What is value-basedmanagement?

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What is value-based
management?

An excerpt from Valuation: Measuring and Managing
the Value of Companies
, Second Edition

Timothy Koller
RECENTYEARSHAVESEENa plethora of new management approaches
for improving organizational performance: total quality management,
flat organizations, empowerment, continuous improvement, re-
engineering, 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 multibusiness 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.
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WHAT IS VALUE-BASED MANAGEMENT?
Exhibit 1
Pitfalls
Examples of VBM’s impact
Yet value-based management
Business
Change in behavior
Impact
is not without pitfalls. It
Retail
Shifted from broad national
30–40% increase in
can become a staff-captured
household
growth program to focus on
potential value
goods
building regional scale first
exercise that has no effect on
Insurance
Repositioned product
25% increase in
operating managers at the
portfolio to emphasize
potential value
products most likely to
front line or on the decisions
create value
that they make.
Oil
Used new planning and
Multimillion dollar
production
control process to help drive
reduction in planning
major change program
function through
A few years ago, the chief
streamlining
planning officer of a large
Prompted an acquisition
Exposed nonperforming
company gave us a preview
managers
of a presentation intended
Banking
Chose growth versus harvest
124% potential value
strategy, even though
increase
for his chief financial officer
five-year return on equity
and board of directors. For
very similar
about two hours we listened
Telecoms
Generated ideas for value
creation
to details of how each busi-
• New service
240% potential value
ness unit had been valued,
increase in one unit
• Premium pricing
246% potential value
complete with cash flow fore-
increase in one unit
casts, cost of capital, separate
Around 40% of planned
NA
capital structures, and the
development projects in one
business unit discontinued
assumptions underlying the
Salesforce expansion plans
NA
calculations of continuing
completely revised after
discovering how much value
value. When the time came
they would destroy
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
VBM aligns a company’s
management, this company simply
overall aspirations,
had value veneering.
analytical techniques, and
management processes with
Not methodology
the key drivers of value
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 behavior as in using valuation as a performance metric and
decision-making tool.
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WHAT IS VALUE-BASED MANAGEMENT?
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
When VBM is working well,
compare the value of alternative strat-
management processes provide
egies and the incentive to choose the
decision makers at all levels
value-maximizing strategy. Such an
with information and incentives
incentive is created by specific finan-
to make value-creating decisions
cial 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 center 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
Senior managers
insufficient. Taken together, they can have a
must have a solid analytical
huge and sustained impact.
understanding of which
performance variables drive
A value creation mindset means that senior
the value of the company
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.
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WHAT IS VALUE-BASED MANAGEMENT?
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 organi-
zation. Such objectives do not contradict
Objectives must be tailored
value maximization. On the contrary, the most
to the different levels
prosperous companies are usually the ones
within an organization
that excel in precisely these areas. Non-
financial goals must, however, be carefully
considered in light of a company’s financial circumstances. A defense 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
Companies that focus only on
of performance.
this year’s net income or
on return on sales are myopic
Exhibit 2 compares various measures
and may overlook major
of corporate performance along two
balance sheet opportunities
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.
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WHAT IS VALUE-BASED MANAGEMENT?
Exhibit 2
Decision making can be
Measuring corporate performance
heavily influenced by the
Greater need for
choice of a performance
long-term view
Growth
Multiyear
of net
discounted
metric. Shifting to a value
High probability
income
cash flow or
of significant
economic profit
mindset can make an enor-
industry change
• Technology
mous difference. Real-life
• Regulation
cases that show how focusing
• Competition
Net income,
ROIC minus WACC,*
Long life of
return on
economic profit
on value can transform
investments
sales
(one year)
decision making are described
Complexity of
in the inserts “VBM in action.”
business portfolio
Greater need for balance sheet focus
(capital intensity)
Working capital
Finding the value drivers
Property, plant, and equipment
An important part of VBM is
* Return on invested capital minus weighted average cost of capital
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
Exhibit 3
Levels of value drivers
that affects the value of the
company. To be useful, how-
Level 1
Level 2
Level 3
Generic
Business-unit
Operational
ever, value drivers need to be
specific
(grass roots level)
organized so that managers
Examples
Examples
Customer mix
Percent accounts
can identify which have the
Revenue
revolving
Salesforce
greatest impact on value and
productivity
Dollars per visit
assign responsibility for them
Margin
(expense
Unit revenues
against revenue)
to individuals who can help
Fixed cost/
Billable hours to
the organization meet its
Costs
allocations
total payroll hours
targets.
Capacity
Percent capacity
management
utilized
ROIC
Operational
Cost per delivery
Value drivers must be defined
yield
at a level of detail consistent
Working
Accounts
capital
receivable terms
with the decision variables
and timing
that are directly under the
Invested
Accounts payable
capital
control of line management.
terms and timing
Generic value drivers, such
Fixed
capital
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. Exhibit 3 shows that value drivers can be useful at
three levels: generic, where operating margins and invested capital are combined
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VBM IN ACTION:
MANAGING THE BALANCE SHEET
In CompanyX, a large consumer products million. Of that total, $146 million derived
company, the performance of each of its
from improved management of working
50 business units was measured by its
capital, particularly inventories. Because of
operating margin or return on sales (ROS).
its emphasis on sales, Company X was over-
As the exhibit shows, Company X was
producing and carrying excess inventories to
“doing better” than its average competitor
minimize the probability of stockout. Obsolete
because it was earning a 15.1 percent ROS
and outdated inventories necessitated
compared with an industry average of
periodic write-downs. Inventory management
only 14.3 percent.
was a shambles.
But Company X had a problem. Its stock
An even larger value creation opportunity
price was not performing well against the
existed in consolidating manufacturing
competition. Management was dissatisfied
operations. Several plants in adjacent
and began to ask questions. No one could
geographical areas were underutilized. When
understand why the stock market “didn’t
the least productive were closed and output
appreciate” the company’s success.
shifted to the most productive facilities, two
Taking the analysis a little further, we see
benefits emerged. First, less capital was
that Company X’s return on invested capital
employed to produce the same finished
(ROIC) pretax was 27.2 percent, while
goods; and second, production became
competitors earned 34.3 percent. Company
more efficient, raising operating margins.
X was employing the wrong performance
The value of consolidating operations was
metric. Using ROS meant that it was
about $364 million.
completely ignoring balance sheet
Company X failed to manage its balance
management. Consequently, its capital
sheet because of its emphasis on the wrong
turnover (sales divided by invested capital)
performance metric – return on sales.
was only 1.8, versus 2.4 for its competitors.
When it moved to ROIC and value creation,
All told, the impact of improvement in the
it discovered opportunities that had
balance sheet amounted to roughly $500
previously been missed.
ROIC tree of Company X versus the competition
Company X
Cost of goods sold
Competitor’s average
1
46.3%
53.7
Return on sales
SG&A
15.1%
35.0
14.3
26.6
Depreciation
3.6
Pre-tax ROIC
5.4
27.2%
Fixed assets
34.3
1
23.5%
15.7
Capital turnover
Working capital
1.8
15.3
2.4
11.6
Net other assets
16.9
14.5
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VBM IN ACTION:
TAKING THE LONG-TERM VIEW
One of the largestdivisions of a money creation potential. It resulted in a 124 percent
center bank, the retail bank, had been
increase in value over the harvest strategy,
pursuing a “harvest” strategy. It had
worth more than $450 million.
been underinvesting and taking cash out of the
business. Unfortunately, it had also been losing
Forecasted ROE for a retail bank
market share, albeit slowly over a long period.
Percent
The new chief operating officer wanted to
50
spend roughly $100 million on a plan to
“Aggressive
growth”
recapture market share by refurbishing branch
40
strategy
facilities, installing new automatic teller
“Harvest”
machines, training tellers to improve customer
30
strategy
satisfaction, and launching a new advertising
20
campaign. This alternative was called the
“aggressive growth” strategy. It was designed
10
to win back market share at the same slow
rate at which it had been lost – a fairly
0 1989
1990
1991
1992
conservative approach.
The crucial measure for this program was
return on equity (ROE) projected over the next
Why did the return on equity and the value
three years, as shown in the exhibit. The ROE
creation performance metrics give such
for the aggressive growth strategy was lower
different answers? The reason is that most
than the harvest strategy for the first year,
of the value creation potential was outside
about the same in the second year, and only
the three-year time frame that was used for
slightly higher in the third year. When these
making ROE comparisons at the bank.
results were shown to the bank’s CEO, he at
Valuation requires a longer view, because
first could not understand how the aggressive
the value of a strategy cannot be estimated
growth strategy could be better, but he
without forecasting the cash flows over the
realized the answer when he saw its value
long run.
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.
Exhibit 4 illustrates value drivers for the customer servicing function of a
telecommunications company. Value driver trees like this one are usually
linked into ROIC trees, which are in turn linked into multiperiod cash flows and
valuation of the business unit. Total customer service expense, on the left-hand
side of the tree, was an expense-line item in the income statement of several
business units. Improving efficiency in this key function would therefore affect
the value of many parts of the company.
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.
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WHAT IS VALUE-BASED MANAGEMENT?
Exhibit 4
Value drivers in customer servicing
Example: Telecoms company
Call volume
Number of
Total
people
Percent
Percent
customer
Personnel
occupancy
time on board
servicing
cost
expense
Cost per person
Average work
Percent
Number of
time per call
training time
stations per SDC
Service
Hourly rate
Percent
delivery
time on breaks
center (SDC)
Equipment cost
expense
per station
Benefits
Percent
Station
vacation time
cost
Equipment
Annual salary
Number of SDCs
maintenance
expense per
Percent
station
Benefits
time paid
Cost per SDC
Other equipment
Span of control
Percent
expense
absence/other
Overhead
Number of
expense
Salary expense
employees
Supervisory
cost
Utilities
Headquarters
Number of
expense
supervisors
Other
Regional center
Building
expenses
operating
Number of
expense
Overhead
employees
Area staff
cost
center expenses
Building
Equipment
maintenance
expense
Allocated G&A
Materials
Other
What is important is that these key value drivers, although only a small part of
the total business system, have a significant impact on value, are measurable
from month to month, and are clearly under
Exhibit 5
the control of line management.
Value drivers for a hard goods retailer
Key areas of focus
Gross margin
To see how the numbers might work, consider
per transaction
Gross
the list of value drivers for a hard goods
margin
Number of
retailer shown in Exhibit 5. The value of the
transactions
company derives partly from gross margin,
Stores per
warehouse costs, and delivery costs. Gross
warehouse
Warehouse
margin, in turn, is determined by gross
Company
costs
value
Cost per
margin per transaction and the number of
warehouse
transactions (which can be themselves further
Trips per
disaggregated if necessary). Warehouse costs
transaction
are a function of the number of retail stores
Delivery
per warehouse and the cost per warehouse.
Cost per trip
costs
Finally, delivery costs are determined by the
Number of
number of trips per transaction, the cost per
transactions
trip, and the number of transactions.
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WHAT IS VALUE-BASED MANAGEMENT?
Analysis of these variables showed that the number of stores per warehouse
significantly affected the cost per transaction: the more stores that could
be served by a single warehouse, the lower the warehouse costs relative
to revenues. The scale economies were substantial enough to support a
strategy of growth through metropolitan concentration, rather than a shot-
gun approach of scattering new
stores over a wide area. The number
In the customer servicing
of stores per warehouse thus became
function of a telecoms
a strategic value driver.
company, it took five levels
of detail to reach useful
Further analysis revealed that the
operational value drivers
number of delivery trips per trans-
action was very high. Whenever there
were errors in an order or goods proved defective, multiple deliveries had to be
made to a single customer. The retailer found that it was making an average of
1.5 trips per transaction, compared with a theoretical minimum of 1.0.
Management believed this was high for the industry and thought it should be
reduced to 1.2. Attaining this performance would increase value by 10 percent.
So trips per transaction became an operating value driver as the company
began to monitor its monthly performance.
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.
Scenario analysis is a way of
What is needed instead is a creative process
assessing the impact of different
involving much trial and error.
sets of mutually consistent
assumptions on the value of a
Nor can value drivers be considered in
company or its business units
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.
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WHAT IS VALUE-BASED MANAGEMENT?
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.
For VBM to stick, line managers
must embrace value-based
There are four essential management
thinking as an improved way of
processes that collectively govern the
making decisions
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
The chosen strategy should
should be built on a thorough understanding
spell out how a business unit
of business-unit strategies.
will achieve a competitive
advantage that will permit
At the business-unit level, strategy develop-
it to create value
ment 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:
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