Download The “Essence” of Value

The “Essence” of Value-Based Finance
A Management Seminar
Presented by:
Roy E. Johnson
Vanguard Partners
Ridgefield, Connecticut
Copyright © Vanguard Partners 2005 - All rights reserved.
Discussion Topics
The “Essence” of Value-Based Finance (VBF)
Page/s
– Overview of VBF
3– 6
– The “Accounting” Model
7 – 13
– Value “Indicators”
• The “Economic” Model
• Financial “Drivers”
14
15 – 17
18 – 21
– Value “Analysis”
• Market Value Added (MVA)
• The “Magnifier” Effect
22
23
24 – 28
– Allocating Resources – Based on “Value Creation”
29 – 31
– Summary
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2
“Overview” of ValueBased Finance
(VBF)
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3
Overview
Value-Based Finance (VBF) is a system to help management deliver
value to “shareholders”.
Focused on financial performance, VBF is part of an overall
corporate management system that needs to “balance” the value
delivered to customers with economic performance.
Therefore, Value-Based Finance (VBF) needs to “fit” within the
strategic direction, level of financial sophistication and cultural
environment of the corporation.
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4
Overview
One way to view VBF is as a sub-system of a larger value-based management
(VBM) system, integrating the needs of customers and shareholders.
Business
Strategy
Workforce
Engagement
Investment and
Operations
Performance
Measurement
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5
Overview
Within this framework, VBF coordinates key financial activities.
Strategy
“Evaluation”
“Alignment” …
Managers to
Shareholders
“Hardwiring”
Strategy to
Budgets
“Economic”
Performance
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6
The “Accounting”
Model
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7
The “Accounting” Model
Most “accounting” analysis begins with a determination of “Gross Profit”.
“Base Period”
CO. ‘A’
CO. ‘B’
CO. ‘C’
Revenue [Sales]
$1,000
$1,000
$1,000
200
500
800
-$
800
500
200
-%
80%
50%
20%
Cost of Sales
Gross Profit
This analysis indicates major differences in the relationship of
selling price(s) to product cost(s) among the three companies.
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The “Accounting” Model
Most “accounting” analysis ends with a determination of “Net Profit”.
“Base Period”
CO. ‘A’
CO. ‘B’
CO. ‘C’
Revenue [Sales]
$1,000
$1,000
$1,000
Cost of Sales
200
500
800
Gross Profit
800
500
200
Operating Expenses
650
350
50
Operating Profit
150
150
150
50
50
50
$100
10%
$100
10%
$100
10%
Taxes @ 33%
Net Profit
-$
-%
Factoring in Operating Expenses essentially completes the analysis.
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9
The “Accounting” Model
The “accounting” analysis can be summarized as follows:
“Base Period”
CO. ‘A’
CO. ‘B’
CO. ‘C’
Revenue [Sales]
$1,000
$1,000
$1,000
Net Operating Profit
[NOP]
-$
-%
$100
10%
$100
10%
$100
10%
The Accounting (“Earnings”) model stops here. In this case,
all companies are the same ... and, all are “profitable”.
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The “Accounting” Model
The “Accounting” model does not do a good job, however, of explaining “Value”.
Market Value / Invested Capital
Correlation of EPS to Market Value
5.5
GIS
5.0
K
4.5
4.0
CPB
MSTR
3.5
HSY
3.0
2.5
R2 = 1%
HNZ CPC
SLE
2.0
RAL
CAG
OAT
1.5
MCCRK
RAH
TYSNA
NA
1.0
2.0
4.0
6.0
8.0
10.0
12.0
EPS Growth
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14.0
16.0
Source: Credit Suisse/First Boston
11
The “Accounting” Model
…And, revenue growth alone does not create shareholder value. There must
be a “return on capital”.
Revenue
CGR - %
Revenue Growth, ROI Spreads and Market Multiples
Average Market Multiples – S&P Industrials
>16%
0.7
1.1
2.1
2.2
4.2
12 to 16%
0.9
1.1
1.5
1.5
2.5
8 to 12%
1.0
0.9
1.2
1.7
3.2
4 to 8%
0.7
0.9
1.2
1.7
3.1
1 to 4%
0.7
1.0
1.0
1.4
2.2
> 1%
0.9
1.1
1.1
1.2
1.6
>-4%
-4 to –2%
-2 to 2%
2 to 4%
>4%
Return on Investment “Spread” … ROI less Cost of Capital
Source: Hewitt Associates
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The “Accounting” Model
Why?
From a financial perspective:



Accounting was not created to do value analysis … rather,
its origins are in “credit” and “liquidation” analysis.
A true measure of value creation must factor in “risk” and
“return” – which accounting does not do. Thus, two critical
elements are missing in the “accounting” model.
Two key concepts that are critical in the understanding of
“value creation” for investors will be explored, namely:
 Economic Profit, and
 Market Value Added.
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13
Value “Indicators”
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Value “Indicators” – Economic Profit
“Base Period”
CO. ‘A’
CO. ‘B’
CO. ‘C’
Revenue [Sales]
$1,000
$1,000
$1,000
Net Operating Profit
[NOP]
-$
$100
$100
$100
-%
10%
10%
10%
-------------------------------------------------------------------------------------Invested Capital [IC]
$600
$800
$1,000
Cost of Capital [CCAP]
12%
12%
12%
--------------------------------------------------------------------------------------
The “Economic Profit” model introduces the concept of Capital
required to produce the “Accounting Profit” and the Cost of this
capital. We begin to see that all the companies are not the same.
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Value “Indicators” – Economic Profit
“Base Period”
CO. ‘A’
CO. ‘B’
CO. ‘C’
Revenue [Sales]
$1,000
$1,000
$1,000
Net Operating Profit
[NOP]
-$
-%
$100
10%
$100
10%
$100
10%
Invested Capital [IC]
$600
$800
$1,000
Cost of Capital [CCAP]
12%
12%
12%
--------------------------------------------------------------------------------------
Economic Profit
NOP [from above]
Capital Charge [CCAP]
Economic Profit [“EP”]
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$100
(72)
$ 28
$100
(96)
$ 4
$100
(120)
$ (20)
16
Value “Indicators” – Economic Profit
We can restate “EP” as “ROC” by changing the formula within our framework.
“Base Period”
CO. ‘A’
CO. ‘B’
CO. ‘C’
Revenue [Sales]
$1,000
$1,000
$1,000
Net Operating Profit
[NOP]
-$
-%
$100
10%
$100
10%
$100
10%
Invested Capital [IC]
$600
$800
$1,000
Cost of Capital [CCAP]
12%
12%
12%
--------------------------------------------------------------------------------------
Economic Profit
Net Oper. Profit [NOP]
$100
Invested Capital [IC or C]
600
Return on Capital [“ROC”] ~17%
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$100
800
~12%
$100
1,000
10%
17
Value “Indicators” – Financial “Drivers”
There are three major support measures for management
focus.



Growth Rates
Invested Capital Intensity
Value Profit Margin
These “drivers” provide a foundation for the Economic
Profit and Market Value Added metrics, and give managers
a simple, yet powerful, template for value creation.
These support measures are also the ones to focus on
when evaluating business strategies and major investment
programs.
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Value “Indicators” – Financial “Drivers”

Growth Rates


Invested Capital Intensity


“Relationship” of Revenue, Operating Profit
and Invested Capital Growth .... CGR’s
How much Capital to Generate One Dollar ($1.00)
of Revenue (Sales) .... in total or incremental ....
encompasses working and fixed capital
Value Profit Margin (VPM )
TM *

Minimum Profit Margin to Create Value for
Shareholders (Owners)
* VPM is a trademark of Vanguard Partners
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Value “Indicators” – Financial “Drivers”
Value Profit Margin is a very useful support measure.

What is it?



A “minimum” profit margin ... in essence, a beginning point
for value creation
A pre and/or post tax financial performance benchmark
Why use it?





Allows for profitability comparisons for businesses of
different size
Simple to calculate and easy to communicate ... especially to
operating managers
Provides managers with a threshold ... generating a positive
“spread” creates shareholder value
Effective for planning ... strategies, acquisitions, investments
...And, provides an “earnings” measure linked to value.
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Value “Indicators” – Financial “Drivers”


How is VPM calculated ?

Pre Tax Basis -- multiply ‘ICI’ by ‘CCAP’ ...
then, divide by ‘one minus the effective tax rate’

After Tax Basis -- multiply ‘ICI’ by ‘CCAP’
Example -- assume Co. ‘A’:
Revenue (Sales) = $1,000, IC = $600 [ICI = $.60]
CCAP = 12%, and the effective tax rate = 30%

“VPM”
-- Pre Tax Basis
.60 x 12% = 7.2% / 70% = 10.3%

“VPM”
-- After Tax Basis
.60 x 12% = 7.2% ... vs. Actual NOP = 10% (Example)
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Value “Analysis”
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Value “Analysis” – Market Value Added
•
Economic Profit (‘EP’) translates into Market Value Added (‘MVA’) –
closely related to Shareholder Value Creation – through a future
financial forecast or outlook. Business strategy should “drive” the
assumptions and rationale of a future outlook.
•
Assume the following assumptions for the ‘A’, ‘B’, ‘C’ Example:
1. All companies maintain same invested capital to revenue ratio.
2. All companies continue to earn same profit margin on revenue.
3. All companies increase revenue by 10% per year … for 4 years.
The implications of these assumptions and the future outlook’s “value”
is dramatic, depending on whether a business is an ‘A’, ‘B’ or ‘C’.
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23
Value “Analysis” – the “Magnifier”
Company ‘A’
Invest capital in growth-oriented
strategies / programs ... with
high return potential
“Go for Growth” -- instill growth
as a driving force throughout the
organization
 Emphasize staying close to existing
margins and capital intensity, with
room for some deterioration if the
opportunity is significant

... Growth adds value -- “Bigger
is Better” !
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Value “Analysis” – the “Magnifier”
For Co. “A” -- More growth adds more value !
$ “MVA”
(Discounted)
$400
$300
+75%
ILLUSTRATION
+51%
+MVA %....
(Cumul.)
+10%
+29%
$408
$351
$301
$200
$233
$256
$100
$0
0%
5%
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10%
15%
% Growth
20% (Sales)
25
Value “Analysis” – the “Magnifier”
Company ‘B’
Earn more operating profit
with the same capital
Squeeze additional profit
from existing capital base
.... Selective pricing
and/or cost cutting
 Emphasize margin
improvement

... Growth is secondary -adds minimal value !
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Value “Analysis” – the “Magnifier”
Company ‘C’

Reduce the level of capital
employed
Streamline / re-engineer / re-structure
operations
 Validate capital invested in major
lines of business

... Growth ‘destroys’ value !
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Value “Analysis” – the “Magnifier”
For Co. “C” -- More growth destroys more value !
20%
15%
% Growth - Sales /
Earnings
10%
5%
0
-$ 75
-$167
-$150
-$183
-$225
-10%
-$300
$ Value - “MVA”
(Discounted)
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-$215
-29%
-$251
-51%
-$291
-75%
28
Allocating Resources –
Based on “Value Creation”
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Allocating Resources based on “Value”
The “value-based” approach takes corporate and business unit evaluations to a
new level. Assume a hypothetical company with four business units.
“Market” Values
Per Share Values
$70
‘Total’ Value
$60
$70
‘Strategy’
Value
$50
$35
‘No Growth’
Value
$40
$35
$30
BU #1
BU #2
$20
$20
$5
$15
$20
$10
$15
$5
BU #3
$15
$10
$5
BU #4
Total Co.
$15
$5
$10
-0-
“Strategy” Values can be determined for the Business Units, and
should be the basis for making investment decisions.
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Allocating Resources based on “Value”
When “market values” and “cash flows” are integrated, corporate and business
unit analysis is completed.
Market Value / Cash Flow
Per Share Values
$70
$70
$60
$35
$50
$40
$35
$30
BU #2
$20
$20
$10
$15
$5
BU #3
Total Co.
$15
$10
$5
BU #4
$15
$5
$10
BU #1
$20
$5
$15
-0-
Negative Cash Flow
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Positive Cash Flow
31
Summary: The “Essence” of VBF
•
“Economic” Profit incorporates income statement performance, balance sheet
investments and a capital cost, making it more robust than “Accounting” Profit.
•
Operating managers can “drive” value creation by focusing on three key
financial indicators:

The relationship of revenue, profit and invested capital growth

The amount of capital needed to generate one dollar of revenue

Margins (before and/or after tax) above a minimum level required for value
enhancement.
•
The “economic” profit approach and supporting financial “drivers” provide a
template to assess progress toward shareholder value goals.
•
Economic Profit translates into Market Value Added through a future outlook,
providing a mechanism for valuing strategy and allocating resources.
•
Growth “magnifies” value creation (positively or negatively) depending on
whether economic returns are above or below the cost of capital.
•
Resource allocation decisions should be based on “strategy value”.
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32