Mounting shareholder pressure to boost stock prices, escalating competition for capital and a wave of industry consolidation have combined to create an intensely competitive environment for today's plastics and specialty chemicals companies. It's more critical than ever to be able to pinpoint where your business is making money, and where profits are seeping through the cracks.
Many companies wrongly assume that their accountants or financial departments are capturing this information. But standard accounting practices often paint an incomplete or inaccurate picture of a company's profitability. Recognizing this, many chemical industry analysts — individuals who have a keen interest in the accurate assessment of a company's profitability — are adopting new systems for measuring whether a company is creating shareholder value.
One of these systems — Economic Value Management (EVM) — is also becoming increasingly popular with plastics and specialty chemical companies themselves, as a means of improving internal decision-making, evaluating company and executive performance and maximizing stock price and market value.
EVM is the measurement and management of economic profit. Its primary goal is to maximize the economic value of a business or business unit by aligning decision-making with creating shareholder value. At its most basic, economic profit is after-tax operating profit minus a capital charge. The capital charge, risk-adjusted and weighted to reflect the composition of capital, is what gives economic profit its analytical power.
EVM helps management create value primarily three ways: by pinpointing activities that deplete rather than generate value; by identifying processes that already are value-creating; and by clarifying which assets or operations return more than their cost of capital and thus become investment opportunities.
In the absence of EVM, managers at all levels often treat capital, especially expensive equity, as a free good. With the cost of capital in the capital-intensive plastics and specialty chemicals industry averaging between 9 percent and 14 percent, this can have a decidedly negative impact on profits.
EVM changes the way management views capital. It forces management to realize that capital is expensive and that it should be allocated only to projects that are expected to generate an economic profit. Using EVM, managers learn to allocate capital based on objective data, rather than relying on top-down budgets.
The plastics and specialty chemicals industry is rapidly consolidating. EVM, because of its strength as a measure of value, provides an excellent tool for evaluating potential merger and acquisition targets. EVM helps management understand exactly the return that an acquisition has to achieve in order to make it worthwhile. It also is useful in setting a fair price for the sale of a company or division, and in helping management decide whether or not to sell.
Take, for example, the parent company that made a strategic decision to sell a noncore manufacturing subsidiary in the specialty materials industry.
EVM analysis identified and quantified that the subsidiary had been making significant ``soft'' investments in its future — for product research, product development and employee training — at the sacrifice of lower reported profits.
When these ``expenses'' were properly characterized as capital investments in the future, it became apparent that the operations were more profitable than the accounting statements revealed.
Management had been investing in new products, new projects and better-trained employees, but all this had been expensed under conventional accounting measures. EVM caused the firm to rethink its decision to sell.
How can your firm use EVM? The basic EVM calculation includes the following steps:
Take your firm's net operating profits after taxes and adjust the number to eliminate any accounting distortions. The optimal number and type of adjustments varies with the company and its industry.
Calculate the amount of capital invested in the business. This number includes both fixed assets, such as machinery and equipment, and working capital assets, such as cash, inventory and receivables.
Determine the capital charge, which is the weighted average cost of the firm's debt and equity. The debt portion is simply the interest charged on a firm's loans. The cost of equity is more difficult to pin down. It varies with a firm's performance and the riskiness of the markets and industries in which it operates.
Multiply total capital invested in the business by the capital charge and subtract this number from the adjusted net operating profits. A positive result means the company is creating value for its shareholders.Hubbell is a Denver-based senior director of KPMG Peat Marwick LLP's Economic Value Consulting practice.
