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The Key to Managing Value Drivers

If you ask a business appraiser what your company’s value drivers are, he may respond with definitions of the variables found in a net present value formula, or a description of the empirical data used to arrive at the cost of capital, financial leverage, and the rate of earnings growth.

This is because valuation calculations are most affected by small changes in four assumptions:

  • The short term growth rate of annual cash flow over a discrete forecast period of 5-10 years.
  • The long term growth rate of annual cash flow following the discrete forecast period, which is used to estimate what the terminal value, or market value will be at the end of the forecast period.
  • The cost of capital expressed as annual rates of return necessary to induce the equity holders and lenders to provide the capital necessary to fund the assets used in production.
  • The capital structure, or ratio of debt to equity, at various points in time during the forecast period.

While the cash flows, discount rates and growth rates that appear in a valuation analysis have a direct effect on the conclusion, they are not the means by which value is created. These are merely numerical representations and estimates of how well the company’s value drivers have been developed and managed.

The true value drivers are those business processes and relationships that management can change and maintain to increase efficiency or utilize excess capacity. They are affected by tangible actions that management can take to improve the performance and position of the company with respect to its suppliers, customers, lenders, employees, local economy, and competitors. Establishing realistic objectives to accomplish this, and specifically defining the actions necessary to achieve them, is the first step toward managing the value drivers. This happens to also be the final step in the strategic planning process after the company’s value drivers have been identified.

 

The concept of a value driver is one way to describe those particular assets and capabilities that allow a company to provide a compelling alternative choice to its customers. It doesn’t even have to result in the best product or service in the market. The value drivers are simply those assets, relationships, knowledge or abilities that induce customers to buy from your company instead of from competitors, from your suppliers directly, or instead of producing the product themselves.  From this standpoint, identifying the value drivers sounds easy enough…but there’s a catch!
The catch is that owners and management often don’t have the data necessary to determine what the value drivers of their company are, let alone manage them. One reason is that the drivers themselves can change over time as a result of competitive, supply, and market demand forces.  Another common reason is that the management information system does not collect or does not adequately present the data necessary to effectively manage the company’s true value driving activities and processes, even if they are well known.

A third reason the right data may not be available is that reporting methods and systems often change with the turnover of management personnel or transfer of ownership. The extreme, yet common example of this is a retiring business owner who has had sole discretion over all operating decisions, and never felt the need to develop a formal management information reporting and control system. This is one phenomenon underlying the statistic that less than 15% of businesses survive to the third generation, and why succession planning is essential for every business owner.

This common inability to obtain relevant data in a timely manner is the reason why one of the first tasks that a turnaround professional typically pursues (after getting short term cash flows under control) is to upgrade the management information system.

During my years as financial risk manager at GE Capital, our operating companies were obsessed with developing and monitoring the relevant metrics for each department, whether it was sales, asset management, purchasing, collections, finance, or human resources. Collecting and analyzing the data necessary for determining what the value drivers are, and then developing the key metrics and putting controls in place to monitor them was a top priority.  The ability to define and control each business division’s value drivers is itself often cited as one of the ways GE management has brought value to the market and often can convert underperforming companies into valuable enterprises.

In a market with no sustainable barriers to entry, the only successful competitive strategy is to increase and maintain higher operational efficiency than is possible for competitors. A specific example is GE’s equipment leasing business. Although it had grown initially through acquisitions, the ability to forecast, reconfigure and redeploy large fleets of equipment around the country became the primary value driver that distinguished GE from competitors in the eyes of customers and its risk-averse creditors. This resulted in the ability to charge higher prices for faster delivery and greater selection, and to obtain financing at lower cost from lenders and investors due to management’s ability to maximize equipment utilization rates and control losses.

While the resulting greater pricing power and lower cost of capital directly affected GE’s cash flows and discount rates, and thereby increased the value of the company, these were not the value drivers. The true value drivers were management’s ability and access to information to better forecast regional supply and demand for equipment, and the geographic location of the 50 branch offices that enabled GE to quickly reconfigure and move the equipment to where customers needed it.  While this ability was in part due to management’s knowledge and experience, the most difficult and persistent problem to overcome was collecting the relevant data needed to calculate the key metrics necessary for making the correct operating, investment and strategic decisions.  These included whether to close or move the branch offices, renegotiate or renew transport and production contracts, and how or when to change prices.

One of the common fatal errors made in strategic planning and corporate restructuring is to rely on inaccurate or insufficient operating data and performance metrics. Value-based management starts with identifying the true value drivers of a company, and managing them requires the ability to collect the relevant data obtained from a reliable accounting system, competitive market research data, and a relevant activity-based costing analysis.

For more information, contact us at info@anewvalue.com.

1 American Institute of Certified Public Accountants, Journal of Accountancy, May 1997.http://www.aicpa.org/pubs/jofa/may97/cpa.htm. This survey corroborated a 1987 study by John Ward of Loyola University in which 70% of family-owned businesses were found to not survive transfer to the second generation, and only 13% continue to be owned by the third generation.