Critical Evaluation of the Discounted Cash Flow-Method as a Value Based Performance Measurement Concept

Contents

1 INTRODUCTION

2 CRITERIA FOR EVALUATING PERFORMANCE MEASUREMENT SYSTEMS
2.1 THE PERFORMANCE OF AN ENTERPRISE
2.2 PERFORMANCE MEASUREMENT SYSTEMS

3 VALUE BASED PERFORMANCE MEASUREMENT SYSTEMS (VBPMS)

4 THE DISCOUNTED CASH FLOW METHOD - DCF
4.1 THE PRINCIPLE OF THE DCF
4.2 HOW CAN THE SHAREHOLDER VALUE BE MEASURED WITH THE DCF .
4.2.1 WACC
4.2.2 OPERATING CF
4.2.3 RESIDUAL VALUE
4.3 PLANNING
4.3.1 CAPITAL INVESTMENT PLANNING
4.3.2 DIVISIONAL INVESTMENT MANAGEMENT PROCESS
4.3.3 GENERAL PLANNING PROCESS
4.3.4 SUMMARY PLANNING
4.4 NAVIGATING AND MONITORING

5 EVALUATION OF THE DISCOUNTED CASH FLOW METHOD
5.1 THE STAKEHOLDERS THAT ARE CONSIDERED BY VBPMS
5.2 COGNITIVE MODEL
5.3 STRATEGIC BIAS
5.4 TARGET CONFORMITY
5.5 FEED- BACK FUNCTION
5.6 FEED- FOREWORD- FUNCTION
5.7 RELEVANCE FOR PRAXIS

6 QUINTESSENCE

7 APPENDIX

8 REFERENCES

Illustrations

Figure 7.1 Measurement of programmes

Figure 7.2 Controllingprocess

Figure 7.3 Using the DCF for calculating the Shareholder Value

Figure 7.4 The influence of the residual value on the shareholder value

Figure 7.5 The system of value driver

Figure 7.6 The different incentive cycles

Figure 7.7 Volume of the M&A transactions

Figure 7.8 Value gap concept

Figure 7.9 implementation of SV- concepts

Figure 7.10 The importance of the DCF

Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1 Introduction

This paper will evaluate the Discounted- Cash- Flow- Method (DCF) as a certain value based performance measurement system (VBPMS). Therefore criteria of evaluating performance measurement systems (PMS) in generally will be created (Chapter 2). This strategy will guarantee the fundamental comparability of the derived features of the DCF with these of other PMS (including non- VBPMS, too). Chapter 3 will emphasize a fundamental feature of VBPMS, the shareholder orientation. After a detailed investigation of the DCF in chapter 4, its criteria will be evaluated in chapter 5. Finally a quintessence closes this paper (chapter 6).

2 Criteria for evaluating performance measurement systems

In this chapter criteria of value based performance measurement systems will be developed. Therefore the sense of performance in connection with enterprises will be explained, at first. Finally, the term “performance measurement system” (PMS) will be defined in order to point out there criteria.

2.1 The performance of an enterprise

Performance of an enterprise stands for its achievement, its power or its output¹. To describe this term exactly, it is important to get an impression of the objectives of an enterprise (see Figure 7.1).The objectives of an enterprise are derived from its mission². The mission of a company stresses its basic function in society. Qualitative aims, called goals, are derived from the mission. If they are expressed in a way that can be measured, they are called objectives. Shareholder wealth maximisation is the traditional objective of firms³. In general, “any group or individual who can affect or is affected by the achievement of the organization’s objectives”⁴ (Stakeholder) can influence its mission and therefore its objectives. And some of them do so, as one can realise for example by investigating the success of the Balanced Score Card⁵ as a performance measurement instrument that emphasises the objectives of several stakeholders⁶. Obviously, not every Stakeholder can by considered. Only the interests of a few key- stakeholders will be regarded by the target system of a firm. Shareholders are one of the considered key- stakeholders because of their influence on the process of creating the mission (consider the rights of co determination of the general business meeting and the supervisory board⁷ at share companies; the influence of the shareholders on partnerships is trivial).

Interim result: A well performed enterprise achieves the objectives of its Shareholders and perhaps of other Key- Stakeholders, too.

2.2 Performance measurement systems

The field of activity of a performance measurement system (PMS) in the manner of this paper is not restricted to collect information. It follows much more a controlling oriented understanding and includes planning, navigating and monitoring on the operative and the strategic level. This understanding of PMS does not differentiate between Performance Measurement and Performance Management like Klingebiel⁸. On the contrary, it subsumes both terms under the term performance measurement⁹. In this connection monitoring means¹⁰ on the one hand to measure the current value of the firm to improve the identified malfunctions within the navigation to revise them (feed- back- function). On the other hand monitoring means to anticipate and prevent problems before they occur by adapting the plan (feed- forward- function)¹¹. To evaluate performance measurement systems, a catalogue of criteria have to be developed. Grüning investigated the literature for such criteria and achieves the following acquirements for PMS¹². Among other things, he emphasizes

1. balance (Ausgewogenheit) - the PMS should consider the whole enterprise with all its divergating elements. After Knorren/Weber an entire and consistent model of the whole enterprise does not exist neither in theory nor in praxis. Nevertheless the enterprises see the work on such a model as a chance to understand its dependencies¹³. To emphasize this the first criterion is called cognitive model. It stands for the part that is focused on by the PMS. E.g. the Balanced Scorecard focuses on the balance of the financial perspective, the customer perspective, the internal business perspective and the innovation and learning perspective¹⁴.
2. Stakeholdergruppen - What stakeholders are considered by the PMS.
3. Verknüpfung der Indikatoren - connection of the indicators: After Gruening there is no general agreement in the literature about a normative kind of connection between the indicators¹⁵. That’s why this point will be substituted by target conformity that investigates the coherence between the PMS as a whole and the targets of the firm.
4. Steuerungs- und Regelungskomponente - feed- back- and feed- forward- function. These two criteria, both are explained above, will be separated for this investigation.
5. Praxisrelevanz - How much is this PMS known and used in praxis.

Furthermore, a PMS should focus on the strategic information requirements¹⁶. Interim result: A PMS can be characterised on the following criteria:

1. considered stakeholders
2. cognitive model
3. strategic bias
4. target conformity
5. feed- back- function (analysing differences between nominal and real figures)
6. feed- foreword- function (Planning, Anticipating problems before they occur)
7. relevance for praxis

3 Value Based Performance Measurement Systems (VBPMS)

VBPMS base on the Shareholder Value- approach that has been developed by professors of American business schools like Rappaport¹⁷ or Copeland¹⁸. The Shareholder Value Approach is very practical to estimate the value of the whole company, but as emphasized in chapter 2.2 a PMS has not only the assignment to monitor the performance of an enterprise. To control this performance, value- oriented controlling- instruments, that allow to plan and navigate the company on an operative level, have to be added to the original shareholder value approach¹⁹. The result is called VBPMS.

VBPMS have one feature in common. They try to maximize the value of the enterprise in sight of the Shareholder. That means they try to maximize the sum of share- price appreciations and dividends. All other Stakeholders are only considered as far as their objectives are contained in these of the Shareholders²⁰. Rappaport argued that creating shareholder value is the only social responsibility of an enterprise because of “corporate management [..] has neither the political legitimacy nor the expertise to decide what is in the social interest.”²¹. He even expressed the assumption that “the stakeholder model [..] makes it easier for corporate managers to justify uneconomic diversification …”²². That could lead to the conclusion that considering other Stakeholders than Shareholders at the target system of a company would be wrong. Such a conclusion is wrong. On the contrary, the target system of a company depends on its culture which is influenced by the key- stakeholders over years (see also chapter 2.1). Therefore the decision, what kind of model is the right one for a certain company, is not a question of the best model, it is a question about which model fits better to the company’s culture. In this matter, it also has to be pointed out that the differences between Stakeholder and Shareholder models are not as clear as it seems at first sight. Much more Shareholder models have to regard for objectives of other stakeholders²³ as well as Stakeholder models have to regard those of the Shareholders²⁴.

Interim result: VBPMS are Shareholder models. Therefore they fit best to companies with a mission that mainly considers Shareholders objectives. Other Stakeholders are considered as far as it is necessary to optimise shareholder value.

4 The Discounted Cash Flow Method - DCF

This chapter will introduce to the DCF- Method as a certain VBPMS. The original approach of this VBPMS comes from Rappaport²⁵. The DCF- Method as a VBPMS has to plan, navigate and monitor the performance of a company or a division. These three functions will be investigated in the next chapters after an introduction to the DCF.

4.1 The principle of the DCF

As a VBPMS the DCF has to pursue the Shareholders’ objectives (see also chapter 3, p.3). Therefore the DCF assumes that the Shareholders’ objective is to maximize their returns from dividends and share- price appreciation. To quantify this objective Rappaport defines the figure Shareholder Value as the difference of corporate value and debts²⁶.

Shareholder value = Corporate value - Debt Debt “includes the market value of debt, unfounded pension liabilities, and the market value of other claims such as preferred stock.”²⁷. Corporate value is the value of the total firm or business unit and is calculated as the sum of the present value of cash flows from operations during the forecast period, the Residual value and Marketable securities²⁸.

Abbildung in dieser Leseprobe nicht enthalten

The difference between operating cash inflows and outflows is the operating cash flow. To calculate the present value of the cash flows from operations one has to discount them back to the present by a certain discount rate (from now on called WACC). The present value of all cash flows that occur after the forecast period is estimated by the residual value. Marketable securities represents “the current value of marketable securities and other investments that can be converted to cash and are not essential to operating the business.”²⁹. And those are therefore not included within the operating cash flows.

Interim result: Figure 7.3 will summarize the calculation of the Shareholder Value with the DCF.

4.2 How can the Shareholder Value be measured with the DCF

The previous chapter introduced the principles of the DCF. To measure the Shareholder Value of a real company or division, it is important to know how to derive the WACC (chapter 4.2.1), the operating Cash- Flows (chapter 4.2.2) and the residual value (chapter 4.2.3). The marketable securities will not be investigated separately because of their individuality .

4.2.1 WACC

Rappaport suggests the WACC as the discount rate for discounting the Cash- flows and the residual value to the corporate value exclusive the marketable securities³⁰. The WACC estimates the yield that investors anticipate at least when investing their money³¹. It is the weighted average of the cost of equity and the cost of debt capital³². Rappaport emphasizes that the relative weights attached to debt and equity are “based on the proportions that the firm targets for its capital structure over the long term planning period”³³.

Abbildung in dieser Leseprobe nicht enthalten

The following three chapters will investigate the derivation of the cost of equity, of the cost of debt capital and of the capital structure.

4.2.1.1 The cost of equity

The cost of equity is estimated by the CAPM³⁴. The CAPM is originally an approach of the portfolio selection theory created in the 60th by Sharp, Lintner and Mossin³⁵. It derives the cost of equity from the risk- free rate “as reflected in the current yield available in government securities”³⁶ plus an additional equity risk premium. Assuming that the unsystematic risk of security papers can be diversificated by the investors³⁷, this equity risk premium has only to contain the individual security’s systematic risk relative to those of the market (as measured by the β - coefficient³⁸ ) and the estimated risk- premium of the market. Therefore it is calculated as:

Abbildung in dieser Leseprobe nicht enthalten

Risk free rate risk relative to these of the market risk premium of the market Obviously it is important for calculating the shareholder value of the company or of a division to derive their β - coefficients. In Germany, the estimatedβ - coefficients of the top- thirty of the DAX are published in the Handelsblatt and other stock exchange journals. All other companies and divisions have to use either analytical or analogical methods³⁹. Analogical methods assume that the beta of a company or a division can be estimated by that of a similar company (pure- play- beta), by that of a certain industry (industry beta) or by that of a certain group of companies that are similar to it (peer group beta). Analytical methods derive the demanded beta with linear regression from a single earning figure (earning beta), or from the fundamental characteristics of the company / division (fundamental beta). Another approach estimates the demanded beta directly as the quotient of the covariance of the equity return (company) or the return on investment (division) and the market rate (accounting beta)⁴⁰:

Abbildung in dieser Leseprobe nicht enthalten

All these approaches have one thing in common. They estimate the systematic risk of a company or division by historical values either of its return rates or of that from other similar companies. Because of using historical values, values from similar companies or predefined indicators⁴¹, all these methods do not consider the influences of risk management strategies in the company / division on their individual risk. They do not include the effect of individual strategies, decreasing the risk⁴².

Another problem is the correlation between the β - coefficients and the debt- equity- ratio (leverage). These effects have to be considered by comparing companies with each other. They are equations that support this conversion. A serious problem is that these connections make it necessary to know the capital structure (leverage) of a division, too⁴³. This capital structure has to be estimated, too and can not be calculated precisely (see chapter 4.2.1.3). Therefore the β - coefficient is only a roughage. Considering the influence from the β - coefficient on the cost of equity, will lead to the conclusion that cost of equity is derived imprecisely.

[...]

---

¹ Cf. Thompson, D, 1996: p.742

² Cf. Joyce/Woods, 2001: pp.94

³ Cf. Joyce/Woods, 2001: p.95

⁴ Cf. Freeman, R. E. (1984), p. 46

⁵ Cf. Grüning, M.(2002), pp. 31

⁶ Cf. Kaplan, R. / Norton, D. (1996)

⁷ Cf. Bea, F.X. / Dichtl, E. / Schweizer, M. (2000), pp. 229

⁸ Cf. Klingebiel, N. (1999), p. 13

⁹ Cf. Grüning, M. (2002), pp. 9;

¹⁰ see also Figure 7.2

¹¹ Cf. Grüning M. (2002), pp. 7

¹² Cf. Grüning M. (2002), pp. 21

¹³ Cf. Knorren, N. / Weber, J. (1997a), p.13

¹⁴ Cf. Kaplan, R. / Norton, D. (1992): p.72

¹⁵ Cf. Grüning M. (2002), p. 21

¹⁶ Cf. Klingebiel, N. (1999), p.17; Joyce, P. / Woods, A. (2001), p.81

¹⁷ Cf. Rappaport (1986)

¹⁸ Cf. Copeland, T./Koller, T./Murrin, J. (1991)

¹⁹ Cf. Brunner, J (1999), p.34

²⁰ Cf. Rappaport (1998), pp. 5

²¹ Cf. Rappaport (1998), p.5

²² Cf. Rappaport (1998), p.7

²³ e.g. contented Customers are a condition for growth and increasing turnover that have a great impact on the objectives of the Shareholders

²⁴ all long term Stakeholders targets depends on the survival of the company.

²⁵ Cf. Rappaport (1998) and the german translation Rappaport (1999)

²⁶ Cf. Rappaport (1998), p.33

²⁷ cited from Rappaport (1998), p.33

²⁸ Cf. Rappaport (1998), pp. 33; Rappaport (1999), pp. 40

²⁹ cited from Rappaport (1998), p.33

³⁰ Rappaport (1998): pp. 37

³¹ This is the main difference between the DCF and the method of capitalizing value of potential earnings. Cf. Behringer (2001), p.139

³² WACC is the abbreviation of weighted average cost of capital.

³³ cited from Rappaport (1998), p.37; This method is a simplification. Precisely, one had to differentiate between several periods of time. Considering the different planed capital structures over the time, cost of capital had been calculated seperately the for each period (r1, r2,…, rn) to discount the Cash flows and the residual value.

³⁴ Another approach to estimate the cost of equity is the Arbitrage Pricing Theory (APT). Here, the cost of equity is a multilinear regression of several influencing factors. E.g. capital structure, specific constants for the market, the branch,…However the CAPM is often used in praxis (Raster, M. (1995), p.66

³⁵ Sharpe (1964); Lintner (1965); Mossin (1966)

³⁶ cited from Rappaport (1998), p.38

³⁷ Cf. AKFin (1996), p.548

³⁸ cov(r i r, M) 2 β = σ M; ri = estimated rate of equity; rM = estimated market rate, σ = variance of the market rate

³⁹ Cf. AKFin (1996),pp.552; Raster, M. (1995), pp.88

⁴⁰ Raster, M. (1995), p.92

⁴¹ used by the fundamental beta

⁴² Perhaps, the fundamental beta is able to do so. But it will only consider risk factors that are already known.

⁴³ The beta of a division has also to be adapted to a certain leverage, because the leverage influences this beta, because of the financing risk.