A Trinity: DCF (Discounted Cash Flow), P/L-accounts & Shareholder Value

A series of anticipated (extra) period profits is the ultimate result of a strategic investment. It starts with generating cash and after deduction of value differences and taxes, net profit remains. Period profit, share capital (embedded value – what really is present), shareholder value (economic value – what might happen, additional to the existing activities or ‘the market value of the company’s shares’ and cash flows, are all inter-related.

Everything that is known including what one believes to know about the future must be processed in order to get the best possible starting data, e.g. estimates of future proceeds between pessimistic lowest levels and optimistic upper boundaries. Investments, initial (pre-operational) expenses, operational costs, savings, additional revenues, etcetera, the numbers that are given in the case of an investment proposal, are indeed given. They are stated in submitted quotations for example, but such quotations are by far not fixed agreements. The given numbers are the result of calculations, estimations and expectations. Deviations are always possible. What is their effect? Which (small) deviations are important and which (big) deviations have only a marginal significance? What are the essentials and what are just side-issues? By means of the so-called Kendall-method (Kendall, M., Multivariate analysis, Charles Griffin & Co., London, 1975), with which parameters can be varied mutually independently, or by multiple-discriminant analysis, one can track down the sensitivity of changes and consequently the most important changing parameters that deserve the closest attention. It is not general information, but specific information that matters. As soon as the effect of a deviation is known, by means of sensitivity analysis, the chances of such deviation occurring must be considered. Many methods are available to do so; see the probability theory, mathematical statistics and the game theory.

What/if calculations result in projected annual accounts, presenting PAT i.e. Profit After Tax to be expected; altogether these are a flight plan. Next it becomes a matter of careful monitoring. The calculated economic life (indeed calculated, not estimated) and all resulting calculations are subject to the dynamics of business. At any point in time management opinion on product life cycles will change, thus the expected useful life of assets will vary over time. As soon as one piece of data changes, all calculations should be thrown away. On the basis of the new set of data, new calculations must be made. Management is in continuous need of up to date financial accounts, which are clear and complete, speak for themselves, contain proven numbers, and unravel the future. These ex ante accounts are signposts on the road to the future. Walking down the road, ex post accounts are made regarding past time periods and new data will generate new signposts for the road ahead.

To create more worth for the owners, VBM (Value Based Management or Value Based Measurement, aligning internal goals with those of investors) presupposes exact measurement of what one values. Extra shareholder value, including loans and current liabilities, is – in bare form – the notion NPV of the net cash flows resulting from an additional strategic investment. The investment, partly proprietor’s capital and partly debt, is a two-in-one. All active capital results in net cash inflows. Calculations should be based on the integral net cash inflows, the operational cash flow totally. Indisputably, net cash inflows and consequently NPV at net standard WACC are the base, the foundation, the bottom line.

There is much ado about WACC in economic literature. Although there are many different WACCs proclaimed by famous writers (according to incomplete definitions, incorporating equity for instance, whereas equity is an accidental market value), they are not good starting-points. This is because such an arbitrary WACC is not an unequivocal measure of the cost of capital. The one and only standard WACC, measuring standard costs, just costs, is what matters, re my free downloadable paper ‘The One and Only Standard WACC’ http://ssrn.com/abstract=756105.

‘Profit’ versus ‘capital charge’ indicates ‘residual income’. The latter is called NVA. In fact NVA (period) is the proven net profit in any given period, less demand. The demand is that amount of profit, which is acceptable to managers and/or shareholders. Here it holds, capital charge (minimum demand) is WACC x invested capital. Quite often demands are not scientific affairs. They will depend on a lot of things, namely the risk of the investment, the level of output, the results from alternative investments, the state of the general economy, the level of interest rates, and so on and so forth. It all ends up in what must be regarded as the NORMAL demand, for the time being, in this firm.

Total balance is share capital (or proprietor’s capital) plus debt. There are fiscal balance sheets based on HC besides those that are usually published. Compare these ‘de jure’ accounts with the real periodical accounts that are prepared solely for the internal use of the managers of the firm, to help them to manage. Suppose in the latter case there were different possible accounts, it can be this, it could be that, that in itself would be misleading information. Good management is not imaginable, anytime, anywhere, with accounts one chooses.

My free downloadable paper ‘A Trinity: DCF, P/L-accounts & Shareholder Value’ http://ssrn.com/abstract=864444, the reading of it is sufficient to give you an introduction, preliminary, nevertheless basically correct and the same schemes can be repeated – when calculations are exercised regarding real investments and/or real companies to be valued –  including literally everything. Prepare time to study Business Economics VI Groundbreaking ISBN 9781086355635 available at www.amazon.com

This book shifts the limits of knowing and rewrites / improves major pieces of the business economics with 8 Scientific Perfections. One of them is The Profit Formula® and these 8 Scientific Perfections are fully explained in this book. Schools / universities that ignore this book, they train students totally wrong in the Business Economics course. Here the content of the book is given:

———

Written by Jan Jacobs.