Financial management is not just budgetary control and internal check. Particularly in public companies, there is the crucial activity of creating value - being in the right businesses, making good investments, continual improvement and enhancing future prospects. But how does this work?
The value of a company is whatever the stock market says it is, but how do investors decide the trading price? The same as for a gilt-edged bond. The future cash flows to redemption, discounted at the market interest rate. For companies this means the post-tax cash flows before dividends, discounted at the weighted average cost of capital (WACC).
To create value, the company has to do things with positive net present value (NPV) – profit improvements or high internal rate of return (IRR) investments. And avoid value-destroying projects.
Too much of shareholders’ money is frittered away on poor projects, particularly company acquisitions. And the low growth rate of most companies implies their average IRR is pulled down by disasters.
WACC is the weighted return that lenders and shareholders expect. Lenders expect the long-term market interest rate plus a premium for the company’s credit rating. Equity is more risky so shareholders expect a higher return.
You can estimate the beta-factor of your shares, you can buy it from the London Business School or you can pay a consultant to do the sums for you. Whatever. The answer is about 11% so avoid spurious accuracy. The company’s average, or policy level, gearing usually gives the appropriate debt: equity weighting.
Performance is then measured by the increase in the NPV of the company’s overall future cash flows. The value created in the year. If you drive that it will eventually be recognised in the share price.
And that’s it. It really is that simple. Invest only in projects with a high IRR, practice continual improvement to ensure projected returns are achieved or bettered and monitor your own value creation. Then the share price will go up.
Now, do accounting standards allow all this stuff to be reliably reported to investors? No they don’t. But they could.
Neil Chisman is a non-executive director of several companies.