Creating and destroying value explained

In economics, the value of a company is known as its enterprise value and is the net present value (NPV) of the company’s future free cash flows discounted by its weighted average opportunity cost of capital (WACC). Value is said to be created whenever a company’s enterprise value increases and value is said to be destroyed whenever the enterprise value of the company decreases. Investments with a positive NPV, or an Internal Rate of Return (IRR) greater than a company’s WACC, create value whereas investments with a negative NPV, or an IRR less than a company’s WACC, destroy value.

It is, however, incorrect to conclude that a company that increases its profit (or free casg flow) in any given year has created value, or that a company where profitability (or free cash flow) has decreased, has destroyed value. This is because profit (and free cash flow) in any given year is a single period measure whereas the enterprise value of a company is determined by its future discounted free cash flow performance. Indeed, a company that increases its profitability (or free cash flow) in one year may in fact be destroying value. Such a situation could arise if the company were either making insufficient investments to retain its competitiveness or has made a misguided value destroying investment decision. Similarly, a company where profitability (or free cash flow) decreased in any given year, may be creating value by virtue of it improving its ability to compete or because it has made a number of value creating investment decisions whose financial benefits have yet to materialise in the current year’s profit and loss account.

Learn more about creating and destroying shareholder value.

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