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CREATING SHAREHOLDER VALUE DURING ECONOMY DOWNTURN

WITH VBM TOOLS AND STRATEGIES

Chetan J Parikh


• Owners of invested capital

• Stewards of invested capital

• Adapting to economic paradigms of the 21st Century

• The role of finance in determining shareholder value

• Cost leadership strategy and supporting tactics

Creating Shareholder Value

~Introduction

Themes


Owners of Invested Capital- The Shareholders


Shrinking competitive advantage periods (CAPs) means that an investor has to understand

– The dynamics of organizational change – The mental models that owners need to have to keep up with change


~Owners of Invested Capital

What does ownership mean?


• Owners must demonstrate – Rational allocation of capital– Reduction of fundamental business risks

• Develop systems thinking based on feedback loops



Competences that owners need


Portfolio Managers

Active Owners

Risk perspective Risks are predetermined, cannot be influenced

Risks can be reduced/ eliminated

Risk management Strategy

Spreading the risks Allocation of capital to risks one can handle

Portfolio optimization

Active/proactive reduction/elimination of risks

Source: “Ownership and Value Creation” by Rolf H. Carlsson



Two fundamentally different ways of managing risk


Source: ‘Ownership and Value Creation’ by Rolf H. Carlsson


Through: Affecting market developments Superior competitive capability

Dominance Market leadership

Organizational Learning When the competitive situation changesstructurallyDeveloping a whole new business

Planning ForecastingContingency planning

‘Protection’ for Mobilizing power – political, military,example mafia through Forming cartels


Different ways of reducing / eliminating business-related risk


Stewards of Invested Capital- The Corporate Managers


Two major differences between CEOs and other employees

– Standards for measuring CEO’s performance are easy to manipulate, makes a CEOs performance harder to measure

– Relations between CEOs and board of directors are very congenial


~Stewards of Invested Capital

Why is CEO performance difficult to measure?


• Short term imperatives have forced CEOs to

– Meet the quarterly numbers– Have a wrong implicit valuation model– Disjointed the interests of shareholders from those of

other stakeholders



Long term must be balanced with the short term


Valuation Model

Stock Price

Financial Statements

Managerial Skill

Business Unit Measurements

Accounting Results

Control Variables• Business Processes• Employee Satisfaction • Customer Satisfaction

• Tangible Assets• Intangibles

• Integration of Control Variables and Accounting Data• Valuation/ Resource Allocation

• Vision• System Efficiency• Innovative Environment• Adaptability• Learning Organisation

• GAAP

Feedback

Feedback

Feedback



Valuation model


Adapting to economic paradigms of the 21st century


Traditional Business Structure E Business Structure


BRAND CAPITAL

HUMAN CAPITAL

WORKING CAPITAL

PHYSICAL CAPITAL

Outsourcing Network

Sales Push Focus

Production Focus

High (Work in Progress,Finished Goods

High (Ownership of Production

Customer Pull Focus

Customer Focus

Low (Direct Delivery)

Low (Outsourcing)

~Adapting to 21st century economic paradigms

The Upside – Down Corporation

Source: Meta Capitalism



Twentieth Century Twenty-first CenturyScarcity Abundance

Physical capital Knowledge capitalTangible assets Intangible assets

Diminishing returns Increasing returnsComparative statics Nonlinear dynamicsCommand and control Networks and webs

Data processing Knowledge managementZero sum Positive sum


Economic Paradigms of the 20th and 21st Centuries



Industry Product Tech Organization Process Tech

FAST CLOCKSPEEDPersonal computers <6 months 2- 4 2- 4

Computer- aided Software engineering 6 months 2- 4 2- 4Toys and games <1 year 5- 15 5- 15Athletic footwear <1 year 5- 15 5- 15Semiconductors 1- 2 years 2- 3 3- 10Cosmetics 2- 3 years 5- 10 10- 20


Industry Clockspeeds




MEDIUM CLOCKSPEEDBicycles 4- 6 years 10- 15 20- 25Automobiles 4- 6 years 4- 6 10- 15Computer Operating systems 5- 10 years 5- 10 5- 10Agriculture 3- 8 years 5- 10 8- 10Fast food 3- 8 years 25- 50 5- 25Beer brewing 4- 6 years 400 2- 3Airlines 5- 7 years 25 <5

(hardware)2- 3 years(software)

Machine tools 6- 10 years 6- 10 10- 15Pharmaceuticals 7- 15 years 10- 20 5- 10




Source: Charles Fine, Clockspeed



SLOW CLOCKSPEEDAircraft (commercial) 10- 20 years 5- 30 20- 30Tobacco 1- 2 years 20- 30 20- 30Steel 20- 40 years 10- 20 50- 100Aircraft (military) 20- 30 years 5- 30 3- 5Shipbuilding 25- 35 years 5- 30 10- 30Petrochemicals 10- 20 years 20- 40 20- 40Paper 10- 20 years 20- 40 20- 40Electricity 100 years 25- 50 50- 75Diamond mining Centuries 20- 30 50- 100




The role of Finance in Determining Shareholder Value



~Using Finance to Determine Shareholder Value

“What remains of his profits after deducting interest on his capital at the current rate may be called his earnings at undertaking or management”.

- Alfred Marshall

A


The basic ingredients in the Economic Profit calculation:

EP = NOPAT - $ Capital ChargeWhere:RevenueLess:Production / Operating ExpensesLess:Unlevered Taxes Equals:NOPAT $ Capital Charge = $ Capital – wacc



The calculation of economic profit


NPV = Present value of expected EP, thus

Wealth Creator :NPV>0, EP>0, RROC>0 * Wealth Neutrality :NPV=0, EP=0, RROC=0 Wealth Waster :NPV<0, EP<0, RROC<0

* RROC = ROIC - wacc



Determining Wealth Creators





V = C + NPV

V/C = 1 + NPV/C

= 1 + [PV of Expected EP]/C

KeyNPV : Net Present ValueC : Book Capital / Invested CapitalPV : Present ValueV : Corporate ValueEP : Economic Profit





Valuation Profitability

Wealth Creator V/ C >1* EP/C>0 , RROC>0Wealth Neutrality V/ C =1 EP/C=0 , RROC=0Wealth Waster V/ C <1 EP/C<0 , RROC<0




Criteria for capital commitment

RROC > 0 EP > 0 NPV > 0RROC = 0 EP = 0 NPV = 0RROC < 0 EP < 0 NPV < 0

RROC > 0 EP< 0 NPV < 0RROC = 0 EP= 0 NPV = 0RROC < 0 EP > 0 NPV > 0

Capital Expansion (C > 0):

Capital Contraction (C < 0):

Source: James L Grant & James A Abate,’ Focus on Value’


Source :James L Grant &James A Abate,’Focus on Value’



Excess Returns Relative to Capital Growth Rate’Economically’ Profitable Reinvestment


• Is the company a major force in a growing market?

• Is the company holding or increasing its shares on those segments?

• Is it resulting in increasing cash flows?

• Is the cash flow being used in a wise manner?

• Does the management walk the talk?

Creating Shareholder ValueCreating Shareholder Value


Questions Shareholders Ask..


Cost Leadership and Supporting Tactics


• Maintain competitive prices

• Pursue market share opportunities to gain scale economies in production and distribution


~Cost Leadership and Supporting Tactics

Sales Growth Rate


• Achieve relevant economies of scale

• Introduce mechanisms to improve rate of learning

• Search for cost reducing linkages with suppliers

• Eliminate overhead that does not add value to the product



Operating Profit Margin


• Minimise cash balance

• Reduce accounts receivables

• Minimise inventory without impairing customer service



Working Capital Investment


• Promote policies to increase utilization of fixed assets

• Obtain productivity-increasing assets

• Sell unused fixed assets

• Obtain assets at least cost, e.g. lease versus purchase



Fixed Capital Investment


• Target an optimal capital structure

• Select least-cost debt and equity instruments

• Reduce business risk factors in manner consistent with strategy



Cost of Capital

Source: Alfred Rappaport, ‘Creating Shareholder Value’


Thank You

capitalideasonline.com creating shareholder value during economy downturn with vbm tools and...

Documents

value creation

century slide

shareholders slide

risksallocation of capital

short term slide

ceos performance harder

wrong implicit valuation

economic paradigms