Corporate Finance Theory v1.0

• Shareholders desire returns consistent with the risk or uncertainty in those returns.
• Returns manifest as increases in share price (capital returns) and dividends.
• Modern corporate finance theory considers "Sustainable" and "Stakeholder" overlays alongside purely financial returns.

Shareholder Perspective - Market Measures

• Shareholders value firms based on perceptions of future success, which are quantified by market measures.
• Market measures are related to accounting measures, but are completely different.
• Market measures reflect the market's perceptions of a company's value.
• Financial statements serve as a 'shop window'.
• The market sets the price for window offerings based on expectations and perceptions of what the offering will deliver.

Uses for Market Measures

• Market measures are used to measure shareholder value creation via share price and dividends.
• They are also used to assess and propose company and project valuations.
• Market measures can be combined with accounting measures.

Enterprise Value (EV)

• 'EV of the business' calculates as Market Value of Net Debt + Market Value of Equity, also known as Market Capitalization.
• Enterprise Value (EV) represents the total market value of the enterprise.
• Enterprise Value (EV) is split between the value of net debt and the value of equity.
• Net debt is used because the cost of an acquisition is offset by the amount of cash in the business.
• Enterprise Value (EV) is the market value based on expectations of cumulative future transactions.
• Net debt is used because the cost of an acquisition is offset by the amount of cash in the business.
• Enterprise Value (EV) is a key real-life valuation measure for an enterprise.
• The difference between EV and the accounting value of equity plus net debt is effectively the market's valuation of brand and future earnings prospects. Enterprise Value (EV) is independent of accounting valuation but strongly related to expectations of accounting numbers like EBITDA and earnings.

Shareholder (Relative) Performance Measures

• Useful for benchmarking, but less so for absolute value creation.
• Share price is a simple, basic indicator; one should get as long a view as possible and correlate it to events

Earnings per share (EPS)

• Calculated as profit after tax divided by the average number of shares.
• EPS can be undiluted (current number of shares) or diluted (if all options etc are exercised).
• EPS is a key internal trend performance metric.
• IFRS requires EPS to be stated on the face of the income statement.
• EPS can be distorted by share issues or repurchases.
• External or competitor comparisons can be distorted by the number of shares in issue.
• EPS is a key element of executive bonus and performance calculations.

Price / Earnings Ratio (PE)

• Follows on from Earnings per share (EPS).
• The Price/Earnings ratio calculates as share price divided by earnings, which is a key earnings multiple.
• The Price/Earnings ratio can indicate how many years' earnings are being bought with each share.
• The Price/Earnings ratio is relevant for both internal and external comparison.
• The Price/Earnings ratio must be compared to peer and sector benchmarks.
• Be aware of 'sector' constituents when comparing Price/Earnings ratios.
• Bloomberg quotes 'blended forward PE', using estimates of future earnings; beware of historic or 'trailing' PE based on accounts earnings due to timing differences between share price and earnings.
• The Price/Earnings ratio is a key valuation indicator.
• A high Price/Earnings ratio often implies shares are in demand relative to earnings and that buyers are confident in future earnings prospects.

EV & EV: EBITDA

• EV & EV: EBITDA is like Price/Earnings (PE) multiple, PE is an equity multiple: value of shares divided by a measure of profits available to shareholders.
• EV : EBITDA is an enterprise multiple: value of enterprise (shares plus borrowings) divided by a measure of profits available to all funders.
• EV & EV: EBITDA is a core 'relative' valuation metric, particularly for takeovers and business valuations.
• Estimates EV independently of capital structure.

Total Shareholder Return (TSR)

• A core performance metric and value created for shareholders.
• TSR is the percentage returns to shareholders from the change in share price plus dividends.
• Usually annualised, take care with changes in the numbers of shares.
• Define start point and initial value invested, and consider risk via fluctuations in earnings. Assumes shares are efficiently priced.
• Note that start and end points being 'unusual' can skew data.

Quantifying Absolute Value Creation: Market Value Added

• Compares a firm's Enterprise Value (EV) to the total capital contributions to date (debt + equity).
• Compares the current value of a firm to that of the finance put in.
• If the assumed actual value of debt now equals the value of debt when first issued, then Market Value Added (MVA) = Market Value of Equity - (Book value of equity).
• Shares need to be efficiently priced to calculate MVA, be wary of fashion, herds, and sentiment.
• There are doubts over the validity of equity correlating to the 'capital invested' number.
• Lacks any indication of when value was created and large firms automatically produce large MVAs.
• MVA gives no clear indication that the rate of return is satisfactory.
• Alternatives to MVA include Excess Return calculations and Market : Book Ratio calculations to eliminate size distortion.

Economic Profit (EP)

• A further attempt to put a dollar value on "excess return."
• It employs a well-established methodology and relies on readily available accounting data rather than difficult-to-obtain cash flow and market data.
• EP potentially shows a better correlation with managers focused on profit and balance sheets rather than cash.
• Economic Profit (EP) is consistent with 'fundamental' valuation methodologies.
• There are 2 approaches: ‘Entity' EP, aligned with the needs of all funders.
• Calculating EP involves subtracting a post-tax charge for the cost of capital (equity plus net debt) from profit before interest, but after tax.
• 'Equity' EP, aligned with the needs of shareholders, subtracts a post-tax charge for the cost of equity from profit after interest and after tax.
• Capital and Equity are measured in accounting terms.
• Economic Profit uses accounting value for "equity" and accounting returns, not cash.
• Disadvantages of accounts numbers can come into play.
• There is potential distortion due to operating leases if IFRS 16 is not applied.
• It is possible to fine-tune Economic Profit by amending hurdle (required return) rates?

Economic Value Added (EVA)

• Supplementary to Economic Profit (EP).
• Economic Value Added is an enhancement to Economic Profit by adjusting hurdle rates and accounting values.
• EVA is calculated as Adjusted NOPAT minus Adjusted Capital x Required Rate of Return.

EVA Adjustments

• Replace accounting depreciation with 'economic' depreciation.
• Add back costs which benefit future periods like Research and Development and Information Technology spending but which the accounting rules don't allow to be capitalized.
• Apply a notional tax charge to adjusted profit.
• Adjusted balance sheet assets to a true value.

EVA Pros & Cons

• EVA is possibly a more "purer" result than Economic Profit
• EVA comes with more judgment, economic depreciation, and economic valuations.
• EVA is complex to construct, potentially opaque and confusing, therefore harder to deploy throughout the business.
• Inputs no longer accounts values are confusing.
• Good for challenging accounting quality, for example, depreciation policy and the treatment of intangibles.
• Provides deeper, more critical means to inform conversations with stakeholders.

Understanding shareholders' desires, market vs accounting measures, and enterprise value (EV). Exploring the limitations of share price as an indicator and calculation of diluted EPS. Analyzing the impact of sustainable initiatives and differences in EV.