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By providing a consistent strategic focus, Value-Based Management is a tool to enhance the techniques through which corporate value is improved.
Every day, people at all organizational levels make decisions that affect their company's value - yet the link between these decisions and change in company value is often not made. Without this link, how can companies be sure the decisions being made are increasing value - the single most important measure of a company's success? Value-Based Management can foster this link by providing three things:
Corporate value is created when the returns on investments are greater than the cost of the capital required to make the investments. The trick is ensuring that everything that is done in the organization adds value to it, and galvanizes everyone to work towards the over-riding aim of growing long-term shareholder value.
Like beauty, value tends to be in the eye of the beholder. You can't exactly appraise any business until you answer two questions: Value to whom and for what purpose? That being said, there are four generally accepted methods of valuation. Each is a correct way of establishing value, and whichever method is used will depend on the particular circumstances, and whether the valuation is being made by a seller or a buyer.
It employs two concepts, these being Shareholder Value ( SV ) and Shareholder Value Added ( SVA ).
The first, Shareholder Value looks at the long-term cash flows generated by an organisation's business units and discounts them back to today's value at the cost of capital. This is also known as free cash flow.
The second, Shareholder Value Added is principally concerned with ensuring that the return from the assets in which management has invested is greater than the cost of the funds invested. This is logical, since management is expected to invest funds in assets and projects that meet shareholder expectations. So while SV delivers a long-term strategic perspective that relates to share value, SVA helps the decision-making process at the level of individual projects and investments. It drives short and medium-term management behaviour - essentially functioning as a day-today management tool to provide a focus for operational improvement aligned with investment decisions. So, Value Based Management can be viewed as an approach to improving SVA as a management tool.
To use a simple example, if someone borrows £1,000 from a bank for one year at an interest rate of 10% ( the cost of capital ), £100 in interest will be paid. If the capital is invested in a business that makes a profit of £150, that return is 15% of the capital. The value added is £50, £150 profit less the interest of £100, or 5% of capital. So it is important to differentiate between return on investment and value added.
But a business has to make more money with the amount it has borrowed than the cost of borrowing it. This is because shareholders will expect a premium on the return compared with a safer investment such as government bonds. So applying the criterion that a prudent investor would use is a much tougher measure of the real performance of a business than profit alone.
The cost of capital reflects the interest paid on debt plus the return expected by shareholders, which will include a premium for the risk of providing equity. In the value calculation, the cost of capital is introduced to remind managers of the commitment to provide returns to all the different sources of capital and to reflect the mix of capital used. Most important here is how Shareholder Value Added can provide a simple measure that guides day-to-day decision-making at every level in the business. Such decisions might include:
In the past, capital has been seen as a scarce resource. SVA shows that capital is plentiful, but expensive.
Increasing value involves managing those factors in a business that influence value. We term these factors value drivers. For example, increasing operating margins without affecting sales volumes will increase value, so operating margins is a value driver. There are seven value drivers that apply in all organizations and we call these generic value drivers. They are:
Doing things differently in a business will usually affect more than one value driver. For example, a price increase might affect volume and working capital and maybe fixed assets as well. Management must assess the relationship between value drivers, which will be different for different businesses. It's possible to model the effect on value of changes to the value drivers, and thereby help identify the best courses of action to increase corporate value.
Yes, the resource allocation, capital budgeting and portfolio management processes are the means by which capital and other resources, including people, are focused on those opportunities that offer the greatest potential to increase value.
In principle this means that capital is invested in those parts of the business that will generate returns in excess of the cost of capital, and withheld from those parts that will fail to exceed the hurdle rate. The test of value-added provides a vital focus on product, customer and business unit profitability. This is a crucial stimulus to improve the business, by acting either to encourage profitable growth, or to stop value erosion caused by unprofitable relationships with customers and unprofitable products.
So although capital should no longer be seen as a scarce resource, other resources become the constraint on what is possible. In most organizations the true resource constraints are people and their capabilities (or lack of them), and time. A company must be able to identify unprofitable products, customers or business units so that it can either find ways of making them profitable, or invest the resources elsewhere.
Capital should be invested when it is clear that increased operating profits will more than cover the charge for additional capital. However, there are several other ways of enhancing value, either to improve operating profits without using additional capital, or to reduce capital where operating profits give an inadequate return. One of line management's primary tasks should be to ensure that business processes are operating at lowest cost and that customers are serviced effectively. Improving efficiency and effectiveness reduces operating expenses, improving stock turns reduces work-in-progress and better arrangements for creditors and debtors reduce financing costs, and so on.
A business that has not successfully re-engineered its core business processes and supporting activities usually offers major opportunities to cut waste, reduce cycle times, increase productivity and improve customer service. Improvements on the order of 20 percent or more are common.
The process of value creation involves taking a long-term view, managing all aspects of cash flow, and understanding how to compare cash flows from different time periods on a risk-adjusted basis. Value-Based Management enables executives to consider all the competing claims for resources such as processes, customers, suppliers, employees, shareholders and so on. The proper balance of resources results in the least waste and the greatest value for shareholders. Using these techniques, I would view long-term value enhancement in the range of 20 percent as realistic.
VBM must be embedded into the normal ways of the business. Above all this is a cultural issue in which two factors are critically important. The first is performance measurement and associated reward mechanisms, and the second is education and communication. The purpose of performance measurement is to focus managers on achieving business objectives. The old adage "what gets measured, gets done" means that the wrong measures are certain to get the wrong things done.
Establishing and communicating the link between increasing SVA and the remuneration received by individuals - or preferably, teams - ensures that people will be keen to know how they can positively influence value. Systems of incentive and reward have a powerful effect on collective and individual behaviours. For example, a sales force targeted and rewarded on revenue alone will inevitably have scant regard for profitability, or departmental measures of cost control may restrain expenditure at the expense of process effectiveness and customer service.
Value-Based Management provides a common goal and framework for an organisation's performance measurement system. It requires a total process perspective, and therefore ensures as far as possible that people and departments have compatible goals, and that co-operation and teamwork are built into the structure of performance measurement and reward.
Value-Based Management challenges much accepted wisdom. Not least it raises questions about conventional ideas of accountability. Conventional cost center-based budgeting, management accounting and financial reporting strongly encourage the notion of individual accountability. The reality is that in any organization there are few accountabilities that are not shared, and value creation is above all a shared accountability.
People need a good understanding of what is meant by value, and how it is created. This often means "unlearning" much of the existing body of knowledge, ideas, assumptions and attitudes that underpin the organisation's ways of working and decision-making. Managers must develop a common understanding of value creation, use a common language and share a common commitment to implementation. Education and good communication are crucial to shared understanding and commitment.
Introducing Value-Based Management has all the potential pitfalls of any change initiative. I'd say ones of special importance are:
