Companies that consistently create added value efficiently tend to show excellent share price performance over periods of three to four years or more. This means that investors can use value-added (VA) data to help select a portfolio of companies that should perform better than the market. VA data on individual companies used to be difficult to find, but there is now a very useful, freely available database of information going back several years for larger UK and continental European companies.
A company's 'value added' is its sales less the cost of all the goods and services it buys in. VA measures the amount of wealth created, but does not explain how efficient the company is at creating it. This efficiency is measured by the ratio of the output (wealth or VA) to the major inputs (the cost of the employees plus the cost of the equipment 'used up' during the year – the depreciation). This ratio is a productivity measure called the wealth-creation efficiency and is termed P2. VA and P2 can be tricky to calculate, but are listed each year for the top 800 UK companies at www.innovation.gov.uk/value_added (The Value Added Scoreboard). We will use VA and P2 to select a diverse group of large and efficient UK companies and then see how such a value-added portfolio performs over a four-year period in comparison with the FTSE 100.
Selecting Sector-Leading FTSE 100 Companies
The simplest company selection technique based on VA is to pick a FTSE 100 company with a high P2 from each sector, provided the company can also grow and its P2 value is above the all-sector average. This last condition ensures that a low P2 company is not picked from a sector where all the large companies have low values of P2. The other condition – growth – requires that the company should have increased its VA over the previous year (or, in difficult years, at least not shown a significant reduction).
What companies emerge from such a simple selection process and how do they perform? To illustrate the process with an example, we use data from the 2004 VA Scoreboard, which gives values of VA and P2 for the top 800 UK companies as of January 2004. The data refers to full-year company accounts for the 2002-03 financial year. This was a relatively low point for the UK stock market, with the FTSE 100 standing at about 4500. Many companies had experienced a downturn since 2000-01 (the end of the dot-com bubble). The specific company selection criteria used were:
• Select one FTSE 100 company with the highest value of the P2 wealth creation efficiency from the top 8 companies in each sector provided that:
• The company has P2 over 143.8 per cent, the all-sector average for that year (to avoid selecting the least poor company from a poor sector);
• The company increased its VA over the previous year (or did not reduce it by more than 4 per cent given that 2002-03 was a relatively difficult year);
• The company had VA over £350m for sectors where there were less than eight companies;
• We include qualifying companies listed in the 2004 Scoreboard that were taken over after January 2004, for example BAA and Hanson.
So how did the system fare? To find out, see the second part of this feature:
You'll need to be a registered user to read this. Registration is free and takes just a few moments - click here for more details.
