VALUE BASED MANAGEMENT

Creating value for shareholders is now widely accepted as the dominant corporate objective. The
interest in value creation has been stimulated by several developments.

• Many leading company like general Electric, Coca Cola, Siemens, Hindustan Lever,
Reliance Industries, and Infosys Technologies which have accorded creation a central
place in their corporate planning serve as role model for other.

• Greater attention is now being paid to link top management compensation to shareholder
returns.

To help firms create value for shareholders, value based management (VBM) approaches have
been developed. VBM represent a synthesis of various business disciplines. From finance, VBM
has adopted the goal of shareholder value maximization and the discounted cash flow model;
from business strategy, VBM has borrowed the notion the value creation stems from exploiting
opportunities based on the firm’s comparative advantage.

This chapter discusses the principal VBM approaches developed by leading consulting
organizations. It is organized into eight sections as follows:-

• Method and key premises of VBM

• Marakon approach

• Alcar approach

• McKinsey approach

• Stern stewart approach

• BCG approach

• Lessons from the experience of VBM adopters

• Potential and hurdles for VBM in India

Key Difference:- The key difference between these methods relates to VBM metrics. For
example, the LEK/Alcar methods uses shareholder value added (SVA), the stern Stewart method
emphasizes EVA and MVA, and the BCG method focus on CFROI and CVA.
Each camp argues that is measures are the best and cites supporting evidence for
the same. It is difficult to objectively assess the validity of the claims.
While the different methods to VBM have their own fan clubs, the
EVA/MVA method seems to have received more attention and gain more popularity.
 MARAKON APPROACH:-

Marakon Associate, an international management consulting firm founded in 1978, has done
pioneering work in the area of value based management.

The key steps in the marakon approach as follows:-

• Specify the financial determinants of value

• Understand the strategic drivers of value

• Formulate higher value strategies

• Development superior organizational capabilities

Specify the financial determinants of value:- The marakon approach is the based on a market
--to- book model. According to this model, shareholder wealth creation is measures the
difference between the market value and the book value of a firm’s equity. The Book
value of equity, B, measures approximately the capital contributed by the shareholders
whereas the market value of equity, M, reflects how productively the firm has emphasis
the capital contributed by the shareholders, as assessed by the stock market.

Hence, management creates value for shareholders if M exceeds B, decimates value of M

is……. Than B and maintains the value of M is equal to B.

Understand the strategic determinant of value:- the key financial determinants of value,
discussed above are the spread (between the return on equity and the cost of equity) the growth
rate is dividends. What influences these factors the two primary strategic determinants of spread
and growth and, hence, value creations are: market economics and competitive position. Exhibit
1.1 shows schematically how the strategic determinants bear the value creation.

Exhibit 1.1 strategic determinant of value creation

Market Economics Financial

Determinants
Structural Average equity
factors and spread and growth of
trends market(S) over time

Average equity
Competitive position
spread over time Value
creation
Differentiatio
Relative equity
n and Average growth
spread and growth
economic cost over time
over time
position
Source: and
James M. Mc Taggart, Peter W. Kontes, and Michael C. Mankins. The value Imprative
Market Economics:- Market economic refers to the structural factors which determine the
average equity spread as well as the growth rate applicable to all competitors in a particular
market segment. The key forces which shape market economic (or profitability) as follows :

• Intensity of indirect competition

• Threat of entry

• Supplier pressures

• Regulatory pressures

• Intensity of direct competition

• Customer pressures

Formulate Higher Value Strategies:- Values is created by participating in attractive

markets and/or building a competitive advantage.

Exhibit 1.2 Element of Business Strategy

Participation
Competitive Entry strategy
strategy
strategy options
options options
In which
market
How should
Alternative should we
we compete Exit strategy options
strategy participate?
in each Product
Cost andstrategy
Pricing offering
asset
Source: James M. Mc
development Taggart,
market? Peter W. Kontes, and Michael C. Mankins.
strategy The value
options options
Develop Superior Organizational Capabilities:- Higher value strategies, discussed in
the previous step are designed to overcome the forces of competition. They should be combined
with superior organizational capabilities which enable a firm to overcome the internal barriers to
value creation.
The key organizational capabilities are:

• A competent and energetic chief executive who is fully committed to the goal of value
maximization.

• A corporate governance mechanism that promotes the highest degree of accountability

for creation or destruction of value.

• A top management compensation plan which is guided by the principal of “relative pay
for relative performance”.

ALCAR APPROACH:-
The Alcar Group Inc.,3 a management education and software company, development and
approach to VBM which is based on discounted cash flow analysis. The Alcar approach is
described fully in the book creating shareholder Values : A Guide for Managers and Investors.
Determinants of Shareholder Value:- According to Rappaport, the following seven factors he
calles them “value drivers” affect shareholder value :

• Rate of sales growth

• Operating profit margin

• Income tax rate

• Investment in working capital

• Fixed capital investment

• Cost of capital

• Value growth duration

While the first six “value drivers” are self-explanatory, the last one, viz. , value growth duration,
require some explanation. It represent the period over which investments are expected to earn
rates of return in excess of the cost of capital. It is an estimate reflecting the belief of
management that competitive advantage will exist for a finite period. Thereafter, the competitive
edge would be lost causing the rate of return to regress to the cost of capital.
Corporate Objective

Valuation Component

Exhibit 1.3 Shareholder Value Creation Network

Value

Drivers Creating shareholder Shareholder return

value
• Dividends

• Capital gain

Cash flow from

Sales growth Discount
Working Debt
Management Decision operation rate
capital
Operating investment
profit
Source : Alfred Rappaport, Creating Shareholder ValueFixed capitalfor Management and
: A guide
Value Income tax investment
Investors Operati Investm Cost
Financ
growth rate
ng ent of
ing
 Assessment of the Shareholder
Value impact of a strategy:- The procedure suggested by Alcar approach for assessing the
shareholder impact of a strategy involves the growing steps :

STEPS
• Forecast the operating cash flow
Stream for the strategy over the
planning Period.
• Discount the forecasted operating
cash flow stream using the weighted
average cost of capital.
• Estimate the residual value of the
strategy at the end of the planning
period and find its present value.
• Determine the total shareholder
value.
• Establish the pre-strategy value.
• The pre-strategy value is
• Infer the value created by the
strategy.
• The value created by the strategy is:
ELABORATION
• The annual operating cash flow
is defined as: Cash flow [ (Sales)
(Operating Profit Margin) (1 –
Effective tax rate)] –
Cash outflow [Fixed capital
investment + Working capital
investment .
• The weighted average cost
of capital is: (Post-tax cost of debt)
(Market value weighted of debt) +
(Post-tax cost of equity) (market
value weight of equity).
• The residual value is:
Perpetuity cash flow
Cost of capital
• The total shareholder value
is:
Present value of operating cash floe
stream + Present value of residual
value – Market value of the debt.
Cash flow before new investment
Cost of capital - Market value of the
debt
Total shareholder value – Pre-
strategy Value.
The above procedure may be illustrated with the help of an example. The income statement for
year 0 (the year which has just ended) and the balance sheet at the end of year 0 for Venture
Limited, an all-equity financed firm.
Venture Limited is debating whether it should maintain the status quo or adopt a new
strategy. If it maintains the status quo:

• The sales will remain constraint at 1,000

• The gross margin and selling, general, and administrative expenses will remain
uncharged at 25 percent and 10 percent respectively.

• Depreciation charge will be equal to new investments.

• The asset turnover ratios will remain constant.

• The discount rate will be 16 percent.

• The income tax rate will be 40 percent.

If Ventura limited adopts a new strategy its sales will grow at a rate of 10 percent per year for
five years. The margins, the turnover ratios, the capital structure, the income tax rate, and the
discount rate, however, will remain unchanged. Depreciation charges will be equal to 10 percent
of the net fixed assets at the beginning of the year.

MCKINSEY APPROACH:-
Mckinsey & company, a leading international consultancy firm, has developed an approach to
VBM which has been very well articulated by Tom Copeland, Tim Koller, and jack Murrir of
Mckinsey & company according to them:
“properly executed value based management is an approach to management
whereby the company’s overall aspiration, analytical techniques, and management processes are
all aligned to help the company maximize its value by focusing decision making on the key
drivers of the value.
 Exhibit 1.4 SHAREHOLDER VALUE MANAGEMENT CYCLE

Strategic
planning

Portfolio review
Investor
and resource
communications
allocation

Incentive Performance
compensatio
Source : nAlfred Rappaport, Creating value
evaluation
for Shareholders : A Guide for
Managers

and Investors

investors

Arcas of activity for making value happen:-

• Aspirations and targets

• Portfolio management

• Organizational design

• Value driver identification

• Business performance management

 • Individual performance management

STERN STEWART APPROACH (EVA® APPROACH)6

Originally proposed by the consulting firm Stern Stewart & Co, Economic Value Added (EVA)
is currently a very popular idea. Fortune magazine has called it “today’s hottest financial idea
and getting hotter “ and management guru Peter Drucker referred to it as a measure of total
factor productivity. Company’s across a broad spectrum of industries and across a wide range of
countries have joined the EVA bandwagon.
EVA is essentially the surplus left after making an appropriate charge for the
capital employed in the business. It may be calculated in any of the following, apparently
different but essentially equivalent ways:

EVA = NOPAT – C* × CAPITAL (33.8)

EVA = CAPITAL (r - c*) (33.9)

EVA = [PAT +INT (1 – t) – c* CAPITAL (33.10)

EVA = PAT _ KE EQUITY (33.11)

Where EVA is the economic value added, NOPAT is the net operating profit after tax, c* is the
cost of capital, CAPITAL is the economic book value of the capital employed in the firm.

What Cause EVA to increase

From the above analysis it is clear that EVA will rise if operating efficiency is improved, if value
adding investments are made, if uneconomic activities are curtailed, and if the cost of capital is
lowered. In more specific terms, EVA rises when:

• The rate of return on existing capital increases because of improvement in operating

performance. This means that operating profit increases without infusion of additional
capital in the business.

• Additional capital is invested in projects that earn a rate of return greater than the cost of
capital.

• Capital is withdrawn from activities which earn inadequate returns.

• The cost of capital is lowered by altering the financing strategy.

BCG APPROACH:-
Boston Consulting Group (BCG), an international consulting organization, has developed
an approach to shareholder value management that builds on the pioneering work of their
specialist group HOLT Value Associates. Two concepts are at the foundation of the BCG
approach: total shareholder return and total business return. For applying these concepts, two
performance metrics are used: cash flow return on investment and cash value added.

Total shareholder return The total shareholder return (TSR) is the rate of return shareholders
earn from owning a company’s stock over a period of time.

The TCR for a single holding period is computed follows.

Dividend Ending market value – Beginning market value

TSR= Beginning market value Beginning market value

The TSR for a multiple holding period is computed using the conventional internal rate of
return computation

Beginning market value = Dividend1 Dividend2 Dividendn ……

1
(1+TSR) (1+TSR)2 (1+TSR)n

Ending market value in year n

(1+TSR)n

There are several reasons why BCG regards TSR as the most useful measure of value creation:
(i) TSR is comprehensive as it includes dividends as well as capital gains. (ii) TSR is widely
used by the investment community and also required by the Securities Exchange Commission.
(iii) TSR can be easily benchmarked against the market or peer groups. (iv)TSR is not biased by
size. (v)TSR is difficult to manipulate.

Total Business Return If TSR is what matter to investors, an internal counter part to it is
needed for managerial purpose. For BCG, the total business return (TBR) is the internal
counterpart of TSR. The link between TSR, TBR, and value drivers is shown is Exhibit.

Exhibit 1.5 TSR, TBR and the Value Drivers

Total business Total

return Shareholder

Capital gain Free cash flow

Return on as
Measured invested
cash flow Growth in new
return on investment
capital investments
 The TBR for a single holding period is computed as follows:

TBR = Free cash flow Ending value – Beginning value

Beginning value + Beginning value

The TBR for a multiple holding period is measured using the conventional internal rate of rate
computation:

Beginning value = Free cash flow1 Free cash flow2

(1+TBR) + (1+TBR)2 + ……..

+ Free cash flow + End value in year n

n
(1+TBR) (1+TBR)n

The beginning and ending values are estimates of market value of the firm or business unit at the
beginning and end of the period. They are estimated using one or more of the following:

Value = Earnings × P / E multiple

Values = Book value × M / B multiple

Value = Free cash flow + cost of capital

Value = NPV of expected cash flow

BCG calculates TBR using a time fade model which assumes that a firm’s return on invested
capital and its growth rate will fade over time toward a national average due to competitive
pressures. Bartley madden of HOLT value associates explains as follows: “When business
succeed in achieving above-average return and try to serve the customer ever more effectively.
The competitive process tends to force high –CFROI firms toward the average. Businesses
earning CFROIs below the cost of capital are eventually compelled to restructure and / or
downsize in order to earn at least the cost of capital, or eventually they cease operations.” Inter
alia, BCG uses the TBR for strategic planning, resource allocation, and incentive compensation.

Cash flow return on Investment (CFROI) The TBR incorporates the returns (CFROIs) both
for the assets in place and the assets to be created. Thus CFROI has an important bearing on
TBR.

What is CFROI and how is it measured? BCG defines CFROI as “the sustainable cash flow a
business generates in a given year as a percentage of cash invested in the firm’s assets”.
Sustainable cash flow is gross cash flow less economic depreciation.

Thus,

Cash flow – Economic depreciation

CFROI= Cash invested

LESSONS FROM THE EXPERIENCES OF VBM ADOPTERS

• Top management support and involvement is essential.

• A good incentive plan is necessary.

• Employees should be properly educated.

• The choice of value metric per se is not critical.

• VBM works well in certain cases.

• One size doesn’t fit all.

EVA and CVA Calculation

• Top management support

• Incentive plan

• Education

• Choice of metric

• Conductive Circumstances

• Need for Customisation