enterprise value

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Measuring enterprise value is challenging. There are no perfect measures. Several measures include --

  • ROIC - return-on-invested-capital --
  • EP - economic profit --
  • MVA - market value add --
  • Tobin's q --

see Barney, 2007, pp 20 - 46 for the definition and discussion of these terms.

Future vs current value --
There is a component of the enterprise value that is due to the current value of the firm and the future value the firm is expected to produce. This is discussed in the article: ROLAND J. BURGMAN , DAVID J. ADAMS , DAVID A. LIGHT and JOSHUA B. BELLIN, The Future Is Now, WSJ, Oct 27, 2007, pg R6.

Imagine you are the CEO of a company that has just enjoyed a year of record sales and earnings. In your annual letter to shareholders, you assure investors that the company's health and growth prospects have never been stronger.
And yet you've seen the company's share price drop 5% over the past year, even as competitors' stocks gained 10%. Worse, the scenario replays itself the following year: Profit margins and profits again increase, but the stock price treads water while rivals' shares rack up impressive gains.
What's going on here? -- The problem is a common one: The boost that outstanding current performance gives to shareholder value can be offset when investors' faith in a company's future begins to evaporate. To avoid this nightmare, executives need a complete picture of both these components of their business's value.
Executives have become increasingly sophisticated in the past couple of decades at analyzing the value of current operations and at using that analysis to help them manage with the goal of increasing shareholder value. But they still need to supplement the well-developed tools they use for value-based management with one that can analyze their company's future value, the portion of the share price that isn't based on the earnings from current operations or products.
We have devised an approach that allows executives to gain a clear outlook on both the current and future components of their company's share price. This can give them a better understanding of how the stock market is evaluating their company's prospects for long-term success. And that can help improve their long-term decision making, by showing them whether, in the eyes of investors, they have struck the appropriate balance between short-term and long-term goals.
A Limited Approach -- By the early 1990s, companies were increasingly zeroing in on whether business operations were adding value. Value-based management tools remain popular today, among them EVA, or economic value added, which takes after-tax operating profit and subtracts from it a charge for the capital employed to generate that profit.
However, a variety of academics and consultants have pointed out the limited usefulness of EVA and other value-based performance measures, particularly given a propensity toward current-period and short-term, backward-looking performance evaluation. For example, EVA fails to quantify the increased value a company might realize in the future through, say, higher levels of investment in programs aimed at increasing brand loyalty, developing talent, generating patents or bolstering research-and-development capabilities. True value-based management requires executives to look both backward and forward.
How important is future value to share prices in concrete terms? As an example, an analysis by AssetEconomics Inc. of the companies in the Russell 3000 Index as of May 2003 found that future-value expectations represented 59% of their overall enterprise value -- the market value of a company's equity plus the net value of its interest-bearing debt obligations. In 12 of 22 industry groups analyzed, future value made up more than half of enterprise value.
To put those figures into dollar terms, approximately $7.6 trillion of the Russell 3000's total enterprise value of $13 trillion was bound up in future value. And that was three years after the market began correcting itself for the inflated expectations of the dot-com bubble. Even in 2006, after corporate profits -- and therefore current value -- had risen significantly over a three-year period, some $6.6 trillion of the Russell 3000's total enterprise value of $19.5 trillion, or about one-third, was represented by future value.
What investors are doing here is placing a significantly higher value on these companies than would seem warranted by the success of their current operations. They are saying, in effect, ""We see that your current operations are worth such-and-such, but we're going to reward you well above that level because we have faith in your growth prospects.""
That extra amount investors are willing to pay is the company's future value. Mathematically, it can be calculated for any company by subtracting current value from the business's overall enterprise value. So, start with enterprise value, which again is the market value of a company's equity plus the net value of its interest-bearing debt obligations. Then subtract current value, which is after-tax operating profit divided by the weighted average cost of capital. The result is future value.
Future value and current value can then be expressed as percentages of enterprise value. This exercise allows executives to put a number on the market's view of how the company is doing today, and what its expectations are for tomorrow -- eliminating the need for guesswork or the temptation of wishful thinking.
While it's crucial for executives to know their company's future value, there is no optimal percentage that any particular company should strive to achieve. The significance of future value lies largely in how it compares with the future values of the company's industry peers. Depending on how a company's industry as a whole is positioned, a future-value component of 20% of enterprise value may be exceptionally high, exceptionally low, or average -- and the same is true for a figure of 80%. Another crucial consideration is which way future value is heading. A decline can be a warning that a company's growth plan needs to be revisited, because it suggests investors have growing doubts about the strategy.
Shaping Strategy -- To understand how an analysis of future value can help executives shape business strategy, consider the big-box retailing sector.
For years, large retailers were rewarded with higher share prices for opening new stores at a breakneck pace. But growth through expansion may be nearing its limit for these retailers as their markets become saturated.
In our research on a select set of major retailers, we saw a downward trend for future value in the industry as a whole. From 1998 to 2006, most of the retailers continued to invest heavily in new-store openings, fueling an increase in the companies' current value. Future value, however, didn't keep pace with the growth in current value. In fact, future value as a percentage of enterprise value for the group as a whole declined from almost 75% to 30%, an indication that investors were losing faith in simple market-penetration and geographic-expansion strategies. Had these companies been tracking future value regularly, they might have recognized earlier that a strategy based on increasing scale was running out of room and begun investing differently for growth.
Best Buy Co. is an instructive exception to the industry trend. In 2002, the retailer faced a huge challenge: Wall Street had come to expect growth of 20% a year, but the company, because of saturation of the North American market, could no longer rely as heavily on adding new stores to generate that growth. Best Buy then launched its ""customer centricity"" strategy, which was designed to pinpoint the most profitable and fastest-growing customer segments in each store. Once it determined the nature of these segments, Best Buy realigned its stores and empowered employees to target those favored shoppers with products and services that would encourage them to spend more and come back often.
The strategy has had remarkable results: The newly formatted stores generated sales at twice the rate of Best Buy's traditional format. And the company largely maintained its future value over the period we examined.
All the company's stores now employ the centricity strategy, which has evolved to emphasize the personal experiences and ideas that each employee can bring to bear in serving the unique needs of each customer.
That isn't to say that Best Buy has completely turned its back on scaling up operations. At the beginning of 2007, the company announced it would open 130 new stores in the U.S., Canada and China. It is clear, though, that Best Buy's growth strategy doesn't depend primarily on penetration, and that investors have shown their approval with their assessment of the company's future value.
The Objective: Executives who are managing with the goal of increasing shareholder value need to be able to analyze their company's future value -- the portion of the share price that isn't based on the earnings from current operations or products. The Process: A relatively simple mathematical formula can be used to determine how much of a company's share price is based on current value and how much on future value. Those proportions can then be compared with those of competitors and can be monitored for signs of changes in how the stock market is evaluating the company's prospects.
The Payoff: A clear picture of both the current and future components of a company's share price can give executives a better sense of whether they have struck the appropriate balance between short-term and long-term goals.
Tracking a Turnaround -- A similar lesson can be found in McDonald's Corp.'s ability to renew investors' confidence in recent years. Before 2003, the fast-food chain had focused heavily on scale growth, aiming to rapidly open large numbers of new restaurants around the world. That strategy worked well for many years, but eventually investor confidence ebbed. The share price peaked in 1999 and dropped more than 70% by early 2003. The company then announced that it would close 175 stores and cut 600 jobs.
In the ensuing turnaround initiated by a new leadership team, increasing same-store revenue became the new focus of top management. Doing so meant renewing the brand through marketing and advertising. It also involved a radical change in the product assortment, with an expanded menu including salads, snack wraps and new sandwich and burger options. Restaurant renovations and redesigns, including the introduction of wireless Internet access, have had a striking impact, along with efforts to make drive-through service faster and more convenient. With increased confidence in the company's future, McDonald's investors have sent its share price skyrocketing from about $12 at its low to $43 by the beginning of 2007 and above $50 for much of this year.
How did the company's future value track over this period? In 1998, future value was around 60% of enterprise value, but by 2002, it had dropped to around 5%. Following the turnaround, the number had risen above 50% by 2006, indicating investor confidence in management's ability to continue to take advantage of future growth opportunities.
We're not saying that Best Buy or McDonald's changed strategy following a future-value analysis such as the one we lay out here. We are saying that any company can use this tool to gauge how investors feel about its strategy and can then consider changes based on that information. Future-value analysis can be especially valuable in detecting early-warning signals that may not show up in the share price if earnings from current operations are robust, thus obscuring long-term flaws in company strategy.
Managing for shareholder value, current and future, requires some technical knowledge to get the numbers right. But it is far more a matter of establishing a mind-set within an organization -- one in which employees at all levels understand how they are adding value. And in the case of future value it is a matter of orienting everyone in the organization toward longer-term horizons. Executives can help foster this mind-set in a number of ways.
They must ensure that the company's investor-relations communications clearly convey a convincing growth story. And analysts aren't the only target of such messages. Top management must continually reinforce the logic of future value for the organization as a whole.
Also, many companies have executive compensation plans, management systems and cultures that reward people and units for achieving accounting results that are set for the coming quarter or year. Integrating future value into incentive plans can help reorient a company's focus so that it is more balanced between the imperatives of today and tomorrow.
--Mr. Burgman is the founder of AssetEconomics in New York and a fellow of the Accenture Institute for High Performance Business in Boston. Mr. Adams is a senior manager with Accenture Ltd.'s Finance and Performance Measurement practice in Chicago. Mr. Light is a research fellow and Mr. Bellin is a research associate at the Accenture Institute for High Performance Business. They can be reached at [email protected]