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Measuring Company Performance

The book value of the company`s equity is equal to the total amount that the company has raised from its shareholders or retained and reinvested on their behalf. If the company has been successful in adding value, the market value of the equity will be higher than the book value. So investors are likely to look favorably on the managers of firms that have a high ratio of market to book value and to frown upon firms whose market value is less than book value. Of course, the market to book ratio does not tell you just how much richer the shareholders have become. Take the General Electric Company, for example. At the end of 1997 the book value of GE`s equity was $59 billion, but investors valued its shares at $255 billion. So every dollar that GE invested on behalf of its shareholders had increased 4.3 times in value (255/59 = 4.3). The difference between the market value of GE`s shares and its book value is often called the market value added. GE had added $255 Ј $59 = $196 billion to the equity capital that it had invested.

Each year Fortune Magazine publishes a ranking of 1,000 firms in terms of their market value added. Table A.15 shows the companies at the top and bottom of Fortune`s list and, for comparison, Pepsi. You can see that General Electric heads the list in terms of market value added. General Motors trails the field: the market value of GM`s shares was $14 billion less than the amount of shareholders` money that GM had invested. Measures of company performance that are based on market values have two disadvantages. First, the market value of the company`s shares reflects investor expectations. Investors placed a high value on General Electric`s shares partly because they believed that its management would continue to find profitable investments in the future. Second, market values cannot be used to judge the performance of companies that are privately owned or the performance of divisions or plants that are part of larger companies. Therefore, financial managers also calculate accounting measures of performance.

Think again of how a firm creates value for its investors. It can either invest in new plant and equipment or it can return the cash to investors, who can then invest the money for themselves by buying stocks and bonds in the capital market. The return that investors could expect to earn if they invested in the capital market is called the cost of capital. A firm that earns more than the cost of capital makes its investors better off: it is earning them a higher return than they could obtain for themselves. A firm that earns less than the cost of capital makes investors worse off: they could earn a higher return simply by investing their cash in the capital market. Naturally, therefore, financial managers are concerned whether the firm`s return on its assets exceeds or falls short of the cost of capital. Look, for example, at the third column of Table A.15, which shows the return on assets for our sample of companies. Microsoft had the highest return on assets at nearly 53 percent. Since the cost of capital for Microsoft was probably around 14 percent, each dollar invested by Microsoft was earning almost four times the return that investors could have expected by investing in the capital market.

Let us work out how much this amounted to. Microsoft`s total capital in 1997 was $7.2 billion. With a return of 53 percent, it earned profits on this figure of .53 7.2 = $3.8 billion. The total cost of the capital employed by Microsoft was about .14 7.2 = $1.0 billion. So after deducting the cost of capital, Microsoft earned 3.8 Ј 1.0 = $2.8 billion. This is called Microsoft`s residual income. It is also known as economic value added, or EVA, a term coined by the consultancy firm Stern Stewart, which has done much to develop and promote the concept.

The final column of Table A.15 shows the economic value added for our sample of large companies. You can see, for example, that while GE has a far lower return on assets than Microsoft, the two companies are close in terms of EVA. This is partly because GE was less risky and investors did not require such a high return, but also because GE had far more dollars invested than Microsoft. General Motors is the laggard in the EVA stakes. Its positive return on assets indicates that the company earned a profit after deducting out-of-pocket costs. But this profit is calculated before deducting the cost of capital. GM`s residual income (or EVA) was negative at Ј$4.1 billion.

Residual income or EVA is a better measure of a company`s performance than accounting profits. Profits are calculated after deducting all costs except the cost of capital. EVA recognizes that companies need to cover their cost of capital before they add value. If a plant or division is not earning a positive EVA, its management is likely to face some pointed questions about whether the assets could be better employed elsewhere or by fresh management. Therefore, a growing number of firms now calculate EVA and tie managers` compensation to it.

MARKET VALUE ADDED The difference between the market value of the firm`s equity and its book value.

RESIDUAL INCOME (ALSO CALLED ECONOMIC VALUE ADDED OR EVA) The net profit of a firm or division after deducting the cost of the capital employed.