The Creation and Measurement of Value Economics in Relation to SDGs
The last financial crisis not only revealed gaps between business practice and ethics, pace Enron, but also a crisis of confidence in the adequacy of financial reporting systems to account for the fundamental value and sustainability of business enterprises.
This has focussed attention on how we “value” the outcomes of economic activity and business practice, and relate value creation to the compensation of business executives, and not only to monetary wealth expressed in terms of market share prices . “Value Economics” looks at the metrics for measuring the creation of economic value and defining codes of business ethics, and proposes that “economic value”, defined as net operating profit after taxes (NOPAT) less the Cost of Capital (ECVAL), becomes a key ”value” metric for evaluating the performance of a business in creating value. This concept of economic value can provide a basis for triple bottom line accounting (TBL), where the accounting for economic value, or “profit”, reported in the statutory balance sheet, can be extended to the reporting of sustainable value in the form of non financial information,(DNF), which,for example, the Dow Jones Sustainabiliy Index. (DJSI) seeks to measure in terms of economic, environmental, and social value. The metrics for doing this still require on the part of the IFRS clear and complete propsals for the accounting standards required for calculating corporate value in this tripartite sense.
Economic Value (ECVAL) as a key “value creation”metric, and Sustainability Value
“Value Economics” examines the definition and measurement of economic value and intrinsic value, and how these values relate to the compensation systems for rewarding the “creation of value” in business. It argues that we need to differentiate between monetary wealth expressed in terms of market share prices, and the fundamental economic values underlying market capitalisations. If we look at the indexes of books on economics, such as “The Origin of Wealth” by Eric Beinhocker, and “Basic Economics” by Thomas Sowell, ( both excellent compendiums on economics and wealth creation) we find more references to “wealth” than to “value”. And, although in “The Value of Everything”, by Mariana Mazzucato, we find a new contribution for defining a theory of value for both the public and private sectors of business, we still need to define and agree what are the metrics for measuring the creation and distribution of economic value added (EVA) between all those who contribute to the creation of the “cooperators’ surplus”, in the wider context of sustainability ,
However, there are today attempts to widen the concept of reporting value in economics, eg BP’s calculation of sustainable value, DuPont’s “clean technology” reporting, the Dow Jones Sustainability Index (DJSI), the work of the UN Division of Sustainable Development project, and the guidelines of the Global Reporting Initiative (GRI). Sustainable balance sheets have now arrived, but, although they contribute to a better understanding of the intangible “goodwill” assets of a business, they do not have agreed accounting standards similar to those for the calculation of “book value”, including the metrics of NOPAT, NAV and FCF, where ECVAL could have the advantage of focussing attention on the cost of capital as a key metric for the calculation of economic value, or “economic profit”, as a company like Apple calls it.
Economic value, cost of capital, intrinsic value, and EPS.
The benefit of calculating economic value (NOPAT less cost of capital) is that it adjusts profitablility to take account of the cost of capital, which Apple reports as “economic profit”. See Apple’s calculation of its economic value added (EVA) at end Sept 2018, where NOPAT was reduced by 11.76% for the cost of capital to give the ”economic profit” of its business. The advantage of this metric is that it provides a more realistic definition of economic value by focussing attention on the efficiency in managing a company’s capital, and also a better metric for rewarding the creation of value than market share prices, which may not reflect the intrinsic, or fundamental, value of the business.
The cost of capital (COC) requires a calculation of the cost of a company’s equity and debt, which reflects the minimum rate of return above the risk free rate required by investors to calculate the company’s weighted average cost of capital (WACC) covering the mix of costs between debt, preference stock, and equity capital. The cost of equity is commonly calculated using the capital asset pricing model (CAPM), where the cost of equity equals the risk free rate of return, plus the risk premium (RP) required by the investor according to the riskiness of the investment. For this reason the risk premium will be determined by the performance of a company in creating economic value and distributable earnings (EPS) now, in the past and in the future.
Here we come face to face with the analytic methodologies of the investment analyst in setting target share prices through the search for value in terms of “Beta”, the measure of the volatility (systemic risk) of a security in comparison with the market, and “Alpha”, which measures the performance of an investment against a market index or benchmark, where the excess value of an investment relative to the benchmark is the investment’s “Alpha”. In this sense the analyst is concerned with the intrinsic value of an investment, which uses various methodologies for calculating value, such as the Dividend Discount Model (DDM), the Residual Income Model (RIM), Discounted Cash Flow (DCF), and the Gordon Growth Model (GGM). The latter seeks to define intrinsic value, where Price over Book Value equals ROE (minus growth) over COE (minus growth), which is the Damodaran thesis, which is the same as saying that the DDM equals the value resulting from the GGM.
All these investment analyst methodologies, implicitly or explicitly not, are concerned with an attempt to define fundamental value in terms of future sustainability, which the UN’s Sustainabiity Development Goals seek to address.
The calculation of intrinsic value is a complex process, where there needs to be a link between the reporting of ECVAL, and the reporting of the net asset value (NAV) in the statutory balance sheet, as well as the reporting of free cash flow (FCF) resulting from the creation of economic value. This means that an analysis of value in terms of ECVAL needs to be reported over a period of time, so that there can be a comparison between earnings per share EPS, and EVA per share, to monitor the correlation between these two metrics historically, and in the future.
Economic Value and Financial Reporting research
If economic value is to become a metric for giving greater emphasis to the creation of value in financial and sustainability reporting, further research and verification of its feasiblity, through an analysis of business experience of different economic sectors and individual companies in those sectors, would be useful, with the objective of understanding the state of the art in the way companies in different sectors are reporting the creation of value . “Value Economics” recognises that metrics for setting target share prices vary between one economic sector and another. For example, Price to Book Value is used for capital-intensive balance sheets like banks and insurance companies, and historically has been preferred to DCF. In valuing a telecom company, a utility or a cyclical company, the DCF method is used because it is a better measure of value than P/BV.
In analysing the “economic value” experience of companies over an agreed number of years, “Value Economics” suggests a “best practice” study of sixteen economic sectors, and individual companies in those sectors, covering, for example, retailing, oil, technology (the FANGS), motor, airspace, chemicals, pharmaceuticals, engineering, food, beverages, metals, electrical, banking, insurance, diversified sectors, eg Berkshire Hathaway, and trading, eg Glencore. The results of this “economic value” study could take the form of an economic value proflle for each company, which the book discusses at the end of Chapter 8, “Economic Value and Intrinsic Value”, incuding the concepts of sustainabiity and social value. An ideal sponsor for such a study might be an economic or financial research institute, in cooperation with selected companies, and their respective industrial associations and unions; control authorities; auditors and professional advisors; investment analysts; rating agencies; and business schools.
Michael Griffiths is author of the book Value Economics (2016), which is available via our website.