Financial Value Creation
The main job of an organization is to create value, according to Peter Drucker, one of the greatest business thinkers of the 20th century. One definition of value revolves around a qualitative and abstract view of value creation around perceived costs and benefits. Although this conceptualization is important, it does not necessarily resonate with all functional departments, such as finance.
In today's uncertain economic environment, most business investments (e.g., purchasing a software solution, various capital initiatives, etc.) need to be vetted by the finance department, and in general, must show a strong Return on Investment (ROI) in order to be funded. Therefore, it is important for business professionals to be able to intelligently discuss true value creation from a financial context. I've created an acronym as a mnemonic to help remember how a company creates WIDER levels of value.
(Please note that my explanations just skim the surface of this important area, and don't account for numerous permutations and costs/benefit factors, but nonetheless, are quite useful for better understanding the whole value based management / decision making process.)
W = Weighted Average Cost of Capital (WACC;
Rather than get into the particulars of how to compute a company's WACC, the main point to know is that it is a weighted average of the company's cost of debt (e.g., bonds floated at 7%) and equity (e.g., investors require a return of 12% given the perceived risk of the business). Each of the terms is weighted depending on the capital structure of the company, for example, debt is 20% and equity is 80%. The WACC is also called the discount or hurdle rate and is often used to discount cash flows in capital budgeting decisions.
With all of that said, if a company is not getting a return on their capital that is higher than the cost of that capital, they are destroying value v. creating value. If you know your company's WACC, and a project's internal rate of return (IRR; an annualized rate of return, taking into account both the amount of money invested and the length of time it has been invested), then you can determine whether value creation is happening from a financial standpoint (IRR should be > WACC). For each business investment (e.g., initiative, project, etc.), try to understand the WACC that your company is using and the different ways that it might be able to lower this hurdle rate (e.g., restructuring capital costs, mitigating project risks, etc.) (Note: The WACC may differ by division and/or risk of a project/investment depending on the particular circumstances of the analysis. Additionally, IRR calculations can occasionally produce an un-interpretable result.)
I = Investment
An investment by nature is generally non-recurring, long-term oriented, and is often one option among many. A company can create value by making investments in projects that have an IRR (or ROI) that is greater than their WACC. A company may want to have a portfolio of investments (e.g., global branding campaign, segmentation study, etc.), each having a particular risk-reward profile (e.g., some have an IRR of 50% or 20%, etc.), as long as they are each above a company's WACC. In making a case to your senior leadership team to obtain funds, make sure that your business initiative/investment has an IRR that more than clears your company's hurdle rate.
D = Divestment
In general, a company should divest of units or projects that are negative value creators. This analysis entails a basic cost/benefit justification. If a company's funds cost 10%, and it has myriad projects and/or units that are returning 6%, it will eventually run out of current funds and/or have difficulty raising new funds (e.g., stock offering) given its value destroying behavior. As another example, if you rent a property for less than your mortgage payment on that property, you are not creating value for yourself nor acting in an economically sustainable manner. In general, the key message is to divest of projects/units that are destroying value or find ways to quickly increase your investments return.
E = Efficiency
Find ways to make your current capital (e.g., business investments) work more efficiently or productively. If you can cut costs, increase cash flows, and/or increase turns (e.g., inventory/asset turnover), then you can use your current capital in a more productive manner. This process comes down to making sure that each project/investment is operationally managed in an effective and optimal manner. When presenting a business case for a business investment, detail how the project will be run, the controls that will be put in place, and the track record of the resources that will hit the budget and timeline targets.
R = Return
If companies are going to beat the market averages and their peer group, they need to go after high return projects/investments. Business initiatives that pursue new, large customer segments and/or growing and substantial markets could produce the high returns that your company needs to break out of the pack and/or achieve new levels of growth. As stated above, high return projects tend to be of higher risk, but if managed well, and situated within a diversified investment (projects/units) portfolio, they are essential for hitting stretch targets and giving the business a new, growth oriented, order of magnitude focus.
In summary, the above acronym can be used to initially evaluate current and future business investments within an organization. If companies are to ultimately survive, and each department is to be viewed as financially accountable, then understanding hurdle rates and project returns is essential for making a tenable, cogent business case for new initiatives. In synthesizing disparate conceptualizations of value, value creation can be viewed as both perceived costs and benefits from a customer's perspective, and from distance above WACC from an internal company perspective. Both perspectives are needed to justify large business investments in today's uncertain economic environment, or at any time for that matter.
Michael L. Perla is a Senior Consultant with a leading Customer Relationship Management (CRM) software company. Michael has worked with numerous Fortune 500 companies in helping them to define and design their go-to-market strategy, build a business case, or better align their core business processes and strategic direction. Michael can be reached at firstname.lastname@example.org .
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