What does ‘value’ in business really mean? Treasurer, Ben Walters, invited by Treasury Today to examine this notion, offers a new real-world approach for financial practitioners.

The most misused word in business today is ‘value’. To treasurers, value means a risk-weighted reward exceeding the cost of capital. But of course, what is near impossible to do is pick up an annual report, a set of management accounts or look at a budget for next year and determine whether value is being created or not. I think this should change and the finance community, with treasurers leading the way, needs to promote value as the central pillar of financial reporting and analysis. There are two key concepts at work here that support this ambition:

• Identifying the correct rate of return to use in the corporate investment setting. The firm operates in the real economy where some of the assumptions behind Weighted Average Cost of Capital (WACC) break down. When it makes investments, the firm must use a rate of return target which I have called MWACC, standing for Modified Weighted Average Cost of Capital [an idea that is trade-marked to Walters].
• The firm can measure value creation over the period from its existing data. Described below is an incredibly powerful technique that can be applied across business unit segments and across a spectrum of core financial areas such as performance measurement, budget and planning, strategy and M&A.

MWACC explained

For investments that the firm makes in its own businesses, the rate of return required is the MWACC. I would not be surprised if many of you reading this work in firms which employ a higher hurdle rate for investment decisions than their WACC. Intuitively, I am sure this feels right. The justification for this might be a combination of factors such as: “it better reflects the risk”, “we can’t take on every project, only the best”, and “we want to push the operations harder”. These reasons are all valid and MWACC reflects them, but in a transparent and more scientific manner.

Put it another way, if your firm simply took on investments that created a return equal to WACC would it meet its profit target for next year? Probably not.

The scientific element to MWACC comes from the acceptance that two core assumptions behind WACC and the financial markets break down in the real economy. These are that capital is restricted and that arbitrage opportunities do exist in the real economy.

Rarely does the firm raise additional equity, so capital available to re-invest in the firm is restricted to that of the level of retained profit. Management time itself is a further constraint both in terms of raising additional capital (a time-consuming task) and the number of new projects the firm can take on. The second critical financial market assumption that breaks down in the real economy is that of arbitrage. Activities such as creating intellectual property or human capital, leveraging economies of scale, creating brands and building barriers to entry, all represent arbitrage opportunities available to the firm and not to others. Indeed, the firm’s strategic positioning is the act of capturing these arbitrage opportunities. Investors in the firm estimate the value of this strategic positioning and communicate it to the firm in the share price. Investors effectively set the firm target: we expect you to create this much value from this much capital over this period of time. The firm needs to read and understand this message and that is exactly what the calculation of the MWACC hurdle rate does.

Where shareholders see value in the firm’s strategic position the internal target rate of return, MWACC is always higher than WACC.

Measuring value

Imagine the power of being able to directly measure value creation from reported numbers. The implications for the finance function’s role in the firm are game changing. Imagine if financial analysis into critical areas such as management performance, budgeting, capital allocation, strategic planning, investment appraisal and M&A went beyond earnings and profit and identified where value truly lies.

Today, there is no need to imagine, as identifying value is relatively simple and involves little if any extra reporting. What it does require is an open mindset and a determination to drive through this change. Conceptually it is straightforward, involving an analysis of incremental cash flow for the business unit segment being assessed, the capital invested in that segment and a simple annuity calculation based on the useful life of the assets created from the capital invested.

Of course, the rate of return within the annuity is MWACC. Working with incremental numbers removes distortions from inflation and historic cost accounting. Adjustments for the timing of profit and cash flow generation are easy enough to factor in, making the technique practically universal in its application. In virtually any existing reporting environment it is a simple overlay which can be bolted onto any business unit segment where incremental cash flow data is available.

Answering that most critical of business questions, where to allocate capital, is now within any business’s grasp. It is a small step beyond traditional accounting analysis, but not vastly so. And once understood it is incredibly powerful because it tells you which business unit segments are creating or destroying value.

Taking action

The firm already has the tools to measure where and how it creates value. This can be broken down into product type, market segment, geography or any other appropriate business unit segment. But to get there the finance function must think differently; it should start measuring value, not profit, and start shaping and supporting strategy as opposed to measuring success or failure in its wake.

As treasurers, we are in a unique position to champion this revolution. As a profession we specialise in cash, risk and value. We have an unparalleled insider view of the firm’s strategy whilst at the same time being plugged into the external markets and wider economic environment.

Ben Walters, FCT, ACA, is a practising corporate treasurer with a keen interest in corporate finance. He has previously published works on measuring risk, value creation in the context of management performance appraisal, and capital allocation strategy. Contact him through his LinkedIn profile.