Sunday, 2 November 2014

International Finance and Financial Management

Introduction

Within the first blog, we looked at shareholder wealth maximization (SWM) and the feasibility of this goal being used as a main corporate objective. We concluded that a conflict of interest between maximizing shareholder wealth in the long term and maximizing profits in the short term could distort the long-term value of a company. In order to implement SWM as an objective, managers must measure SWM effectively (Arnold, 2013). Within this blog, we consider the most common and increasingly old-fashioned measures of SWM and evaluate the success and implications of each.

EPS and ROCE

It is commonly stated that earnings per share (EPS), is a managers most preferred measure for business performance (Cheng et. al., 2011; Financial Times, 1996; Dodge, 1991) and similarly, return on capital employed (ROCE) is a major financial ratio used by financial analysts (Robin, 2010). According to Watson & Head (2013), an increase in EPS typically refers to an increase in share price in addition to ROCE being renowned as one of the most important measures for in investment decision-making.

However, there are explanations to why some investors find both measures misleading:

Firstly, both measures can be easily manipulated (Arnold, 2013; Watson & Head, 2010; Koller et.al., 2005). Evidence of this derives from Kim & Yang (2010) study where 50% of S&P 500 firms use EPS to correspond with incentive schemes. Within my previous blog, we discussed profit maximization as a corporate objective and how managers manipulate figures to enhance financial performance. Likewise, to improve earnings performance, self-interest managers may manipulate the accounts for short-term gains. A classic example of this again stems from the company Enron, where the board of directors stated in their 2000 annual report that “growth in earnings and earnings-per-share was to be the firm's paramount goal” (Stewart, 2006). Relating back to my first blog, Do Corporate Objectives Conflict? we can argue that EPS as a measure links to Agency theory and coincides with the clash between short term profit maximization and SWM.

Case Study: Tesco

A second topical example relates to the supermarket chain Tesco. In order to maximize short-term profit it is alleged that £250m of supplier rebates were included in the accounts, which technically were inadmissible.

   (Figure 1)

Note: Image from Google Finance (2014). Retrieved Jan 2015 from http://www.google.co.uk/finance

The consequences have been dire with a major downward realignment of the Tesco share price (Figure 1) and in this extreme example, the Serious Fraud Office have become involved (BBC, 2014). It is fair to say that ROCE also has its critics as like EPS, the usage of accountancy data rather than cash flows exposes both metrics to manipulation.

Secondly, EPS fails to take investment and risk into consideration. To consider this, it is best shown in an example. Company X and Y have the same EPS value, but X has invested more money in P&E in order to deliver the profit gained, whereas Y did not need to embark on the additional investment (Arnold, 2013). Obviously, if we were to pick a company, Y would win, as more cash will be generated to its shareholders. However, at a high-end view, we would not be able to determine who the better company would be. Here we can criticize EPS. As an investor, we need to ask ourselves: Is the risk and return from the investment sufficient enough for me to hold on to my shares? Unfortunately, we can’t answer that question whilst only considering EPS as a measurement tool. This therefore jeopardizes SWM as a result.

While we can argue that ROCE provides us with useful information regarding an investment, it ignores the timing of cash flows within a project (Watson & Head, 2010). Lets ask the question: Company X offers a steady return annually over a 5 year project; whereas Company Y offers a large return with the final year of the project. Which is more favorable? Again, investors cannot answer this question by considering ROCE. Additionally, ROCE cannot determine the return on an investment considered (Watson & Head, 2010). If the timing of cash flows is unknown then ROCE could potentially have a negative effect on SWM.

Discounted Cash Flows

Unlike EPS and ROCE, Net present value (NPV) offers a method of valuing an investment by taking the concept of time value of money into consideration (Liesen et. al., 2013; Lumby & Jones, 2011). This concept is best explained by Arnold (2013) who describes it as sacrificing the money you have now for investment with hope that the money invested will gain a higher level of return in the future.

Why is NPV good for SWM? NPV has the straightforward approach of accepting a project with positive NPV and rejecting those that show a negative value (Liesen et. al., 2013; Lumby & Jones, 2011). NPV uses cash flows rather than accounting profit over the life of a project (Watson & Head, 2010). It is therefore easier to favor this as a method. Within my last blog, I mentioned the concept of manipulating accounts in order to enhance short-term profits. NPV cannot be manipulated unlike EPS and ROCE. It gives an absolute measure of project desirability. Therefore, we can argue that if a manager bases their investment decision on NPV, the project as a result, is successful in producing long-term value for the company. Hence, we can state that NPV is a SWM metric.

However, NPV is primarily based on estimation (Connor, 2006).  We can argue that there is an opportunity cost for investments and risk associated from choosing one project over the alternative (Arnold, 2013). We can therefore criticize NPV for over/under rating the returns on particular investments, and, as a result, damaging SWM as a consequence.

What metrics are investors looking for?

All financial measures considered show their own advantages and disadvantages in their own right. But which metric is most desired by investors? We can argue that it solely depends on the company’s aims and objectives. Though as mentioned in the opening of this blog and in my previous blog, SWM is a common objective used.
As financial measures have only been considered within this blog, academic literature has also recently highlighted the concept of measuring non-financial factors for overall business value (Asaf, 2004; Financial Times, 1999; Parmenter, 2010). In Asaf (2004) Executive Corporate Finance: the business of enhancing shareholder value, the author describes that business performance “cannot be found in financial data alone.”

Conclusion

Therefore, to conclude my evaluation, this blog considers Kaplan and Norton (1992) theory of a balance scorecard that ponders both financial and non-financial metrics. The balance scorecard is an integrated performance measurement that allows executives to measure and manage objectives clearly and effectively (Asaf, 2004). Hence, the introduction of a balance scorecard, including KPIs on customer satisfaction e.g. OTIF, employee satisfaction measures e.g. H&S and the company’s contribution to the local community and environment i.e. CSR  (Arnold, 2013) can assist on the evaluation of a company’s performance by potential shareholders.

Though we have solely criticized the financial metrics in this blog, we cannot completely ignore these in our managerial decisions. Looking at historical data to provide accounting ratios does question the relevance for long-term company value. However, so does discounted cash flow metrics. How can we realistically predict the return on an investment?  Therefore, using financial metrics as guidance, coinciding with non-financial indicators should enhance overall SWM in an organisation. 

References

Arnold, G. (2013). Value-Based Management. Corporate Financial Management. 5th Ed. 605- 612

Asaf, S. (2004). Key performance measures in active use. Executive Corporate Finance: the business of enhancing shareholder value. 316

BBC (2014). Serious Fraud Office starts Tesco criminal investigation. BBC News. Retrieved 29th October from, http://www.bbc.co.uk/news/business-29825016

Cheng, L. T., Davidson III, W. N., & Leung, T. Y. (2011). Insider trading returns and dividend signals. International Review of Economics & Finance, 20(3), 421-429.

Connor T. 2006. Net present value: Blame the workman not the tool. Strategic Change, 15(4): 197–204

Dodge, R. (1991). Earnings per share. In The Concise Guide to Accounting Standards. Springer US. 13-18.

Kaplan, R.S. & Norton, W. (1992). The Balanced Scorecard: Measures That Drive Performance. Harvard Business Review 70(1): 71-9

Kim, D., & Yang, J. (2010). Beating the target: A closer look at annual incentive plans. Working paper, Indiana University.

Koller, T. & Goedhart, M. & Wessels, D. (2005). Performance Measurement. Measuring and Managing the value of companies. Valuation University edition. 401

Lumby, S.& Jones, C. (2011). Net Present Value and Internal rate of return. Corporate Finance: Theory & Practise. 8th Ed.

Liesen, A., Figge, F., & Hahn, T. (2013). Net Present Sustainable Value: A Value-Based Approach to Sustainable Investment Appraisal. 175-189.

Parmenter, D. (2012). Key Performance Indicators (KPI) Developing, implementing and using winning KPI. 2nd Ed.

Stewart, B. (2006). The Real Reasons Enron Failed - Lessons for Directors. NACD Directorship, 32(3), 26-29.

The Financial Times (1996 & 1999). The Financial Time’s Lex Column Database.

Watson, D. & Head, A. (2010). Corporate Finance: Principles & Practice. 5th Ed.