It's all about value

Focusing on the factors investors use to value companies can improve strategic planning and operational execution

SHARAD APTE

The primary objective of a business is to create economic value for investors or shareholders, while also recognising the needs of other stakeholders such as employees, suppliers, the community, the environment and debt providers.

Value-based Management (VBM) is a philosophy and a set of frameworks and processes that helps senior executives and managers develop, implement and pursue strategies that generate value for shareholders while also recognising the effect these will have on the other stakeholders. No successful strategy can ignore the needs of all of the stakeholders involved in on-going businesses if it wants to create and sustain value for shareholders over the long-term.

VBM is a method of evaluating the strategic decisions facing businesses by focussing on the factors that investors use to value companies. The underlying principle is the development of a rigorous fact-base that addresses the following critical strategic and operational issues including: Where is the value in the business currently? Where has value been created historically? Where is future value going to be created? What is driving this future value creation? What are the critical assumptions inherent in the strategy? How aggressive are the assumptions in the strategic plan? Where are value risks/opportunities? Where should scarce management and resources be focussed to create and sustain value?

One of the key steps in successfully implementing a VBM approach is to link performance measures and targets throughout the organisation to the creation of value for shareholders. This requires an understanding of key value drivers so that appropriate performance indicators can be tracked to measure progress and incentivise value-creating behaviour among senior executives and managers. A typical value-based approach has four high-level phases.

Phase 1: Value driver mapping. The key to successful implementation lies in building a fundamental understanding of the ``economic roadmap'' of the key business processes. Value driver mapping involves documenting, for each of the major activities within the business, the inputs and outputs associated with the business. It is also critical to identify the key variables and economic interrelationships within the business.

To be meaningful, the economic roadmap must extend beyond the financial drivers to incorporate the real day-to-day activities of the operations of the business. It is the decisions that operating managers are making at the front lines of the business that usually create or destroy shareholder value.

Phase 2: Relationship analysis and projections. The major goals of the second phase of a value-based implementation programme are to establish the validity and stability of important relationships, as well as to prepare longer-term projections of the critical assumptions of the business.

It will be important to understand those relationships identified as having a significant effect on the value of the business. Relationships to be investigated fall broadly into two categories: those between important physical variables (ie. production speed versus rejects and defectives), and those that link the physical variables to the financial flows.

The second element involves the development of long-term physical and financial projections, to develop a series of planning scenarios for a particular business unit, or what is commonly referred to as a business or strategic plan. This strategic plan should include a base case with no improvements in performance anticipated; a target case, including currently planned improvements; and alternative cases, for example, entering new markets or offering new product lines or services; and the capital, revenue and operating costs associated with each of these alternatives.

Phase 3: Construction of a business model based on the business plan. The understanding of the business gained from Phases 1 and 2 can now be expressed in an economic model that links physical and operational variables to their financial outcomes. L.E.K. recommends developing a discounted cash flow model because it takes a long-term perspective, incorporates the cost of capital, and allows results to be expressed in terms of effect on shareholder value, the ultimate decision-making yardstick. The model serves as a tool to help with deciding what strategic options should be pursued, to quantify the risk versus return trade-offs, and to develop specific performance measures for each option.

Phase 4: Developing key performance indicators and linking them to compensation. Value drivers and performance indicators are developed at the operating level. This allows operating managers to quickly identify those value drivers or performance indicators that are critical to delivering the core value of the business. Additionally, it develops accountability around delivering specific levels of operational performance within the organisation. These indicators can then be integrated into the compensation programme to ensure that there is a clear and direct connection between the business plans that managers submit, the results delivered and compensation.

Benefits of a value-based approach. Applying a value-based approach provides a number of benefits. First, it gives top management the ability to evaluate strategic trade-offs and allocate capital more efficiently, as it provides an understanding of key factors driving the value of the business and a better understanding and assessment of risks. Second, it gives senior executives and managers more control over the direction and performance of each asset. This is done via a disciplined value-based framework that enforces more realistic forecasts, encourages the creation of achievable plans and greater accountability.

Finally, a value-based approach encourages a fundamental improvement in performance of each asset by encouraging a greater focus on capital efficiency and ensuring that performance measures and incentives are aligned around the concept of shareholder value creation.

uSharad Apte is a director of and co-head of L.E.K. Consulting's Bangkok office. He can be reached at sapte@lek.com.

Back to index page