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Overdue diligence.

Stewart has analysed several sectors of the FTSE-350, looking at the change in market value against the level of capital investments over three years (see table). The resulting figure is a Value Creation Ratio, which needs to be above 1 if the company or sector is to avoid destroying shareholder worth. “If you can’t quantify (the added value from a project) there’s got to be a question in your mind as to whether you should be making that investment at all,” argues Stewart. Price Waterhouse recommends that any capital programme should go through a four-stage process to weed out the value-destroying projects. It starts with project generation, the strategic end of the process where “big ideas” first emerge. Often, the finance department will come up with schemes to cut investment which isn’t adding value. The second stage is project appraisal. In many situations, the prime concern is not creation of value, but avoiding losses. Stewart thinks it’s this stage which requires the most attention. “On the downside risk, lots of companies would do a cashflow forecast, but that’s only one of the potential outcomes,” he says. Enforcing this level of due diligence – looking at financial matters alongside market and operational considerations – also helps to weed out any unforeseen problems at the project generation stage. “This is a chance for the finance director to be involved at the coalface of decision making,” Stewart stresses, “rather than being at the rear-end and just having to measure the outcome of those decisions. It will require a broader skill set in the finance function.” It also means the finance function is more significant in stage three, project selection. The classic case here is a project which will clearly create value for shareholders but which is limited by fixed capital expenditure. The FD is well placed, for example, to weight budgets towards those projects which create higher value. Finally, every project must be subject to ongoing review. Financial reports are often an insufficient measure of whether a project continues to add value. “If you get rid of the projects that destroy value,” says Stewart, “that’s just as good as adding more that create value.” This portfolio management role for finance is important, but there are a host of related activities needed to make the process really work. Not least of these is linking executive remuneration with value creation, a topical metric. “Because there’s no linkage with remuneration,” Stewart says of the usual project development process, “there’s no urgency to review one-off projects. But it’s essential.” Stewart believes that the sign that company culture has really changed will be when sacred-cow projects are put on the back-burner because it transpires that they fail to create value.

 Value creation, 1995-97                               (a) Change in     (b) Capital     (a/b) Value                               market value     expenditure          Sector                                      (£bn)           (£bn)  ratio creation  Breweries, pubs, restaurants          12.1             3.6             3.4 Commodity chemicals                    0.9             3.7             0.2 Electricity                            1.0             3.9             0.3 Food producers                         4.5             7.7             0.6 Food retailers                         6.5             6.9             0.9 Integrated oil                         0.7             3.5             0.2 Pharmaceuticals                       25.3             3.7             6.8 Telecoms                              (3.0)           11.1            (0.3) Water                                 (0.6)            1.7            (0.3) Publishing                            13.3             3.8             3.5 TOTAL                                 60.7            49.6             1.2  Source: Price Waterhouse/Datastream. Only FTSE-350 companies with full 3 years on Datastream are included.

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