explanatory variables
-The central explanatory variable: the free cash flow and its allocation The literature diverges on ways of measuring free cash flow as defined by Jensen (Lang et al., 1991). it is measured in various ways in empirical studies9. Whereas some authors define it as operational income before interest, tax and depreciation, divided by the book value of total assets in order to take account of effects linked to size (Lang et al., 1991), other authors adopt a different conception, which involves deducting interest charges, and even dividends paid, from cash flows. Lehn and poulsen (1989) determine the amount of free cash flow by deducting the total amount of tax from operational income before depreciation, given the variations in deferred taxation over the course of the year, the gross interest paid on short and long-term debt, the total amount of dividends paid on ordinary shares and of preferential dividends. gul and Tsui (1998), for their part, define this as operational income before depreciation, less the total amount of tax, gross interest spent on short and long-term debt, ordinary and preferential dividends, standardised, firstly, by the total book value of the shares, and secondly, by the total assets for the previous year. Nevertheless, the fact remains that these various measurements do not in themselves provide a measurement of the availability of projects with a positive net present value. In combination with a low level of growth, they suggest the existence of cash flow in excess of what is required for financing projects with a positive net present value.
9 See, for example, Lehn and Poulsen (1989), Lang et al. (1991), Agrawal and Jayaraman (1994), Gul and Tsui (1998), Jaggi and Gul (1999), Estridge and Lougee (2007).
The interpretation of free cash flow adopted in this study is fairly similar in spirit to the conception defended by Jensen, and is derived from the Corporate Focus Premium database, which calculates it as follows:
net operating profit (less adjusted tax) - increase in working capital
- capital expenditure
= free cash flow
This calculation method is certainly not exempt from criticism. It deducts the amount of investments made by companies from cash flow, the hypothesis being that the latter all present a positive net present value, which is obviously a simplification. nevertheless it has been used, because what is important here is to assess the nature of the allocation of discretionary funds, rather than their amount in terms of absolute value. Two independent variables are taken into account for this purpose, in accordance with the theories advanced:
- allocation to debt servicing: the capital repayment of the total financial debt (medium and long-term, as well as short-term) plus interest charges (over the period 2001-2005) is related to the global amount of free cash flow (over the period 2001-2005);
- allocation in the form of dividend distribution: the total dividend payment made (over the period 2001-2005) is related to the global amount of free cash flow (over the period 2001-2005).
- Investment and financing variables
investments were apprehended via expenditure on tangible fixed assets related to sales turnover excluding tax, on average, over the period 2001-2005.
it should be made clear that specific financing variables, such as a financial debt/
stockholders’ equity ratio, have not been introduced into the analysis, as one of the two alternative methods of assigning discretionary funds used in the study, i.e.
debt, is representative, in its own right, of companies’ financing policy (a variable which, as indicated above, takes the form of the financial debt capital repayment + financing costs/free cash flow ratio).
- Growth opportunities
Jensen’s theory requires that the “growth opportunities” variable be fully integrated into empirical analysis. The effectiveness of the disciplinary instruments that it proposes to use is contingent upon the particular situation of each firm. as indicated earlier, debt, or failing this, dividend distribution, are only effective in firms that are generating substantial free cash flows and have low growth opportunities.
The measurement of growth opportunities, which by definition cannot be observed, is the subject of debates in the literature, suggesting various alternative ways to do this10. myers (1984) reckons that the excess of the firm’s total value over the value of the assets in place constitutes a good approximation of this. One way of apprehending growth opportunities thus involves considering them in the light of the value creation perceived by the market, as share values are supposed to reflect the market’s anticipations of firms’ ability to create value, provided of course that the theory of market efficiency is adhered to. in this way, the Tobin’s Q, which relates the market value of a firm to the replacement value of its assets, is frequently used (Lang and Litzenberger, 1989). A q higher than one is supposed to show that a firm has profitable investment opportunities, and vice-versa.
Determining the market value of the debt and the replacement value of the asset, assuming that specific information is held, is usually one of its approximations that is used, a ratio relating the firm’s market value to the book value of its assets (smith and Watts, 1992; Bizjack et al.,1993) or the ratio relating the market value of the shares to their book value (Lewellen et al., 1987). However, this is not the way adopted in this study, given the obvious risks of a very strong correlation between this measurement and the dependant variable, both of which incorporate a measurement of the company’s market value. Other studies use the rise in sales turnover (Jensen et al., 1992; Agrawal and Jayaraman, 1994; Johnson, 1995), the variability of profits or the rate of return on assets (gaver and gaver, 1993; smith and Watts, 1992). again, this operationalisation method has not been adopted here, as a company’s sales turnover may increase without it necessarily making any new investments (especially if it operates at overcapacity), and also because other variables determining value creation, which are taken into account simultaneously in the study, involve similar or even identical measurement methods. Other measurements include the level of intensity of research and development, taking the view that investment opportunities are linked to expenditure on research and development, and the latter can then constitute an approximate measurement of this (Crutchley and Hansen, 1989; Jensen et al., 1992; Bizjack et al., 1993; Gaver and Gaver, 1993). In the end, this method was adopted in this study. Consequently,
10 see, for example, smith and Watts (1992), gaver and gaver (1993), skinner (1993), and also gul and Tsui (1998) for an application to the problematic of free cash flow.
the average level, over the period 2001-2005, of intangible assets in relation to total assets has been used here as an approximation of investment opportunities. This is an imperfect measurement: in addition to the fact that a company may commit a high level of expenditure to r & d without achieving a profitable outcome in the process, one major criticism concerns the accounting methods used to post intangible assets, by companies undertaking similar research and development expenditure, which may present different balance-sheet structures, depending on whether or not this type of expenditure is activated. Thus, the average level of intangible assets is only an imperfect reflection of the level of intensity of R&D expenditure. However, the unavailability of alternative measurements has obliged us to choose this measurement method. Its shortcomings mean that any interpretations of the results of a comparison between firms with weak and high growth opportunities must be scrutinised more vigilantly.
-economic variables
given that rappaport (1986) and copeland and al. (1991) recommend using firms’
levels of activity and margin as determining variables of shareholder value, growth in sales over the period 2001-2005 and gross operating margin, corresponding to the ratio of EBITDA to net sales (average level over the period 2001-2005), were also included in the analysis.
-Shareholding structure
The aim of the shareholding structure variable is to take into account the influence of shareholder quality on value creation. From this point of view, two categories of companies were distinguished, managed-owned and family firms, on the one hand, and managerial and controlled companies on the other. Asset-holding and family-owned companies were defined using a quantitative criterion based on two threshold levels: every company in which at least 20% of the share capital was controlled either directly or indirectly by one or more individuals, regardless of whether they belonged to the same family, was deemed to be a managed-owned and family-owned company11 however, in an attempt to be realistic, firms in which at least 10% of the share capital was controlled either directly or indirectly by one or more individuals, regardless of whether they belonged to the same family, provided that this asset-holding and family-owned shareholding represented a majority of the capital, in relative terms, were also, by extension, deemed to be managed-owned
11 see, for example, article L233-16 of the french commercial code: “a significant influence on the management and financial policy of a business is assumed to be exercised where a company owns, either directly or indirectly, a share equal to at least one fifth of the voting rights of this business”.
and family-owned companies. Conversely, any companies that did not meet these criteria were deemed to be managerial or controlled companies.
The quantitative criteria of capital ownership clearly suffer from several limitations, the first being the relativity of the notion of capital control, the second relating to the non-inclusion of qualitative factors, such as, for example, shareholders acting as managers or the intent to pass on the business to the next generation. In the absence of any reliable alternative criteria, these criteria have nevertheless been used.
-Size and sector of activity
In order to gain a comparative vision of the companies’ performance from a strictly financial point of view, and, by extension, of value creation, it is essential to take the effects of their size and sector of activity into account. A smaller size may indeed result in shareholders exercising greater control over the managers’ actions.
The size variable was measured using the logarithm of total assets (average value over the period 2001-2005). Companies’ value creation also has to be assessed in relation to the performance of the sector overall. This variable was therefore taken into account in the form of grouping the firms making up the sample into two categories: those belonging to the industrial sector and those belonging to the commercial and service sector12.
although it presents several practical difficulties – changes in industry classifications over the course of time or the small number of companies in certain industries make any comparison difficult – it nevertheless appeared necessary to take this variable into account.
The dependant variable: value creation
Shareholder value creation was assessed in two ways.
First of all, it was assessed by a stock-market value-added indicator, inspired by Stewart’s “Market Value Added” (MVA) method (1991), which measures the wealth creation accumulated by the company based all of the funds committed by investors. a simplified version of the stock-market value-added indicator had to be used, compared to the version defended by Stewart (1991). The many accounting restatements or adjustments used to report the total amount of stable resources regarded by Stewart as wealth-creating have not been used, for reasons both
12 The regrouping of the companies in two categories, according to their branch of industry, appears simplifying, but seems to be able to be justified insofar as the branch of industry is a simple control variable.
of substance and form. Insofar as the research does not strictly apply the MVA concept to French companies, it undoubtedly loses some of its interest, although it gains here in terms of operationality, as the data-gathering necessitated by the restatements would have been made more problematic, and the exercise would have been more difficult in terms of scientific and methodological rigour, because inter-company comparisons, which would paradoxically have been made more problematic by a more detailed approach to the notion of value creation, prove to be more pertinent. The relative stock-market value added in 2005, relating the difference between the market value and the book value of the capital employed to the book value of this capital, was the figure calculated.
Shareholder value creation was then apprehended using the Marris ratio, which represents a measurement of anticipated value creation. This ratio is calculated by the relationship between the stock-market value and the book value of the stockholders’ equity. The value observed in 2005 was incorporated into the study.
Table n°1 provides a summary of all the variables used in the study.
Table no. 1 : Summary presentation of the variables of the study
Variables to be explained: value creation
MVA MARRiS
Market Value Added: (Market value of capital employed-book value of capital employed)/book value of capital employed (2005) (*)
Ratio of Marris: (Market value of equity/accounting value of equity) (2005) Explanatory and control variables
FCFDE Allocation of the free cash flow to the debt servicing
(financial debt amortisation+interest and similar charges) /free cash flow (2001-2005) FCFDi Allocation of the free cash flow to the distribution of dividends
dividends paid/free cash flow (2001-2005) inV investment policy
Capital expenditure/net sales (2001-2005) GRoWTHGrowth opportunities
Intangibles/total assets (2001-2005) ACTi
MBE
oWn
SiZE
SECToR
Activity level
Growth in sales turnover (2001-2005) Gross operating margin
EBITDA/net sales (2001-2005)
Share-ownership variables, 0=not an owned-managed or family-owned company, 1=owned-managed or family-owned company
Owned-managed or family-owned company: more than 20% (or 10%) of the capital owned by one or more individuals, whether or not linked by family ties.
Not an owned-managed or family-owned company: less than 20% (or 10%) of the capital owned by one or more individuals
Size
Total assets logarithm (2001-2005) Sector of activity
0=industry, 1=commerce+services
*Market value of capital employed: stock-market capitalisation +book value of other sources of financing (minority interests+provisions for liabilities and charges+ financial debts)
Book value of capital employed: equity capital+minority interests+provisions for liabilities and charges+ financial debts
Admittedly, the ideal situation would have been to use several proxies in the study, so as not to rule out the various possible options for measuring variables.
Unfortunately, this ambition quickly came up against several methodological problems. Thus, it proved impossible to use other proxies to assign FCF in the form of debt and dividend distribution, and likewise for shareholder value creation, for reasons linked to the non-availability of additional data.