Home > Ownership Culture > Articles Online >

A Simple Exercise for Explaining Corporate Value

There is nothing more important for employees to understand about being an owner than how value in the company is created. Understanding that value requires understanding price to earnings ratios. Once people grasp this basic concept, they can see why it is so important to grow the bottom line. After all, increases in profits usually result in increases in share value several times the dollar value of these added earnings. Explaining the price-to-earnings ratio and its impact on stock prices, can seem a daunting task. In NCEO meetings with employees, however, we have found a simple exercise does the trick pretty well. Here’s how it works.

The Setup

Ask employees to sit in circles of four to eight people, dividing their group into buyers and sellers. One person should be designated to report back the results of the discussion to the whole group. Now tell employees to imagine that the buyers want to buy the rights to 50% of the future income of the sellers. Tell them the sellers currently make $30,000 per year, are in good health, and plan to work for at least another 10 years. Beyond that, they can make any assumptions they like about the economy in general, the seller's future job prospects, inflation, or anything else. Employees should be given 15 minutes to negotiate a sale price. They will ask questions about just what they should assume, but let them decide what assumptions to make; making this exercise too specific will decrease its value. When the 15 minutes are up, ask each group’s reporter to tell the price they agreed on. Write these on something everyone can see. Then ask each group (or a sampling if time does not permit asking everyone) to explain the reasoning behind their results. Ask questions to find out what assumptions, if any, they made about such things as inflation, pay increases, alternative investments the buyers could make, risks to the buyer and seller, job security, etc.

Putting the Numbers in a Corporate Context

The numbers will usually vary widely, as will people's assumptions. Most groups will at least have tried to come to grips with the basic concept that someone will pay some multiple of current earnings today to get the right to those earnings in the future. The moderator now needs to explain some of the things that will make this number vary, including:

How much someone could make in real dollars investing in something else: Buyers must ask themselves "what else could I do with this money and how much would I make doing it?"
Risk: Knowing how much alternative investments could make, buyers now need to assess their relative risks. Show employees how when the risk of an investment increases, the needed rate of return does as well. A CD has little risk and a low rate of return; bonds have more; stocks even more; individual companies the most. Where does investing in one individual fit? What are the risks? Ask employees now to think about what rate of return they would expect from an investment in an individual employee.
Inflation: Inflation is essentially another risk factor. The higher it is, the higher the rate of return needs to be. Moreover, inflation erodes the value of future earnings. Earnings 10 years from now, in current dollars, are worth a great deal less under inflation rates of 5%, for instance; after 15 or 20 years, almost any rate of inflation makes the "present value" of these future dollars negligible unless future earnings increase faster than inflation does. Thus, it may be relatively unimportant how long people assume a person works over 10 years.
Expected future earnings: What someone makes today is a good indicator of what they will make in the future, but not a perfect one. What factors can cause current earnings to change?
Time horizon for the investment: Does the investor expect to invest for a long period of time or a short one?

Once these issues have been discussed, it is easy to move to the company parallel. Like the individual, companies have earnings, and they are subject to variation in part due to general market conditions and in part due to the efforts of the individuals who make up the organization. If these earnings are going steadily uphill, people will pay more (explain why). Just as in the individual earnings scenario, investors will also assess their alternative investments to determine a minimum rate of return, based on inflation expectations, risk assessments, and their time horizon.

For instance, say the investor wants a 20% annual return. Then the investor will pay five times an individual’s (or company’s) earnings. That’s because if a company makes $1 million, and the investor pays $5 million, 20% of $5 million is $1 million. You can show now how if earnings go up, the price-to-earnings ratio will go up as well, and, even better, if earnings are on an uphill slant, the ratio will go much higher. For employees, this is the real payoff: by increasing earnings, their share value grows not by the value of the increment in earnings, but by a multiple of it. Nothing communicates employee ownership as well.

^^Top of Page