Measuring Shareholder Value
© David T. Lupia
Shareholder value is created when profitability exceeds investor
expectations as measured by the cost of capital. Unfortunately,
companies often do not measure profitability the same way investors
do, and this makes it hard for managers to identify under-performing
operations and take corrective action. This article describes a rate
of return metric that measures profitability the same way investors
A commonly used measure of profitability is the Return On
Capital Employed (ROCE), defined as Operating Profit After Tax (the
sum of net income plus operating (gains)/losses after tax and interest
expense after tax) divided by Net Capital Employed (the sum of debt
and equity reported on the balance sheet). The problem with this and
most other profitability measures is they do not measure operating
profits and capital employed the way investors do.
concerned about economic profits and the amount of debt and equity
actually invested in the business. These amounts may differ materially
from those reported in company financial statements because of various
accounting practices that were designed for other purposes. Accounting
reserves, for example, tend to understate economic profits and the
amount of equity capital actually invested in the business.
Off-balance sheet liabilities, such as operating leases and receivable
factoring programs, understate the true amount of debt outstanding.
Because of these shortcomings, ROCE provides little guidance about a
company’s profitability relative to its cost of capital, which is the
blended return that equity and debt investors expect to earn on their
combined investment in the company. By adjusting ROCE to measure
profitability the same way investors do, it is possible to relate
current operating performance directly to shareholder value. The major
adjustments are summarized below.
- Permanent accounting reserves, such as deferred income tax
reserves and site restoration reserves, are added back to equity
because they are unlikely to be paid by companies that remain going
concerns. The corollary adjustment to operating profit is to add
back increases in these reserves and subtract decreases.
- Operating profit is adjusted for changes in other accounting
reserves, like bad debt reserves, because these accruals distort the
timing of when these costs are actually incurred. Corollary
adjustments are also made to net capital employed.
- LIFO inventory reserves represent real economic value to
investors and therefore are added back to equity. The corollary
adjustment to operating profit is to add increases in LIFO reserves
and subtract decreases.
- Step-up the cost of acquisitions to prices actually paid and add
back related goodwill amortization to operating profit.
- Add the present value of future operating lease commitments to
debt and the after-tax interest component of the annual lease
payments to operating profit.
- Because non-operating losses and gains are not reflected in
operating profit, consistency requires that accumulated
non-operating losses be added back to equity and non-operating gains
To illustrate the effect of these adjustments, Table 1 shows
returns for the U.S. refining and marketing operations of a major
integrated oil company over five years.
Net capital employed (NCE) attributable the company’s U.S.
downstream operations increased from $724 million in 1996 to $1,623
million in 2000, largely as a result of an acquisition in 1999.
Operating profit after-tax (OPAT) fluctuated widely over the
five-year period and averaged $139 million per year. Conventional
ROCE ranged from 4.5% in 1996 to 19.0% in 2000 and averaged 12.1%
over the five-year period.
The cost of capital for the company’s U.S. refining and marketing
operations was estimated using the average asset beta of pure
refining and marketing companies and the company’s marginal
after-tax cost of long-term debt and capital structure. The
resulting cost of capital was found to average approximately 10.5%
over the period under review.
Comparing the 10.5% cost of capital to 12.1% ROCE would suggest that
the company has created significant shareholder value: (12.1%
-10.5%) x $1,125 million = $18 million per year x 5 years = $90
million. However, a far different picture emerges after ROCE is
adjusted to reflect the capital and profit adjustments described
As shown in the table, capital adjustments averaged $779 million
over the five-year period and profit adjustments averaged $15
million per year, resulting in an 8.1% Return on Adjusted Capital
Employed (RACE). This return is well below the cost of capital and
indicates a $228 million diminution in shareholder value over 5
years: (8.1%-10.5%) x $1,904 million = -$45.7 million per year x 5
years = -$228 million. (The increase in capital adjustments in 1999
and 2000 is largely the result of stepping-up the cost of a large
acquisition to its actual purchase price.)
2000 was one of the best years ever for the industry as a whole in
terms of the spreads between wholesale and retail product prices and
refinery feedstock costs, yet the company was still shy of earning
its cost of capital in that year. It thus seems unlikely that margin
improvements alone will be sufficient to create shareholder value in
Under these circumstances, the immediate objective should be to: (i)
identify individual business units that are destroying shareholder
value because their RACEs are below the cost of capital and then;
(ii) implement plans to create shareholder value through a
combination of efficiency improvements and asset sales.
RACE is an
essential tool for measuring shareholder value and for identifying