Key factors in generating maximum value for a company

The IPL tournament has analogy in financial performance.

Written by N Sivasankaran | Published:May 14, 2013 12:54 pm

The IPL tournament has analogy in financial performance. The answer may vary from person to person,but the consensus would be synergy in performance such as batting,bowling and fielding. In finance,though the stakeholders differ in their expectations in terms of the financial performance of a company,the goal is to generate maximum value.

Drivers of value

What drives the value of a firm? Is it the growth in sales or is it the increase in bottomline? Or,is it the reduction in its risk (operating,business and financial risks) or the increase in return on invested capital? The following are the drivers of value of a firm/entity including an individual like you and me.

Growth rate: This refers to the rate at which the operating profit is expected to increase in the future life of the entity. The rule here is that higher the expected growth rate in the after-tax operating earnings,higher is the value of the entity. For instance,Jubin Chandra,an assistant manager with a PSU would get a higher personal value at an yearly growth rate of 10% compared to an yearly growth rate of 7%. The assumption here is that all other variables except growth rate are kept constant in the calculations.

Rate of risk or discount rate: Risk in finance refers to variation in the expected returns from the actual returns of those who provide funds to the operations of an entity. As all of us are well aware of the relationship between risk and return,we know that a per cent increase in the systematic risk of the investment entity certainly calls for at least a per cent increase in its expected return. When valuing an entity,we take the weighted average cost of capital as the discount rate and the value is derived by computing the present value of the expected cash flow.

Hence the rule here is lower the risk,lower is the discount rate and higher is the value of the entity. This sounds very rational when we attempt to value a company/individual. The inference is that entities need to reduce their business,operating and financial risk to the optimal extent in order to command a higher value in the market. For instance,Jubin’s value would be higher at a discount (weighted average cost of capital) rate of 12% compared to a weighted average cost of capital of 15%. Jubin can reduce his rate of risk by getting into a regular earning activity (permanent job compared to a contractual job) by reducing fixed cost as a per cent of his total cost (operating leverage) and by reducing his debt/equity ratio to the optimal level.

Re-investment requirement: It refers to the additional long-term (capex) and short-term investment (working capital) in the entity required for maintaining its level of operations.

The re-investment rate is computed by dividing the sum of additional net capex and additional working capital by the entity’s after-tax operating earnings. The rule here is lower the re-investment rate,higher is the efficiency of the entity in investment utilisation and hence higher is its value. Jubin can command a higher value at a 3% reinvestment rate compared to a 10% reinvestment rate.

Net profit margin: Net income margin is computed by dividing the after-tax net income of the entity by its net revenue. The rule is higher the net profit margin,higher is the value for the entity. Jubin would command a higher value at a net income margin of 12% compared to a 5% margin.

Return on invested capital: It refers to the return generated by an entity on its invested capital. The rule is higher the ROIC,higher is the value of the entity. This variable differs from the net income margin because of the inputs taken for its calculations. ROIC considers the operating profit while net income margin takes net income (includes other operating income also).

In addition to the above,ROIC considers the invested capital (sum of long-term borrowing/debt and owners’ equity at the end of the previous period) as the denominator while net income margin considers the net revenue as its denominator.

Though each one of the above stated fundamentals drive the value of an entity. An individual/company would be able to command a much higher value by increasing its growth rate,decreasing the rate of risk and re-investment rate and by increasing its net profit margin and ROIC.

As in the IPL match,the bowling or batting department alone cannot win matches. Rather,it is teamwork that brings success to the team. Similarly,a company or an individual can maximise the value by doing the right thing to get the right score in each of the above discussed variables.

The writer teaches accounting and finance courses at IIM Ranchi

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