VALUE-BASED MANAGEMENT APPROACHES
The following explanation of value-based management is based on an article in the
McKinsey quarterly 1994, adapted from a book Valuation: Measuring and Managing the Value of Companies, Second edition by Tom Copeland, Tim Koller and Jack Murrin. 1994 John Wiley and Sons.
VBM aligns an organisation’s overall aspirations, analytical techniques, and management processes with the key drivers of value. So, VBM takes the idea of creating value through return on future cash flow and embeds this in the organisational culture in its strategy, as well as making this a performance measure to be used throughout the organisation.
What is value-based management?
Value-based management (VBM) starts with the philosophy that the value of a company is measured 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 this philosophy by focusing on how companies use the idea of value creation to make both major strategic and everyday operating decisions. So VBM is an approach to management that aligns the strategic, operational and management processes to focus management decision making on what activities create value.
VBM focuses on better decision making at all levels in an organisation. Hierarchical command-and-control structures cannot work well, especially in large multi-divisional organisations. Managers need to use value-based performance measures for making better decisions. This means that they must manage the statement of financial position (balance sheet) as well as the income statement, and maintain a balance between long- and short-term perspectives. This approach to performance measurement is known as the value mindset.
The Value mindset
VBM requires companies to move on from only using traditional financial performance measures, such as earnings or earnings growth as these do not focus enough on value creation. Companies should set also goals in terms of discounted cash flow value, the most direct measure of value creation. These targets can then be cascaded down the organisation as shorter-term, more objective financial performance targets.
However, non-financial goals such as customer satisfaction, product innovation, and employee satisfaction are also important as these inspire and guide the entire organisation.
The most prosperous companies are usually the ones that combine their financial and nonfinancial goals to have a balanced approach to performance review and measurement.
A value mindset means that senior managers are fully aware that their ultimate financial objective is maximising value. They have clear rules for deciding when other objectives (such as employment or environmental goals) outweigh this objective; and that they have a solid analytical understanding of which performance variables drive the value of the company.
Planning, target setting, performance measurement, and incentive systems need to be linked to value creation at the different levels of the organisation. Management processes and systems encourage managers and employees to behave in a way that maximises the value of the organisation.
- For the head of a business unit, the objective may be stated as value creation measured in financial terms.
- A functional manager’s goals could be expressed in terms of customer service.
- A manufacturing manager might focus on operational measures such as cost per unit, cycle time, or defect rate.
The focus of VBM should be on the why and how of changing the organisation’s corporate culture. A value-based manager balances an awareness of organisational behaviour with using valuation as a performance metric and decision-making tool.
How VBM works
The article explains how VBM works in practice.
‘When VBM is working well, an organisation’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 compare the value of alternative strategies and the incentive to choose the value-maximising strategy. Such an incentive is created by specific financial 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.
Line managers and supervisors 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 organisation, on the other hand, VBM informs the board of directors and corporate centre 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 insufficient. Taken together, they can have a huge and sustained impact.’
VBM requires that management understand the performance variables that create the value of the business that is the key value drivers. Management cannot act directly on value, but can respond to things it can influence such as customer satisfaction, cost, and capital expenditure.
A value driver is any variable that affects the value of the company.
Value drivers need to be ranked in terms of their impact on value and responsibility assigned to individuals who can help the organisation meet its targets.
Value drivers must be matched to the appropriate level of management so that they are consistent with the decision variables that are directly under the control of line management.
Value drivers are useful at three levels in the organisation.
- Generic, where operating margins and invested capital are combined to compute ROIC; (ROIC Return on Invested Capital is the USA equivalent of ROCE, Return on Capital Employed (UK))
- Business unit, where variables such as customer mix are particularly relevant;
- Grass roots, where value drivers are precisely defined and tied to specific decisions that front-line managers have under their control.
So value drivers are usually cascaded in ‘trees’ down the organisation so that each layer of management has clear targets relevant to areas under their control.
These ‘trees’ are then usually linked into ROIC trees, which are in turn linked into multiperiod cash flows and valuation of the business unit.
It can be difficult to identify key value drivers because it requires an organisation to think about its processes in a different way and existing reporting systems are often not equipped to supply the necessary information. Mechanical approaches based on available information and purely financial measures rarely succeed. What is needed instead is a creative process involving much trial and error. Nor can value drivers be considered in isolation from each other. The article suggests that a good way of relating a range of value drivers is to use scenario analysis. 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.
VBM also requires that managers must establish processes that ensure all line managers adopt value-based thinking as an improved way of making decisions. VBM must eventually involve every decision maker in the company.
The article notes that there are four essential management processes that collectively govern the adoption of VBM. These four processes are linked across the company at the corporate, business-unit, and functional levels. The four processes which run in order are expressed below as steps:
|A company or business unit develops a strategy to maximise value.|
|This strategy translates into short- and long-term performance targets defined in terms of the key value drivers.|
|Action plans and budgets are drawn up to define the steps that will be taken over the next year or so to achieve these targets.|
|Step 4||Finally performance measurement and incentive systems are set up to monitor performance against targets and to encourage employees to meet their goals.|
Corporate level. Under VBM, senior management devises a corporate strategy that explicitly maximises the overall value of the company, including buying and selling business units as appropriate. This should be built on a thorough understanding of business-unit strategies.
Business-unit level. Alternative strategies, should be weighed up and the one chosen 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. The VBM elements of the strategy then apply. They include:
- Assessing the results of the valuation and the key assumptions driving the value of the strategy.
- Assessing the value of the alternative strategies that were discarded, along with the reasons for rejecting them.
- Looking at resource requirements. Business-unit managers need to focus on the statement of financial position (balance sheet) and also consider human resource requirements.
- Summarising the strategic plan projections, by focusing on the key value drivers. These should be supplemented by an analysis of the Return on Invested Capital (ROIC) over time and relative to competitors.
- Analysing alternative scenarios to assess the effect of competitive threats or opportunities.
The next step, after strategies for maximising value are agreed, is to translate these into specific targets. In applying VBM to target setting, several general principles are helpful:
- Base targets on key value drivers. This should cover both financial and nonfinancial targets. The latter serve to prevent manipulation of short-term financial targets.
- Tailor the targets to the different levels within an organisation. So that senior business-unit managers should have targets for overall financial performance and unit-wide non-financial objectives. Functional managers need functional targets, such as cost per unit and quality.
- Link short-term targets to long-term ones. The article gives the example of setting linked performance targets for ten years, three years, and one year. The ten-year targets express a company’s aspirations; the three-year targets define how much progress it has to make within that time in order to meet its ten-year aspirations; and the one-year target is a working budget for managers.
The article notes that ‘Ideally, targets should be expressed in terms of value, but since value is always based on long-term future cash flows and depends on an assessment of the future, short-term targets need a more immediate measure derived from actual performance over a single year.
Economic profit is a short-term financial performance measure that is tightly linked to value creation. It is defined as: Economic profit = Invested capital x (Return on invested capital – Weighted average cost of capital)
Economic profit measures the gap between what a company earns during a period and the minimum it must earn to satisfy its investors. Maximising economic profit over time will also maximize company value.’
Action plans and budgets
Then, management must translate strategy into the specific steps that an organisation will take to achieve its targets, particularly in the short term through action plans. The plans must identify the actions that the organisation will take so that it can pursue its goals in a methodical manner.
Finally performance measurement and incentive systems will track progress in achieving targets and motivate managers and other employees to achieve them. VBM may force a company to modify its traditional approach to these systems by linking performance measures to long-term value creation and strategy. In particular, it shifts performance measurement from being accounting driven to being management driven. Key principles include:
- Tailor performance measurement to the business unit. Each business unit should have its own performance measures which it can influence.
- Link performance measurement to a unit’s short- and long-term targets. Performance measurement systems are often based almost exclusively on accounting results.
- Combine financial and operating performance in the measurement. Financial performance is often reported separately from operating performance, whereas an integrated report would better serve managers’ needs.
- Identify performance measures that serve as early warning indicators. Early warning indicators might be simple non-financial indicators such as market share or sales trends. Once performance measurements are an established part of corporate culture and managers are familiar with them, it is time to revise the compensation system.
The pitfalls of VBM Case Study
Value-based management is not without some problems however as the article illustrates.
‘A few years ago, the chief planning officer of a large company gave us a preview of a presentation intended for his chief financial officer and board of directors. For about two hours we listened to details of how each business unit had been valued, complete with cash flow forecasts, cost of capital, separate capital structures, and the assumptions underlying the calculations of continuing value. When the time came 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 management, this company simply had value veneering. ‘.
- VBM aligns an organisation’s overall aspirations, analytical techniques, and management processes with the key drivers of value. So, VBM takes the idea of creating value through return on future cash flow and embeds this in the organisational culture in its strategy, as well as making this a performance measure to be used throughout the organisation.