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.
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.
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.
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.