Sixfoot4 Shareholder wealth white paper

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A short paper describing the drivers of shareholder wealth

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  • 1. WhitePaper#7 Howtodevelopastrategytogrowshareholder wealth Aspecialreportontheissues,conflictsandopportunitiestocreateshareholdervalue July2012 By: GarthHolloway ManagingDirector Sixfootfour Tel:+61(0)294510707 garthh@sixfoot4.com www.sixfoot4.com.au

2. Synopsis Alookattheprimarydriversoforganisationalvalue:Profitability,Productivity,Cashflow andStrategicGrowth. Introduction Shareholdervaluecreationcanbedefinedastheprocessofbuildinglastingeconomicvalue foracorporationsshareholdersandkeystakeholderssuchastheemployees,customers, suppliers,financiersandsociety. Theproblemisthattheobjectivesoftheshareholdersandstakeholdersareoftendifferent andmostlikelyinconflictwitheachother.Thesedifferencesstemfromthefactthatwhile managersfacethedailychallengeofmaximisingsales,profitandmarketshare,thirdparty institutionsgenerallyownthemajorityofshares. Thiscreatesaseparationofownershipandcontrol.Theoryhasitthatmanagersarethe agentsoftheownersandinaperfectworldthesharepricewouldreflectthepresentvalueof allfutureactivitiesthecompanyandgoodmanagementpracticewoulddriveuptheshare price. Inreality,institutionsarejudgedontheshorttermperformanceoftheirportfoliosandthey thereforepressuremanagementtodeliverhighincreasesintheshortterm. Thisinturncausesbusinessmanagerstoadoptinappropriatemanagementpracticesatthe expenseofthemidtolongterm.MichaelHalliday. KeyIssues Thefourprimarydriversoforganisationalvalue:Profitability,Productivity,Cashflowand StrategicGrowth Thestrategicchoicebetweendiversificationordifferentiation Togrowshareholdervalue,abusinessmustunderstanditsmarkets,understandhow demandiscreatedfromthosemarkets,understandhowthisdemandwillimprovethe ReturnonCapitalEmployed,andchooseafinancingmethodology. Page 2 of 14 3. Theobjectivesoftheshareholdersandstakeholdersareoftendifferent andmostlikelyinconflictwitheachother Developingastrategytogrowshareholderwealth Bywayofacknowledgement,themodelIuseforthispaperwasgiventomebymyMBA lecturerthelateMichaelHalliday.Ifounditatthebackofareadingheaskedustolookat. ThereadingwentontosayShareholdervaluecreationcanbedefinedastheprocessof buildinglastingeconomicvalueforacorporationsshareholdersandkeystakeholderssuch astheemployees,customers,suppliers,financiersandsociety. Theproblemisthattheobjectivesoftheshareholdersandstakeholdersareoftendifferent andmostlikelyinconflictwitheachother.Thesedifferencesstemfromthefactthatwhile managersfacethedailychallengeofmaximisingsales,profitandmarketshare,thirdparty institutionsgenerallyownthemajorityofshares. Thiscreatesaseparationofownershipandcontrol.Theoryhasitthatmanagersarethe agentsoftheownersandinaperfectworldthesharepricewouldreflectthepresentvalueof allfutureactivitiesthecompanyandgoodmanagementpracticewoulddriveuptheshare price. Inreality,institutionsarejudgedontheshorttermperformanceoftheirportfoliosandthey thereforepressuremanagementtodeliverhighincreasesintheshortterm. Thisinturncausesbusinessmanagerstoadoptinappropriatemanagementpracticesatthe expenseofthemidtolongterm.MichaelHalliday. Theabovequotereferstopubliccompanies.ButIbelieveitisequallytrueforprivate companies.Thedifferenceisthatinprivatecompanies,theowneristhemanager.And,as such,timepressures(quarterlyreporting)arereducedandthereislessscrutinyonhis/herPage 3 of 14 4. behaviouranddecisionmaking.Butinpractice,theendgameforbothtypesofcompanyis thesamenamelyvaluecreation. Therearefourprimarydriversoforganisationalvalue:Profitability,Productivity,Cashflow andStrategicGrowth Thesefourdriversareofequalimportanceanditisdifficulttopickastartpoint. Youneedcash,otherwiseyoucantstart,butyoualsoneedamarketandabusiness otherwiseyoucantapplyyourcash.Youmayhaveidentifiedyourmarket,butifyoudont haveasalesproposition,thenyouwontsellandyouwontplacedemandonyourassets (productivity). IwillstartwithGrowth. Growthrepresentsthemarketsthatyoutradeinorplantoenter.Ansoffarticulateditwell withhisgrid,asfollows: Newmarket Existing market NewProduct Existingproduct Theoptionsaretotakeaneworexistingproductintoanewmarket,ortofurtherdevelop theexistingmarketthroughbetterpositioningofanexistingproductortheintroductionof anewproduct.Page 4 of 14 5. Thestrategicchoicebetweentheseoptionsis:diversificationordifferentiation. Thispaperfocusesondifferentiationonlyimprovingreturnsfromanexistingmarket. Differentiationiseasierofthetwostrategies,asthemarketalreadyknowswhoyouareand ispreconditionedtotrustyourproducts. Withdifferentiationthemanagerhastwochoicesattheirdisposal. 1. Competethroughbetterproductpositioning.Degreeofdifferentiation. 2. Competethroughcostleadership. Considerthefollowinggraph: OntheYaxisisthedegreeofdifferentiation.Howaretheproductsorservicespositioned andperceivedinthemarket?Isitpositionedastailormadeorisitseenasacommodity orsomewhereinbetween? Page 5 of 14 6. Thescale1isasfollows 1. 2. 3. 4.Commodity Quality Exclusive TailormadeThemoreaproductispositionedandperceivedasexclusiveortailormade,themorethe marketwillpayforit. AproductpositionedasTailorMadeisdevelopedforaspecificindividualaccordingtotheir specificneeds.Thisbyitsnatureishighlydifferentiatedandveryexpensive. OntheXaxisiscostleadership.Howcheaplycanyousellyourproductorservice?This automaticallypositionstheproductasacommodity.Thestrategyishighsalesvolume Traditionallyyoucanthavebothandthesetwoaxesworkinverselytoeachother.Themore youdifferentiate,themoreitcosts. Todifferentiateyourproductinanexistingmarketrequiresthatyouknowhowitis positionedrelativetotherestofthemarket.Considerthefollowingexamplemarketplot.1I first saw this scale while working with IBMPage 6 of 14 7. TheXaxisisFunctionalityandtheYaxisisPrice.Bothaxesareratedhigh/low.Theplots representtheproductpositioninginthemarket.Therearesomegreattoolsetsinthe markettoassistwiththistypeofanalysis. Theplotidentifiesopenareas,wheretherearefewornoproducts.Theseareasrepresent theopportunitytoeitherrepositionyourexistingproductorlaunchanewproducttofillthe void.Page 7 of 14 8. Theriskisthatexistingproducts(includingyourown)haveanexistingpositioninthemarket andcustomersunderstandthis.Ifthedistancefromthecurrentpositiontothenewposition istoogreat,thecustomerwillbecomeconfusedanditislikelyyouwilllosesales.Forbigger distancesitisbettertolaunchanewproductthatisclearlydifferentfromtheexisting products. Thistypeofrepositioninghappensintheprofitabilityleg.Thegrowthlegdeterminedwhich marketsyouwillsellin;theprofitabilitylegdetermineshowyouwillselltothatmarket.The primaryleversforproductre/positioningare: 1. Pricing 2. Salesapproach 3. Salessupport Theneedfor,andnatureof,thesalessupportmakesahugedifferencetoprofitability.A productthatrequiresfacetofacesalessupportrequiresahighermargin.WhenintroducingPage 8 of 14 9. anewproduct,thistypeofsupportshouldbeconsidered.Ifthenewproductisapremium product,thenthecostofhiringandtrainingspecialistsalesstaffshouldbeconsidered.Or,if thestrategyistorepositionanexistingproductasmoreexclusive,thentheexistingsales staffmaynotbeoftherightprofiletosell/representthenewposition. Thestrategyoftheprofitabilityleg'istocreateabalancebetweenmarginandvolume. Volumeequalsdemandfortheproduct.Inmanyrespects,volumeisthemostimportant variableinthebusiness.Youcanhavegreatpeople,outstandingmarketing,topproducts, butifyoudontsellanythingyoudonthaveabusiness.Youalsoneedanappropriatereturn fortheproductorservice.Ifthemarginishigh,thenthevolumecanbelow.Thisisperfectly acceptableinabusinessdesignedforlowvolumes.Butinmanycasesahighmarginisnot enough.Volumemustbehighaswell.Considera$1productthatproducesan80%margin. Goodmargin,butnomoney. Volumeistheprimarydriverfortheproductivityleg. TocompeteoncostrequiresafocusAssetProductivity.AkeymeasureisReturnonCapital Employed. Considerthefollowingfourassets: 1. HumanResources 1. Machinery/Plant/Facilities 2. Money/Finance/Treasury 3. Inventory. Thesefourassetsarethetangiblesideofthebusiness.Improvingtheyield(productivity) fromtheseassetswillgrowthevalueofthebusiness. Productivityismeasuredasaninput:outputratio.Thereforetoimproveproductivitythe optionsare: 1. Sameinput:improvedoutput 2. Increaseinput:morethanincreaseoutput Page 9 of 14 10. 3. Decreaseinput:maintainoutput(orsmalldecreaseinoutput) Theinputsaretheassets.Theoutputistheproductorservicethatthecustomerbuys. EarlierinthearticleInotedtheneedtocreatedemandforthebusinessandthatthelegsof growthandprofitabilitycreatedemand.Inthiscase,demandmeansdemandforthe outputofthebusiness.Themanagersjobistomaintainandgrowthisdemandandtowork theassetstomaintainatargetproductivityratio. Unfortunately,mostmanagersonlyhavecontrolovertheassetsandnotthemarketplace. BymarketplaceImeanthesalesandmarketinginitiativesofthecompany.Thismeansthat mostmanagershavelittlecontroloverthecreationofdemandfortheassetsintheir managerialportfolio,andtheonlylevertheycanpull(especiallywhentimesaretough)is option3thecostreductionleverdecreasedassetinput.Thisisoftenresultsinlayoffsas thehumanassetistheeasiestonetomoveandistheassetthatdeliversimmediatecost reductions. Butifthebusinesswantstolowerthecostofproductionwhilstmaintainingispointof differentiationthenIrecommendamodelIpickedupfromIBMcalledthedynamicstability model. Thewayitworksistoseparatemarketingfromproduction. Asdiscussedpreviouslystrategicproductmarketingisbrokendowninto4segments: 1. Commodity 2. Quality 3. Exclusive 4. Tailormade Fromaproductionpointofviewthereis: a. Massproduction Page 10 of 14 11. b. Continuousimprovement c. Invention d. Masscustomisation Prevailingwisdomsaysthattheseconceptsarecloselyaligned.TailorMaderequires InventionandCommodityrequiresMassproduction. Thestrategyistobreaktheconnectionbetweenthetwoconcepts.Intheextremethis meansthatyousetupamassproductionenvironmentforaTailorMadeproduct. Massproductionreducesthecostoftheproducingtheproduct.TailorMademaximisesthe valueoftheitem.Thedifferenceisamaximisationofthegrossmarginoftheproduct.Ifyou cankeepamassproductionenvironmentworkingtheassetshavelittletonodowntimeand productivityratiowillbehigh. Page 11 of 14 12. Stakeholdervalueiscreatedwhenabusinessisabletolowerthecostofproductionwithout compromisingthepointofdifferentiation.Thisistheidealpositionanditrepresentsthe pointatwhichthecompanycanchargeapremiumpriceandtakeaninflatedgrossmargin. Itisonethingtoknowwhattodo.Itisanotherthingtopayforit.Thisintroducesthelastleg ofthemodelfinances.Financeisrelativelystraightforward.Youhavetwooptions: 1. Debt 2. Equity. Itisvitaltounderstandtheassumptionsbehindtheventurebeforemakingthefinancing decision.Itiscommonforentrepreneurs,managersandbusinessanalyststobuildan investmentspreadsheetandconsidertothatitreflectswhatwillhappeninreallife. Onpaperitallseemsreasonable,butwillithappeninpractise.Thedevilisinthedetail.To validatethemodelIsuggestthefollowingsequence: 1. Writedowntheassumptionsyouhavemadeaboutthebusiness 2. BuildamodelbasedontheseassumptionsPage 12 of 14 13. 3. Holdanopenworkshopwithtrustedadviserstorigorouslychallengethe assumptions 4. Refinethemodelandprepareasensitivityanalysisonthekeyvariables 5. Produceafinalanswer. Itisimportanttonotonlyvalidatethewrittenassumptions,butequallyormoreimportant, tovalidateassumptionsthatarenotthere.Whathastheauthormissed?Whatsnotwritten down? Ifyouhaveanexistingbusinessthenthemodelshouldfocusontheplannedextensionto thebusiness.Inotherwordscouldtheextensionstandonitsownmerits?Ifitcannot,you couldbegrowingrevenuebutdilutinggrossmargin.Ifitcan,whatsynergieswillyoupickup bymergingthenewwiththeexistingbusiness? Theanswerisreallytheleastofyourworries.Donotanticipateit,donotrushit.Arushed modelwillprovidetheanswersyouwantratherthantheansweryouneed. Onceyouhavetheansweryouarenowinapositiontodetermineyoursourceoffunds.I acknowledgethemodelwillneedtoincludefundingoptionsinordertotakeintoaccount interestexpense.Butyoushouldmodelwithaswitchtoturnthisoptiononoroff. Ifthemodelindicatesstablegrowthandthereisconfidenceintheassumptions,thendebt isprobablythewaytogo.Ifitappearsthattheventurewillrequirealongrunwaytogetoff thegroundthenequitymaymakemoresense,dependingwhetherornotyoucanfundthe interestpaymentsondebt.Myexperienceisthatthingsalwaystakelongertomaterialise thanexpectedandifyougothedebtoption,allowyourselfagoodcushionoftime. Itmustbesaidthatequityisthemostexpensiveformofmoney.Notintermsofdividends etc,butwhenitcomestosellingtheasset.Whatatthestartseemslikeareasonableequity percentagecouldbecomeaverybigpayoutfigureattheend.Agoodequitypartnershould assistthebusinessandhelpitgrow.Ofteninvestorshavegreatmanagementskillsandcan bringalottothebusiness. Page 13 of 14 14. Inclosing,togrowshareholdervalue: 1. Understandyourmarkets 2. Understandhowyouwillcreatedemandfromthosemarkets 3. UnderstandhowthisdemandwillimprovetheReturnonCapitalEmployed 4. Chooseafinancingmethodologythatwillsupportyourbusinessthroughthedifficult firstyearsbutwillnotbetooexpensivewhenitcomestimetoexit. Iwelcomeyourcommentsontheabove.Ifyoudisagreewithmeletshavethedebateasit drivesthelearningprocessforbothofus. Forfurtherinformation,pleasecontactGarthHollowayat: Telephone: Email: +61294510707 garthh@sixfoot4.com.au Page 14 of 14