Drive value (ver 2)

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A primer for value management in a firm setting.

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Drive value (ver 2)

  1. 1. Creating Value a Primer Scott L. Thomas, CFA, CMA RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 1
  2. 2. What is Creating Value? l Value is created by maximizing long-term sustainable cash flows not the notion of accounting profit. Value is only created when returns on invested capital exceed the cost of that capital. Corollary; value is destroyed when returns on invested capital are less than the cost of that capital. l Creating value requires the alignment of corporate decision making with the long-term view of maximizing value to all relevant stakeholders. l Cash flows are only sustainable over the long-term if aligned with the interest of all relevant stakeholders. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 2
  3. 3. Who is a Stakeholder? l As defined in the Oxford Dictionaries: noun 2 a person with an interest or concern in something, especially a business. l Value maximization over the long-term is unlikely if relevant stakeholders are marginalized. l Value maximization involves trade-offs amongst stakeholders with mutually exclusive wants. Risk adjusted value. l Who are your relevant stakeholders, is “the” fundamental question. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 3
  4. 4. How is Corporate Value Managed? l For Corporate Value to be effectively managed changes are required in the following areas: – corporate culture – decision making techniques and – supporting processes. l Stakeholder versus shareholder is the focus. l The goal? Create long-term “economic” value for all stakeholders by optimizing free cash flow returns on capital deployed! RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 4
  5. 5. Introduction Why this matters! l Adopting Value Management techniques refocuses the way a company operates: l robust decision making, l decisions are made at the appropriate organizational level, l creating a culture of value requires behavioural changes within the context of firm management, l Value Management is a method of managing the business with a long term view of maximizing the value to all Stakeholders; by maximizing free cash flow to the firm. l Incomplete and/or incorrect decisions destroy firm value! RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 5
  6. 6. Foundation for Value Generation l Core foundation can be represented by four pillars; – Control environment. – Governance. – Risk Management. – Operations. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 6
  7. 7. Control Environment l Integrity and Ethical Values. l Effective board. Tone at the top has a significant impact on human capital effectiveness. l Human Capital Management. Effective companies have effective human capital management processes; documented, linked to business strategy and effective performance management. Drive the “right” decisions that are focused on long term economic sustainability. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 7
  8. 8. Governance l Board and management structure. l Planning cycle. l Quality of reporting (earnings). l Internal/external review process (audits). RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 8
  9. 9. Risk Management l Linked to corporate strategy and tactics. l Encompass business, market, credit and operational issues. l Three parts, managers are: – Paid to take – business risk. – Paid to manage – market and credit risk. – Paid to mitigate – operational risk. l Business risk is a function of relative sales volatility and operating leverage. l Financial risk – acceptable capital structure leverage should be inverse to business risk. The higher the business risk the less sustainable leverage becomes. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 9
  10. 10. Operations : Factors that matter Understanding the “Macro” environment of the firm l Regulatory influences. l Special interest groups may in fact be relevant stakeholders. l Externalities. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 10
  11. 11. Operations : Factors that matter Understanding the “Macro” environment of the firm Michael Porter provides a well reasoned outline for understanding the “Macro” environment; • How attractive is the industry(s) in which the company operates? • What is the company’s relative competitive position and its strategy? Must understand • How well does the company execute its strategy? Potential your business Entrants and competitive Threat  of  new  entrants landscape. What Suppliers Bargaining  Power  Suppliers Industry Bargaining  power  of  buyers Buyers Competitors business are you in? What Threat  of  Substitutes strategies do you, Substitutes Each quadrant influences and frames the operating environment of the firm! should you, Michael  Porter deploy? RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 11
  12. 12. Operations : Factors that matter l Each aspect of the business must be understood, often it is easiest to analyze based on; – Demand-side of the business (Customer). – Supply-side of the business (Suppliers, Manufacturing/Distribution Etc.). – Infrastructure-side component of the business (Employees, systems and processes). l A value management approach is the recommended process and tool to pull all of this together! RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 12
  13. 13. How is Value Measured? l Total return models while valid for public companies, have no meaning in the context of a private company. l Maximize Free Cash Flow to the Firm is “our” basis for measuring Value and applies equally to public and private companies. Total value is determined by the after tax cash-flow generating abilities and associated risk of a firms assets. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 13
  14. 14. Why Stakeholders and not Shareholders? l Shareholders are important, but the firms value is impacted on how it manages all relevant stakeholders. l The government(s) a firm operates in provides boundaries on management. l Societal expectations can have a profound impact if not managed properly, (example, Green House Gas emission management and business impact of the environmental lobby and other special interest groups). Keystone XL Pipeline process is top of mind. l Capital structure choices produce equity and debt owners. Leverage has impact on operational sustainability and risk sustainability. l Employees are important stakeholders that must be properly engaged for operations to be effective. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 14
  15. 15. Value Management : a new alignment? l Focus on stakeholder value not solely shareholder. l How is value impacted? – Customers (revenue, quality, competitive strategy, engagement). – Employees (governance, control environment, risk, operations, structure, value “work”). – Suppliers (relationships, cost/quality impacts, supply chain management). – Government (taxation, legislative). – Society (in which you operate, expectations of a good corporate citizen, improve society = improve value opportunities?). – Firm reputation risk. Components can have potential positive and negative impacts and thus must be fully understood and managed. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 15
  16. 16. The Value Management Process Is a cross functional process and impacts many aspects of the organization: end goal is to enhance value to stakeholders. Sociological Culture  and  Competency •Communicate strategies •Train  individuals   •Align  processes •Define team Value   Define Management   Value   Develop   Align  compen– creation   value  perfor– model  the   value  creating   sation  with  value   Architecture part  of  the   strategies mance   Mission Business creation measures •Align  organizational  structure •Integrate  tools  into  management  process •Align  accountabilities   with  value  management Process  and   Infrastructure Information •Assess  processes/ •Redesign  reporting  structure  to   •Implement  processes    and  value   information support  value  management management    reporting Externalities Society,  Special  Interest  Groups  and  Government •Assess  potential  impacts   •Design  feedback  loops  to  support     •Link  economic  impact  of  externalities  to   related  to  existing  and   and  improve  decision  making  with   value  management  reporting  system. proposed  projects.  Quantify   respect  to  externalities. all  risks. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 16
  17. 17. Why Value Model the Business? l Improved decision making – value modelling can be used for testing the outcome of possible business decisions on value creation. – focuses decision making on profitable growth now versus grow now, profit later. l Understand key value drivers – enables managers to understand what aspects of the business drive value. l Model the Business – the development of the valuation model, requires an in-depth understanding of the operations of the business. l Cross-functional view of the business – enables a group approach while working towards the common goal of value creation. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 17
  18. 18. Value Drivers l An operating value driver is at the customer, product, process or combination level that can be managed to create value for the firm. l Once value drivers are identified, they should be linked to operational decisions and financial measures. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 18
  19. 19. What is Value Modelling? Value Modelling tools should contain: l Relationships between operational and financial value drivers. l What-if capability to allow managers to understand the implications of changes to operational value drivers in the business and the impact such changes have on value. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 19
  20. 20. Maximizing Value-in the Long Term Illustrative  and  not  exhaustive Cash  Flow   Financial  Value  Drivers Value  Creation  Tactics Value  Measures Indicators New  Product  Development Revenue  from  new  products Cash  Flow Revenue  Growth New  Customers Revenue  from  new    Customers New  Markets Revenue  from  new  Markets Eliminate  unprofitable  business  units/products/ Operating  loss  eliminated Operating  Margins customers Improve  supply  chain  management Supply  chain  cost  by  customer  by   product Reduce  cash  conversion  cycle Increase  Inventory  turns Working  Capital Demand  pull  manufacturing Reduce  A/R  days Reduce  order  to  ship  cycle Investment Eliminate  unproductive  assets Return  on  Assets Asset  Productivity Increase  revenue  per  deployed  asset  base Technology  opportunities RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 20
  21. 21. Project Evaluation and Time Value of Money The recommended process: – The investment proposal, – The estimation of cash flows, – The evaluation of cash flows, – Selecting the appropriate risk adjusted project required rate of return, – The ranking of proposals, – The selection of proposals (based on certain criteria) and, – The re-evaluation of accepted proposals. l Project Internal Rate of Returns (IRR) below the Weighted Average Cost of Capital (WACC) destroy value, while Project IRR’s that exceed the WACC create value. Put another way Net Present Value (NPV) greater than zero creates value, less than zero destroys value. l Incremental after-tax cash flow. l Terminal value. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 21
  22. 22. Free Cash Flow to the Firm (FCFF) l Cash flow available to the supplier of capital to the firm after all operating expenses (including taxes) have been paid and necessary investment in working capital and fixed capital have been made. l Cash Flow from Operations Method: – FCFF = CFO {cash flow from operations} + Interest(1-Tax Rate) – FCInv {Required Fixed Capital Investment} – Working Capital for valuation purposes excludes cash and cash equivalents and short term debt (notes and current portion of long-term debt). l Bankers View (EBITDA method/earnings before interest,tax and depreciation) – FCFF = EBITDA(1- Tax Rate) + Depreciation{CCA}(Tax Rate) – FCInv – Canadian version would reference capital cost allowance versus depreciation expense. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 22
  23. 23. Maximizing Firm Value- Example Components; drivers Factors Component  Item Drivers Questions Cash  Flow  from   Revenue • Revenue  Growth; •  Product  development; • AVractiveness  of  industry  (s)  company  operates  in; •  Companies  relative  competitive  position  and  competitive   Operations   •Customer  retention  and  satisfaction; strategy; •  Quality  of  products  /  services; •  How  effective  does  the  company  execute  its  strategy  and   (CFO) •  Pricing  /  Service  method; future  prospects; •  Product  /Service  differentiation  or  focus; •  Bargaining  power  of  buyers; •  Sales  process(s); •  Barriers  to  entry; Operational   •  Supply  chain  value  management  (how,  when,   •  Substitutes; Productivity where  is  the  final  end  user  located  on  this  value   chain); •  Does  my  pricing  and  supply  chain  tactics  flow  from  my   overall  business  strategy; •  Direct  customer/product  profitability  analysis •  How  do  I  get  new  customers,  retain  current  customers  and   ensure  appropriate  customer  satisfaction  is  achieved; •  How  do  I  identify  profitable  customers  and  fix  unprofitable   customers? •  Reputation  and  societal  impact  management Costs •  Cost  of  goods  sold; •  Supply  chain  value  management; •  Bargaining  power  of  suppliers; •  Culture  and  motivation;   •  Employees; •  Organizational  behavioural  conflicts; •  General  and  administrative; •  Control  environment; •  Cash  taxes •  Operational  effectiveness; •  Legislative  environment; •  Tax  management  process  (compliance,  transfer  pricing,  etc.); •  Societal  impact  management Working  Capital •  Cash  Conversion  Cycle A/R  days,  Inventory  Days,  A/P  days Objective  is  to  shorten  the  cycle RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 23
  24. 24. Maximizing Firm Value- Example Components; drivers Factors Component  Item Drivers Questions Add  back:  After  tax  interest  costs Fixed  Capital   Capital   •  Idea  generation; •  Fits  corp  strategy •    Is  the  project  categorized  as; •  replacement Investment  (FCInv) Budgeting   •  Proposal  Analysis; •  expansion •  after  tax  incremental  cash  flows     •  new  product/service Process (opportunity  cost  basis)  not   •  regulatory,  safety,  environmental Asset  Productivity accounting  constructs •  Are  cash  flows  based  on  incremental  after-­‐‑tax  cash  flows   •  tax  impact  fully  reflected discounted  at  the  opportunity  cost  of  funds? •  timing  of  cash  flows •  Financing  costs  are  ignored! •  required  rate  of  return •  Do  you  use  sensitivity/simulation  analysis? •    Financing  costs  ignored  (captured   •  Use  of  Real  Options  along  with  discounted  cash  flows?  Real   in  WACC) options  along  with  discounted  cash  flow  assist  with  optimizing   •  Profitability  index decision  making    and  price  flexibility,  (timing,  sizing,flexibility,   •  Planning/Implementation; fundamental). •  Monitor/Post  Audit; •  Common  issues; •  Profitability  Index  (PI  )  >  1  invest,   •  Externalities  and  economic  responses  ; otherwise  value  destroyed; •  Errors  in  standardized  template  not  matching  project   •  Externalities  and  impact; realities; •  R&D  impact  and  conversion  from  idea  to   •  Pet  projects; product. •  NPV  is  beVer  than  IRR; •  Properly  accounting  for  all  relevant  cash  flows; •  Sunk  costs  are  to  be  ignored; •  Project  discount  rate  should  be  based  on  its  risk; •  Failure  to  consider  valid  alternatives. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 24
  25. 25. Summary: a framework for value creation l Management Framework to focus on long-term “economic” value creation; – Control environment. – Governance. – Risk management. – Operations (Value Management is a component). l Stakeholders more relevant focus versus shareholders; l Value Management; – What, why, how and tools. – Without an effective management framework Value Management is an empty concept! – Expanded to include stakeholders and externalities. RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 25
  26. 26. Summary: value management l What? – Create Value (robust capital budgeting process). – Manage Value (framework or core pillars). – Measure value (value modelling). l Why? – Align interest between company stakeholders. – Set clear priorities. – Facilitate better decision making. – Balance short, medium and long-term value trade-offs. – Fully understand the impact of externalities and outside stakeholders on intrinsic value. – Encourage value creation investments . RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 26
  27. 27. Finally: Some thoughts on underperformance l Failure of human capital to affect asset capital to create economic value: – DeMarco/Lister review over 500 corporate projects, over 25% are failures (destroy value). – Reasons? People related failure. Purely sociological. – Toyota; traditionally a hallmark of quality, design, production, continuous improvement and value? Handling of the “brake” crisis. n Blame placed on others. n Leadership lacked emotional intelligence. n Leadership arrogance. – British Petroleum; Will their Brand ever recover from the Gulf Oil spill and prior challenges to create a culture of safety? l Failure of management - behaviour triggers emphasize a short term focus with usually negative consequences: – Florida law firm receives $1,300 for each foreclosure processed in the State. Speed, versus an adherence to legal tenets is focus. Outcome, challenge to legality of packaged mortgages through-out the industry. l Failure to assess true cost of externalities - Keystone XL pipeline debacle in the United States: – Sometimes the “straight” path destroys value! RDT Management Group Inc. Creating Value | Imagining the FutureMonday, 30 April, 12 27

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