VALUE : Measuring value creation
The tools used for measuring creation of value can be classified under four headings:
- Net present value is the only true financial tool for measuring value creation.
- Financial/accounting tools, which factor in returns required by investors (the weighted average cost of capital) and do not depend directly on the sometimes erratic price movements of markets. EVA, the popular term for economic profit, measures how much the shareholder has increased his wealth over and above standard remuneration. However, EVA has the drawback of being restricted to the financial period in question; EVA can thus be manipulated to yield maximum results in one period at the expense of subsequent periods.
- Market tools, which measure MVA (market value added), or the difference between the company's enterprise value and its book value, and TSR (total shareholder returns). TSR is the rate of shareholder returns given the increase in the value of the share and the dividends paid out. These market tools are only useful over the medium term, because to be meaningful they should avoid the market fluctuations that can distort economic reality.
- Accounting indicators, which have the main drawback of being designed for accounting purposes, i.e. they do not factor in risk or return on equity. They include earnings per share (EPS) linked to the value of the share by the price–earnings ratio (P/E), shareholders' equity linked to the value of the share by the price–book ratio (PBR), accounting profitability indicators (shareholders' equity, return on equity (ROE), return on capital employed (ROCE)) to be compared with the cost of equity (or the weighted average cost of capital, WACC).
A thorough understanding of the weaknesses of all of these tools is vital. Given the lack of a generally accepted standard measure for value creation, companies quite naturally rely on those criteria that show them off in the best light.