A value-based management system

Business Horizons, Sept-Oct, 1996 by Stanley F. Slater, Eric M. Olson

The fundamental economic purpose of a corporation is to create wealth for its owners. This has become so powerful a motivation that one might say that "Create shareholder value" has become management's mantra for the 1990s. Because of the development of analytical techniques based on discounted cash flow analysis, equity spread, and economic value added, managers now have an extensive set of tools for determining which parts of their businesses add to or subtract from shareholder value. They can also use these tools to assess the value creation prospects of new strategies or new lines of business.

Unfortunately, as has been the case with other management paradigms such as total quality management and reengineering, many firms are finding that applying the tools of value-based analysis and planning is not sufficient in itself to increase shareholder value. These tools focus on financial management and the actions of the top management team, whereas value creation is the result of the actions of individuals and groups throughout the firm.

Thus, a comprehensive value-based management (VBM) system must engage, motivate, and reward the people throughout the organization who create shareholder value. The system we present here is designed to accomplish that. Instead of developing a new set of techniques to implement VBM, we show how free-standing management techniques can be combined into a holistic VBM system whose strength is found in the synergy' of its component parts. The benefit of institutionalizing an integrated VBM system is that it coordinates and focuses the efforts of the entire work force on activities that will create value for shareholders and for themselves.

VALUE-BASED MANAGEMENT

A VBM system, as depicted in Figure 1, is initiated by conducting a thorough assessment of where the greatest opportunities for creating additional value exist. Based on this knowledge, a commitment is made by managers from all functions to the goals of VBM and a few high-impact stretch targets are established. Line workers are then integrated into the process, first through education on the purpose, importance, and techniques of value-based planning, and then by having broad access to operating information. Using their knowledge about current performance and the stretch goals, employees are given the responsibility to develop and implement improvement plans. The organization supports them by providing task-focused training in key areas. The circle is made whole when a follow-up value-based analysis is conducted. Rewards are then shared and the process continues. In the following sections, we describe what occurs at each stage.

Stage 1: Value-Based Analysis

Value-based analysis and planning techniques are built on modern financial tools that are routinely used to evaluate individual projects or investments. However, they are applied at the business unit level to evaluate new strategies, such as the development of a new' product or entry into a new market, or to assess the effectiveness of the current strategy or operations of an existing business. The fundamental premise underlying all of the various approaches to value-based planning is that shareholder value is created when a firm's return on capital exceeds the cost of capital.

Because of their different objectives, we separate the value-based approaches into techniques for (a) planning and evaluating new strategic initiatives and (b) analyzing and improving current operations. Discounted cash flow (DCF) techniques are most appropriate for evaluating new strategic initiatives. This approach forces the analyst to forecast all investments and other expenditures that an initiative requires (cash outflows) and all of the revenues generated by the initiative (cash inflows). All of the cash flows are discounted to their present value at the firm's cost of capital. A positive net present value indicates that value is created; a negative net present value indicates that value has been destroyed. Forecast cash flows can be converted into specific goals such as profit margins or asset turnover ratios, which then become the basis for operating targets.

Because of its focus on future cash flows, DCF analysis is very difficult to apply to the analysis of current operations. Whereas financial ratios based on previous DCF analyses may be used to rate progress toward a financial goal, the economic value added (EVA) and equity spread (ES) models were developed specifically with assessing the value-creating potential of current operations in mind. Improvements in both EVA and ES have been shown to be strongly related to the creation of shareholder value.

EVA seems to be the more popular of the two, having been adopted by such leading firms as Coca-Cola, AT&T, and Quaker Oats. Very simply, EVA is a company's net operating profit after taxes and after deducting all costs of capital, both debt and equity. However, determining a firm's total cost of capital is not a simple matter. Decisions must be made as to whether investments in R&D, training, and advertising, among others, should be treated in the conventional manner as an expense or rather as capital. If they are treated as capital, what are their useful lives and at what rate should they be amortized? Once the total investment in capital has been determined, the weighted average cost of debt and equity must be applied against it. This too is tricky, particularly for units of multibusiness corporations that have no unique equity. On average, though, investors expect to earn about six percentage points more on stocks than on government bonds. With current long-term interest rates around 7 percent, the average cost of equity is about 13 percent--more if the business being analyzed is riskier than average.