The Need for Value Management

You Can’t Build a Business By Cutting Costs

Entrepreneurs tend to focus on sales. It’s not that they ignore costs; they just put winning customers first – because without customers there is no business. Somewhere along the line in many organisations, the emphasis seems to switch and the denominator manager emerges. A virtue is made of ‘trimming the fat’, reducing costs to the lowest level possible. There is talk of being ‘lean and mean’. Such positive language can conceal a potentially disastrous shift in attitude. Managers become internally-focused and short-termist. They keep an eagle-eye on this quarter’s results, slash costs and reduce spending.

I am not denying that cost-control is important, just trying to redress the balance a little.

The world is changing and organisations must adapt. An over-emphasis on costs is like a virus that slowly robs an organisation of the ability to change; it destroys imagination and enthusiasm. We need to keep in mind Peter Drucker’s statement:

“The purpose of a business is to create a customer.”

When an organisation loses sight of this simple tenet it condemns itself to ever-decreasing circles of cost-cutting and the destruction of value. Which leads onto …

 

The Need For Shareholder Value

Shareholders make money in two ways: dividends and share price growth. With a dividend the shareholder receives the money immediately. Share price gains are only realized when the share is sold. Whether the shareholder is interested primarily in dividends (for instance a pension fund or older individual) or share price growth, they are not only interested in this quarter’s results. Shareholders are interested in total returns.

Strange though it may seem – and despite their rhetoric to the contrary – too many companies are managed with an emphasis on short-term performance. Bonuses, commissions and incentive schemes are usually based on short-term measures – this month’s sales, annual profits. The short-term is important but often the action that increases short-term profits will lower shareholder value. Imagine that you have been appointed to a new CEO position and your remuneration package is based on this year’s net profit. If you want to maximize it, you should probably:

 

  • cancel all training
  • close the R&D department
  • make customer service staff redundant
  • halt non-direct marketing
  • introduce short-term incentives for all staff

I am sure that I don’t need to state what the likely affects of these actions will be on long-term profitability and shareholder value. Similarly, the failure to invest in assets can destroy value. As Henry Ford said:

“If you need a machine and don’t buy it, then you will ultimately find that you have paid for it and don’t have it.” 

I have mentioned several times the importance of intangibles. Intangibles don’t appear in the financial statements and yet are the main drivers of financial performance. A short-term focus using primarily accounting based measurements discourages investment in these intangible performance drivers. Professor Peter Doyle commented:

“Accounting profits encourage an excessively short-term view of business. They also encourage an under-investment in information-based assets – staff, brands, and customer and supplier relationships. In today’s information age, the accounting focus only on tangible assets makes little sense now that these intangible assets are the overwhelming source of value creation.”

Let me illustrate by comparing two strategic options for a company. Here are the profits over a five year period for the two options.

The myopic strategy shows double the profits in Year 1. Many companies would look no further and select this option. The value strategy though delivers a much higher total return over the five year period. Here is what happens under the value strategy in year one:

  • investment in brand – enabling a higher price to be charged in later years because consumers recognize and value the brand
  • the strong brand enables new products to be introduced more quickly
  • as customer numbers grow the company begins to market to them directly, thus reducing promotion costs and increasing sales since they are marketing to existing customers who like the brand
  • staff are trained in customer service – customers tell others about the great customer service, bringing in new customers
  • investment in employee relations reduces labor turnover – it is a good place to work and customer service improves further
  • on-going product development provides a stream of new product launches

One can see that the value approach is laying a solid foundation for future success. The actions underpinning the value approach incur costs. In the accounts these costs are treated as operating expenses. Expenses come straight off the current year’s bottom line. Hence, the profits in year one are only half those of the myopic strategy. Yet from a value perspective, with its emphasis on total returns, it is clear that value approach is the most effective strategy.

Nevertheless, we should still exercise some caution. Forecasting profits five years ahead is fraught with danger. There are many factors outside the control of any company. Managing for value does not mean that the short-term can be ignored. At the very least we need to ensure that the company will still be around to take advantage of its year one investments.

We will encounter ‘value management’ in later modules, where I will introduce a range of tools that you can use in your own business for evaluating business proposals.

The Value of Money in the Future

How do you decide whether to pursue a project or buy a piece of production machinery? You do a cost-benefit analysis. You look at the costs incurred and the revenues that will be created. If the revenues are greater than the costs then you should go ahead.

Or should you?

Let’s consider the purchase of a machine to make a new product. Would you count the revenues that are produced from the product in 3 years’ time as being worth the same as revenues this year? Probably not – because if you had the money this year, you could invest it. Furthermore, there is a greater risk attached to the revenues forecast for Year 3.

So how do I convert the future revenues into their value today?

That’s what this video is about.

https://vimeo.com/168042920

The spreadsheet file below has 4 tabs:

  • a table and chart showing the present value of $1,000 at different discount rates in different years
  • an activity for your to calculate the present value of different sums
  • the answer to the activity
  • the sheet you saw in the video

 


Click to Download Present Value File (Excel)

Capex v Opex

Capex

Capital expenditure (CAPEX or capex) occurs when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life that extends beyond the taxable year. Capex is used by a company to acquire or upgrade physical assets such as equipment, property, or industrial buildings.

For tax purposes, capital expenditures are costs that cannot be deducted in the year in which they are paid or incurred, and must be capitalized. The general rule is that if the property acquired has a useful life longer than the taxable year, the cost must be capitalized. The capital expenditure costs are then amortized or depreciated over the life of the asset in question.

So basically, capex means buying fixed assets. These fixed assets are used to generate future profits; the assets are a means to an end. It is the future profits that add value to the company rather than the capex. Let me illustrate this through the telecoms industry. Operators invested billions in networks and yet these operators are now being acquired for mere millions. Why – because the income from the assets in which they invested has plummeted with the fall in bandwidth prices. The assets have a value in the accounts but the value that counts to an investor is based on the income that they can generate.

It is the market that determines the real value of capex.

Opex

Opex or operating expenses are those expenses that relate to keeping the business running in the current period – in other words COGS, SG&A (Selling, General and Administrative) and R&D. So Opex is what you deduct from Revenues to get EBITDA.

Which is Preferable: Capex or Opex?

You often hear of firms restricting capex and may have got the impression that capex is bad. Capex ties up money. It is risky because technology, customer preferences or economic conditions may change. So avoid capex. Rather than invest in plant and equipment, outsource. Let others manufacture whilst you safeguard your capital and minimize risk. Or so the logic goes.

It isn’t quite that simple. As we shall see when we look at shareholder value, the key factors that we need to consider in evaluating our future strategy from a financial perspective are:

  • the cash flows generated by investment
  • the timing of cash flows
  • the risk involved

Here are two reasons why investing in capex can be the better option:

  • outsourcing, increases opex and lowers capex. However, actual margins will generally be lower, so the future stream of cash flows will be lower
  • not investing in plant and equipment increases risk through dependency on other companies – which could be taken over, fail or stop making products

Capex, of course, doesn’t only relate to manufacturing. A professional services firm may invest in a management information system or buy their own offices. There is currently a debate raging relating to the merits of using cloud computing or one’s own servers. Like most arguments around capex v opex, there are other factors to consider and whichever option is chosen, there are trade-offs to be made: scalability, loss of control, data security, support staff and so on.

The key point is: neither capex nor opex is inherently right or wrong. A business case should be developed which considers all factors.