Relative Strengths and Weaknesses of Financial Analysis Methodologies

The Value Analytix SVA Approach versus The Boston Consulting Group CFROI Approach

As a result of publishing the following table in our spring 1997 newsletter, we received many enquiries regarding CFROI (Cash Flow Return on Investment). This article outlines the concepts underlying CFROI and compares them to SVA (Shareholder Value Analysis). At Value Analytix our view is that there is no single measure of financial performance that will work in all situations. We believe that each financial analysis technique has its own strengths and weaknesses. for example, SVA or DCF is not good for compensation systems whereas EVA is. Conversely, EVA is not very good for analyzing value drivers or testing sensitivities to strategies whereas this is the strength of an SVA/DCF analysis. In the first chart, we have rated each of the four financial analysis techniques against various common applications. The four methods are Shareholder Value Added, Cash Flow Return on Investment, and Accounting Measures. We also thought it would be useful to rate each of these four financial analysis techniques on the basis of the intellectual rigor in the technique, the ease of use to perform the analysis and ease of communications in terms of the comfort level of the listener rather then the presenter of the analysis. In the case of both charts we have awarded from zero to 3 stars for each category with three stars representing the highest rating Application Methodology Choice SVA/DCF EVA CFROI Company Valuation M&A Analysis Planning System Compensation Controls/Reporting Portfolio Management Correlation to share prices *** *** *** * 0 *** ** ** * * *** * ** * * 0 0 0 0 * * Accounting Measures * * * * *** ** *

Characteristic

Methodology Choice SVA/DCF EVA CFROI Accounting Measures

Intellectual Rigour Ease of Analysis

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* ** ***

0 0 0

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Ease of Communication **

Comparison of SVA and CFROI

The following comparison of CFROI and SVA was developed by Tom Nodine, formerly of Booz Allen Hamilton, Australia. THE Value Analytix APPROACH

The Value Analytix model links strategies to cash flows and value. It uses management expertise, Michael Porter's Value Chain and so called "Value Drivers" to translate strategies into forecasted cash flows. These drivers include: Sales Sales Growth Operating Profit Margin Tax Rate Incremental Fixed Capital Investment Incremental Working Capital Investment The Cost of Capital Value Growth Duration The Value Analytix Approach incorporates both systematic and specific risk into its analyses. Systematic risk is included through the cost of equity in the weighted average cost of capital using any of a number of methods depending on the situation at hand. These methods include CAPM, APT, Peer Group Analysis, Cross-Sectional Analysis and others. The cost of equality is relevered using the Hamada algorithm(1) whenever future financial leverage (gearing) is anticipated to differ from past levels. Specific risks of explicitly incorporated into the cash flows using scenario analysis. The last value driver, Value Growth Duration, corresponds to the length of the time that a firm is expected to create value (i.e. earn returns above its cost of capital). It varies from less than 3 years for companies whose strategies are quickly emulated (e.g. high technology firms) to over 20 years for companies with strategies that take a long time to reproduce (e.g. natural resource companies). The Value Analytix Approach calculates corporate value as follows:

1. Forecasted cash flows are calculated for a length of time corresponding to the Value Growth Duration. 2. The cash flows are discounted by the cost of capital to determine what Value Analytix calls the "value created during the forecast period". 3. To the "value created during the forecast period", Value Analytix then adds the present value of the firm at the end of the forecast period. They call this the "Residual Value". Residual Value often comprises 50% or more of total corporate value and is determined using different approaches in different situations. Perhaps the most common method of calculating residual value is to take a perpetuity of the Net Operating Cash Flow before New Investment in the final forecast period (normalised for nonrecurrent events). Other approaches include "perpetuity with growth" (used in the very few situations when value creation is anticipated to continue indefinitely) and "break-up" value (used when the firm ceases operations at the end of the forecast period). (1) Developed by Robert S. Hamada (University of Chicago) on the basis of Miller and Modigliani's proposition number two and corporate taxes. THE BCG APPROACH:

The keystone in the BCG approach is Cash Flow Return On Investment (CFROI). It is analogous to an internal rate of return (IRR), but the way they calculate the "Investment" terms and forecast cash flows is distinctive. The components of CFROI are: 1. Current Dollar Annual Cash Flow: Last year's inflation-adjusted cash flow 2. Current Dollar Gross Investment: Inflation-adjusted total assets minus non-debt liabilities and intangibles 3. Current Dollar Value of Non-Depreciating Assets: Inflation-adjusted current assets and land 4. Asset Life: Average depreciation term for all assets BCG calls the "Investment" term in the CFROI calculation "Current Dollar Gross Investment". This is calculated by converting historical cost financial statement data into current costs. This is necessary because the BCG approach uses real cash flows discounted by a real cost of capital(2). It also involves many complex adjustments to financial statement data including Goodwill and Inventory. The material I reviewed did not offer detailed information on these adjustments. The next component of CFROI to be calculated is Current Dollar Annual Cash Flow. To estimate these future cash flows, BCG employs the following steps: 1. It estimates the remaining useful life of depreciating assets using Asset Life.

2. It estimates the annual cash flow of the assets are expected to produce through the end of their economic lives. 3. It allocates non-depreciating assets to depreciating assets pro-rata basis and assumes that they are "recovered" (i.e.converted into cash) at the end of the economic life of the depreciating asset. BCG then calculates CFROI as the internal rate of return that equates the present value of future cash flows with the estimate of the Current Dollar Value of Gross Investment. Similar to Value Analytix , BCG assumes that a firm's rate of return (in this case CFROI) will eventually be driven down to a competitive equilibrium. Unlike Value Analytix , the BCG approach assumes that this process takes 40 years to complete in all cases. To calculate corporate value, BCG takes the Current Dollar Value of Gross Investment and applies its CFROI to produce future cash flows over a term equal to the depreciating life of the assets. When retired, depreciating assets are assumed to be replaced according to a historical asset growth rate. However, both the cash flows and asset growth rates decay exponentially from their recent historical rates to Australia-wide averages over the 40 year horizon according to what BCG calls the "Fade Rate." After 40 years, all Australian firms are assumed to have CFROIs of 5.5% and Real Asset Growth rates of 2%. To discount the cash flows, the BCG approach utilizes one "market derived discount rate" for all businesses in a country. In short, BCG uses the country average CFROI and Asset Growth rates to project "market" cash flows and uses the current value of the market to backsolve for the discount rate. This rate is always adjusted for investor's taxes and sometimes adjusted for financial leverage. The BCG approach seems to ignore specific risk entirely. (2) This is just as conceptually sound as discounting nominal cash flows by a nominal cost of capital (Value Analytix's approach), and also partially explains why BCG's Australian discount rate (5.2%) seems so low. THE DIFFERENT PURPOSES OF THE MODELS:

Why are these models so different? The answer lies in their original purposes. BCG's 1993 brochure mentions that the Value Analytix approach was "developed especially for corporate planning and related applications". This is in contrast to their model which was, "designed as a tool to assist the institutional investor in picking stocks". For picking stocks, BCG needs a systematic means of sorting through the historical data of thousands of businesses to identify potentially undervalued companies. They also need to be able to backtest the model to identify how well it did in the past. Developing separate yearly cashflows estimates, costs of capital and forecast periods for each company would simply be too time consuming for their purpose. Accordingly, they developed a series of assumptions (cash flows determined by a 40 year CFROI fading to Australia-wide averages, Constant Cost of Capital, etc.) that would allow them to avoid explicit forecasts and be able to backtest their model(3).

While these assumptions are useful in helping BCG to pick stocks, they make their model less useful for corporate planning. Corporate planners are primarily interested in one company, its business units and competitors. In this situation, producing explicit forecasts that match proposed strategies becomes much more manageable and appropriate. Corporate planners want to understand how changes in strategy will affect their company's value. If you have the average company with the average strategy and the average investment policy and the average level of systematic risk and your strategy is not going to change, then BCG's approach will model your firm effectively. For any company that is not average on all these accounts, the BCG model will miss the distinctions. For example, would a natural resources company really want to "fade" to the same CFROI and the asset growth as a computer company? BCG's model would have it that way despite the fact that the rates of return and investment growth vary significantly from firm to firm and industry to industry. Value Analytix's approach is more appropriate for corporate planning because it includes strategyspecific forecasts. These bring out the distinctions in alternative strategies and allow corporate planners to measure their effect on a firm's value. The strategic implications of the Value Analytix model are also more clear and intuitive. Strategies that will legitimately increase a firm's value through their net effect on sales, profits, taxes, investments, the cost of capital and value growth duration should be undertaken. Because BCG's model was designed for picking stocks, its strategic implications are less straight forward. If we follow the model to its strategic conclusion, we could increase value arbitrarily by growing assets (any assets) as fast as possible. In fact, the sooner we do it the better because our CFROI is likely to be downward sloping over the next 40 years! Clearly, neither implication makes economic sense. I don't blame BCG for seeking out corporate applications for their model. If I had invested in such a tool for my investment clients, I would want to apply it to as many other markets as possible. Nonetheless, applying BCG's assumptions to strategic planning is rather like using a belt sander when a find hand sanding is required: it levels the very distinctions we are trying to bring out. (3) The materials I reviewed did not present any results of these backtests. WHAT BCG SAYS ABOUT THE Value Analytix APPROACH

Here are several comments BCG has made regarding the Value Analytix Approach and how I would respond to them. 1. It involves subjectivity and, "cannot be backtested." Guilty as charged. Value Analytix's approach preferably involves specific forecasts about operating factors into the future. Because it incorporates managerial judgement and strategic thinking, subjectivity is also necessarily added. However, BCG's approach avoids this subjectivity only at the cost of relying on historical data and applying restrictive assumptions about CFROI, Asset Growth,

Fade Rates and Cost of Capital to all firms in a country. BCG claims that their approach "removes the need to make explicit forecasts to cash flows." I would argue that they have not removed the need to forecast cash flows at all. Instead, they have merely employed a series of assumptions that meet the established need to estimate future cash flows. 2. Residual Value is highly sensitive to the cash flow in the last forecast period and the rate of growth in perpetuity. Both of these are also true. To address the cash flow concern, Value Analytix excludes non-recurrent events and normalizes the cash flow used as the basis for Residual Value. I believe Value Analytix would argue that Residual Value should be highly sensitive to the growth in perpetuity assumption. A firm that can create value indefinitely into the future (i.e. one with a perpetuity growth greater that zero) should be much more valuable than one that does not. They would also be quick to add that the perpetuity with growth assumption for residual value is only applicable to the very few firms that have an economic advantage that cannot be reduced by competition. I also find it strange that BCG should bring up this objection. In fact, their assumption that all future cash flows are driven by last period's CFROI is analogous to taking a perpetuity value today instead of at the end of a defined forecast period (as it is in the Value Analytix approach). This makes their model at least as sensitive to a perpetuity-like assumption as Value Analytix 's and probably more so. 3. The Alcar model "relies on CAPM as a means of determining the discount rate." As I mentioned before, this is not the case. The Alcar model can incorporate any method of estimating systematic risk be it CAPM, APT, BCG's estimate or another approach. BCG has criticized CAPM by claiming that it does not reflect investor taxes. Although this is true in strict sense, the CAPM is still valid as long as personal income tax rates and capital gains tax rates are approximately the same. I would be happy to review other critiques of CAPM from Roll, Ross, Fama and French if you so desire. However, the bottom line is that CAPM remains among the most appropriate and applicable methods of estimating systematic risks for firms. At minimum, applying CAPM will test whether systematic risk levels warrant different costs of capital for different firms. BCG's approach assumes that systematic risk is constant across all companies. I have not seen, and think it unlikely that I will ever see, any academic support for this point of view. Finally, when comparing strategies for corporate planning purposes, an error in the cost of capital may have minimal impact if it affects all strategies similarly. For corporate planning purposes, relative value (i.e. the difference in value between strategies) is more important than absolute value (i.e. the price you would pay today to buy the firm). Any errors that effect the proposed strategies equally will cancel out in the analysis. QUESTIONABLE ASPECTS OF THE BCG APPROACH:

In addition my concern that BCG's approach forms a sort of "Procrustean Bed" approach to corporate valuation, I have identified several other aspects of their model that are, in my opinion, suspect. 1. With respect to the CFROI calculation, how can it be reasonable to assume that a firm's nondepreciating assets will be converted to cash under anything other than liquidation scenario? This assumption seems unreasonable whenever the firm being analyzed is expected to be a "going concern". 2. How can a firm's cash flows be logically linked to specific assets? Unless all depreciating assets have the same life, this assignment process will affect the final result of the CFROI calculation. 3. My information included no description of how the inflation adjustments are made in determining Current Dollar Value of Gross Investment. Without knowing this process, it is impossible to determine whether the adjustments result in a reasonable value for the "investment" term in the BCG's CFROI calculation. 4. BCG's application of its approach to identify undervalued stocks seems to ignore market expectations and assume that stock markets are not weak-form efficient (i.e. abnormal returns can be earned by using historical information only).This contradicts studies conducted around the world showing that weak form efficiency is satisfied. If BCG had identified a method of successfully identifying under-valued companies, they could make much more money using it as an investment strategy themselves that they could by trying to sell it to others. 5. BCG's calculation of Current Dollar Gross Investment excludes Goodwill which often has economic value. 6. BCG's calculation of Asset Life corresponds to accounting depreciation, not economic depreciation. ASSET LIFE = GROSS PPE/DEPRECIATION = AVERAGE DEPRECIATION PERIOD 7. One of the statistics used to support the BCG model is flawed. BCG's primary "proof" that their model applies in Australia is an analysis showing an R-Squared statistic of 40% when "Value/Cost is plotted against CFROI minus Discount Rate". Since BCG defies "Cost" and "Investment" as Current Asset Value, both sides of the regression equation contain the factor "1/Current Asset Value". In this situation you would be surprised if there were not a significant R-Squared static(4). (4) For a discussion of this error, see Eynon, Philip J. and Nodine, Thomas H., "Seven Critical Success Factors for Value Creating Acquisitions" M&A Europe, March/April 1991, p.5. ADDITIONAL QUESTIONS I WOULD ASK

1. In the BCG materials I reviewed, the Fade Rate changed from 5% to 20%: How is the Fade Rate Determined? Is it determined using Australian data? What is the basis for the change?

How can we be confident that it is right now? On what basis does it vary from firm to firm? 2. How is specific risk incorporated into the BCG model? 3. Why have they not chosen to use the standard Hamada algorithm to adjust their country-wide cost of capital for financial risk? 4. How are historical cost financial statement data converted a current cost basis for use in the CFROI calculation? 5. What are the results of backtesting BCG's model in the US and Australia? WHY OUR CLIENTS ARE BETTER OFF WITH THE VALUE ANALYTIX APPROACH

With a basic understanding of the models, we can now get back to the reasons that our clients are better served by the Value Analytix model. 1. The Value Analytix approach is better suited to corporate planning: As I've mentioned, the Value Analytix approach was, "developed especially for corporate planning and related applications," while the BCG approach was "designed as a tool to assist the institutional investor in picking stocks". This difference in focus has lead to BCG to employ assumptions that ignore important distinctions between corporate strategies and make their model less appropriate for corporate planning. Since our clients' application is corporate planning, they would do best to stay with the Value Analytix approach. 2. The Value Analytix model is more explainable: Value Analytix uses terminology that is much more comprehensible to operating managers. I've never had a problem talking about sales growth, profit margins, and investment with operating managers. Even without an accounting / financial background, the managers understand the major factors of the model. This may at first appear to be a small issue, but it becomes critically important when describing and implementing new strategies. The BCG approach is not nearly so intuitive. I would not want to explain CFROI to the average operating manager, much less his or her specific role in making it happen. 3. BCG's model may not be suited for application to Australian firms, or natural resources companies. In the US, BCG says that their model achieves an "acceptable" tracking for 80% of the Value Line 1400 Industrials. Stated differently, they believe that their model does not track acceptably for 20% of the largest firms in the US. Even if their model was fully applicable to the Australian market how can we be sure that a given client is not one of the 20% to which the model does not apply? BCG has had problems with their model in Australia. This is primarily because Australian accounting standards allow more freedom to restate asset values than the US GAAP allow.

This problem is exacerbated in natural resource companies where many of their assets don't "hit" the balance sheet in the US until they are unearthed, but are often "written up" in Australia. BCG openly admits that the application of their model to natural resources companies is, "still in the embryonic stage". Their 1993 brochure states, "it may well prove that the unusual characteristics of the resource sector may best be handled by a traditional DCF model". SUMMARY:

As you can tell, from my perspective the race between Value Analytix and BCG for the best corporate planning model is not even close. BCG assumes away the very distinctions that are important in identifying optimal strategies