Privately held companies are often their owners' most significant asset. But when resources are diverted from profitable products to concentrate on short-term revenue, a company's future value may be at stake. This article explains how CPA/ABVs and other valuation professionals can help their business clients stay focused on long-term value creation.
CREATING SHAREHOLDER VALUE
Value creation relies on two critical components: (1) revenue growth and (2) return on invested capital ("ROIC") in excess of the cost of capital. The cost of capital, which is generally referred to as the weighted average cost of capital CWACC"), is determined by weighting the company's after-tax cost of debt with its cost of equity. ROIC is calculated by dividing the company's after-tax net operating profits by the sum of working capital and fixed assets. Since earning a return in excess of the company's WACC is necessary to increase value, management should understand and use it as a benchmark for strategic decision making.
WACC is a combination of the company's cost of debt and cost of equity. The cost of debt is the interest rate the company pays on its long-term debt. Banks and other lending institutions charge an interest rate that reflects the risk of nonpayment. The cost of equity is the rate of return necessary to compensate shareholders for their investment in the company. Unfortunately, many business owners often overlook the cost of equity. This is a big mistake from an individual wealth-accumulation perspective. Business owners, just like other investors, have a choice--they can either keep their capital in the company or move it to an alternative investment. If the capital stays invested, its return should reflect the risk of doing so.
Since equity returns from investments in privately held companies are not readily observable, valuation practitioners generally use return data from similar publicly traded companies as a proxy. If investors in similar public companies are earning an average annual return of 15%, investors in the privately owned company should probably be earning at least that much or they would be better off investing in the public company. In reality, the proxy rate derived from public company data must be adjusted up or down to reflect the private company's actual risk profile.
The following formula is used to calculate the WACC:
WACC = [(Dc X (1 - t)) X Wd] + [Ec X We]
Dc = Cost of debt
t = Marginal tax rate
Wd = Weight of debt (percentage of the capital structure represented by long-term debt)
Ec = Cost of equity
We = Weight of equity (percentage of the capital structure represented by equity)
For illustration purposes, assume a capital structure of 60% equity and 40% debt (at market weights) and the following costs:
Dc = 6%
t = 40%
Ec = 18%
Using the above inputs, the company's WACC is calculated as follows:
WACC = [6% X (1 - 40%) X 40%1 + [18% X 60%]
WACC = 12.24%
For decision-making purposes, management should view 12.24% as a minimum return threshold. To increase the company's value, revenues must grow and produce a net return greater than 12.24%. Returns below the threshold will diminish the company's value.
From a value-creation standpoint, the lower the company's WACC, the better. More value is created by a lower WACC because of the resulting increased spread between it and the ROIC. The most effective ways to reduce the WACC are to: (1) lower the cost of equity or (2) change the capital structure to include more debt.
Since the cost of equity reflects the risk associated with generating future net cash flow, lowering the company's risk characteristics will also lower this cost. If the...