Why Manage for Value Creation?

Before making an investment, structural or operational decision the key question you should be asking is

Is the decision you are making creating value?

Or,

• Once we make the decision is the value of equity for the owners going to increase or will we destroy value? Or
• Is the present value of the expected future cash benefits of my decision going to exceed the initial cash outlay.

By determining if the proposal is going to generate a positive net present value (NPV)? you are able to determine the benefit (if any) of many key decisions that a company has to make, including;

• Should I make this investment?
• Should I make this acquisition?
• Should I modify the firm's capital structure?
• Or should the company pay a dividend and if so how much?
• Which existing assets are destroying enterprise value or the worst performers?
• Actions that could be taken to increase enterprise value?

For example: In the case of identifying a new project or market opportunity the present value of the future profitability (net cash benefits) of the project must exceed the cost of capital (Either cash, equity (shares) or debt (loans) or a combination of the three). If this is the case the project will have a positive NPV and will generate more cash for the company and in turn, create enterprise value. By applying this concept across the organisation you can help to ensure that you do not destroy value through making poor or uneducated decisions.

Poor decisions can result in investment, finance and dividend implications. From an investment perspective, in the case where a past decision has resulted in value destruction, this may limit the enterprises future debt raising ability and the ability to act on positive NPV investment opportunities in the future.

Without going into the details and keeping this short, a method of doing this is to use a market value balance sheet. Here the traditional balance sheet, is simplified into a managerial balance sheet and ultimately into a market value balance sheet which concentrates on projects, defined as the present value of the future cash flow, generated by the current and non-current assets of the firm. Potentially the most important feature of the market value balance sheet is that all assets and liabilities are valued at current market values, rather than using historical costs. By doing so, any change in enterprise value due to a decision can be calculated, and in turn any equity value change determining if you are adding value for the owners.

By understanding the key financial concepts, and applying them in a methodical manner you are able to guide yourself through key financial management decisions that will govern future value creation decisions forming the foundation for a value based management system. This includes but not limited to a system that assists with answering the following questions;

1. How to manage the firm's current assets?
2. Which are the underperforming or value destruction assets?
3. Actions to take to improve or remove the assets from the portfolio
4. How to make value based management decisions
5. Should I make this investment or acquisition?
6. Should I modify the firm's capital structure and what is the optimal design?
7. What is the best financial structure for the firm
8. What is the best combination of long and short term debt?
9. What is the optimal management of the firms working capital requirement?
10. How to manage risk (Business and Financial)?
11. How to manage the distribution of wealth to the owners?
12. What is the optimal dividend payout to retained earnings?

NOTE: An important concept to understand is that creating value for shareholders should not destroy value for customers, employees, and suppliers. Research indicates that the most successful companies are able to create value for customers, employees and suppliers through creating owner value, in fact there is a relatable correlation between the ability of a firm to create value for their shareholders and the ability to create value for the customers, employees and community. In saying this, there is a balancing act between the groups, as without happy shareholders you lose the flexibility of curating the other groups. Ultimately the focus of a firm should be on the creation of value, and in turn this will create value for its stakeholders and society.

 References

Hawawini, G., & Viallet, C. (2015). Finance for executives : managing for value creation (Fifth edition.). Cengage Learning.