The quest for long-term business value starts with a clear understanding of those variables that actually create value in a significant way: the key value drivers. This is not an easy journey – but the potential pay-off makes the process worth the effort.
Krogger Highlights | 2015
For many companies, creating long-term business value is obviously an explicit objective – yet, only a handful of them can actually identify with precision those factors that have the largest impact on such concept – let alone, link these factors to concrete activities management should focus on to maximize it.
The quest for long-term business value starts therefore, with a clear understanding of those variables that actually create value in a significant way: the key value drivers. And for these drivers to be useful, they (more specifically, their impact) should be controllable or at least manageable to a certain degree.
In most cases, key value drivers need to be broken down into concrete components that can prompt to action. For example, is not enough to determine ‘cost’ as a key value driver (it always is anyway) – for this to be useful, a company needs to go deeper – at least a couple of levels – which are, by necessity, specific to each company.
Identifying Value Drivers
The value of a company is determined by its ability to consistently maximize its risk-adjusted cash flow generation. It follows then, that companies should focus on those factors that help them generate more cash, for longer periods of time and with the least risk possible.
In this sense, there are three broad types of business value drivers: operational, financial and sustainability drivers.
Operational drivers encompass all those variables that impact the cash generation capacity of the company either by boosting growth or increasing efficiency. At their most basic level, these drivers include revenues and costs and in turn all those variables that increase the former and reduce the latter (e.g. volume, price, etc.).
In general, management has a high degree of influence over these drivers – after all managing them is core part of the job. Thus, most value drivers tend to be operational and the vast majority of resources the company has is spent on affecting them.
On the other hand, there are many important operational drivers on which management has little or no control. Take for instance the case of a food manufacturer, whose cost is heavily driven by the price of wheat. As a commodity, wheat has a price that is dictated by global demand and supply and therefore manufacturers have little control over it. Or consider the cost for an insurance company when honoring claims for floods or similar natural events. Their occurrence is an externality on which insurers have no influence beyond calculating probabilities. In all these cases, management can’t really control the drivers, but they are so important that their impact on the business has to be managed (by for example, hedging the price of a commodity or re-insuring a particular risky event).
The importance of a key operational value driver is determined first by its impact on cash flows and then by management’s ability to control it. But sometimes a driver is so impactful that even if it cannot be controlled, just by managing its impact, management can actually add significant business value.
Financial drivers include all those variables that minimize the cost of capital incurred by the company to finance its operations. By optimizing the cost (i.e. finding the cheapest source of financing), structure (i.e. finding the best mix of instruments and terms) and allocation of its capital (i.e. using it in the most productive and efficient way), a company can significantly increase its value in the medium and long term.
In their most basic form, financial drivers define the capital structure of a company –what are the ratio of debt and equity and the mix of all their different variations in the capitalization table of the company. Going further, these basic drivers can be broken down into detailed financial strategies, with key value drivers taking the form of very concrete actions to enhance value. Consider the case of a global tech company that funded dividend payments and share buy-backs by raising debt at low interest rates. By raising cheap debt, the company reduced its overall cost of capital (via low interest rates), kept its cash reserves intact for potential opportunities (which could bring value-accretive acquisitions) and even boosted its depressed share price through the buy-back – all three, value creating actions that stemmed from a solid understanding of the company’s financial drivers.
Financial drivers not only determine where and how a company sources its capital, but also how it uses it to finance its operations. Actively managing variables that impact a company’s working capital or expenditure in fixed assets can create sustainable value in the medium and long term.
In the case of retailers, for instance, drivers such as inventory turns, days receivable and days payable can fundamentally change the value of their businesses. Those with ‘faster’ turns are, other things being equal, more valuable than their competitors because their operations are far more efficient (they have little or no inventory, collect payments from clients faster and manage to pay their suppliers later) – in a nutshell, they need less capital to operate. The same applies to any business able to reduce its capital expenditure without impacting the quality of its operations (due to a new technological development for instance) – it will be more valuable because its return on assets will be higher. That is, other things being equal, it requires less capital to generate the same (or better) results than its competitors.
As in the case of operational drivers, management usually has a good amount of influence over financial drivers, and with the exception of factors such as interest rates or required returns on equity from shareholders (whose impact can be similarly managed by the way), companies tend to find many actionable items in this area.
Sustainability drivers refer to all those variables that enable a business to keep on functioning consistently and optimally for long periods of time. Their focus is to find ways to capture synergies with external forces that operate in the company’s environment with the purpose of creating value (or avoid the destruction thereof).
Generally, the impact created by these drivers becomes evident in the long-term and by definition, management’s control over them is relatively low compared to the other categories.
Base level drivers include variables such as regulatory changes, environmental impact or mandated employment and safety policies. As in the case of less controllable drivers in the other two categories, sustainability drivers are usually born from external factors affecting the environment where the company operates. Thus, actions generated by them are reactive and focused on reducing their impact (if the effect is negative) or on ‘taking advantage’ of them (if the effect is positive).
Consider the case of a paper company increasing its use of planted trees over harvesting naturally grown trees. This action reacts to the potential negative impact of three sustainability drivers: (1) harsher environmental legislation, (2) depleted sources of raw material, and (3) negative brand perception in the context of the company’s corporate social responsibility. By increasing the use of planted trees, the company is offsetting any additional short-term cost of planting trees with the, arguably much larger, long-term value created by reducing (and potentially avoiding) the negative impact mentioned above.
Value Driven Management
Once the main key drivers across the three categories have been identified, management should focus on developing a plan to change the parameters of these drivers and creating a permanent mechanism that links them to daily activities in one hand and value on the other. This is the essence of Value Driven Management.
The following are the 10 steps management teams can follow to implement Value Driven Management in their organizations:
- Select those key value drivers the organization is going to focus going forward.
- Determine the exact and correct parameter that needs to be measured for each of the key value drivers (e.g. cost/unit, ARPU, EBITDA/Debt, etc.) as well as its current value.
- Establish what is the desired direction of change and if possible a specific target value for each value driver.
- Define the actions that need to be taken today in order to achieve the target.
- Assign clear responsibilities for each of the actions defined above.
- Design a compensation or incentive mechanism to reward people for achieving established targets.
- Build a monitoring system to keep track of progress.
- Review the validity of key value drivers as often as necessary but especially if and when targets have been achieved.
- Ensure all three value driver categories are included in the process at all times.
- Measure the value created by those drivers where targets have been achieved
Challenges of Managing Value Drivers
Identifying and using key value drivers are not easy tasks. They demand time and resources that not many organizations are willing to commit – despite the obvious pay-off.
Some of the challenges of managing value drivers include:
Lack of information
Identifying key value drivers requires having access to information that not necessarily is readily available. In an ideal world, all components ‘add-up’ and can be easily identified. This is rarely the case and therefore, companies need to engage in a targeted data gathering exercise before attempting identifying key value drivers.
Once all the data is handy and organized, the different categories need to be broken down into manageable and actionable components that most likely have never been measured before. Without a way to determine the current status of a key value driver, is impossible to know how changing it will impact the business. For example, unless a plant knows how much it exactly pays for electricity (both rate and consumption), is impossible to define what actions need to be taken to reduce its energy costs.
After key value drivers have been identified, their appropriate measure needs to be clearly defined and actively shared with all relevant parties – for example, by creating a new management reporting system or adding these measures and their desired targets to the annual budget review.
Not enough control
There is no ‘perfect’ value driver. In many instances, either control over them is partial and insufficient to create real impact or the company finds out that a driver is not really under its control as previously thought. For example, a home improvement retailer might think that has full control over the mix of products it offers in one of its branches, but it turns out that suppliers just don’t ship certain products to that region. For that specific branch, the company has less control over the product mix driver than what it thinks.
In this case, a company has three options: (1) find another key value driver ‘below’ the one just found and over which management has more control (e.g. focusing on product mix for the largest category of home improvement products for which suppliers do offer shipping instead of the overall product mix); (2) change the company’s structure to capture control over the key value driver (e.g. shift business to suppliers that do offer shipping to that specific branch); or (3) reduce the impact of the non-controllable part of the value driver (e.g. offering substitute products on that particular branch or paying for the shipping of the desired products).
Just because a value driver has been identified, doesn’t mean that its relevance will continue indefinitely. Many value drivers, particularly sustainability drivers, have limited life spans and those that have been actively managed before tend to present diminishing returns when they move towards their optimal level (e.g. there is so much value that can be added by increasing prices – at some point demand will subside). Value drivers need to be constantly monitored. When a driver’s value generation potential has been ‘exhausted’, management needs to find new value drivers.
Key value drivers are interconnected and do not work in isolation. What can be achieved by managing a value driver might have unintended consequences at a different level in the organization or even affect the value generated by another driver. For instance, layoffs might have immediate positive impact on value created as less cost is in the system, but they can undermine staff morale and reduce productivity as well, thus destroying value in the long term.
In implementing Value Driven Management, companies should consider the potential impact these challenges could have. The whole process needs to be continuously tested against these and adjusted accordingly to maintain its integrity and ensure that value is indeed created.
Identifying a business’s key value drivers and acting upon them are powerful tools. Value driven management aligns the company’s operational and financial ‘tactics’ with its long-term strategy. It allows management to focus on what can be done today to create value in the future and adjust the course when needed. Finally, it serves as a natural prioritization tool – enabling companies to discern what is important (i.e. what creates more value) and consequently channel the always limited time and resources to the right areas.
The quest for long term business value creation is not an easy journey – but the potential pay-off makes the process worth the effort.