Value-based financial management E-Book

Maximiliano González Ferrero

• Herausgeber: CESA
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 206

Veröffentlichungsjahr: 2021

Beschreibung

This book poses the question: Can a private company be managed using the same criteria as a publicly traded company, basing its decisions on the same financial tools? The answer is yes, and the main objective here is to describe a basic dynamic valuation model through which senior managements can determine the "market" value of a company at any moment. In other words, although these companies remain private, the management model proposed in the book makes their decision-making process as rigorous and professional as if they were listed companies, by using appropriate financial tools that serve as the main support in the decision-making process. The model also encourages the use of different risk management tools to analyze some of the variables that affect value, so that after establishing the allowed movement ranges (risk map), hedging or mitigation mechanisms can be implemented. The objectives outlined in this book are relevant for management practice since they seek to promote a systematic, orderly, documented, and value-oriented decision-making process.

Leseprobe

658.152 / G643g 2021

González, Maximiliano

Value-based financial management: Towards a systematic process for financial decision-making / Maximiliano González, Alexander Guzmán Vásquez, María Andrea Trujillo Dávila. Bogotá: CESA School of Business, 2021. 234 p.

DESCRIPTORS:

1. Financial management 2. Financial analysis 3. Risk (Finance) 4. Valuation 5. Decision-making 6. Information technology

© 2021 CESA School of Business

© 2021 Maximiliano González [[email protected]]

© 2021 Alexander Guzmán Vásquez [[email protected]]

© 2021 María Andrea Trujillo Dávila [[email protected]]

Digital ISBN: 978-958-8988-57-3

CESA Publishing

Incolda House

Diagonal 34a No 5a - 23, Bogotá – Colombia.

www.editorialcesa.com

www.cesa.edu.co

[email protected]

English edition: October 2021

The English translation of the book was possible thanks to funding received from the Faculty of Administration of the University of the Andes.

Translation: Erika Tanacs

Editorial CESA

Copyediting: José Ignacio Cursio

Design: Yimmy Alberto Ortiz Arias

All rights reserved. This work may not be reproduced without prior written permission. Made and printed in Colombia

Diseño epub:Hipertexto – Netizen Digital Solutions

Table of contents

Introduction

Chapter 1

What Is a Good Financial Decision?

Chapter 2

Historical Financial Analysis

Chapter 3

Financial Modeling

Chapter 4

Valuation

Chapter 5

Weighted Average Cost of Capital (WACC)

Chapter 6

Risk Management

Bibliography

Appendix 1

Adjusted Net Present Value

Appendix 2

Forwards, futures, and options for risk hedging

Endnotes

Introduction

When does a company add economic value for its owners? In theory, when the return on assets invested in the business exceeds the risk-adjusted cost of financing sources.

Although the answer seems simple at first, it is not so in practice, because: i) How to measure the return on assets invested? And, for the effect, it is necessary to begin by answering: What are assets invested in a business? (ii) How to determine the profit flow produced by such assets? Is it possible to obtain this information directly from accounting reports? (iii) What is the cost of financing sources? Was the company’s level of indebtedness established a priori or was it the result of financial decisions made on a day-to-day basis? (iv) Is the risk assumed by the company in accordance with the strategic objectives of its shareholders and other people involved in it?

This series of questions—complex to answer in practice—are of crucial importance to determine whether a company is creating or destroying value, given that an organization can continue, for many years, having accounting profits, paying dividends to its shareholders, creating sources of employment, and, even so, destroying economic value, that is, generating a return that does not compensate for its opportunity cost.

When the market perceives that a publicly traded company is destroying its value (or will do soon), it immediately sets off the alarm bells and almost immediately the price of its shares begin to fall, which makes current shareholders start to sell them. On the other hand, if the market perceives that the company management is making decisions that add value, the shares’ price starts to rise and becomes attractive to investors until reaching an equilibrium price. This is why the market, which is nothing more than the average expectations of investors regarding the value of a company, assumes the role of supervisor in the management decision-making process.

To fulfil this role, it is necessary that capital markets be efficient in valuing the assets traded there, in this case, shares. In other words, companies are required to disclose both financial and non-financial information in a timely and appropriate manner, so that investors can adequately assess the impact of their decisions on future cash flows.

In this sense, the stock market is a mirror that reflects the executive management of publicly traded companies. But what about companies that are not listed on the stock market? In this case, this mirror does not exist, and because these companies focus on day-today operations, many of them do not know whether they are really generating economic value for their shareholders, or, on the contrary, they are destroying value.

Does not the income statement—the famous P&L—solve this problem? Is a good analysis of traditional financial ratios not enough? Unfortunately, accounting information does not reflect more than past decisions, given that it is based on historical results. Is not that important? It certainly is; nevertheless, by looking at the past, not much can be said about how today’s decisions will affect tomorrow’s results.

It should be noted, for example, that upon receiving information on a publicly traded company, the market immediately evaluates its investment plan and its growth potential. If the decisions observed (e.g., investments) are perceived as good, it will include in the company’s current share value the value generated by these growth opportunities, but this value is not a specific account included in the financial statements, since it has not yet been carried out.

What happens, for example, if the market perceives that an investment is very risky and the expected return does not exceed the cost of financial sources? As mentioned earlier, if the expected return is less than the opportunity cost of these sources, it means that the company is destroying value, and investment analysts who follow this company’s shares immediately put them under “observation” or simply sell them. On the contrary, if the project looks promising, they begin to recommend its purchase to their clients, pushing the price up.

Before making a decision, the manager of a listed company performs a systematic process of analysis, as does an external investor, to evaluate the impact of their decision on the share price. Now, what happens when a company is not listed on the stock exchange? In the absence of a supervisory body such as the market, countless managers make decisions hoping that things will go well and that they will be able to see the results reflected in the company’s financial statements in the future, when the project is completed. However, many times, the day-to-day prevents evaluating this type of decisions ex post; thus, despite the fact that the mission statement of many companies speak of “adding value” for shareholders, very few manage to properly measure this.

The same is true for risk management. Listed companies rely on a risk map that provides them with a dynamic knowledge of the movements of all variables that can significantly affect their share price. If, for example, one of the risk factors is exchange rate, they measure the range of this variable’s movements, which should be reasonable or allowed, so that it does not affect too negatively the results; similarly, they evaluate hedging mechanisms when the exchange rate is outside the established parameters.

The story is very different in many unlisted companies, which not only have very little clarity about the multiple risks they face, but, even worse, they lack an efficient way to mitigate them. It is clear that if these companies listed their shares on the stock exchange while they do not have clearly established mechanisms to manage their risks, they would be severely punished by the market.

One of the financial ratios used by companies that orient their decisions towards maximizing wealth is net present value (NPV) that allows measuring how much value is added by a certain decision. In practice, even though NPV is relatively easy to calculate, few private companies use it as a decision-making tool. What happens if a company does not use NPV to guide its decision-making process? In principle, it might not generate or might even destroy value, but as explained, this loss of value does not necessarily indicate that the company is going bankrupt or will stop generating accounting profits.

A complication of NPV as a financial decision-making tool is that it is built by estimating free cash flows that will be generated in the future. The ability to make cash flow projections is affected by multiple factors that, as they are not entirely predictable, affect the calculations of the generated value. It is enough to mention the change in cash flows experienced by companies engaged in air passenger transport or the hotel industry with the emergence of the Covid-19 pandemic: none of the cash flow projections made in 2019 could possibly anticipate this exogenous event.

Another complication for calculating the NPV is that the procedure necessarily involves estimating the discount rate to be used or the opportunity cost of the company. How much should the company yield as a minimum? The cost to finance its investment in assets. Since this financing is composed of resources provided by financial creditors, such as banks, and by shareholders, it is necessary to estimate their cost. It is always easier to estimate the cost of debt because it is closely linked to the conditions established by financial creditors, such as the interest rate to be paid for the financing granted, installments, transaction or processing costs, and something very important, which is tax reduction due to interests that affect the company’s earnings before taxes, that is, the basis to calculate its income tax.

The most complex thing to calculate is the opportunity cost for shareholders. In their first financial math classes, undergraduate students are explained that the opportunity cost is different for each person, and that it depends on their investment opportunities. However, when estimating the opportunity cost of shareholders, it is assumed that the behavior of each individual is rational, and that the company will compensate for the money contributed considering the opportunities offered by the market and the inherent risk of investing in it. Consequently, to project future cash flows and estimate the discount rate, assumptions are made through a process that involves uncertainty and the revaluation or updating of beliefs whenever new information is available on the market or the company, which affects the estimates made.

The question that arises is: Can a private company be managed using the same criteria as a publicly traded company, basing its decisions on tools such as the NPV? The answer is yes, and the main objective here is to describe a basic dynamic valuation model through which senior managers can determine the market value of a company at any moment. In other words, although the company is still private, the proposed management model makes the decision-making process as rigorous and professional as if it were a listed or public company, using NPV as its main decision-making criteria or, in its absence, economic value added (EVA). The model encourages the use of different risk management tools to analyze some of the variables that affect value, so that after establishing the allowed movement ranges (risk map), hedging or mitigation mechanisms can be implemented.

The objective outlined in this book is relevant for management practice, since many companies—private or listed on the stock exchange—show a negative EVA (Rivas, 2019), which evidences value destruction in their decision-making processes. One hypothesis to explain this is that most of the managers do not base their decisions on a systematic, orderly, documented, and value-oriented process.

This fact alone is of great importance because it allows, among other things, that managers and owners of small and medium-sized companies review their financial management models, become more exigent in terms of performance measurement criteria, make a better use of available public information for comparison with national and international peers, and establish committees responsible for the company’s risk management. This book also aims to leave theoretical or mathematical formalisms in the background and serve as a practical guide for senior managers of Latin American companies to make better financial decisions.

Before continuing, it is necessary to make a clarification: as explained in the subtitle, this book addresses the basic concepts of financial decision-making, that is, those concepts that are used in the early stages of financial valuation and risk assessment. This approach, focused on generating economic value for shareholders, does not deny the shared value approach, but rather pays special attention to the tools used in the early stages of assessment. To better understand this clarification, the evolution of the concept of value generation in companies is described below.

Milton Friedman’s propositions in 1970 opened a wide-ranging discussion: Should companies be dedicated exclusively to generating economic value or do they have a responsibility to society? For the author, the only social responsibility of companies is to generate value for their shareholders for two reasons: i) using the company’s money for social programs implies investing the profit of shareholders in activities not related to corporate purposes, a decision that does not correspond to the company’s management, but to each shareholder according to their preferences; and ii) the company pays taxes, which must be used by the State in programs designed to efficiently redistribute wealth and to address social problems. This function is performed by the State better than by the manager of a company.

This approach gave rise to the view that the objective of companies is to maximize the wealth of shareholders; thus, they should be managed, governed, and directed with this specific purpose in mind. It is commonly stated in the financial economics literature that corporate governance seeks to guarantee for the providers of financial resources the return of their investment (Shleifer & Vishny, 1997); that is, companies are governed to meet the expectations of shareholders. However, in recent decades, another position has gained strength (Tirole, 2001), according to which companies must be governed in such a way that internalizes the expectations of different interest groups, since for a company its shareholders and financial creditors who provide money should be as important as its workers who invest their human capital to carry out the company’s purpose, its customers who demand products, and its suppliers who provide the necessary input to make possible the production of goods or services.

According to Porter and Kramer (2011), the concept of social responsibility evolved into the concept of shared value, according to which companies are dedicated to generating value for different stakeholders, without denying the importance of maximizing shareholder wealth, but with explicit restrictions. It could be said that this process is subject to internalizing the expectations of other interest groups too. Thus, the company can invest in the training of its suppliers so that its products and services have a better quality, in the well-being of its employees so that they are more productive and make better contributions to the organization, as well as in its customers, promoting their loyalty to guarantee business continuity, all of which do equally serve the interests of shareholders as well.

Furthermore, an adequate behaviour of companies toward their different interest groups facilitates the acquisition of financial resources. The principles for responsible investment, established in the first decade of this century as a United Nations initiative, allow institutional investors worldwide to evaluate the companies and projects they finance using criteria that are not only economic, but also social, environmental, and related to good corporate governance practices. In other words, more and more providers of financial resources are interested in the social, environmental, and economic impact of the companies they support.

Nevertheless, under the logic of sustainable finance, this does not imply that investment funds have neglected profitability. On the contrary, it means that at the moment of making an investment, environmental, social, and corporate governance risks are as relevant as operational and financial risks, since companies must be financially viable. Once this aspect is guaranteed, any social, environmental or corporate governance problem that arises must be managed without delay, since it could end the company. For example, a social problem with the community in which the company carries out its operations, or with its employees, or accusations of forced or child labor can significantly affect different aspects that could range from the partial generation of cash flows to the granting of operating licenses.

The same is true for environmental issues: pollution can lead to the imposition of fines or even to the cancellation of operating licenses. In addition, corporate governance issues involving disputes among shareholders, or poor controls on the opportunistic behavior of decision makers, can compromise the financial stability of a company that has the potential to generate economic value. Therefore, at present, the financial approach is not limited exclusively to financial aspects.

In conclusion, this book does not ignore the approach under which companies are called to generate shared value for the society as a whole, nor the importance of generating economic value for their shareholders. In practice, they are complementary approaches that legitimize the capitalist model, encourage sustainable economic development and a better redistribution of wealth, as well as cause a moderate impact of the economic activity on the environment. However, the book examines the basic concepts that allow evaluating the financial viability of projects and companies, which constitute the first necessary, although not sufficient, step to ensure that decisions made in a company generate value.

The book has the following structure: Chapter 1 answers a simple question, which is not always easy to answer: What is a good financial decision? Chapter 2, taking the example of a hypothetical company, describes the first step in the decision-making process: historical information. Chapter 3 reviews some concepts related to financial modeling, in particular the creation of an assumptions table to subsequently project the financial statements. Chapter 4 analyzes the main financial assessment tools, especially NPV and other relevant ratios; Chapter 5 estimates the weighted average cost of capital (WACC), while Chapter 6 uses the base case developed in the previous chapters to carry out a risk analysis, including sensitivity, break-even, and scenario analyses, as well as a Monte Carlo simulation, to end with a risk map. Finally, the book concludes with a series of practical and useful recommendations dedicated to all managers who want to orient their administration towards maximizing the wealth of their organizations.

Chapter 1

What Is a Good Financial Decision?

For this study, a good financial decision is the one that follows a systematic and organized process of analysis. It should be noted that one thing is a good decision and another one is the result. The decision-making process can be monitored, while the result cannot. In this context, the quality of decisions is independent of their results. A good result without a systematic and orderly process of analysis has not been the product of a good decision, it was only luck!

Figure 1 outlines the most complete decision-making process possible. However, it should be clarified that companies constantly make three types of decisions: operating, financing, and investment. The first type is related to liquidity managment necessary for the company’s operations, as well as to revenues and expenses that are reflected in the operating profit. Investment decisions refer to the purchase or sale of long-term operating and non-operating assets, including an analysis of the return generated by this investment. Finally, financing decisions refer to the long-term capital or financing structure of the company, along with an assessment of the cost associated with each financing source.

Figure 1. Process of Making a “Good” Financial Decision

Regardless of its type, every decision requires a certain modeling process. The most complete process involves the projection of cash flows, their discount with the opportunity cost, and sensitivity analyses associated with the stochastic behavior of the projected cash flows.

A financial review of historical information allows obtaining parameters to construct an assumptions table based on which financial statements are projected, especially the income statement or p&l, the balance sheet or balance sheet, and the statement of cash flow. Based on this information, the free cash flow (FCF) is constructed and then discounted using the weighted average cost of capital (WACC) to calculate the NPV (and other ratios) of the decision. This would be the base case. The risks are then examined to carry out sensitivity, break-even, and scenario analyses, as well as a Monte Carlo simulation. Completing this whole process provides the necessary basis to make a “good” financial decision.

Before describing the process, it is necessary to answer the following question: What is a good financial decision? As already explained, a good financial decision is the one that follows a systematic process that seeks to add value as its ultimate goal. What does it mean to add value? It means to increase the long-term wealth (possibilities of consumption) of the shareholders or owners of a company, which can be measured through the concept of net present value (NPV).1

There are three important concepts included in this definition. The first one is that the present value of the FCF produced by an asset, based on which the decision is made (e.g., company, project), is wealth. In other words, a decision always implies a present event (e.g., investing in an asset) with an effect that will be observed in the future. Therefore, it is necessary to estimate the present value of the FCF that will occur in the future, and to do this, the decision maker must be clear about its opportunity cost. For a company, this opportunity cost is the WACC, that is, the cost of financing an asset. Then, the FCF is discounted using the company’s (or decision maker’s) WACC.

To understand this more clearly, let us suppose that a company is studying the possibility of investing a certain amount of money in an investment project. This amount can be invested in any other project of similar risk. Therefore, for the decision to make sense, the expected return must be higher than the opportunity cost. This opportunity cost is precisely the WACC. However, in practice, most entrepreneurs—and even managers of small and medium-sized firms—are unaware of the opportunity cost of the company. In other words, they do not know their company’s WACC. This implies that decisions are made without knowing with certainty the cost associated with obtaining financial resources. To make a good financial decision, it is essential to have at least an approximate idea of the company’s WACC, estimating the cost of financing with financial creditors, and the cost of financing with shareholders, that is, the opportunity cost of those who contribute to the firm’s capital. An entire chapter is devoted to this calculation later.

The second concept is market value. The main difference between accounting and finance is that the former generally works with historical values, while the latter uses market values. It is necessary to clarify that records in the accounting books seek to reflect the financial reality of the company, which implies properly evaluating its assets. For example, under the International Financial Reporting Standards (IFRS or NIIF as known in Spanish), assets are revalued to reflect a value closer to its market value. Similarly, the impairment of assets such as inventories and accounts receivable are adjusted, so that they reflect their true market value. However, from a financial point of view, assets are worth their ability to generate future cash flows, which may mean a higher value than the market would pay if the company was being liquidated. Thus, it is always possible that there is a difference between the estimated asset value, from the financial point of view, and the book or accounting value.

In the case of a publicly traded company, the market value reflects the present value of future cash flows expected by shareholders. Therefore, the market value of a share is a break-even value that arises when the demand price is equated to the supply price. Thus, if the share price of a publicly traded company is below its true valuation (undervalued), many investors would be interested in acquiring it, pushing its price up; on the contrary, if the price is higher than expected by the market (overvalued), investors would be incentivized to sell, pushing the price down. An example of how this notion of market value generates financial statements that are very different from accounting statements is examined later.

The third concept is related to the meaning of NPV itself. It measures the amount of value being generated (npv > 0) or destroyed (npv < 0). The NPV can be understood in colloquial terms as the amount of wealth generated by a project or an investment. To explain this, let us consider the following example: an investment of $1,000 generates a FCF of $1,500 within two years. If the WACC is 12%, is this a good project? To answer this, the NPV is calculated first:

According to the result, it is a good project because it generates a positive NPV equal to $196; nevertheless, the following question arises: if $196 represent a real increase in wealth today, then, in principle, could consumption capacity increase today? Can those $196 be spent today if necessary? The answer is yes, recognizing the existence of financial markets. Let us suppose that you want to spend this money today, but you will receive the FCF in two years; then you can go to the financial market and borrow the money needed. Additionally, let us assume that the financial market agrees with you about the risk-return ratio of the project and lends you at 12%.