A Vision For The Future: In Conversation With Financial Strategists

This volume presents a collection of 15 interviews on strategic financial management with leading experts in the field, including various luminaries such as Tom Copeland, Merton Miller and Professor H. Markowitz. The interview covers a range of subjects from financial risk management to the question of whether transparency can be increased by improving the implementation of corporate governance. Dirk Swagerman provides information on how financial institutions have evolved, particularly in the wake of mammoth mergers, and the evolution of financial markets following the introduction of the euro.

Chapter 1: New Developments in Valuation

One of the most eminent authorities in the field of valuation is Tom Copeland, not least because of the fact that he is the co-author of the standard work in the field of valuation, i.e. the well-known valuation book that will be appearing in its third edition in the spring of 2000. Professor Copeland is the most appropriate person to ask which subjects are currently under discussion in the field of finance and financing. Are fundamental changes taking place or are the developments merely a temporary fad? The developments we are thinking about in this respect are value-based management, corporate governance, discussions about the basic valuation model, the modification of discounted cash flow model and the modification of the capital costs for smaller companies, as well as the separation of elements of financial risk and business risk in order to give them a separate valuation. Professor Tom Copeland is also the man who can best judge whether new valuation theories, such as the application of option theory on valuation and other financial decisions, will continue to be a subject that is confined to financial scientists or whether there is a possibility that they will break through to the everyday life of financial management. These are subjects that will be discussed with Professor Copeland.

Could you please say a little about your background?

Copeland: I gained a Bachelors' degree in economics from the John Hopkins University in Baltimore in 1968, an MBA from Wharton in 1969 and a PhD from the University of Pennsylvania in 1973. Between 1973 and 1987, I was a faculty member at UCLA's Anderson graduate school of management where I became a full professor and chairman of the department. Between 1987 and 1998, I was a partner at McKinsey & Co. in New York, where I was head of the corporate finance practice and since July 1998 I have been at Monitor, where I am a partner and also head of the corporate finance practice here. In addition, between 1988 and 1998 I was also adjunct professor at New York University and I have just been appointed adjunct professor at MIT where I will be teaching a course on financial engineering this coming winter. Why should accountants use the discounted cash flow method for valuation purposes?

Copeland: The first thing is to understand that the discounted cash flow valuation method is an entity or an enterprise approach where the cash flows from all sources of capital are valued and then one subtracts the value of debt to get the value of equity. The dividend discount model is an approach that is very similar in spirit. What it does is it takes the free cash flows to the shareholders, discounts them at the cost of equity and in fact one gets the same answer as with the enterprise approach.

There is an important additional consideration which is that both the discounted cash flow method and the dividend method are used to forecast the future cash flows, while the intrinsic value method uses historical information. Taking the book value of equity as an example, this has little to do with the market value of the equity and the ratio of market value to book value is rarely equal to one. There are in fact many companies that have negative intrinsic value if one is using the book value of equity as a measure. Book value is therefore not highly correlated with the market value of the company or the market value of the equity.

What is really new about value based management compared to methods used in the past?

Copeland: Value based management should first be defined. The general idea is to find measures of performance at the company level or the business unit level which are highly correlated with the changes in the value of the company, in other words with the total return to shareholders. In an ideal world, if you had measures of performance that were highly correlated with the total return to shareholders then you could link your actions on a daily basis in a very direct manner to the impact on the shareholders of the company. That has proved to be a very illusive ideal so I should mention three different approaches to value based management. The approach that has been very popular in recent years is an approach that has been developed by Stern Stewart from a New York company called EVA (Economic Value Added). The idea is to take the company's return on invested capital and compare it with the weighted average cost of capital for the company. The spread between those two numbers is multiplied by the amount of invested capital to come up with an economic value added figure. In my own publications I call this "economic profit" in honour of Lord Alfred Marshall who first wrote about the subject in 1896. Recent research that I have conducted shows that the correlation between economic profit and the total return to shareholders or between economic value added and the total return to shareholders indicate is very low, 5% or less. Furthermore, the change in economic profit or the change in economic value added when correlated to total return to shareholders also has very low correlation. The reason for this leads to a second definition of value based management, which I think is better than the first. The basic idea of this definition is that management should be looking at the difference between the return on invested capital they actually earn and the return on invested capital that the market expects them to earn. This is very different to comparing the return on invested capital to the weighted average cost of capital. To give an example, in October 1997 one of the world's most profitable companies, Intel, announced that its earnings were up 19% compared to the year before. So Intel has very positive economic profit...