FREE online courses on Financial Management and Creating Value - Chapter 2

 

Value Based Management 

 

So far, we have focused our attention on how the accounting and finance functions can help create higher values for the organization. The financial functions must think differently in terms of economic performance and not just accounting performance. This means going outside the traditional accounting model and recognizing that success is no longer measured by earnings per share, but by the present value of future cash flows. Therefore, one of the mandates for creating value is to invest in assets that will provide returns higher than the cost of capital. This requires that we manage assets in accordance with the following:

 

1. Cash is as important, if not more so, than earnings.
2. New investments in assets must earn their keep by generating positive net present values.
3. Existing assets are subject to regular review for economic performance. The mix of assets is always changing to meet our overall goal of increasing value and growing the business.

 

The Accounting and Finance Function can lead the way for the entire organization when it comes to value-creation. After all, the financial function usually has insights into all other functions within the business and only the financial function can fully grasp the principles behind value-creation. However, before the financial function embarks on this bold new strategy, we must first transform the financial function into a "real" finance department. In the words of Robert Darretta, CFO for Johnson & Johnson, "Finance creates value by having the best business people, not by having the best accountants." This concept of having "business people" must spillover and become part of the entire organization.

 

Decisions should be made in the context of how does this decision affect the value of the organization. Having the entire organization committed to value-creation is very difficult since it requires a new mindset; everyone has been driven by profits - bonus checks are based on earnings, performance has been evaluated through accounting returns, etc. The overall process of managing for value is called Value Based Management. Implementing Value Based Management requires:

 

1. Driven from the Top: The Chief Executive Officer, upper level management, board of directors and other key personnel must be the driving force behind value based management. This is critical since everyone has been managed under a different set of principles and now the rules have changed - economic performance and not accounting performance is important.
2. Cross Functional Team: Since value based management cuts across the entire organization, it should be implemented through a cross-functional team. The cross-functional team is the vehicle by which the organization makes the cross over to value based management. Therefore, team members must be leaders of change, committed to making value based management work. Team members must be highly skilled in communicating since they must sell and get people to "buy in" to value based management. Some of the objectives of the team will include:

§         Guiding the implementation of value based management.

§         Facilitating open communication about value based management.

§         Coordinating and designing how value based management will work within different parts of the organization.

§         Acting as a bridge between executive management and the rest of the organization; working to resolve discrepancies between what management wants and what is possible.

o        The cross-functional team will need to engage people who have to implement value based management. This may involve the following:

§         Holding meetings to acquaint everyone on value based management - who will be responsible, how will it work, how can employees influence value, etc.

§         Providing formal training sessions to convince key people why value based management is important.

§         Having manager's assist in the analysis of value-creation. Allowing managers the ability to change existing performance standards to better fit with the concepts of value based management, such as emphasizing cash rather than profits.

§         Correcting alignment problems between upper levels of the organization and operating units.

Linking Compensation to Value: The compensation for key personnel should be linked to how much value they created. Traditional incentive plans which are linked to earnings or budgets must be phased out. The objective is to account for what it is people do with the capital that they have been entrusted with. Incentives should be objective and determined based on current standards. For example, using an estimate of future values is too subjective. Since the value-creation process is long-term, compensation linked to cumulative measures seems to work best. Also, it is important to calculate incentive programs at the beginning of the year to ensure fairness and objectivity. The value of the capital and the cost of capital must be clearly communicated to each manager.

 

Value Based Management is not easy to implement; it is an entirely different way of thinking. One way to sell people on the idea of value based management is to communicate the benefits of higher values. When the wealth of the organization expands, this benefits everyone, not just the shareholders. In the past, the organization has relied on lagging indicators like return on assets and the organization has failed to account for how capital is used. Since capital is a scarce resource, we can no longer run our business this way. We need to refocus our attention on what really matters - increasing returns from the capital we have deployed.

 

Value Based Management (VBM) requires benchmarking value-creation against the competition. All companies compete for capital. VBM must be connected and tied to the strategic plans of the business, the operating decisions, and the investment decisions. All of this has an impact on the creation of value. Managers must make distinctions between good capital (capital that is under their control that is generating returns higher than the cost of capital) and bad capital (just the opposite of good capital). The benefits of this new way of thinking can be tremendous. 

 

Of course, you will run into problems as you implement VBM. For example, some managers will feel that measuring value does not make much sense. Others will not understand what it is they are supposed to do. However, once everyone begins thinking in terms of economic performance, you will reap the benefits of increased values.