Reading: Value Creation

By now, we have studied many different aspects of the firm's financial performance. One important piece that is still missing, however, is whether the firm's activities actually add financial value. Finding a full answer to this question goes beyond the scope of this course. Still, with the knowledge and information that we have gathered so far, we should at least be able to get a rough understanding of a firm's ability to generate financial value. 

When discussing the income statement in one of the previous sections, we have derived the firm's Net Operating Profit Less Adjusted Taxes (NOPLAT). We have seen that NOPLAT indicates the firm's net income that is attributable to its operating business. Put differently, NOPLAT shows how much net income the firm would generate if it did not engage in any financing activities.

It can be shown that, for mature firms that operate in a fairly stable environment, NOPLAT is an acceptable measure of how much money a firm generates for its providers of capital.

However, NOPLAT is NOT a measure of value creation. The reason is that it ignores an important production factor: Capital.

Capital is not free of charge. It has a cost: The providers of capital want to earn a return on their investment. Investors will not be willing to contribute capital to a project of firm if they cannot expect to at least earn this required rate of return. So the key question is whether NOPLAT is sufficiently large cover the financier's required rate of return. If the answer is yes, the firm actually adds value. If the answer is no, the firm destroys value. 

To find the answer, we need to know two additional things:

• Invested capital: how much money the providers of capital have invested?
• Cost of capital: What rate of return do investors require?

Once we have this information, we can do the following to roughly assess whether the firm adds financial value in a given period:

1. Estimate the rate of return the providers of capital earn on their invested capital if they receive NOPLAT. This is the so-called Return on Invested Capital (ROIC). We find ROIC as follows:
   
    
   Return on Invested Capital (ROIC) = \( \frac{\text{NOPLAT}}{\text{Invested Capital}} \).
    
   
   
2. Compare the ROIC with the rate of return the providers require to earn on their investment. In many instances, this is the so-called Weighted Average Cost of Capital (WACC). The concept of WACC and its estimation is the topic of another course. The difference between ROIC and WACC indicates the firm's so-called return spread, that is, the rate of return the firm generates in excess of the cost of capital in a specific period:
    
   Return spread = ROIC - WACC.
     

Let's review this with a simple example. Let's assume the following for a hypothetical firm:

• NOPLAT: 100 million
• Invested Capital: 800 million
• Required rate of return (WACC): 10%.

The NOPLAT of 100 million corresponds to Return on Invested Capital (ROIC) of 12.5%:

The firm's operating profitability therefore implies a return of 12.5% on the invested capital. Given that the providers of capital only require a rate of return (WACC) of 10%, the firm's return spread is 2.5%:

Put differently, the invested capital yielded 2.5% more than it cost. Ultimately, this is the economic value the firm adds. After all stakeholders have received their fair compensation, there is an extra return of 2.5% on the invested capital. Given an invested capital of 800 million, this corresponds to a value-added of 20 million. This is the so-called Economic Value Added:

While this approach to value estimation is fairly simple, we should note that it is also not very accurate. The reason is that it is rather tricky to measure the various ingredients of the equation. NOPLAT, for example, is the result of many accounting practices and it is not guaranteed that these practices correctly reflect the economic reality. Also, it is not always clear what exactly the invested capital is and, equally importantly, how to measure the rate of return the providers of capital require (WACC). Therefore, the results from the above considerations should be taken with a grain of salt.

Still, let's quickly return to Hershey and test whether the firm managed to create value according to the above measure. We need the following information:

• NOPLAT: We now from the previous sections that the firm's NOPLAT was 590.3 million in 2015. 
• Invested Capital (at the beginning of the year): It is common practice to rely on book values of debt (financial liabilities) and equity at the beginning of the period under consideration. We have already computed these book values in the section on Leverage Ratios. At the beginning of 2015, the firm had financial liabilities of 2'117.8 million and book equity of 1'519.5 million. The firm's invested capital was therefore 3'697.3 million.
• Required rate of return (WACC): We have not discussed how to come up with the required rate of return. In principle, what we are looking for is the return (in %) that the providers of capital together (debt and equity) require, on average, to provide capital to the firm. Let's just assume that this return is 6.5% (in the prevailing market environment, this would seem to be a fairly realistic return assumption).

With this information, we can now assess Hershey's value creation in 2015:

Therefore, the numbers imply that the firm has added value for its providers of capital. The return it earned on the capital was 9.5% higher than the required rate of return. This return spread of 9.5% corresponds to an economic value added of roughly 350 million.

This is the amount of money the firm made after all its stakeholders (including the shareholders) have received their fair compensation. Therefore, it is value it ADDS for its shareholders.