Key concepts
Key concepts
Shareholders invest their funds in companies, putting their wealth at risk with the intention to receive a greater amount in return. If this is accomplished, in general, this can be considered value creation.
The purpose of this White Paper is to highlight the methodologies used by companies to manage their value creation process based on VBM (Value Based Management) and to demonstrate how they align this with the Unified Performance Management (UPM) framework.
From an accounting perspective, profit can be defined as the amount of income exceeding costs. In many cases, this simple perspective is sufficient to define value creation.
Economic profit is defined as the amount by which cash inflow exceeds the costs associated with all factors. This not only includes expenses incurred in operating the business but also the cost of capital invested in the business.
As companies became more complex – mainly driven by globalization and technological developments, driving efficiency and growth – factors such as time differences, depreciation and amortization of assets, book versus tax accounting policies, and investments such as inventories and accounts receivable cause profits to become more difficult to measure. In addition, the continuous changes of international accounting standards (e.g. US-GAAP or IFRS) have led to more complexity with regard to the correct valuation of assets and liabilities. At the same time, the disparity between accounting profits and economic profits diverges more and more.
In order to create value, a company cannot only generate accounting profits, it must also generate economic profit to account for the cost of capital (usually referred to as WACC or Weighted Average Cost of Capital) and thus take into account the risk of investing in an asset. On the one hand, if a business does not produce sufficient return to generate Economic Profit, it will ultimately lose value. On the other, this also means that if a company only generates return that is equal to the cost of capital, the value of the company will remain the same, i.e. the shareholder will simply have swapped one asset for another with the same value.
Time plays a very important role in assessing the value of a business. Normally, measuring profit over just one year does not capture whether value has been created or not, as investments in a business typically generate return over a longer period of time. This period, known as the economic life of an investment, is the relevant period for value measurement.
Assessing the value of a company (or a group), a business unit, division or legal entity is more of an art form than a science. But well-designed processes and models support value assessment, help companies to evaluate risk and allocate capital efficiently to drive value – through VBM and UPM.
Shareholders invest their funds in companies, putting their wealth at risk with the intention to receive a greater amount in return. If this is accomplished, in general, this can be considered value creation.
The purpose of this White Paper is to highlight the methodologies used by companies to manage their value creation process based on VBM (Value Based Management) and to demonstrate how they align this with the Unified Performance Management (UPM) framework.
From an accounting perspective, profit can be defined as the amount of income exceeding costs. In many cases, this simple perspective is sufficient to define value creation.
Economic profit is defined as the amount by which cash inflow exceeds the costs associated with all factors. This not only includes expenses incurred in operating the business but also the cost of capital invested in the business.
As companies became more complex – mainly driven by globalization and technological developments, driving efficiency and growth – factors such as time differences, depreciation and amortization of assets, book versus tax accounting policies, and investments such as inventories and accounts receivable cause profits to become more difficult to measure. In addition, the continuous changes of international accounting standards (e.g. US-GAAP or IFRS) have led to more complexity with regard to the correct valuation of assets and liabilities. At the same time, the disparity between accounting profits and economic profits diverges more and more.
In order to create value, a company cannot only generate accounting profits, it must also generate economic profit to account for the cost of capital (usually referred to as WACC or Weighted Average Cost of Capital) and thus take into account the risk of investing in an asset. On the one hand, if a business does not produce sufficient return to generate Economic Profit, it will ultimately lose value. On the other, this also means that if a company only generates return that is equal to the cost of capital, the value of the company will remain the same, i.e. the shareholder will simply have swapped one asset for another with the same value.
Time plays a very important role in assessing the value of a business. Normally, measuring profit over just one year does not capture whether value has been created or not, as investments in a business typically generate return over a longer period of time. This period, known as the economic life of an investment, is the relevant period for value measurement.
Assessing the value of a company (or a group), a business unit, division or legal entity is more of an art form than a science. But well-designed processes and models support value assessment, help companies to evaluate risk and allocate capital efficiently to drive value – through VBM and UPM.
Advanced Financial Planning (AFP) is defined as a corporate financing model that looks at the profit & loss account, the balance sheet and cash flows – where the impact of all relevant business and value drivers is determined – from a profit, expense, asset, financing or capital perspective and this, in one coherent loop.
The basis for a functioning AFP model is the identification of the relevant value drivers of an organization and the ability to understand sensitivities of these as well as the competence to create what-if scenarios around the key value drivers.
AFP ultimately enables finance organizations to communicate the impact of plans to the respective stakeholders, from top management and executives to the board effectively.
VBM is based on a functioning AFP model, as it requires all aspects of value creation – profit and capital.
Advanced Financial Planning (AFP) is defined as a corporate financing model that looks at the profit & loss account, the balance sheet and cash flows – where the impact of all relevant business and value drivers is determined – from a profit, expense, asset, financing or capital perspective and this, in one coherent loop.
The basis for a functioning AFP model is the identification of the relevant value drivers of an organization and the ability to understand sensitivities of these as well as the competence to create what-if scenarios around the key value drivers.
AFP ultimately enables finance organizations to communicate the impact of plans to the respective stakeholders, from top management and executives to the board effectively.
VBM is based on a functioning AFP model, as it requires all aspects of value creation – profit and capital.
Advanced Financial Planning (AFP) is defined as a corporate financing model that looks at the profit & loss account, the balance sheet and cash flows – where the impact of all relevant business and value drivers is determined – from a profit, expense, asset, financing or capital perspective and this, in one coherent loop.
The basis for a functioning AFP model is the identification of the relevant value drivers of an organization and the ability to understand sensitivities of these as well as the competence to create what-if scenarios around the key value drivers.
AFP ultimately enables finance organizations to communicate the impact of plans to the respective stakeholders, from top management and executives to the board effectively.
VBM is based on a functioning AFP model, as it requires all aspects of value creation – profit and capital.
Advanced Financial Planning (AFP) is defined as a corporate financing model that looks at the profit & loss account, the balance sheet and cash flows – where the impact of all relevant business and value drivers is determined – from a profit, expense, asset, financing or capital perspective and this, in one coherent loop.
The basis for a functioning AFP model is the identification of the relevant value drivers of an organization and the ability to understand sensitivities of these as well as the competence to create what-if scenarios around the key value drivers.
AFP ultimately enables finance organizations to communicate the impact of plans to the respective stakeholders, from top management and executives to the board effectively.
VBM is based on a functioning AFP model, as it requires all aspects of value creation – profit and capital.
The identification and management of value drivers draws the attention of management to activities that will have the greatest impact on value. Thus, management will be able to translate value creation into tangible and specific actions.
There are three categories of value drivers: growth drivers, efficiency drivers and financial drivers. By focusing on value drivers, management can prioritize the specific activities that will affect performance in each area (using KPIs to measure and manage performance and outcome).
To identify those value drivers that a company should focus on, the company has to address two key questions:
There are two simple ways to identify value drivers:
The identification and management of value drivers draws the attention of management to activities that will have the greatest impact on value. Thus, management will be able to translate value creation into tangible and specific actions.
There are three categories of value drivers: growth drivers, efficiency drivers and financial drivers. By focusing on value drivers, management can prioritize the specific activities that will affect performance in each area (using KPIs to measure and manage performance and outcome).
To identify those value drivers that a company should focus on, the company has to address two key questions:
There are two simple ways to identify value drivers:
Value driver analysis is an important foundation for strategic planning: it helps management to identify and define critical strategic levers. If, for example, efficiency drivers are important to a company, management can direct strategic planning to focus on efficiency strategies and activities supporting it. In short, value drivers ensure that a strategy is grounded in the reality of operating performance.
Identifying value drivers is a three-step process
Step 1
—
Develop a value driver “map”
To understand where your company’s value drivers lie, first, you need to break down the broad operating parameters of the business into progressively smaller components, until you reach the level where daily operations management decisions are made. Then, the specific factors influencing sales growth, operating profit (represented as NOPAT margin – net operating margin after tax), capital efficiency (capital turns), etc. are documented.
Step 2
—
Test for driver sensibilities
The company must first define the basis level for each operating factor, after which it can test changes of each factor impact on the overall value of the business (based on net present value calculation methods such as the discounted cash flow method). This usually leads to valuable and interesting insights into the relevance of the specific operating factors and often also leads to a change of management priorities.
Step 3
—
Test for controllability
Each of the operating variables must then be examined to discover those that management can control and influence.
A value driver analysis requires significant investments in terms of time and energy. It may also require information that is difficult to obtain and involves the development of an interrelationship model between variables within the business. This kind of complex modeling can be facilitated by the use of appropriate tools – such as functional databases like IBM Cognos TM1. Modern functional databases are designed to support this kind of modeling and sensitivity testing with multiple variables and large number of data sets.
However, companies that have made this investment have discovered that this analysis helps to draw management’s attention to a manageable number of value drivers. Further, it provides a foundation to optimize the strategy around value driver performance and maximize value creation.
Value driver analysis is an important foundation for strategic planning: it helps management to identify and define critical strategic levers. If, for example, efficiency drivers are important to a company, management can direct strategic planning to focus on efficiency strategies and activities supporting it. In short, value drivers ensure that a strategy is grounded in the reality of operating performance.
Identifying value drivers is a three-step process
Step 1
—
Develop a value driver “map”
To understand where your company’s value drivers lie, first, you need to break down the broad operating parameters of the business into progressively smaller components, until you reach the level where daily operations management decisions are made. Then, the specific factors influencing sales growth, operating profit (represented as NOPAT margin – net operating margin after tax), capital efficiency (capital turns), etc. are documented.
Step 2
—
Test for driver sensibilities
The company must first define the basis level for each operating factor, after which it can test changes of each factor impact on the overall value of the business (based on net present value calculation methods such as the discounted cash flow method). This usually leads to valuable and interesting insights into the relevance of the specific operating factors and often also leads to a change of management priorities.
Step 3
—
Test for controllability
Each of the operating variables must then be examined to discover those that management can control and influence.
A value driver analysis requires significant investments in terms of time and energy. It may also require information that is difficult to obtain and involves the development of an interrelationship model between variables within the business. This kind of complex modeling can be facilitated by the use of appropriate tools – such as functional databases like IBM Cognos TM1. Modern functional databases are designed to support this kind of modeling and sensitivity testing with multiple variables and large number of data sets.
However, companies that have made this investment have discovered that this analysis helps to draw management’s attention to a manageable number of value drivers. Further, it provides a foundation to optimize the strategy around value driver performance and maximize value creation.
The value driver matrix on the left illustrates a framework for the prioritization of value drivers.
The key task here is to identify those variables that reside in the red quadrant and to manage the resources directed at influencing variables in the orange quadrants.
Based on the insights gained during the value driver analysis, process management can easily assess where to allocate value drivers and communicate priorities effectively within the organization.
The value driver matrix on the left illustrates a framework for the prioritization of value drivers.
The key task here is to identify those variables that reside in the red quadrant and to manage the resources directed at influencing variables in the orange quadrants.
Based on the insights gained during the value driver analysis, process management can easily assess where to allocate value drivers and communicate priorities effectively within the organization.
Measuring and allocating cost of capital
Valuing a business
Get in touch today about FP&A and let’s explore its potential at your company together.
Get in touch today about FP&A and let’s explore its potential at your company together.
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