Drive value (ver 2)

RDT Management Group Inc.Creating Value | Imagining the Future

Creating Valuea Primer

Scott L. Thomas, CFA, CMA

1Monday, 30 April, 12


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.

What is Creating Value?



l As defined in the Oxford Dictionaries:noun2 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.

Who is a Stakeholder?



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!

How is Corporate Value Managed?



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!

Why this matters!

Introduction



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

Foundation for Value Generation



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.

Control Environment



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

Governance



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.

Risk Management



l Regulatory influences.l Special interest groups may in fact be relevant stakeholders.l Externalities.

Operations : Factors that matter

Understanding the “Macro” environment of the firm



Understanding the “Macro” environment of the firm

PotentialEntrants

IndustryCompetitors

Suppliers Buyers

Substitutes

Bargaining Power Suppliers

Threat of Substitutes

Bargaining power of buyers

Threat of new entrants

Michael Porter

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?• How well does the company execute its

strategy?

Each quadrant influences and frames the operating environment of the firm!

Must understand your business and competitive landscape. What business are you in? What strategies do you, should you, deploy?




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!




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.

How is Value Measured?



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.

Why Stakeholders and not Shareholders?



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.

Value Management : a new alignment?



Is a cross functional process and impacts many aspects of the organization:end goal is to enhance value to stakeholders.

Align compen–sation with value creation

Society, Special Interest Groups and Government

Sociological

Management Architecture

Process and Information

Externalities

Culture and Competency

•Communicate strategies •Define team •Train individuals •Align processes

Value creation part of the Mission

Value model the Business

Develop value creating strategies

Definevalue perfor–mance measures

•Align organizational structure •Integrate tools into management process •Align accountabilities with value management

•Assess processes/information

•Redesign reporting structure to support value management

•Implement processes and value management reporting

Infrastructure

•Assess potential impacts related to existing and proposed projects. Quantify all risks.

•Design feedback loops to support and improve decision making with respect to externalities.

•Link economic impact of externalities to value management reporting system.

The Value Management Process



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.

Why Value Model the Business?



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.

Value Drivers



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.

Value Modelling tools should contain:

What is Value Modelling?



Cash Flow Indicators

Financial Value Drivers Value Creation Tactics Value Measures

Cash Flow Revenue Growth New Product Development Revenue from new productsCash Flow Revenue GrowthNew Customers Revenue from new Customers

Cash Flow Revenue Growth

New Markets Revenue from new Markets

Cash Flow

Operating Margins Eliminate unprofitable business units/products/customers

Operating loss eliminated

Cash Flow

Operating MarginsImprove supply chain management Supply chain cost by customer by

product

Cash Flow

Operating Margins

Cash Flow

Working Capital Reduce cash conversion cycle Increase Inventory turns

Cash Flow

Working CapitalDemand pull manufacturing Reduce A/R days

Investment

Working Capital

Reduce order to ship cycleInvestment

Asset Productivity Eliminate unproductive assets Return on Assets

Investment

Asset ProductivityIncrease revenue per deployed asset base

Investment

Asset Productivity

Technology opportunities

Illustrative and not exhaustiveMaximizing Value-in the Long Term



– 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.

The recommended process:

Project Evaluation and Time Value of Money



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.

Free Cash Flow to the Firm (FCFF)



Factors Component Item Drivers Questions

Cash Flow from Operations (CFO)

Operational Productivity

Revenue • Revenue Growth;• Product development;•Customer retention and satisfaction;• Quality of products / services;• Pricing / Service method;• Product /Service differentiation or focus;• Sales process(s);• Supply chain value management (how, when, where is the final end user located on this value chain);• Direct customer/product profitability analysis

• AVractiveness of industry (s) company operates in;• Companies relative competitive position and competitive strategy;• How effective does the company execute its strategy and future prospects;• Bargaining power of buyers;• Barriers to entry;• Substitutes;• Does my pricing and supply chain tactics flow from my overall business strategy;• 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;• Employees;• General and administrative;• Cash taxes

• Bargaining power of suppliers;• Culture and motivation; • Organizational behavioural conflicts;• Control environment;• 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 daysObjective is to shorten the cycle

Maximizing Firm Value- Example Components; drivers



Factors Component Item Drivers Questions

Add back: After tax interest costs

Fixed Capital Investment (FCInv)

Asset Productivity

Capital Budgeting Process

• Idea generation;• Fits corp strategy

• Proposal Analysis;• after tax incremental cash flows (opportunity cost basis) not accounting constructs• tax impact fully reflected• timing of cash flows• required rate of return• Financing costs ignored (captured in WACC)• Profitability index

• Planning/Implementation;• Monitor/Post Audit;• Profitability Index (PI ) > 1 invest, otherwise value destroyed;• Externalities and impact;• R&D impact and conversion from idea to product.

• Is the project categorized as;• replacement• expansion• new product/service• regulatory, safety, environmental

• Are cash flows based on incremental after-‐‑tax cash flows discounted at the opportunity cost of funds?• Financing costs are ignored!• Do you use sensitivity/simulation analysis?• Use of Real Options along with discounted cash flows? Real options along with discounted cash flow assist with optimizing decision making and price flexibility, (timing, sizing,flexibility, fundamental).• Common issues;

• Externalities and economic responses ;• Errors in standardized template not matching project realities;• Pet projects;• 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.

Maximizing Firm Value- Example Components; drivers



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: a framework for value creation



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 .

Summary: value management



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!

Finally: Some thoughts on underperformance


Date post:	01-Nov-2014
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