The six drivers of shareholder value used in the VPF are:
1. Sales growth.
2. Relative pricing strength.
3. Operating effectiveness.
4. Capital effectiveness.
5. Cost of capital.
6. The intangibles.
Factors such as interest rates, market conditions, and irrational in- vestor behavior will, of course, affect the price of a company’s stock.
However, the six value drivers identified here are those that management teams and directors can use in order to build long-term sustainable share- holder value.
It is important to recognize that the significance of each driver will vary from firm to firm and will also vary over time for a particular firm.
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For example, a firm with increased competition in a low-growth market will likely place significant emphasis on operating and capital effectiveness, whereas a firm with a significant opportunity for sales growth is likely to fo- cus on that driver and place less emphasis on capital management or operat- ing effectiveness. At some time in the future, however, this high-growth firm may have to deal with a slower growth rate and may have to shift emphasis to other drivers, such as operating efficiency and capital management.
In order to attain its full potential value, a firm must understand the po- tential contribution of each driver to shareholder value. The Value Perfor- mance Framework introduced in Chapter 1 is presented again in Figure 5.1.
It starts with the six value drivers that ultimately determine shareholder value. Underneath these value drivers are some of the key activities and processes that determine the level of performance in each value driver. In ad- dition, the framework identifies some of the key performance indicators that can be used to measure the effectiveness of these activities and processes. For example, sales growth is a key driver of shareholder value. A subset of sales growth is the level of organic growth, excluding the impact on sales growth of any acquisitions. Organic sales growth will be driven by a number of fac- tors, including customer satisfaction, which can be tracked by key metrics such as on-time deliveries (OTD) and the level of past due orders.
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FIGURE 5.1 The Value Performance Framework
Source:Reprinted by permission of Value Advisory Group, LLC.
Value Drivers
Levers
Key Performance
Indicators
Strategic Acquisitions Sales Growth
Relative Pricing Strength
Operating Effectiveness
Capital Management Shareholder Value
External Factors Economy, Valuations,
Interest Rates
Intangibles:
Credibility, Future Expectations Cost of
Capital
Supply Chain Management
Risk
WACC
Forecasting Accuracy
Employee Retention, Performance, Satisfaction, and Development Beta
Capital Structure Consistency of Performance Design for Manufacturability
Quality Process Efficiency Organic
Growth
Market Attractiveness Competitive Position Customer Satisfaction
SG&A%
Cost productivity Inventory turns 1” time yield Cost of quality
DSO
Supplier performance metrics Working capital turnover Past due collections Technology Leadership
OTD Past due orders
% of sales—new products R&D effectiveness
Strategy
At the foundation of the Value Performance Framework is the em- ployee. A firm cannot build sustainable value for shareholders without developing and retaining a competent and motivated workforce. This framework is very useful in helping employees and managers throughout the organization link their specific roles and objectives to the value of the company. A brief description of each of the value drivers within the framework follows. In subsequent chapters, each driver will be explored in detail.
Sales Growth
Revenue growth is the most significant driver of shareholder value over the long term. Other drivers are very important, but tend to reach a limit in terms of value creation. For example, a firm can improve management of working capital to a certain level, but will eventually reach a point of di- minishing marginal contribution. However, a firm with a strong competitive advantage in an attractive market can enjoy sales growth over an extended period of time. In due course, this driver also tends to slacken for nearly all firms as they approach the mature stage in the life cycle of a company.
Despite its importance, managers must not focus exclusively on sales growth. To reach full potential value, some level of attention must be paid to each value driver. Additionally, it is important to note that not all sales growth leads to value creation. Sales growth must be profitable and capa- ble of generating positive cash flow and economic returns in a reasonable period of time in order to create value.
It is fairly straightforward and relatively easy to measure and track sales growth over time. Two common measures are the growth in sales over the prior year and the growth over an extended period of time, usu- ally measured as compound annual growth rate (CAGR). Predicting future revenue levels, however, is much more difficult and requires considerable thought and analysis. In fact, estimating future sales and sales growth is typically the most difficult element of any planning or forecasting process.
Under the VPF, we understand that value will be driven, to a signifi- cant extent, by the expectation of futurerevenue growth. Therefore, con- siderable emphasis will be placed on understanding the factors impacting future revenue levels. Key factors in evaluating potential revenue growth include the market size and growth rate, the firm’s competitive position in the market, pricing pressures, costs, product mix, new product introduc- tions, product obsolescence, customer satisfaction, and impact of foreign currency exchange rates, to name a few. The sales growth driver will be re- viewed in greater detail in Chapter 6.
Growing the firm through acquisitions is a very different proposition
than organic growth. This subject is reviewed in detail in Chapter 12, on the economics of mergers and acquisitions.
Relative Pricing Strength
The firm’s ability to command a strong price for its products and services will have a significant impact on financial performance and building share- holder value. Clearly, if a firm has a strong competitive position, it should have greater pricing flexibility. This will allow the firm to set its pricing at a level that covers its costs and investments, and earns an acceptable return for shareholders. However, if the firm is in a relatively weak position in a highly competitive market, it could be subject to significant pricing pres- sure that will limit financial returns and drive cost containment and reduc- tion. The subject of relative pricing strength will be explored more fully in Chapter 6.
Operating Effectiveness
Operating effectiveness is a broad term that covers how effectively and effi- ciently the firm operates. Operating effectiveness is an extremely important value driver and is often measured in terms of costs, expenses, and related ratios. Consider a firm that has operating margins of 15 percent of sales.
This firm consumes 85 percent of its revenues in operational costs and ex- penses. If this firm is able to improve its productivity and reduce costs, a significant improvement in its financial performance, and ultimately its val- uation, will occur.
A couple of obvious topside measures of operational effectiveness in- clude gross margin and selling, general, and administrative (SG&A) ex- penses expressed as a percentage of sales. These measures can be supported by a number of indicators of process efficiency. A less obvious but no less important element of operational efficiency relates to the level of invest- ments a company is making in future growth and the manner in which the firm manages these investments. Many firms have high levels of investment directed toward future growth. The disciplines around evaluating growth programs and eliminating dubious investments are important contributors to future financial performance and value creation. Eliminating invest- ments in dubious investments at the earliest possible time allows managers to redirect the investment dollars to other projects or to improve margins.
An analogous issue for many companies is the frequency and diligence management applies to evaluating business units and/or products that rou- tinely lose money. Thoughtful and disciplined managers can add significant shareholder value by addressing underperforming businesses or product
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lines. In addition to the ability to make the tough calls on these businesses, managers must have visibility into the true economic performance of the units and/or products.
Chapter 7 explores in further detail these and other business processes and key measures for operating effectiveness.
Capital Effectiveness
An often underutilized lever to improve cash flows and shareholder value is effective capital management. Capital effectiveness has two broad cate- gories: operating capital requirements and investments in property and equipment. Failing to manage investments in operating capital and in property and equipment has a significant impact on cash flows and return on assets, and ultimately on valuations.
Our definition of operating capital in the VPF includes accounts receiv- able and inventory, offset by accounts payable and accrued expenses. We will focus primarily on the business processes and conditions that drive the levels of receivables and inventories for a firm.
For property, plant, and equipment (PP&E), we will look at the processes for reviewing and approving large expenditures, measuring uti- lization, and conducting post implementation reviews. In addition, we will address the impact of underutilized assets and the hidden potential value of assets that are quite frequently carried at low accounting values.
Capital effectiveness is explored in detail in Chapters 8 and 9.
Cost of Capital
As we noted in Chapter 3, the firm’s cost of capital is a significant value driver because it is the rate used to discount future cash flows. Cost of cap- ital is influenced by a number of factors, including the firm’s capital struc- ture, perceived risk of future performance, operating leverage, and stock price volatility. General economic factors, such as interest rates, also play a role in determining the cost of capital for a firm. Cost of capital, capital structure, and related topics are discussed in Chapter 10.
The Intangibles
In addition to the more quantitative, hard factors discussed earlier, there are any number of soft, intangible factors that play a significant role in dri- ving share value. These include expectations of future performance, the re- liability and consistency of financial performance, and the credibility of management. The intangibles will be discussed in Chapter 10.