Corporate Finance White Paper
Capital Efficiency and Firm Value Creation
Management’s primary task is to maximize the Value of the Firm. This is true whether there are plans for a near-term exit or not because the benefits to future owners cannot exceed those to current owners given access to the same resources. This maximum value occurs when prospects for the firm’s future profitability are at their most sanguine, and cannot happen without satisfied customers, employees, suppliers, and owners.
The three variables determining Firm Value are:
Free Cash Flow to the firm
Expected growth rate of Free Cash Flow to the firm
Weighted Average Cost of Capital
The first two items in the Firm Value Formula do not come as any surprise. The third item,
Weighted Average Cost of Capital, however, is not well understood by most management teams, and is often not very well used by those teams who believe they do understand it. And yet, it is, in fact, one of the most important concepts affecting Firm Value.
A common misconception is that for publicly traded companies the value of the firm is its market capitalization based on stock price, and while many stock market trends illustrate the dynamics captured by the Firm Value Equation, there's a big difference between stock market values and true Firm Value. Stock market values are not primarily about perceptions of the entity's future earnings. They're not even about meeting analysts' expectations for future earnings. They're essentially based on investor expectations about other investors’ expectations of stock price
movements. Facebook met analysts' projections for Q2 2012 earnings, for instance, and grew revenue by 32% - clearly a value-creating achievement - but its stock price dropped by 10%. It's not about financial achievement, and it's not about meeting earnings expectations. It's about speculation regarding investor sentiment. Public companies simply have to deal with that reality, but sacrifice their long-term well being if that distracts them from core value-creating financial engineering. Privately held companies have their own distractions as well. The reality is that value is determined by the three primary variables listed above. How does a CFO use that to guide her decisions? First of all is to not be distracted from the axiom. The big problem may be related to
Cost of Capital if one is focused on its calculated value rather than as the primary foundational concept it is. Because of the uncertainties, complexities, and inconsistencies in the definitions and uses of the variables in the Cost of Capital equation, especially during the last few years, the numbers are unreliable. But then to dismiss the concept of Cost of Capital would be a grave error. Cost of Capital has to do with the risks involved in deploying capital, and the best way to minimize Cost of Capital and thereby maximize Firm Value is to demonstrate efficiencies in deploying it. How is that done? Well, in the current environment that's hard to say because there's been no single metric for it. Finance professionals use a very wide variety of measurements if they consider this at all (and experience shows that few actually do address this on any regular or meaningful basis). This is ironic inasmuch as finance theory defines Cost of
Capital as critical in affecting Firm Value. The chart below demonstrates how sensitive Firm
Value is to changes in Cost of Capital, assuming constant Free Cash Flow and Expected Growth
Rates, and especially at lower ranges.
Firm Value at Various C of C
That's why it is important to have a single metric that accomplishes, in a practical way, what
Cost of Capital does so well in theory, but so poorly in practice, one which can be used to track trends in an enterprise's record of efficiently deploying capital, and one that compares the enterprise with others'