Any business model that can be done on a brief spreadsheet, such as our restaurant model in the previous chapter, can be done shorthand. In 1999 I developed the Value Equation, or V-Formula, a tool that incorporates the Six Variables into a shortcut designed to compute corporate pre-tax current equity returns (ROE) as follows:¹

Now, here is the V-Formula applied to the restaurant business case study from the prior chapter:

EVA and EMVA

The idea for creating a value equation came from my appreciation for the concept of economic value added (EVA), which was developed by consulting firm Stern Stewart & Co. and detailed by G. Bennett Stewart in his 1991 book The Quest for Value. The basic idea behind EVA was to take a financial approach to a corporate income statement, much as we did in the previous chapter. However, when computing EVA, you would not simply have a cost of OPM, but would also have an equity charge for the expected cost of equity. Then, to the extent you still had a profit from operations, that profit would be the amount by which your results from business operations exceeded your cost of capital (OPM and equity). The result is EVA. Over time, EVA accumulation translates into market value added (MVA), which is the amount a company is worth in excess of its cost to create. Unsurprisingly, the notions of EVA and MVA have garnered the attention of shareholder representation groups as a leading metric for corporate capital efficiency.

The primary beneficiaries of EVA creation are the equity investors in a company. Part of EVA creation may also go to OPM providers. However, if you compute your cost of OPM and discover that it exceeds the cost of OPM were you to get it today, who cares? Your OPM providers will have made a little money by having loans or leases worth more than they cost, which is fine.

I decided that trying to exceed my estimated current cost of capital was far less important than trying to exceed my current cost of equity. I also wanted a relative, easy-to-calculate metric, rather than an absolute hard number like EVA. I wanted to know my current pre-tax rate of return on equity and conceived the V-Formula to do just that. More than this, I wanted a metric that focused only on equity value creation, which was the inspiration for the formula. By understanding my current pre-tax equity return (in the case of our restaurant, 85%) and the return requirements investors might demand of a company having similar risks and growth prospects (in our case study, 20%), then I could calculate the equity market value added (EMVA) as follows:

Equity Market Value Added (EMVA) Computation

There are two more reasons why current equity returns and EMVA are more important to know than the overall cost of capital and EVA.

First, the two V-Formula variables associated with OPM (the percent of the company funded with OPM and the cost of the OPM) are less important variables. They are not part of the Big Three variables (sales, business investment, and operating profit margin) that collectively and individually have the greatest impact on equity returns.

Second, assuming highly informed business leadership, the degree of OPM's impact on equity rates of return tends to be rangebound. OPM providers are not all the same, but the differences they make on overall corporate capital stack composition tend to be limited, assuming business leaders well-versed in OPM alternatives.

Making the V-Formula Even Simpler

As you will see throughout this book, the framework created by the V-Formula is powerful. Within just the Six Variables lie all the financial levers at the hands of business leaders that impact corporate equity returns and shareholder wealth creation.

As simple as the V-Formula is, you can make it even easier. In the case of your restaurant, the relationship represented by the first two formula variables, sales ÷ business investment, can simply be represented by a ratio of 1.5 ($1,500,000 ÷ $1,000,000). This is a key measure of business efficiency. In your case, your restaurant gets $1.50 in sales for every $1.00 invested in the business. What if you could reduce your required business investment without impacting your sales so that the ratio of sales to business investment increases to 2:1? Your current pre-tax rate of return on equity would rise to 125%, as follows:

Likewise, I tend to think of annual maintenance capex requirements as a percentage of business investment, which is how the variable was introduced in the prior chapter. With your restaurant, a $20,000 annual maintenance capex cost is 2% of the $1 million in business investment. So just use that. If the maintenance capex requirement were to change to 4%, your current pre-tax equity returns would fall a bit, to 117%.

A lesson to be taken away from the above illustrations is that no numeric inputs are required to understand the ability of a corporate business model to produce current equity returns.

The potency of the V-Formula is centered in relative numeric relationships, such as the relationship between sales and business investment, or the relationship between maintenance capex and business investment. In terms of your capital stack, you are looking at the relationships between the percentage of the business investment funded with OPM and then between the portion of the business investment funded by OPM and the current cost of that OPM.

With the V-Formula reduced to simple relative numeric relationships, the same can be done with EMVA creation. Assuming the same investor current pre-tax return hurdle rate of 20%, then the equity valuation multiple rises from 4.25X from the initial 85% pre-tax rate of return to 5.85X at a current pre-tax rate of return of 117%. Of this amount, 4.85X (the equity valuation multiple minus 1) is EMVA creation, or just shy of 83% of your equity value. As a measurement of wealth creation efficiency, creating 4.85 dollars in wealth for each dollar of invested equity is unquestionably impressive. Now you have a business having equity valued at $1,462,500, meaning you have made $1,212,500 in EMVA over your initial $250,000 equity investment, and have achieved millionaire status with a single, high-performing restaurant.

What started out in the last chapter as a restaurant business model has now become a universal business performance and valuation model centered on relative numeric relationships.

Solving for Other V-Formula Variables

Any formula that can be done one way can be done backwards to solve for other variables. What if, for example, you wanted to invert your V-Formula to solve for the desired amount of OPM needed to achieve a required rate of return of 60%? In such a case, you could reduce your use of OPM from 75% in the preceding formula to just 47.1%, as follows:

V-Formula variants can be made to solve for desired business investment, operating profit margin, or OPM cost as well. One common metric businesspeople use to determine corporate risk is the ability to cover interest payments on OPM to arrive at an interest coverage ratio. Yes, there is a V-Formula variant for that, too!

As seen above, your company's current pre-tax cash flow could cover your interest and lease payments by 8.49X, which is extremely healthy. If we were to revert to the original example of your restaurant described in the prior chapter, using 75% OPM, a 2% annual maintenance capex spend, and a 1.5 sales-to-business investment ratio, you would still have a terrific interest coverage ratio of 4.1X. For reference, private company interest coverage ratios tend to hover in an area nearer to 2X.

Would it be possible for you to achieve Mort's Model and use just OPM and no equity? The answer is yes. If you took the initial restaurant business model at the beginning of this chapter and found a way to have OPM fund the full $1 million in business investment, your payment would be $90,000 and your restaurant would still throw off $190,000 annually in pre-tax cash flow, equating to an interest coverage ratio of 3.1X. The key would be getting someone to put up all the money (and at the same interest/lease rate), which is no simple task.

A fixed charge coverage ratio is a more important cousin to the ratio of interest coverage. This ratio computes the amount of times your company can meet its annual OPM payment obligations from operating cash flow. The difference between payments and interest is the amount of principal that must be paid. If you simply take the sum of your payments and divide them into the amount of OPM obtained, you will arrive at what is called a payment constant, which will be higher than the 9% interest/lease rate. If you were to use that payment constant in the denominator of the preceding formula, rather than the interest rate on OPM, you would arrive at a corporate fixed charge coverage ratio.

V-Formula Data Tables

I love data tables. In Excel, you can select to use one or two variables, which is my general preference. Of the six V-Formula variables, business leaders tend to focus the most attention on the first three. Sales, business investment, and operating profit margin are the biggest contributors to current equity returns. They are the Big Three variables. Of these, the first two (as we saw earlier) can be combined into a single efficiency ratio of sales to business investment. This means that you can make a two variable data table that incorporates the Big Three V-Formula variables as follows:

Current Pre-Tax ROE

The sales to business investment ratio of our restaurant starts out at 1.5:1, with an operating profit margin of 20%. The result is an 85% current pre-tax equity rate of return. Raise the ratio to 2:1 as illustrated earlier in this chapter, and you arrive at a current pre-tax equity rate of return of 125%. Raise the operating profit margin to 25%, while keeping the sales-business investment ratio at 2:1, and you now achieve a current pre-tax equity return of 165%.

Given that we have taken a restaurant business model introduced in the prior chapter, reduced it to the Six Variables formula, and then taken away the numbers, what remains is a Six Variable universal business model. So, the preceding table, given our remaining three V-Formula variables, effectively represents a universal business model truth when it comes to current ROE estimation. If you were to create but a single universal business model two-variable data table, this would be it.

Of course, behind the preceding data table is another important two-variable data table to estimate the equity value multiple of a business. Equity value multiples are the starting point for EMVA estimation, which is the measure of business wealth creation. In this case, the two variables used are simply the current pre-tax ROE and the current pre-tax ROE hurdle rate, which is the current return other investors would expect given investments having similar growth prospects and risk. In the case of the restaurant, which has a current pre-tax equity rate of return of 85% and an investor hurdle rate of 20%, the equity value multiple is 4.25X, which means the EMVA multiple is one less, or 3.25X. The blank parts of the table occur where the hurdle rates exceed the business returns, resulting in value destruction. With companies capable of growing operating profits rapidly, the Gordon Growth Model will tend to lessen investor hurdle rates to potentially low levels resulting in elevated equity value multiples. Like the earlier table, the equity value multiple data table is important, showing universal truths regarding the capabilities of businesses to create value.

Equity Value Multiple

When it comes to understanding the basics of corporate finance and value creation, I know of no better tool than the V-Formula. As I noted early on, there are potentially infinite ways to operate your business as you seek to elevate your corporate efficiency. But in a corporate business model, just Six Variables collaboratively work together to produce equity returns.