Drive value (ver 2)

Creating Value
a Primer
Scott L. Thomas, CFA, CMA

RDT Management Group Inc.
Creating Value | Imagining the Future

Monday, 30 April, 12 1

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.



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.



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!



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!



Foundation for Value Generation

l Core foundation can be represented by four pillars;
– Control environment.
– Governance.
– Risk Management.
– Operations.



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.



Governance

l Board and management structure.
l Planning cycle.
l Quality of reporting (earnings).
l Internal/external review process (audits).



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.



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.



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.



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!



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.



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.



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.



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.



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.



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.



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.



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



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.



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.



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



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.



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.



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 .



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!



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