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NEW: Business intelligence – Capital value.

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What do investors look for? If organisations are looking to ensure that they are attractive investment propositions, then knowing what drives these investment decisions is a critical knowledge-set for any management team. Research for the report, Building and Communicating Shareholder Value, has found that there are four key performance areas that are analysed.

– what drives value in the business?

– the organisation’s ability to sustain value over time;

– the quality of the management team;

– the company’s present stock valuation.

So what drives value in the business?

On this point, Francois Langlade-Demoyen, a London-based partner with Buttonwood Capital, says:

“We will analyse the business not only from a purely financial perspective, but from a strategic standpoint. In financial terms we are looking for businesses that generate a good return on investment, but this is dependent on the strategic perspective. Here we will look at the competitive environment, pricing strategies and relationships with customers and suppliers. We look at what is unique about the product or service and the risk level if substitutes are found for these. Essentially we assess the competitive position and the quality of the business.”

Therefore, this stage is all about ensuring that the fundamental building blocks of success are in place, as the investor will be scrutinising the business for signs of any weakness in this value-building foundation. It’s interesting that Langlade-Demoyen mentions the importance of relationships with customers and suppliers, recognising that value-building capabilities must be found within the whole value chain, from suppliers through to customers, leading to shareholder value. This would appear to give some credence to the importance of organ-isations taking a stakeholder, or balanced, approach to value creation, in that organisational relationships with stakeholders other than shareholders are paramount to sustainable value creation.

But this stage, although important (for if investors are uncomfortable with what drives value they will be reluctant to invest), will not by itself provide all the requisite information for investment decisions.

What is also required is an understanding of the organisation’s ability to sustain value over time. This is particularly important given the oft-quoted figure that only 10% of well thought-out strategies are implemented successfully.

The organisation’s ability to sustain value

In the knowledge era it may be said that this stage is becoming increasingly difficult to judge. Indeed, it’s to both manage and monitor the sustainability of value into the future within a turbulent and unpredictable market dynamic that largely drove the development of the balanced scorecard.

The scorecard design recognises that past financial performance, for example, does not in itself provide valuable pointers on the organisation’s likelihood of sustaining value over time. A good example being that companies may have to cut investment in future wealth-generating capabilities, such as research and development, which may make the short-term figures look good but destroy future wealth creation.

Research for this report finds that the sustainability of value can be more of a challenge for high-return/high-growth businesses than for average-to-low-return/growth businesses. For, as is explained in chapter 3 of the full report, companies with a high Cash Flow Return on Investment (CFROI), tend to attract competition that will force returns to fall and lessen growth potential. Thus at this stage, the investor will be looking for signs that the organisation is aware of competitive threats and what it must do to meet them, and that it’s building the capabilities (such as around new product design) to create future value.

Investors may also look at the real options available to the organisation to ensure future survival and leverage benefits from new applications of existing products. (For further discussion on real options theory, see chapters 5 and 9 of the full report.) Being able to sustain value over time forces attention on to point 3: the ‘quality’ of the management team. During 2000, this gained a new emphasis given the huge investments being placed within start-up internet-based firms, and the subsequent realisation that many flounder as a result of possessing a management team without the right skills to manage a fast-growing business (see chapter 9).

The quality of the management team

There can be little doubt that the quality of the management team is a primary indicator of an organisation’s likelihood of building shareholder value. It is senior management who make the most significant capital allocation decisions as well as identifying and planning the execution of corporate strategy. Chapter 5 provides greater detail about the importance of ensuring that managerial decision-making processes are focused on value creation. As Langlade-Demoyen says: “We want to make sure the management is doing all it can to maximise shareholder return.”

Of course, the majority of organisations recognise that the most senior management is the pivot on which value creation revolves. This is why such huge compensation packages have been given to management (see chapter 7).

A great deal has been written on developing market-focused managerial competencies, and this is central to both Economic Value-Added (EVA) and CFROI approaches. In addition, there have been innumerable examples of where senior management was blamed when companies that were perceived as value-creative began to destroy value.

Tom Larsen, director of HOLT Value Associates (which sets out to “marry” managerial actions with investor decision-making and communication processes via its CFROI model; see chapter 3), states that irrespective of the industry, key top management skills now include:

– providing the vision;

– focusing on total-company efficiency;

– promoting an innovative environment;

– creating a continuous-learning organisation.

The present stock market valuation

The important point here, according to research for this report, is that institutional investors looking for a long-term, sustainable payback, will look at the stock value last. As Langlade-Demoyen says:

“We wouldn’t invest in a stock just because it looks cheap. Stocks could get cheaper and we wouldn’t sell just because it looks expensive, as there are lots of examples where stock gets even more expensive.”

Likhit Wagle, a UK-based partner with the professional firm PricewaterhouseCoopers, stresses that:

“Contrary to popular opinion, what investors are not doing is trying to determine whether companies are over-valued or under-valued, although there’s a community that does this and this is why we see such increasing volatility in the stock market. But the core institutional investor doesn’t do this.”

Thus, and remaining with a key learning point from this report, the institutional investor is not short-termist in his analysis, or expectations of, organisational performance. As Wagle points out, this goes some way to exploding the myth that it is only short-term financial performance or share price movement that interests the investment community.

EPS and the financial markets

In Wagle’s view, if the present value is not a key determinant of decisions, neither are traditional financial measures such as accounting profit or EPS. He says: “One question I am repeatedly asked by clients when we say that profit or EPS measures are no longer that important to investors, is ‘if that’s true, how comes the financial markets still talk about EPS?’ This, I say, is because there’s a lack of transparency around accounting information. While EPS is certainly not an important measure in driving value, in the absence of transparency it does have significant information content.”

He continues by saying that the market-place’s view is that there’s such an opportunity for companies to massage numbers, and that if they do not hit their EPS forecast it suggests that there’s something wrong in the organisation. He says: “Companies can report high EPS growth but below their target, and see their share price fall because the investors feel that if these companies have not been able to massage the figures to hit the EPS target then there must be a significant underlying problem. If companies can’t explain this away then the shares will fall.”

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