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In a previous post we talked about the Cash Paradox. Our report showed that in Australia, small cash holding companies have experienced higher revenue growth since 2009 –a five-year compound annual growth rate (CAGR) of 6.5%, compared to large cash-holders that experienced a CAGR of 1.9% over the same period. More striking is the relative share price performance of the two groups. A clear divergence of performance exists from 2009, with small cash-holders producing better returns.
The fact that the effective deployment of capital drives improved shareholder returns is of course not surprising. But how can organisations best optimise their capital allocation and synchronise their strategies with a firm market value agenda in mind?
This blog post outlines some impactful but often overlooked principles and steps that can help organisations improve the market value impact of their strategies. Access our full report for a more detailed look at the below principles.
The economics of value creation
Although the optimal way to drive ‘market value’ is a topic of considerable complexity, the basic parameters are clear – there will be an explicit or implicit aspiration of where the share price should be in a few years’ time. Various strategies and initiatives should then put in place to close the resulting ‘value gap’. However, what often receives little attention is the economics of value creation. The frequent omission of internal value focused analysis, for example, a discounted cash flow (DCF) model estimating the intrinsic value of an organisation is often surprising considering an internal value model will answer a number of important strategic questions:
• Taking known financial projections and planned strategic initiatives into account, would the resulting DCF value be consistent with the aspirational goals?
• Does the market already anticipate the expected results of a company’s 5-year plan or will they actually move the needle in terms of share price performance?
• If not, can the resulting ‘value gap’ be closed through a combination of additional efficiency and growth initiatives?
• Should the focus be on growth or would the share price be more responsive to cost reduction?
• What market expectations in relation to capital growth rates and returns are already built into the share price?
“Intrinsic value [is] an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”
—Warren Buffet, Chief Executive Officer, Berkshire Hathaway [An Owners Manual, Warren Buffet, Berkshire Hathaway Inc 1996.]
An economic profit model shows that market value is linked directly to two drivers: the quality of capital returns and the volume of capital investments. In other words, in order to create additional value, capital should be invested at returns above the cost of capital with a growing volume of such investments (Figure 1).
Future funding and capital allocation decisions therefore need to focus on business units generating superior returns and at the same time need to fund emerging opportunities that can be converted into businesses yielding excess returns in the future.
Consequently, strategies to reach aspirational value targets should be founded on a sufficiently robust economic analysis, providing guidance on the value potential of current strategies and at the same time directing additional actions towards the aspirational goal.
A structured approach
We have developed a three-step approach to help our clients assess their current strategies and progress towards their aspirational value goals:
1. Benchmark economic returns – what are the current market implied growth rates and returns, and what is a potential value target? Even this high-level analysis will already provide guidance on where the emphasis of future investment decisions should lie. If a company is already in the group of high ROIC performers, the strategic focus will most likely be on growth as further increases in returns will be difficult. Conversely, if returns are near or below the cost of capital an efficiency imperative is most appropriate
2. Create a portfolio view of market value – business unit leaders have a wealth of knowledge about a company’s projected future performance, which can be leveraged to estimate the intrinsic enterprise value in aggregate and the value contribution from individual business units. By creating a portfolio view, a company can develop a picture of how individual business units and segments are performing. It is not uncommon to find that a small number of business units contribute the majority of the value, that strong variations in capital efficiency exist and that the portfolio is overweight towards mature businesses, with emerging opportunities contributing much less – even in the long run – than previously thought
3. Quantify the value of additional strategies – once the value contribution of existing forecasts, strategies and projects are known, additional initiatives to close the value gap should be identified and quantified. We find that as a result of this process, new initiatives remain firmly aligned to a value agenda (Figure 2)
Every company must find new ways to improve market value creation. Taking a structured approach not only helps to create visibility and better governance of capital spend, but also ties strategic decision making back to a value agenda. By doing this, companies can improve strategic planning, optimise their capital spend and better manage market value creation and investor expectations. This is of relevance to any company wanting to drive the best outcomes from their portfolio of assets. To learn more about our three step approach to improve value creation and how we helped a global supply chain logistics company to improve its value creation strategies access the full report here.