4. Operational Definitions

4.1 Introduction

In this chapter we shall formalise the operational definitions of various concepts and

variables which have been used in the research. These variables have been used by

various researchers in their earlier research, though, not all together. Various

researchers who have used them in their research earlier have been mentioned in the

literature review chapter.

The variable definitions are different for different authors. We have picked up the

definitions that are most logically appropriately suitable to our research.

4.2 Shareholder Value Creation

There are a lot of authors like Marshall, Rappaport, Stern, Stewart, Chen, Fernandez,

etc. who have defined shareholder value creation as "an excess return over the cost

of capital".

What differs between the authors is the definition of the words "return" and "cost of

capital".

Alfred Marshall in his theory of "residual income" defines return as "profit after

tax" and cost of capital to be "cost of equity".

Rapport in his theory of "Shareholder Value Added" considers "increase in market

value" as shareholder value added and does not consider cost of equity at all.

Stern, Stewart & company that own the trademarks "EVA" consider "net operating

profit after tax" as return and "weighted average cost of capital" as cost of capital.

Pablo Fernandez has considered Rappaport's theory of "shareholder value added"

with minor modifications as return and considered "cost of equity" as the cost of

capital.

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Oncrease.,of4 Equity Ki-rk.ef L>

Since EVA and PFM consider all the possible definitions of "return" and "cost of

capital" given by various authors, these have been considered to be our definitions of

shareholder value creation for the purposes of research.

For instance (Maddin, 1996) used Market Value Added (MVA) as the difference in

index at two points of time. Whereas (Alfred Rappaport) in his book "Creating -

Shareholder Value" has defined MVA as excess of Market Value to Book Value. We

found the definition of Rappaport to be more convincing and thus, we have used this

as a definition for the research.

Some variables have also been tweaked. So this difference in interpretation of various

authors and our adoption of the same and tweaking of a few variables is explained

wherever it is done while giving operational definitions below.

4.3 Pablo Fernandez Model

PFM is a model of measuring Shareholder Value Creation as proposed by a famous

Lain American economist Pablo Fernandez. He professed on calculating Shareholder

Value base on the market price. According to Pablo the market price reflects all the

information and the information is available to all at the same time.

His model is as follow:

Figure 4.1: PFM Model

I. Equity Market Value: Equity Market Value is a price of the company

stock on the bourses. In our study we have taken NSE;

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II. Increase in Market Value : Increase in Market Value is calculated as:

Imv = (Pt — Pt-i) Pt-i

Where;

• lIVIV = Increased Market Value

• Pt = Price of the stock today;

• Pt-i = Price of the stock one year before

III. Shareholder Value Added (SVA): Shareholder Value is calculated as

SVA =IIMV + DIV + Bonus + OP — Outlays — Cony t-i

Where,

• SVA = Shareholder Value Added

• IMV = Increased Market Value;

• DIV = Dividend paid by the company in the year;

• Bonus = Bonus shares issued

• OP = Other payments to Shareholders such as Sharebuybacks,

discount on issue of share,

• Outlays = Outlays by Shareholders like increase in capital,

exercise of options, warrants, etc.

• Cony. = Conversion of convertible debentures, etc

IV. Shareholder Return (SR) = Shareholder Return is calculated as under:

SVA SR = n

t-1

Where,

• SR = Shareholder Return;

• SVA = Shareholder Value Added;

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• Pt_l= Market Price at the beginning of the year

V. Required return on Equity = Required Return on Equity is calculated

using Capital Asset Pricing Model (CAPM)

Ke= rf + (rn, — rf)

Where,

• Ke= Cost of Equity;

• rf=Risk free rate of return;

• /3 = Beta of the stock

• rn, = Market Return i.e. return that is given by the Index;

Market Return is calculated as:

MR = (It— It_i)± (It_i)

Where It= Index today;

It_i = Index one year back

VI. Created Shareholder Value = Created Shareholder Value is the excess of

Shareholder Return over the Required Rate of Return on the equity. It is

calculated as follows:

SVC = EMV X (SR — Ke)

or

SVC = SVA— (EMV X Ke)

Where,

• SVC = Shareholder Value Created;

• EMV = Equity Market Value. Equity Market Value is calculated as:

EMV = MP X OS

Where,

• MP = Market Price of a stock;

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• OS = Outstanding Shares

• If = Cost of Equity;

The following points need to be noted here:

1. The market price is the closing price on the NSE. The rationale for taking

NIFTY and NSE is because as Index N11-1Y is more broad based and NSE

has higher turnover in comparison to other markets in the country;

2. Outstanding shares are the shares outstanding in that particular company as

on 31st March of that particular year;

3. For the purposes of calculating risk free rate of return we have taken a

weighted average yield of 364 day treasury bill of that particular year;

4. Market return is the return on NLI. I Y;

5. (3 values are a covariance of the individual stock returns with NIFTY

return.

4.4. Economic Value Added (EVA)

EVATm is an improvement over the concept of "Residual Income" by noted

economist Alfred Marshall. This is concept which is popularized and copyrighted by

Stern, Stewart & co. It is excess of Operating Profit after Tax over the Weighted

Average Cost of Capital. It is, thus, calculated as follows:

EVA = NOPAT —WACC

Where,

• EVA = Economic Value Added;

• NOPAT = Net Operating Profit after Tax. Though, Stern and Stewart have

recommended about 160 manipulations to the accounting figures, practically

there are not more than 5 manipulations practiced in real life (Weaver, 2001).

These are:

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1. Other Income is not included;

2. Depreciation and non cash expenses are added back;

3. Non operating expenses are excluded;

4. Interest is not considered;

5. Tax (Tax and Fringe Benefit Tax is deducted but deferred tax is not

considered)

• WACC = Weighted Average Cost of Capital is calculated by calculating total

cost of capital and taking a weighted average.

WACC = (D X I) (K p X P) (K e X E)

(D+P+E)

Where,

• WACC = Weighted Average Cost of Capital;

• D = Total Debt;

• I = Interest;

• Kp = Preference Dividend;

• P = Preference Capital;

• E = Total Shareholder's Funds calculated as Paid up Equity Capital

plus Reserves and Surplus;

• K,= Cost of Equity as calculated by using CAPM.

Following points may be noted here:

1. A lot of researchers have not considered financial institutions, banks, non

banking finance companies (NBFC) while conducting research on EVA.

We have, however, included all the finance sector companies which were a

part of NIFTY.;

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2. While calculating EVA for these companies we have used our rationales as

actual calculation of EVA for finance companies is not available in the any

of the publicly available research;

3. Our rationale while calculating was that money was a commodity and

interest expended and interest spent is a part of finance company

operations specially banks and thus, we have considered interest earned

and interest expended while calculating Net operating profit after tax;

4. For Indian companies we need to make only 5 manipulations is again not a

part of any literature earlier but from our understanding of accounting and

as per Indian Accounting Standards.

4.5 Net Operating Profit after Tax (NPAT)

Net profit after tax is a traditional accounting measure calculated as:

NPAT = (Revenue + Non operating Income)

— (Operating Expenses + Non operating Expense + Tax)

This is taken straight from the company records on Capitaline a financial

statements database by capital markets.

4.6 Earnings per Share (EPS)

EPS is again a traditional accounting method and taken straight from the company

records on Capitaline a financial statements database by capital markets. It is

calculated as:

EPS = NPAT OS

Where;

• EPS = Earnings per share;

• NPAT = Net Profit after Tax;

• OS = Outstanding shares

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4.7 Earnings before Interest, Depreciation & Tax Margin (EBIDTAM)

This is again a traditional accounting method and taken straight from the company

records on Capitaline a financial statements database by capital markets. It is

calculated as:

EBIDTAM = (EBIDTA ± Sales) x 100

Where:

• EBIDTAM = Earnings before Interest, Depreciation and Tax Margin;

• EBIDTA = Earnings before Interest, Depreciation and Tax

4.8 Earnings before Interest and Tax Margin (EBITM)

A few researcher such as (weaver, 2001); (Maddin, 1996) used this variable along

with EBIDTAM as absence of depreciation in their opinion made a significant impact

on the final analysis. We have, therefore, considered this. It is calculated as:

EBITM = (EBIT ÷ Sales) x 100

Where,

• EBITM = Earnings before Interest and Tax Margin;

• EBIT = Earnings before Interest & Tax

4.9 Earnings before Depreciation and Tax Margin (EBDTM)

There was a paper by (Mishra and Goyal, 2005) who felt that interest was a financial

charge and should be considered while considering traditional accounting measures.

We have, thus, considered this. This is nothing but Earnings after interest but before

depreciation and tax. It is calculated as follows:

EBDTM = (EBDT ± Sales) x 100

Where,

• EBDTM = Earnings before Depreciation and Tax Margin;

• EBDT = Earnings before Depreciation and Tax

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4.10 Return on Capital Employed (RoCE)

Return on capital employed is again a regular traditional accounting method which we

picked up straight from the company records. It is calculated as follows:

ROCE = (NPAT CE) x 100

Where:

• ROCE = Return on Capital Employed;

• CE = Capital Employed which is equal to Debt plus Equity capital

4.11 Return on Net Worth (RoNW)

Return on Networth is yet another traditional accounting measure which is taken from

the company records. It is calculated as follows:

RONW = (NPAT TNW) x 100

Where:

• RONVV = Return on Networth;

• NPAT = Net Profit after Tax;

• TNVV = Tangible Networth which is calculated as follows:

TNW = GNW — IA

Where:

o TNVV = Tangible Networth;

o GNVV = Gross Networth calculated as Capital (Preference + Equity)

plus reserves and surplus;

o IA = Intangible Assets like Goodwill, Patents, etc.

4.12 Return on Equity (RoE)

Return on Equity is a traditional accounting variable used by almost all the

researchers. It has also been taken from the records of the company. It is calculated

as:

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RoE = (PAT ÷ NW) x 100

Where,

• RoE = Return on Equity;

• PAT = Profit after Tax;

• NW = Net Worth

4.13 Net Profit after Tax Margin (NPM)

It is net profit margin. It is calculated as:

NPM = (NPAT ÷ Sales) x 100

4.14 Reported Net Profit after Tax

This is the absolute figure of Net Profit after Tax. We have taken it from the profit

and loss account of the companies.

4.15 Book Value (BV)

Book Value of the share is a most important variable as it is important from the point

of view of calculating MVA. Also BV by itself is used as a dependent variable to

ascertain if it explains the Market Value Added better than others. This figure is also

taken from the financial details of the company. It is calculated as:

BV = TNW OS

Where;

• BV = Book Value;

• TNW = Tangible Net Worth;

• OS = Outstanding number of Equity Shares

4.16 Market Value (MV)

Market Value is the price at which the share is traded on the NSE. This is important

variable for us to calculate PFM and MVA. We have taken closing prices of the

shares on the NSE web site.

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4.17 Debt Equity Ratio

Also called as leverage ratio (Pandey, 2010) is used as a proxy for Capital Structure.

Debt Equity Ratio is taken from the financial statement of the company (Balance

Sheet). It is calculated as:

DER = TOL NW

Where;

• DER = Debt Equity Ratio;

• TOL = Total Outside Liabilities;

• NW = Net Worth

4.18 Managerial Remuneration

This variable is a very interesting study used by researchers such as (Riceman,

Cahan and Lal, 2002 and Dimitris, Kyriazis and Anastassis, 2005). Managerial

Remuneration is defined by them as the remuneration paid to Board of Directors. We

have taken this figure form the company profit and loss account.

4.19 Dividend

Dividend has been a debatable issue for antiquity. Right from the era of Modigliani &

Miller and Walter and Gordon, relevance of Dividend is debated. The importance of

Dividend is also pointed out in the literature review chapter. The dividend is a figure

taken from financial statements of the companies.

4.20 Market Value Added (MVA)

Increase in Market Value or Market Value Added (MVA): Market Value Added is

calculated as excess of Market Value over Book Value. The rationale is if a share is

trading above the book value then what is the factor that explains the premium. Thus,

it is calculated as:

MVA = MV — BV

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Where,

• MVA = Market Value Added;

• MV = Market Value;

• BV = Book Value

4.21 EVA Is a Performance Metric

To understand economic profit, it helps to distinguish between a performance metric

and a wealth metric. A performance metric refers to a measure under company

control, such as earnings or return on capital. A wealth metric, on the other hand, is a

measure of value that - such as equity market capitalization or the price-to-earnings

(P/E) multiple -depends on the stock market's collective and forward-looking view.

Now, although these two types of metrics are distinct, they are related.

Every performance metric has a corresponding wealth metric. In theory, over the long

run, a performance metric can be expected to impact its corresponding wealth metric.

For example, consider the matching pair of earnings per share (EPS), a fundamental

performance metric, and the P/E multiple, its corresponding wealth metric. The

variables that determine EPS - earnings and shares outstanding - are numbers affected

only by the company's actions and decisions. On the other hand, the P/E multiple,

which is determined by the company's stock price, depends on the value of these

actions and decisions assigned by the stock market. The company therefore influences

the P/E ratio but cannot fully control it. Here is another way to think about the

difference between the two: EPS is a current (or historical) fact but P/E is a forward-

looking and collective opinion.

The key criterion for the pairing of a performance and wealth metric is consistency:

each half of the pair should reference the same group of capital hdders and their

respective claims' on company assets. For example, EPS by definition concerns the

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allocation of earnings to common shareholders; the P/E multiple refers to equity

market capitalization, which is the value held by shareholders.

Consider another example: return on capital (ROC) is a performance metric that

represents the return both to debt and stockholders, and its corresponding wealth

metric is the EBITDA multiple - the value of total debt, plus equity market

capitalization (also known as the "enterprise value" or "entity value"), divided

by earnings before interest, taxes, depreciation and amortization (EBITDA). This is

also called the "price-to-EBIDTA multiple", or "the enterprise multiple". Note how

ROC and the EBITDA multiple meet the consistency test. Like ROC, EBITDA

captures earnings that accrue to both holders of stock and debt. The EBITDA

multiple, therefore, reveals how the market values the company in light of earnings to

stockholders and debt-holders.

Below is a chart listing a few performance metrics and their corresponding wealth

metrics. Note that economic profit's corresponding wealth metric is market value

added (MVA). We explore this relationship below as we come to understand

specifically what economic value is and how works:

Table 4.1: Performance and wealth metrics:

Performance metric . Wealth metric

Return on Equity (ROE), EPS growth P/E Ratio

Return on Capital (ROC or ROIC), Operating Income Growth

Ratio of: Entity value ÷ EBITDA

Economic Profit (For us it is EVA) Market Value Added (MVA)

Free Cash Flow Equity Market Capitalization (price x common shares outstanding)

Cash Flow Return on Investment (CFROI)

Total Shareholder Return (TSR)

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(Rappaport, 1960, Stern, and Stewart, 1991) used this as a wealth metrics, which is

followed in the research as well as there was no evidence to think contrary.

The wealth metrics typically becomes the dependent variable and all the other

variables are independent variables.

It must also be noted that as per the established finance literature market whether _

satisfies Efficient Market Hypothesis "Strong" or "Semi strong" form does reflect

almost all the information in the market price. Only the "weak" form of efficient

market hypothesis says that "all the possible information is not reflected in the market

price". It has been stated in the literature review Indian markets project "semi strong"

theory efficient market hypothesis.

Therefore, we found MVA to be a suitable dependent variable to relate all the

independent variables and test the hypothesis listed out in the research methodology

chapter.

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