returns to investors are, in this projection, greatest as the tunnel approaches completion and begins operations.

Table 2.7: Shareholder Returns: Eurotunnel (£m)

Market value Capital gain Net dividend Excess return

19901995200320202040 39,9458,13616,12541,56224,996 8788111,2731,42214,998 -1265651,7776,277 479123-116-857-8,720

Source: Own calculations based on prospectus and Warburg Securitie’s estimates

Once the tunnel is established it becomes a rather dull utility stock offering relatively poor shareholder returns, and there arc large capital losses to shareholders as the concession expires.

There is something paradoxical about the concept of predicted excess returns. These projections should be seen as a view of what shareholders will receive if certain events transpire – the tunnel is completed to time and budget, and the concession expires worthless. The tunnel will not have been completed to time and budget, so shareholders are earning less than this projection allowed.

Table 2.8 brings together the three measures of performance described above. Although the three columns display completely different patterns of returns, they have the same present value. Cash flows, added value and shareholder returns are all equivalent in the long term. Each provides a valid measure of the value, over time, of a firm’s competitive advantages and strategic assets.

Table 2.8: Eurotunnel’s Performance (£m)

1990199520032020* -7286428122,5982,316 -244884712,4132,316 -479123-116-8572,316

* Present value over life of concession

Profits and earnings per share remain by far the most widely used measures of performance, and despite challenges accountants retain a dominant grip on the manner in which corporate financial statements arc presented. There is a tradition in which advocates of alternative measures shower scorn on each other and, particularly, accountants. For some strategists, it is preoccupation with accounting numbers that is at the root of the decline of Western economies. For many economists, accounting information is meaningless mumbo-jumbo. The shareholder value movement has argued that accounting profits are not related to investor returns, and proposes a return to a cash-flow basis of assessment.

Figure 2.3: The Equivalence of Measures of Financial Performance

But this disagreement is exaggerated and unnecessary. Cash flow, profits, shareholder returns and competitive advantage are not different things but different ways of measuring the same thing and the different interest groups concerned with a company’s performance are not pulling it in radically opposed directions but adopting different perspectives on the same phenomenon. And the full exploitation of a firm’s competitive advantage serves the interests of every observer and enhances every measure of corporate performance. As Figure 2.4 shows, the concept of added value underpins them all.

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