VALUE BASED MANAGEMENT
What is Value - Based Management?
RECENT YEARS HAVE SEEN a plethora of new management approaches for improving
organizational performance: total quality management, flat organizations,
empowerment, continuous improvement, reengineering, kaizen, team building,
and so on. Many have succeeded – but quite a few have failed. Often the
cause of failure was performance targets that were unclear or not properly
aligned with the ultimate goal of creating value. Value-based management
(VBM) tackles this problem head on. It provides a precise and unambiguous
metric – value – upon which an entire organization can be built.
The thinking behind VBM is simple. The value of a company is determined
by its discounted future cash flows. Value is created only when companies
invest capital at returns that exceed the cost of that capital. VBM extends
these concepts by focusing on how companies use them to make both major
strategic and everyday operating decisions. Properly executed, it is an
approach to management that aligns a company’s overall aspirations, analytical
techniques, and management processes to focus management decision making
on the key drivers of value.
Principles
VBM is very different from 1960s-style planning systems. It is not a
staff driven exercise. It focuses on better decision making at all levels
in an organization. It recognizes that top-down command-and-control structures
cannot work well, especially in large multi business corporations. Instead,
it calls on managers to use value-based performance metrics for making
better decisions. It entails managing the balance sheet as well as the
income statement, and balancing long- and short-term perspectives. When
VBM is implemented well, it brings tremendous benefit. It is like restructuring
to achieve maximum value on a continuing basis. It works. It has high
impact, often realized in improved economic performance, as illustrated
in Exhibit 1.
Examples of VBM’s impact: Exhibit-1
Pitfalls
Yet value-based management is not without pitfalls. It can become a staff-captured
exercise that has no effect on operating managers at the front line or
on the decisions that they make.
A few years ago, the chief planning officer of a large company gave us
a preview of a presentation intended for his chief financial officer and
board of directors. For about two hours we listened to details of how
each business unit had been valued, complete with cash flow forecasts,
cost of capital, separate capital structures, and the assumptions underlying
the calculations of continuing value. When the time came for us to comment,
we had to give the team A+ for their valuation skills. Their methodology
was impeccable. But they deserved an F for management content.
None of the company’s significant strategic or operating issues were
on the table. The team had not even talked to any of the operating managers
at the group or business-unit level. Scarcely relevant to the real decision
makers, their presentation was a staff-captured exercise that would have
no real impact on how the company was run. Instead of value-based management,
this company simply had value veneering.
Not methodology
The focus of VBM should not be on methodology. It should be on the why
and how of changing your corporate culture. A value-based manager is as
interested in the subtleties of organizational behaviour as in using valuation
as a performance metric and decision-making tool.
When VBM is working well, an organization’s management processes provide
decision makers at all levels with the right information and incentives
to make value-creating decisions. Take the manager of a business unit.
VBM would provide him or her with the information to quantify and compare
the value of alternative strategies and the incentive to choose the value-maximizing
strategy. Such an incentive is created by specific financial targets set
by senior management, by evaluation and compensation systems that reinforce
value creation, and – most importantly – by the strategy review process
between manager and superiors. In addition, the manager’s own evaluation
would be based on long- and short-term targets that measure progress toward
the overall value creation objective.
VBM operates at other levels too. Line managers and supervisors, for
instance, can have targets and performance measures that are tailored
to their particular circumstances but driven by the overall strategy.
A production manager might work to targets for cost per unit, quality,
and turnaround time. At the top of the organization, on the other hand,
VBM informs the board of directors and corporate centre about the value
of their strategies and helps them to evaluate mergers, acquisitions,
and divestitures.
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.
The value mindset
The first step in VBM is embracing value maximization as the ultimate
financial objective for a company. Traditional financial performance measures,
such as earnings or earnings growth, are not always good proxies for value
creation. To focus more directly on creating value, companies should set
goals in terms of discounted cash flow value, the most direct measure
of value creation. Such targets also need to be translated into shorter-term,
more objective financial performance targets.
Companies also need nonfinancial goals – goals concerning customer satisfaction,
product innovation, and employee satisfaction, for example – to inspire
and guide the entire organization. Such objectives do not contradict value
maximization. On the contrary, the most prosperous companies are usually
the ones that excel in precisely these areas. Nonfinancial goals must,
however, be carefully considered in light of a company’s financial circumstances.
A defence contractor in the United States, where shrinkage is a certainty,
should not adopt a “no layoffs” objective, for example.
Objectives must also be tailored to the different levels within an organization.
For the head of a business unit, the objective may be explicit value creation
measured in financial terms. A functional manager’s goals could be expressed
in terms of customer service, market share, product quality, or productivity.
A manufacturing manager might focus on cost per unit, cycle time, or defect
rate. In product development, the issues might be the time it takes to
develop a new product, the number of products developed, and their performance
compared with the competition.
Even within the realm of financial goals, managers are often confronted
with many choices: boosting earnings per share, maximizing the price/earnings
ratio or the market-to-book ratio, and increasing the return on assets,
to name a few. We strongly believe that value is the only correct criterion
of performance.
Exhibit 2 compares various measures of corporate performance along two
dimensions: the need to take a long-term view and the need to manage the
company’s balance sheet. Only discounted cash flow valuation handles both
adequately. Companies that focus on this year’s net income or on return
on sales are myopic and may overlook major balance sheet opportunities,
such as working capital improvement or capital expenditure efficiency.
Measuring Corporate Performance: Exhibit-2
Decision making can be heavily influenced by the choice of a performance
metric. Shifting to a value mindset can make an enormous difference. Real-life
cases that show how focusing on value can transform decision making are
described in the inserts “VBM in action.”
Finding the value drivers
An important part of VBM is a deep understanding of the performance variables
that will actually create the value of the business – the key value drivers.
Such an understanding is essential because an organization cannot act
directly on value. It has to act on things it can influence – customer
satisfaction, cost, capital expenditures, and so on. Moreover, it is through
these drivers of value that senior management learns to understand the
rest of the organization and to establish a dialogue about what it expects
to be accomplished.
A value driver is any variable that affects the value of the company.
To be useful, however, value drivers need to be organized so that managers
can identify which have the greatest impact on value and assign responsibility
for them to individuals who can help the organization meet its targets.
Value drivers must be defined at a level of detail consistent with the
decision variables that are directly under the control of line management.
Generic value drivers, such as sales growth, operating margins, and capital
turns, might apply to most business units, but they lack specificity and
cannot be used well at the grass roots level. Value drivers can be useful
at three levels: generic, where operating margins and invested capital
are combined to compute ROIC; business unit, where variables such as customer
mix are particularly relevant; and grass roots, where value drivers are
precisely defined and tied to specific decisions that front-line managers
have under their control.
It took five levels of detail to reach useful operational value drivers.
The “span of control,” for example, was defined as the ratio of supervisors
to workers. A small improvement here had a big impact on the value of
the company without affecting the quality of customer service. Percent
occupancy is the fraction of total work hours that are spent at an operator
station. Relatively minor changes here also have a major impact on value.
Key value drivers are not static; they must be regularly reviewed. Once
the retailer reaches its goal of 1.2 delivery trips per transaction, for
example, it may need to shift its focus to cost per trip (while continuing
to monitor trips per transaction to make sure it stays on target).
Identifying key value drivers can be difficult because it requires an
organization to think about its processes in a different way. Often, too,
existing reporting systems are not equipped to supply the necessary information.
Mechanical approaches based on available information and purely financial
measures rarely succeed. What is needed instead is a creative process
involving much trial and error.
Nor can value drivers be considered in isolation from each other. A price
increase might, taken alone, boost value – but not if it results in substantial
loss of market share. In seeking to understand the interrelationships
among value drivers, scenario analysis is a valuable tool. It is a way
of assessing the impact of different sets of mutually consistent assumptions
on the value of a company or its business units. Typical scenarios include
what might happen if there is a price war, or if additional capacity comes
on line in another country? Thinking about such issues helps management
avoid getting caught off guard and brings to life the relationship between
strategy and value.
Management processes
Adopting a value-based mindset and finding the value drivers gets you
only halfway home. Managers must also establish processes that bring this
mindset to life in the daily activities of the company. Line managers
must embrace value-based thinking as an improved way of making decisions.
And for VBM to stick, it must eventually involve every decision maker
in the company.
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.
Strategy development
Though the strategy development process must always be based on maximizing
value, implementation will vary by organizational level.
At the corporate level, strategy is primarily about deciding what businesses
to be in, how to exploit potential synergies across business units, and
how to allocate resources across businesses. In a VBM context, senior
management devises a corporate strategy that explicitly maximizes the
overall value of the company, including buying and selling business units
as appropriate. That strategy should be built on a thorough understanding
of business-unit strategies.
At the business-unit level, strategy development generally entails identifying
alternative strategies, valuing them, and choosing the one with the highest
value. The chosen strategy should spell out how the business unit will
achieve a competitive advantage that will permit it to create value. This
explanation should be grounded in a thorough analysis of the market, the
competitors, and the unit’s assets and skills. The VBM elements of the
strategy then come into play. They include:
• Assessing the results of the valuation and the key assumptions driving
the value of the strategy. These assumptions can then be analyzed and
challenged in discussions with senior management.
• Weighing the value of the alternative strategies that were discarded,
along with the reasons for rejecting them.
• Stating resource requirements. VBM often focuses business-unit managers
on the balance sheet for the first time. Human resource requirements should
also be specified.
• Summarizing the strategic plan projections, focusing on the key value
drivers. These should be supplemented by an analysis of the return on
invested capital over time and relative to competitors.
• Analyzing alternative scenarios to assess the effect of competitive
threats or opportunities.
Developing business-unit strategy does not have to become a bureaucratic
time sink; indeed, the time and costs associated with planning can even
be reduced if VBM is introduced simultaneously with a reengineering of
the planning process.
Target setting
Once strategies for maximizing value are agreed, they must be translated
into specific targets. Target setting is highly subjective, yet its importance
cannot be overstated. Targets are the way management communicates what
it expects to achieve. Without targets, organizations do not know where
to go. Set targets too low, and they may be met, but performance will
be mediocre. Set them at unattainable levels, and they will fail to provide
any motivation.
In applying VBM to target setting, several general principles are helpful:
Base your targets on key value drivers, and include both financial and
nonfinancial targets. The latter serve to prevent “gaming” of short-term
financial targets. An R&D-intensive company, for example, might be
able to improve its short-term financial performance by deferring R&D
expenditures, but this would detract from its ability to remain competitive
in the long run. One solution is to set a nonfinancial goal, such as progress
toward specific R&D objectives that supplements the financial targets.
Tailor the targets to the different levels within an organization. Senior
business-unit managers should have targets for overall financial performance
and unit-wide nonfinancial objectives. Functional managers need functional
targets, such as cost per unit and quality.
Link short-term targets to long-term ones. An approach we particularly
like is to set linked performance targets for ten years, three years,
and one year. The ten-year targets express a company’s aspirations; the
three-year targets define how much progress it has to make within that
time in order to meet its ten-year aspirations; and the one-year target
is a working budget for managers. Ideally, you should always set targets
in terms of value, but since value is always based on long-term future
cash flows and depends on an assessment of the future, short-term targets
need a more immediate measure derived from actual performance over a single
year. Economic profit is a short-term financial performance measure that
is tightly linked to value creation. It is defined as:
Economic profit =
Invested capital x (Return on invested capital – Weighted average cost
of capital)
Economic profit measures the gap between what companies earns during
a period and the minimum it must earn to satisfy its investors. Maximizing
economic profit over time will also maximize company value.
Action plans and budgets
Action plans translate strategy into the specific steps an organization
will take to achieve its targets, particularly in the short term. The
plans must identify the actions that the organization will take so that
it can pursue its goals in a methodical manner.
Performance measurement
Performance measurement and incentive systems track progress in achieving
targets and encourage managers and other employees to achieve them. Rarely
do front-line supervisors and employees have clear performance measures
that are linked to their company’s long-term strategy; indeed, many have
none at all.
VBM may force a company to modify its traditional approach to these systems.
In particular, it shifts performance measurement from being accounting
driven to being management driven. All the same, developing a performance
measurement system is relatively straightforward for a company that understands
its key value drivers and has set its short- and long-term targets. Key
principles include:
1. Tailor performance measurement to the business unit.
Each business unit should have its own performance measures – measures
it can influence. Many multi business companies try to use generic measures.
They end up with purely financial measures that may not tell senior management
what is really going on or allow for valid comparisons across business
units. One unit might be capital intensive and have high margins, while
another consumes little capital but has low margins. Comparing the two
on the basis of margins alone does not tell the full story.
2. Link performance measurement to a unit’s short- and long-term
targets. This may seem obvious, but performance measurement systems
are often based almost exclusively on accounting results.
3. Combine financial and operating performance in the measurement.
Too often, financial performance is reported separately from operating
performance, whereas an integrated report would better serve managers’
needs.
4. Identify performance measures that serve as early warning
indicators. Financial indicators can only measure what has already
happened, when it may be too late to take corrective action. Early warning
indicators might be simple items such as market share or sales trends,
or more sophisticated pointers such as the results of focus group interviews.
Once performance measurements are an established part of corporate culture
and managers are familiar with them, it is time to revise the compensation
system. Changes in compensation should follow, not lead, the implementation
of a value-based management system.
Compensation design
The first principle in compensation design is that it should provide
the incentive to create value at all levels within an organization. Compensation
for the chief executive officer – though a popular topic in the press
– is something of a red herring. Managers’ performance should be evaluated
by a combination of metrics that reflects their organizational responsibilities
and control over resources.
At the chief executive level in a publicly-held company, increases in
stock prices are directly observable, and therefore a CEO’s bonus can
take the form of stock options or stock appreciation rights. Even so,
many stock price changes result from factors outside the CEO’s control,
such as falls in interest rates. Stock appreciation plans can, however,
be adjusted to remove such general market influences so that they focus
on the aspects of company performance that are directly attributable to
the skill of top management.
Discounted cash flow (DCF) is not one of the performance metrics in Exhibit
6 for good reasons. DCF is the present value of forecasted cash flows.
If compensation relied on DCF, it would be based on projections, not results.
However, we do recommend using DCF in conjunction with economic profit
to establish benchmarks and reward performance at the business-unit level.
The long-term perspective provided by DCF can balance the short-term,
accounting-based metric of economic profit. The latter is often negative
in, for example, start-up or turnaround projects, even though value is
being created.
The role of DCF is to act as a corrective so that compensation can be
calculated appropriately at the business-unit level.
At the front line of management, where financial information is rarely
an adequate guide, operating value drivers are the key. They must be sufficiently
detailed to be tied to the everyday operating decisions that managers
have under their control.
Implementing VBM successfully
Although putting a VBM system in place is a long and complex process,
successful efforts share a number of common features (see Exhibit-3).
Most of these points have already been discussed, and others are self-explanatory,
but the first feature is worth elaborating.
Keys to successful implementation: Exhibit-3
1. Establish explicit, visible top management support.
2. Focus on better decision making among operating (not just financial)
personnel.
3. Achieve critical mass by building skills in a wide cross-section of
the company.
4. Tightly integrate the VBM approach with all elements of planning.
5. Underemphasize methodological issues and focus on practical applications.
6. Use strategic issue analyses that are tailored to each business unit
rather than a generic approach.
7. Ensure the availability of crucial data (e.g. business-unit balance
sheets).
8. Provide standardized, easy-to-use valuation templates and report formats
to facilitate the submission of management reports.
9. Tie incentives to value creation.
10. Require that capital and human resource requests be value based.
As with any major program of organizational change, it is vital for top
management to understand and support the implementation of VBM. At one
company, the CEO and CFO made a video for their employees in whom they
pledged their support for the initiative declared that the basis of compensation
would shift at the end of the year from earnings to economic profit, and
gave examples of what VBM meant. All business units, for instance, would
be expected to earn their cost of capital. “If our cost of capital is
12 percent,” the CEO said, “a 12 percent rate of return on the capital
that we have invested is not good enough. An 11 percent return destroys
value, and a 13 percent return creates value. But a 14 percent rate of
return creates twice as much value as a 13 percent return.”
Most managers had not thought about their business in these terms. The
video caught their attention and showed them that top management supported
the change that was under way.
Though active top management support is a necessary condition for the
successful implementation of VBM, it is not sufficient in itself. Value-based
management, as we have suggested, must permeate the entire organization.
Not until line managers embrace VBM and use it on a daily basis for making
better decisions can it achieve its full impact as an aid to the long-term
maximization of value.
Conclusion
Although putting a VBM system in place is a long and complex process,
successful efforts share a number of common features. Most of these points
have already been discussed, and others are self-explanatory, but the
first feature is worth elaborating.
Most managers had not thought about their business in these terms. The
video caught their attention and showed them that top management supported
the change that was under way.
Though active top management support is a necessary condition for the
successful implementation of VBM, it is not sufficient in itself. Value-based
management, as we have suggested, must permeate the entire organization.
Not until line managers embrace VBM and use it on a daily basis for making
better decisions can it achieve its full impact as an aid to the long-term
maximization of value.
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