With analysts and fund managers increasingly disillusioned with available valuation techniques, particularly since the start of the prolonged downturn in the world’s stock markets, the concept of ‘Wealth Added’ may quickly gain ground. Stern Stewart, the consultancy that developed the concept of Economic Value Added (EVA), says that its new Wealth Added Index (WAI), introduced in 2002, allows investors to gauge a company’s performance in light of its cost of capital, and provides shareholders with an effective measure of management performance.
One of the most widely-used measures for calculating value, the price-to-earnings ratio, is deemed unsatisfactory by many analysts, since it’s prone to manipulation through creative accounting. WAI purports to overcome such pitfalls by measuring the change in market cap, plus dividends, minus the shareholder’s required returns (amount invested multiplied by the required rate of return, or discount rate,) and minus the value of the shares issued.
WAI is ‘a powerful planning framework that explicitly links together financial strategy, business performance and value creation,’ says Erik Stern, managing director of Stern Stewart Europe. WAI’s four elements are: the perpetuity value of the current cash generated, or value of profitability; the market expectation for future improvement in returns, or value of prospects; the funding of the business through debt/equity, or financing; and shareholders’ expected ROE.
A particular profile
One of WAI’s central themes is that companies only create value for shareholders when returns to investors, as represented by increases in the share price plus dividend returns, exceed the cost of equity, which is taken as the rate of return that shareholders require for investing into shares with a particular risk profile. This is as important a concept for management as it is for shareholders, because if they fail to meet investor expectations, it will be harder and more expensive for them to raise further capital in the future.
‘Wealth Added is based upon equity performance,’ says Stern. ‘As such it incorporates investors’ insights into the firm’s future prospects and reflects the performance of the top management.’ For middle management, operational performance is more relevant.
Unlike the widely-used Total Shareholder Return (TSR), WAI takes into account the risk profile of the companies being assessed, as represented by investors’ expected rate of return. For example, two companies may have an identical TSR, but if one has a significantly lower level of business risk than the other, then that company has delivered a superior performance. The company’s managers have done a better job of producing wealth for their shareholders, insofar as they have produced the same returns even though shareholder funds were subject to a lower level of risk. WAI is thus an effective tool for planning management incentive schemes.
TSR does not take account of cash invested in a company during a period under analysis, only the money put into the company at the beginning and end of that period. But WAI considers all debt and equity financing during the period being examined.
Take British American Tobacco, for example. The WAI measure shows that the change in the present value of the company’s profitability is canceled out by the reduction in the value of the company’s future prospects caused by the 1998 sale of its insurance and asset management businesses.
However, money raised from this sale helped the company achieve a positive reading in WAI terms. Many incentive programs depend on assets under management, so although a divestment may be a positive move from the company’s perspective, managers may be reluctant to advise this because of the negative effect on their bonuses. In this context, WAI is a sound basis for incentive schemes because the creation of wealth for shareholders is its central theme.
Another key aspect of WAI is the identification of a ‘governance discount’ built into share prices since recent corporate scandals. Stern says it will take time to bridge this gap, and will only happen through improvements in business processes, transparency and accountability. Another advantage of the WAI model is that it ‘allows management to improve their internal decision processes and underline their commitment to stringent governance principles.’
