Value Based Management

Prof. Prapti Paul

Agenda

Principle Value Based Management Approaches Key Premises of Value Based Management

Introduction / Why and What Is Value Based Management

Why VBM?
VBM has been developed to facilitate the realization of the objective Create value for share holders Institutional Investors have begun exerting influence on corporate management to create value. Business press emphasizes shareholder value creation in performance rating Top management compensation is linked to shareholder value creation

What is VBM?
Value-based management (VBM) A discipline that focuses on the management of the organization holistically Emphasizes the creation of value as defined by its stakeholders and priorities defined by management Focuses on the deployment of strategy and value creation by managing processes, activities, jobs, compensation and organization structure Uses analytical methods, facts, computing /communications technology in an integrated framework

Key Premises of VBM

The value of a company is equal is to the present value of the future cash flows the co. is expected to produce. Conventional accounting earnings are not a sufficient indicator of value creation because they are not the same as cash flow, they do not reflect risk, they do not include an opportunity cost of capital, they do not consider time value of money and they are not calculated in the same way because of variations in accounting policy. For managing shareholder value, firms should use metrics that are linked to value creation and employ them consistently in all facets of financial management. A well designed performance measurement and incentive compensation system is essential to motivate employees to focus their attention on creating shareholder value.

Principle VBM Approaches

Marakon Approach Alcar Approach Mckinsey Approach Stern Stewart Approach BCG Approach

Marakon Approach
Specify the financial determinants of value. Understand strategic drivers of value. Formulate higher value strategies. Develop superior organizational capabilities. M/B= (r-g)/(k-g) r= return on equity; g= growth ; k= cost of equity

Understand the Strategic Determinants of Value

Market Economics: Intensity of indirect competition, Threat of entry, Supplier Pressures, Regulatory Pressures, Intensity of direct competition, Customer Pressures.
Limiting forces

Direct forces

Competitive Position: Possible sources of relative economic advantage are: Access to cheaper raw materials, Efficient processes, Low cost distribution channels, Superior management, Economies of scale.

Formulate Higher Value Strategies

Participation strategy: Which business to enter which to exit? Competitive Strategy: Product differentiation, configure and manage business unit costs, pricing.

Develop Superior Organizational Capabilities.

Competent and energetic CEO who is fully committed to the highest degree to shareholder wealth maximization. Corporate Governance that promotes the highest degree of accountability for creation and destruction of value. Top mgmt pay based on the philosophy Relative pay for Relative Performance 4 Principles of Resource Allocation: Zero based resource allocation Funding strategies and not projects. Principle of no capital rationing. Zero tolerance for bad growth.

Alcar Approach
The Alcar Approach is a type of Value Based Management model based on the discounted cash flow analysis and was developed by Alcar Group Inc. (renamed as Corporate Performance Systems), a management education and software company. The Alcar approach focuses on cash flows and avoids accounting based methods for calculating the shareholder value created.

Determinants of value
Shareholder value is the cumulative effect of the following factors, known as value drivers, namely,

Rates of sales growth Operating profit margins Income tax rates Investment in working capital Fixed capital investments Cost of capital Value growth duration.
Value growth duration is the time period over which investments are expected to earn rates of return in excess of cost of capital. This is an indicator of the competitive advantage that the company enjoys.

Assessment of the shareholder value impact of a strategy

1. Forecast the operating annual cash flows over the planning period. 2. Discount the forecasted operating cash flow stream using weighted average cost of capital. 3. Estimate the residual value of business plan/strategy at the end of the period and find its present value. The residual value can be calculated by dividing Perpetuity cash flows by Cost of capital. 4. Calculate the total shareholder value, which is equal to Present value of operating cash flows + Present value of Residual value Market value of Debt. 5. Establish the pre-strategy value through similar process. Pre strategy value = Cash flows before decision making/Cost of Capital Market Value of Debt. 6. Calculate the value created by the strategy.

Mckinsey Approach
VBM is an approach to management whereby the companys overall aspirations, analytical techniques and management processes are all aligned to help company maximize its value by focusing decision making on the key drivers of value. Value-based management can best be understood as a marriage between a value creation mindset and the management processes and systems that are necessary to translate that mindset into action. Taken alone, either element is insufficient. Taken together, they can have a huge and sustained impact.

 A value creation mindset means that senior managers are fully aware that their ultimate financial objective is maximizing value; that they have clear rules for deciding when other objectives (such as employment or environmental goals) outweigh this imperative; and that they have a solid analytical understanding of which performance variables drive the value of the company. They must know, for instance, whether more value is created by increasing revenue growth or by improving margins, and they must ensure that their strategy focuses resources and attention on the right option. Management processes and systems encourage managers and employees to behave in a way that maximizes the value of the organization. Planning, target setting, performance measurement, and incentive systems are working effectively when the communication that surrounds them is tightly linked to value creation.

Key Steps to Value based maximization

Ensure the supremacy of value maximization Find the value drivers Establish appropriate managerial processes. Implement value-based management properly.

 There are four essential management processes that collectively govern the adoption of VBM.

First, a company or business unit develops a strategy to maximize value. Second, it translates this strategy into short- and long-term performance targets defined in terms of the key value drivers. Third, it develops action plans and budgets to define the steps that will be taken over the next year or so to achieve these targets. Finally, it puts performance measurement and incentive systems in place to monitor performance against targets and to encourage employees to meet their goals.
These four processes are linked across the company at the corporate, business-unit, and functional levels. Clearly, strategies and performance targets must be consistent right through the organization if it is to achieve its value creation goals.

Stern Stewart Approach

Economic Value Added is a trademark of the Stern Stewart Consulting Organization. Stern Stewart maintains that the implementation of a complete EVA-based financial management and incentive compensation system gives managers both better information and superior motivation to make decisions that will create the greatest shareholder wealth in any publicly-owned or private organisation. Measurement metrics- ROI, ROE, ROA and EPS theoretically do not correlate with share holder wealth creation very well. VBM receiving lot of attention in recent years. These performance metrics seek to measure periodic performance in terms of changes in value. Maximizing value means maximizing long term yield on share holder investment

 Most important technique : Economic Value Added (EVA) EVA measures whether the operating profit is enough compared to the total costs of capital employed. EVA = NOPAT- CAPITAL COST EVA= NOPAT- cost of capital * capital employed EVA= (rate of return- cost of capital)*capital Where rate of return is NOPAT/Capital Capital = total balance sheet minus non interest bearing debt in the beginning of the year EVA= (ROI-WACC)* capital employed

Market Value Added (MVA)

EVA is aimed to a measure that tells what has happened to the wealth of the share holders. According to this theory, earning a return higher or greater than the cost of capital increases the value of a company and earning less decreases the value. For listed company Stewart defined another measure if the company has created share holder value. If the total market value of the company is more than the amount of capital invested in it, the company has managed to create shareholder value. If the case is opposite the market value is less than the capital invested the co. has destroyed share holder value. Difference between the companys market value and book value is called Market Value Added. MVA= companys total Market value- Capital Invested

 If a companys rate of return > cost of capital the co. will on the stock market with premium compared to the original capital (positive MVA)
Companys rate of return is < cost of capital it would sell on discount compared to the original capital investment in the co. (negative MVA) All this applies to EVA as well Thus positive EVA means also positive MVA and vice versa MVA is equal to the present value of all future EVA. Increasing EVA a company increases its MVA or in other words increases the difference between companys value and amount of capital invested.

Link between EVA and MVA

Market Value Added (MVA) is the difference between the current market value of the firm and the capital employed by the firm. Example: if the market value of the firm (the sum of market value of debt and equity )is 12000 and its economic book value of capital is 10,000, the MVA IS 2000. MVA is simply the present value of all the future EVAs:

MVA = EVA1 + EVA2 +. (1+c*)1 (1+c*) If the market value of a company exceeds its capital employed it means that MVA is positive; on the other hand if the market value of a company is less than its capital employed it means that MVA is negative

Every third sentence spoken by the Muthuraman (MD of TISCO) seems to have 'EVA' in it. Muthuraman breathes, sleeps and eats the word, and is trying to get the rest of the company to do so as well. Every sign, placard and memo in Jamshedpur has it." Businessworld, June 23, 2003. Implementing the EVA framework is a key business performance initiative in support of our efforts to evolve as a world class organization and enhance shareholder value. Our main objective behind implementing EVA is to be driven, measured and rewarded by our ability to create sustainable shareholder value." 1 - Adi Godrej, Chairman of Godrej Group.

BCG Approach
Specialist group HOLT Value Associates 2 concepts lay the foundation 1) total share holder return and 2) total business return For applying these concepts 2 performance metrics are used 1) cash flow return on investment and 2) cash value added Total share holder return (TSR) : is the rate of return shareholders earn from owning a companys stock over a period of time. The TSR for a single holding period is computed as:
TSR= dividend beginning market value + ending market value- beginning market value beginning market value

TSR is comprehensive as it includes dividends and capital gains TSR used by investment community and also by Securities Exchange Commission TSR can be easily benchmarked against market or peer groups TSR not biased by size TSR is difficult to manipulate

 Total Business Return (TBR): TBR is an internal counterpart to TSR needed for managerial purposes. TBR for a single holding period is computed as follows: TBR = free cash flows + ending value- beginning value beginning value beginning value
The beginning and ending values are estimates of the market value of the firm or business unit in the beginning and end of the period. They are estimates using: Value = earnings* P/E multiple Value = Book value * M/B multiple Value = Free cash flow / cost of capital Value = NPV of expected cash flow BCG uses TBR for: Strategic planning Resource allocation Incentive compensation

 Cash Flow Return on Investment (CFROI): sustainable cash flow a business generates in a given year as a percentage of the cash invested in the firms assets. Sustainable cash flow is gross cash flow less economic depreciation. CFROI = Cash Flow- Economic Depreciation Cash invested
Ex: a new plant entails an initial investment of Rs.3,00,000, Rs.250,000 towards fixed assets and the balance towards net working capital. The plant has an economic life of 14 years. At the end of the 14 years the fixed assets will fetch nothing but net working capital will be recovered in full. The annual depreciation charge on fixed assets will be 2,50,000/14 = Rs.17,857. the plant is expected to produce NOPAT of Rs. 21,080 each year. The cost of capital is 10%. It will cost Rs.2,50,000 to replace the fixed assets.

 Solution: ROCE = NOPAT/Book Capital ROGI = Cash Flow/ Cash Invested

Annual Measurement of the Project in Three Sample Years

Year 1
1. 2. 3. 4. 5. 6. 7. 8. 9. NOPAT Depreciation Cash flow (1+2) Economic depreciation Sustainable cash flow (3-4) Book capital (beginning) CFROI (%) ROCE (%) ROGI (%) 21080 17857 38937 8937 30000 300000 10 7.03 12.98

Year 6
21080 17857 38937 8937 30000 210715 10 10 12.98

Year 12
21080 17857 38937 8937 30000 103573 10 20.35 12.9812

 To judge the accuracy of these measures, they may be compared with IRR .
r works out to be 10 percent. Comparing the three measures with IRR we find that: ROCE understates IRR in the initial years and overstates IRR in the later years. ROCE shows a rising trend over time, though the project is a constant cost of capital performer. Unlike ROCE, ROGI does not show a rising trend. However it has a constant upward bias of about 3 percent as it does not take into account what must be with held to replace the asset at the end of its economic life. CFROI equals IRR throughout. It takes into account the replacement need and provides the correct signal each year.

 Cash Value Added (CVA): CFROI is the key metric used by BCG for measuring performance and valuing a company. However, BCG has also developed a measure of economic profit :Cash value added. BCG claims that CVA is superior to EVA because it removes the accounting distortion that may bias EVA. CVA= Operating cash flow economic dep capital charge on gross inv
EVA and CVA Calculations Year 1 1. NOPAT 2. Book capital 3. Cost of capital 4. Capital charge EVA (1-4) 21080 300000 10% 30000 (8920) Year 6 21080 210715 10% 21072 8 Year 12 21080 103573 10% 10357 10,723

Year 1 1. NOPAT 21080

Year 6 21080

Year 12 21080

2.Depreciation
3. Cash Flow 4. Economic depreciation

17857
38937 8937

17857
38937 8937

17857
38937 8937

5.Cash invested
6.Cost of capital 7. Capital charge CVA (3-4-7)

300000
10% 30000 0

300000
10% 30000 0

300000
10% 30000 0