Value can mean different things to different stakeholders: the firm’s owners see value as the worth of the firm, while the internal management of the firm see value as creating returns from the strategic position and real asset investments the firm makes.
In other words, the financial market values the firm based on its prospects while the internal priority is very much around growing business unit profitability. The conundrum many CFOs face is how to join these two perspectives up. How do you create internal targets that align to the valuation owners of the firm have placed on it? How do you measure which business units in the firm are meeting or exceeding these targets and which are not? Answer these questions and you are long way down the road to efficiently allocating capital and increasing the value of the firm.
If you strip the purpose of being in business down to its most basic level you could summarise it as the process of buying low, selling high. In other words, making something worth more than you pay for it. There is an alchemy going on here in which the business best positions its resources and products to create value. We call this process strategy.
And the great news is that the financial markets transmit the value of the firm’s strategy to it through the share price. The share price tells the firm how much value the market expects it to be able to create in the future. And here’s the critical step: if you know the value of something and you know how much capital you have available to invest you can work out the rate of return needed to generate this value. This can be translated into internal targets in pretty much any form that really contribute to the realisation of the strategy. Better still by understanding precisely what these targets are, capital within the firm can be re-allocated to those parts of the business that are expected to exceed them and produce a market beating performance.
Budgeting or target setting?
Budgeting is a critical part of the financial cycle within a firm and is essential in providing a financial framework for control and reward. But how often is the budget grind largely an exercise is batting about a bit of revenue growth and cost reduction rather than focused discussions about returns on capital. To get to the heart of target setting with purpose the firm needs to understand the cash flow growth its valuation demands of it. Once this is understood it can be turned into other targets such as revenue and profit growth which can be easily communicated within the firm. Embedding this process in the budget cycle creates a target setting process with genuine purpose.
Where can an appreciation of value take us?
I’ve concentrated so far on a discussion around setting targets for budgeting purposes. These clearly then fold into performance targets and incentive schemes. But there are many other areas a fundamental understanding of value creation can take you. These include capital allocation across the firm’s business units to maximise value, business unit, product or brand portfolio management, M&A activity and divestitures, to name but a few. The whole gamut of strategic financial activities is addressable in a value-based framework bringing rigour, transparency and purpose of direction.
Author: Ben Walters FCT, ACA