Value-Based Management Term Paper

Excerpt from Term Paper :

Value-Based Management (VBM) is a management philosophy that aims to achieve superior results (Niedell, 1996). This process measures performance by the value that is returned to shareholders. Successful implementation of VBM requires a successful change in corporate culture, as well as the adoption of VBM concepts at all levels and functions within an organization. VBM includes an integration of performance measurement, compensation, strategic planning, training, and communication (Porter, 1986). The process translates a value creation mindset into an action plan.

The key elements of Value-Based Management are as follows (Niedell, 1996):

Prioritization of investment funds, which promotes improved correspondence between allocation of resources and strategy;

Tightening of capital expenditure discipline, focusing on supporting strategic potential within business units;

Introduction of value-based management tools. This is helpful in measuring results in terms of profitability and capital input throughout the company, and understanding how value is actually created; and Introduction of performance related pay systems throughout the company to further encourage creation of value.

About Value-Based Management

Basically, a company's value is equal to the future cash flows that shareholders expect to receive from investing in it (Niedell, 1996). There is has been the way business has worked in the United States for years. Managers typically use discounted cash flow analysis to evaluate projects, and investors have valued the shares of companies on this basis for decades.

Both managers and investors try to forecast future cash flows associated with the specific business. Due to the fact that capital has so many uses for a firm and its investors, who actually provide the capital, it is important to attach some sort of time value to it. Therefore, future cash flows are discounted using the cost of capital to evaluate how much future cash flows are valued at today, meaning its present value. This procedure is the most widely used method to value a company.

In today's market, managers of major corporations are now responsible to global capital markets. In the past, these firms did not consider themselves accountable to shareholders. The past few decades have seen vast amounts of cash flow wasted on unsuccessful diversification, needless defensive investment and pay and perquisites for managers of major corporations. However, a market for corporate control has come about in which predatory conglomerates and trade buyers seek to realize value from companies run by under-performing managers. In recent years, institutional investors have started demonstrating greater power as far as executive remuneration and corporate strategy are concerned. As a result, in today's market, there can be no doubt that it is the manager's responsibility to build value for the shareholders of the organization.

Value-based management combines discounted cash flow modeling with the concept of shareholder value to provide a method to ensure that each strategic decision will increase shareholder value. VBM has been touted as a more reliable assessment of strategy than traditional methods. In addition, it stresses the importance of improving shareholder value.

The value-based management concept is simple. VBM describes how managers can maximize future cash flows by investing at a rate of return above the cost of the capital invested. According to, "Investing for a return below the cost of capital will decrease company value, while returns in excess of the cost of capital will increase it. The concept forces companies to concentrate on increasing cash flows to shareholders in the form of dividends and share price appreciation. It is these cash flows, rather than accounting earnings which are the most important indicator of increasing shareholder value."

VBM and Shareholder Value

Successfully implementing value-based management demands commitment on the part of an organization to maximizing shareholders returns (Niedell, 1996). Simply stated, VBM is a process of adapting company vision, values, and culture to a new and completely different way of thinking. When taking on the elements of VBM, managers must learn to concentrate on the things that actually create shareholder value within the organization. Porter's value chain model is the most popular way of finding value, as it enables managers to break down the business system into its component activities and figure out how and where value is created within the organization.

For example, airlines understand that passenger load is the most important factor affecting their profitability. Thus, by increasing their passenger load, they are creating as much shareholder value as possible without destroying value in other areas of the business. Similarly, a magazine publisher understands that the number of subscribers is the most important variable in determining its profitability.

For all organizations, the main goal of value chain analysis is to discover these major drivers of shareholder value by understanding how each activity the company does creates value for customers.






Figure 1: The value chain for a cable television company (Niedell, 1996).

The above diagram below illustrates the value chain of a cable television company. The activities of the firm are broken down into five broad categories. Inbound logistics handles the inputs the business needs to operate in the cable television business, including quality programming. The operations department performs those tasks involved in producing the finished product. Outbound logistics handles distributing the product to customers, such as transmitting the programming to subscribers. Sales and marketing departments build and maintain relationships with actual and potential customers. Services and support activities maintain the relationship with customers after purchase, such as repairs.

Value is added as the company performs activities within the chain. At the end of the chain is the margin, which describes the difference between the cost to the business to perform these activities and the price customers are paying for them. The greater the value created for customers, the greater the margin earned. Thus, the greater is the shareholder value created.

Key value drivers describe the variables that determine the value given to customers. Managers must analyze these key value drivers both individually and as a while to maximize value for both customers and shareholders.

Economic Value Added

Often the goal of VMB is to increase Economic Value Added (EVA), which is the after-tax cash flow generated by a business minus the cost of the capital it has used to generate that cash flow (Keen, 2000). Representing real profit vs. paper profit, EVA is the basis of shareholder value, which is the basic goal of most companies.

The main differences between EVA, earnings per share, return on assets, and discounted cash flow, as a measure of a company's performance are as follows: Earnings per share does not reveal the cost of generating profits. Profits also increase taxes, which reduces cash flow, so that engineering profits through accounting tricks can actually decrease economic value. A company's earnings are actually the real cash flow after all taxes, interest, and other obligations have been paid. Return on assets is a more realistic measure of economic performance, but it ignores the cost of capital

Determining a company's cost of capital requires making two calculations, one simple and one complex (Keen, 2000). The simple one determines the cost of debt, which is the after-tax interest rate on loans and bonds. The more complex one calculates the cost of equity and involves analyzing shareholders' expected return based on the price they have paid to buy or hold their shares. Investors expect a higher return for higher risk. To attract investors, smaller firms often offer premium in the form of a lower stock price than larger firms can command. This lower price amounts to the equivalent of a higher interest rate on loans and bonds; the investor's premium increases the firm's cost of capital.

Implementing VBM Strategies

When managers understand how value is created within their organizations, they are prepared to assess each key value driver to find out exactly where value can be added, as well as determine where they can prevent the destruction of value.

At this point, company analysis will take a great deal of time and effort, as key value drivers are often hard to identify, and must not be considered in isolation from one another (Niedell, 1996). Key drivers are, by nature, dynamic and intertwined, and must be analyzed as such. The practical benefits of the analysis are realized as managers understand more about their business, as well as accept the importance of meeting the needs both of customers and of shareholders.

A great deal of management time, effort, and skill are the keys to successful implementation of VBM strategies. The company must be willing to commit to the process at all levels to add value, and to stress the importance of this commitment to all employees. Demonstrating the key functions of the VBM analysis into both the strategy process and control systems is an effective way to communicate this commitment. By doing so, management can create an awareness of the need to create value at all levels of the company.

Planning, target setting, performance measurement, and incentive systems must be combined to successfully link value creation with strategy. In most cases, this involves the entire organization and helps focus…

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