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capitalideasonline.com
CREATING SHAREHOLDER VALUE DURING ECONOMY DOWNTURN
WITH VBM TOOLS AND STRATEGIES
Chetan J Parikh
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• Owners of invested capital
• Stewards of invested capital
• Adapting to economic paradigms of the 21st Century
• The role of finance in determining shareholder value
• Cost leadership strategy and supporting tactics
Creating Shareholder Value
~Introduction
Themes
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Shrinking competitive advantage periods (CAPs) means that an investor has to understand
– The dynamics of organizational change – The mental models that owners need to have to keep up with change
Creating Shareholder Value
~Owners of Invested Capital
What does ownership mean?
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• Owners must demonstrate – Rational allocation of capital– Reduction of fundamental business risks
• Develop systems thinking based on feedback loops
Creating Shareholder Value
~Owners of Invested Capital
Competences that owners need
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Portfolio Managers
Active Owners
Risk perspective Risks are predetermined, cannot be influenced
Risks can be reduced/ eliminated
Risk management Strategy
Spreading the risks Allocation of capital to risks one can handle
Portfolio optimization
Active/proactive reduction/elimination of risks
Source: “Ownership and Value Creation” by Rolf H. Carlsson
Creating Shareholder Value
~Owners of Invested Capital
Two fundamentally different ways of managing risk
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Source: ‘Ownership and Value Creation’ by Rolf H. Carlsson
Creating Shareholder Value
Through: Affecting market developments Superior competitive capability
Dominance Market leadership
Organizational Learning When the competitive situation changesstructurallyDeveloping a whole new business
Planning ForecastingContingency planning
‘Protection’ for Mobilizing power – political, military,example mafia through Forming cartels
~Owners of Invested Capital
Different ways of reducing / eliminating business-related risk
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Two major differences between CEOs and other employees
– Standards for measuring CEO’s performance are easy to manipulate, makes a CEOs performance harder to measure
– Relations between CEOs and board of directors are very congenial
Creating Shareholder Value
~Stewards of Invested Capital
Why is CEO performance difficult to measure?
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• Short term imperatives have forced CEOs to
– Meet the quarterly numbers– Have a wrong implicit valuation model– Disjointed the interests of shareholders from those of
other stakeholders
Creating Shareholder Value
~Stewards of Invested Capital
Long term must be balanced with the short term
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Valuation Model
Stock Price
Financial Statements
Managerial Skill
Business Unit Measurements
Accounting Results
Control Variables• Business Processes• Employee Satisfaction • Customer Satisfaction
• Tangible Assets• Intangibles
• Integration of Control Variables and Accounting Data• Valuation/ Resource Allocation
• Vision• System Efficiency• Innovative Environment• Adaptability• Learning Organisation
• GAAP
Feedback
Feedback
Feedback
Creating Shareholder Value
~Stewards of Invested Capital
Valuation model
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Traditional Business Structure E Business Structure
Creating Shareholder Value
BRAND CAPITAL
HUMAN CAPITAL
WORKING CAPITAL
PHYSICAL CAPITAL
Outsourcing Network
Sales Push Focus
Production Focus
High (Work in Progress,Finished Goods
High (Ownership of Production
Customer Pull Focus
Customer Focus
Low (Direct Delivery)
Low (Outsourcing)
~Adapting to 21st century economic paradigms
The Upside – Down Corporation
Source: Meta Capitalism
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Creating Shareholder Value
Twentieth Century Twenty-first CenturyScarcity Abundance
Physical capital Knowledge capitalTangible assets Intangible assets
Diminishing returns Increasing returnsComparative statics Nonlinear dynamicsCommand and control Networks and webs
Data processing Knowledge managementZero sum Positive sum
~Adapting to 21st century economic paradigms
Economic Paradigms of the 20th and 21st Centuries
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Creating Shareholder Value
Industry Product Tech Organization Process Tech
FAST CLOCKSPEEDPersonal computers <6 months 2- 4 2- 4
Computer- aided Software engineering 6 months 2- 4 2- 4Toys and games <1 year 5- 15 5- 15Athletic footwear <1 year 5- 15 5- 15Semiconductors 1- 2 years 2- 3 3- 10Cosmetics 2- 3 years 5- 10 10- 20
~Adapting to 21st century economic paradigms
Industry Clockspeeds
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Creating Shareholder Value
Industry Product Tech Organization Process Tech
MEDIUM CLOCKSPEEDBicycles 4- 6 years 10- 15 20- 25Automobiles 4- 6 years 4- 6 10- 15Computer Operating systems 5- 10 years 5- 10 5- 10Agriculture 3- 8 years 5- 10 8- 10Fast food 3- 8 years 25- 50 5- 25Beer brewing 4- 6 years 400 2- 3Airlines 5- 7 years 25 <5
(hardware)2- 3 years(software)
Machine tools 6- 10 years 6- 10 10- 15Pharmaceuticals 7- 15 years 10- 20 5- 10
~Adapting to 21st century economic paradigms
Industry Clockspeeds
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Source: Charles Fine, Clockspeed
Creating Shareholder Value
Industry Product Tech Organization Process Tech
SLOW CLOCKSPEEDAircraft (commercial) 10- 20 years 5- 30 20- 30Tobacco 1- 2 years 20- 30 20- 30Steel 20- 40 years 10- 20 50- 100Aircraft (military) 20- 30 years 5- 30 3- 5Shipbuilding 25- 35 years 5- 30 10- 30Petrochemicals 10- 20 years 20- 40 20- 40Paper 10- 20 years 20- 40 20- 40Electricity 100 years 25- 50 50- 75Diamond mining Centuries 20- 30 50- 100
~Adapting to 21st century economic paradigms
Industry Clockspeeds
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Creating Shareholder Value
~Using Finance to Determine Shareholder Value
“What remains of his profits after deducting interest on his capital at the current rate may be called his earnings at undertaking or management”.
- Alfred Marshall
A
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The basic ingredients in the Economic Profit calculation:
EP = NOPAT - $ Capital ChargeWhere:RevenueLess:Production / Operating ExpensesLess:Unlevered Taxes Equals:NOPAT $ Capital Charge = $ Capital – wacc
~Using Finance to Determine Shareholder Value
Creating Shareholder Value
The calculation of economic profit
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NPV = Present value of expected EP, thus
Wealth Creator :NPV>0, EP>0, RROC>0 * Wealth Neutrality :NPV=0, EP=0, RROC=0 Wealth Waster :NPV<0, EP<0, RROC<0
* RROC = ROIC - wacc
~Using Finance to Determine Shareholder Value
Creating Shareholder Value
Determining Wealth Creators
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~Using Finance to Determine Shareholder Value
Creating Shareholder Value
Determining Wealth Creators
V = C + NPV
V/C = 1 + NPV/C
= 1 + [PV of Expected EP]/C
KeyNPV : Net Present ValueC : Book Capital / Invested CapitalPV : Present ValueV : Corporate ValueEP : Economic Profit
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~Using Finance to Determine Shareholder Value
Creating Shareholder Value
Determining Wealth Creators
Valuation Profitability
Wealth Creator V/ C >1* EP/C>0 , RROC>0Wealth Neutrality V/ C =1 EP/C=0 , RROC=0Wealth Waster V/ C <1 EP/C<0 , RROC<0
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~Using Finance to Determine Shareholder Value
Creating Shareholder Value
Criteria for capital commitment
RROC > 0 EP > 0 NPV > 0RROC = 0 EP = 0 NPV = 0RROC < 0 EP < 0 NPV < 0
RROC > 0 EP< 0 NPV < 0RROC = 0 EP= 0 NPV = 0RROC < 0 EP > 0 NPV > 0
Capital Expansion (C > 0):
Capital Contraction (C < 0):
Source: James L Grant & James A Abate,’ Focus on Value’
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Source :James L Grant &James A Abate,’Focus on Value’
Creating Shareholder Value
~Using Finance to Determine Shareholder Value
Excess Returns Relative to Capital Growth Rate’Economically’ Profitable Reinvestment
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• Is the company a major force in a growing market?
• Is the company holding or increasing its shares on those segments?
• Is it resulting in increasing cash flows?
• Is the cash flow being used in a wise manner?
• Does the management walk the talk?
Creating Shareholder ValueCreating Shareholder Value
~Using Finance to Determine Shareholder Value
Questions Shareholders Ask..
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• Maintain competitive prices
• Pursue market share opportunities to gain scale economies in production and distribution
Creating Shareholder Value
~Cost Leadership and Supporting Tactics
Sales Growth Rate
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• Achieve relevant economies of scale
• Introduce mechanisms to improve rate of learning
• Search for cost reducing linkages with suppliers
• Eliminate overhead that does not add value to the product
Creating Shareholder Value
~Cost Leadership and Supporting Tactics
Operating Profit Margin
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• Minimise cash balance
• Reduce accounts receivables
• Minimise inventory without impairing customer service
Creating Shareholder Value
~Cost Leadership and Supporting Tactics
Working Capital Investment
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• Promote policies to increase utilization of fixed assets
• Obtain productivity-increasing assets
• Sell unused fixed assets
• Obtain assets at least cost, e.g. lease versus purchase
Creating Shareholder Value
~Cost Leadership and Supporting Tactics
Fixed Capital Investment
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• Target an optimal capital structure
• Select least-cost debt and equity instruments
• Reduce business risk factors in manner consistent with strategy
Creating Shareholder Value
~Cost Leadership and Supporting Tactics
Cost of Capital
Source: Alfred Rappaport, ‘Creating Shareholder Value’