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Value-Based Management

 

As   known, the value of a firm is based on the present value of its future cash flows. In fact, there are two distinct components: (1) present value of free cash flows from existing assets and (2) present value of free cash flows from growth opportunities . For a high-growth firm, a significant part of its value can lie in the second variable (cash flows from growth opportunities), and this is likely to depend on its ability to innovate in every part of its business.

Value drivers can be useful at three levels: the generic level where cash profits (“cash in”) and invested capital (“cash out”) are combined to compute free cash flows for the firm as a whole. At the business unit level, variables such as sales growth and customer mix are particularly relevant. And at the operational level, variables are defined as precisely as possible and tied to specific decisions and metrics that frontline managers can control. The  balance sheet must also be included.
Some experts believe that 100 percent of value created comes from no more than 50 percent of the capital employed.

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The value-based management (VBM) approach attempts to create streams of value relating to products, brands, channels, and customer segments (also known as value centers) that can be associated with their costs and the resources they use. Once they haveidentified the value stream and its associated assets, managers can use VBM models to evaluate its net present value. By placing values on these business components and then aggregating them, the VBM methodology can derive the total value of a business. This is not as easy as it appears because accounting systems run vertically up and down the hierarchy, whereas economic value runs horizontally along product an customer-based value streams. VBM expert Peter Kontes reckons that redrawing the organization map is the key. “Most organizational boundaries are political,” notes Kontes. “The new map should be economic, defining units that can be managed for value largely independently of other units—for example because they have few shared costs.”  Redrawing the map serves two purposes: first, it builds executive consensus around shareholder value, and second, the outcome produces business units with enough financial integrity that executive teams can take full shareholder value responsibility.
The four rules of value creation
1. Companies create value by generating future cash flows at rates of return greater than the cost of capital. The combination of revenue growth and return on invested capital (ROIC) drives value creation.
2. Value is created when companies generate higher cash flows, not by rearranging investors’ claims on those cash flows.
3. A company’s share price is driven by changes in investor expectations, not just the company’s actual performance (the greater the expectation built into the share price, the harder it is to keep up).
4. The value of a business depends on who is managing it and what strategy he or she pursues. Most managers have an intuitive or implicit understanding of what drives actual and potential performance. American Express, for example, has three value drivers that leaders monitor: average card-member spending, card attrition rates, and average assets per financial client.

In creating the framework for a new forecasting system, business units had to identify value drivers based on company- specific algorithms. The key question was: how would $1 in billings or one additional card member affect the bottom line? Previously, staff had given a lot of attention to the impact of salaries and benefits on net profits. Managers had believed that all they needed to know was the cost of adding or eliminating an employee. However, they found that these numbers had only a 5 percent effect on the net figures. What they needed to identify were the volume drivers, those that influence 80 percent of the numbers. This turned out to be only fifteen lines on the profit-and-loss statement. “If we identified our drivers correctly, we would accurately gauge the P&L,” explained project leader Jamie Croake.
The team found that billings were what really drove American Express’s businesses—how much card members spent at restaurants, on airline tickets, and for major purchases. Two specific drivers behind this volume were the number of American Express cards and the average spending per card.
Knowing those two items allowed them to calculate the billings numbers. These numbers, in turn, affected quite a few other items on the profit-and-loss statement, such as membership rewards, level of delayed billings, amount of interest income, measure of risk for bad debts, and so forth. The trick was to create the algorithms that accurately forecast the billings.
To see how a value-based model works, consider the list of value drivers for a distributor . In this example, value may be derived from a combination of gross margin, warehouse costs, and delivery costs. Gross margin is determined by gross margin per transaction and the number of transactions. Warehouse costs are a function of the number of retail stores per warehouse and the cost per warehouse. And delivery costs are determined by the number of trips per transaction, the cost per trip, and the number of transactions. Analysis of these variables might, for example, show that the number of stores per warehouse significantly affected the cost per transaction: the more stores that could be served by a single warehouse, the lower the warehouse costs relative to revenues.

The scale economies can be substantial enough to support a strategy of growth through urban concentration, rather than a shotgun approach of scattering new stores over a wide area. The number of stores per warehouse thus becomes a key value driver. Further analysis might reveal that the number of delivery trips per transaction was very high. Whenever there were errors in an order or goods proved defective, multiple deliveries had to be made to a single customer.

Cycle times are often key drivers in many businesses. Take Progressive Insurance, which focused on speeding up the process of settling claims, an idea that sounds counter intuitive to many finance managers. The idea was to unload payments as quickly as possible by getting its claims adjusters out of the office and at the scene of the problem. The logic behind such a radical notion was that happier customers and more productive claims reps would more than make up for the lost interest income.
At Progressive, that radical notion is spelled IRV, “immediate response vehicles,” a fleet of cars loaded with enough communications gear—laptops, printers, and cellphones—to allow adjusters to settle claims right at the scene of an accident. Not only did the program help improve customer retention by 20 percent, it also helped Progressive to cut labor costs. Progressive’s mobile adjusters can handle nearly twice the workload they could before the changes.

Alfred Rappaport notes that “companies that fail to embrace this first principle of shareholder value will almost certainly be unable to follow the rest. Unfortunately, that rules out most corporations, because virtually all public companies play the earnings expectations game.
What’s so bad about focusing on earnings? First, the accountant’s bottom line approximates neither a company’s value nor its change in value over the reporting period. Second, organizations compromise value when they invest at rates below the cost of capital (overinvestment) or forgo investment in value-creating opportunities (underinvestment) in an attempt to boost short-term earnings. Third, the practice of reporting rosy earnings via value- destroying operating decisions or by stretching permissible accounting to the limit eventually catches up with companies. Those that can no longer meet investor expectations end up destroying a substantial portion, if not all, of their market value. WorldCom, Enron, and Nortel Networks are notable examples.”

Most companies evaluate and compare strategic decisions in terms of the estimated impact on reported earnings, when they should be measuring against the expected incremental value of future cash flows instead. Expected value is the weighted average value for a range of plausible scenarios. (To calculate it, multiply the value added for each scenario by the probability that that scenario will  materialize, then sum up the results.) A sound strategic analysis by a company’s operating units should produce informed responses to three questions: First, how do alternative strategies affect value? Second, which strategy is most likely to create the greatest value? Third, for the selected strategy, how sensitive is the value of the most likely scenario to potential shifts in competitive dynamics and assumptions about technology life cycles, the regulatory environment, and other relevant variables.

 

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