Managing for the Long Term by Maximizing Value, Not Profit
The first decade of the 21st century saw two economic downturns, and quite a few corporate failures.
This has caused corporate leaders to examine how to guide their organizations through these times effectively, so that they continue to be successful.
But what does "success" really mean? Does it mean high profits, or high dividends for shareholders? Or does it mean being more efficient, building for the future, and operating with a structure that will survive the difficult times?
If your success strategy is primarily based on profit, it probably won't provide enough incentives to consider the long-term impacts of your decisions. For example, you could increase your prices to increase profits, or you could choose to cut costs dramatically, and increase your quarterly earnings to satisfy your investors.
However, this approach is likely to affect your market share, and your ability to compete in the long term. It may also have an impact on quality, and affect your ability to attract and retain talent.
Everyone wants to operate profitably and efficiently, with cost-effective teams, projects, and organizations. You don't want to ignore your short-term goals, but sacrificing long-term profitability for short-term profits isn't a sustainable strategy. Ultimately, you want to build and maximize your ability to be profitable in the long term. One way of doing this is to use Value-Based Management (VBM).
In this article, we'll look at the ideas behind VBM, and highlight strategies that you can apply to boost the overall value of your organization. We'll also identify the drawbacks to VBM, and look at situations where VBM may not be suitable.
This article focuses on applying Value-Based Management in an organizational context. But you can also apply the ideas behind it to a department or small team, if this fits with your organization's overall objectives.
Principles of Value-Based Management
In a Value-Based Management (VBM) approach, your overall goal is to maximize the value of your organization. This means that the decisions that you make today are not simply driven by short-term profit. Rather, you consider the longer-term effects that the decisions will have on organizational sustainability and profitability, reflected in future cash flows.
VBM asks people within a company to think like owners, and to make decisions that will ultimately benefit the owners. Managers and executives must constantly look for investment and growth opportunities that will create value, and use the company's capital in ways that ensure long-term success.
A fundamental principle of VBM is the belief that future cash flow and growth are the source of a company's value. Looking at accounting-based measures – like quarterly earnings, earnings per share, and the price/earnings ratio – is not how advocates of VBM make decisions. This may be difficult, particularly when there's significant pressure from short-term investors.
VBM is both a philosophy and a methodology. It recognizes that the decisions that you make on a daily basis all contribute to the value of the organization. Therefore, VBM must be pushed throughout the organization; not just in the boardroom. People at all levels must participate in driving this overall value.
Weaknesses of VBM
Although a VBM approach can boost the value of your organization, it's important to remember that it's not suitable for all situations. This is because it adopts a longer term perspective, where you must rely on forecasts, projections, and assumptions about what will (and will not) contribute to the value of the organization.
For example, while you may be sure that an upgrade to your software systems to improve efficiency will create value, it's much harder to predict the effects of a new technology that disrupts your services, yet has the potential to increase market share significantly. Using VBM as your only criteria may cause you to discount projects and strategies that have a highly uncertain outcome, but could make a large contribution to long-term growth and sustainability. This may make it unsuitable for early stage technology ventures, for example.
Also, VBM may not be suitable in companies that are well established and that have successfully used a particular business model for a long time. For instance, commodity-based companies, such as those in the steel and lumber industries that have stable markets and reasonably stable stock prices, may find that implementing VBM is actually more disruptive than any potential gains. So, in creating new organizational value, you also have to make sure that the projects that you take on as part of the VBM process don't detract from the value of the work that you already do.
A VBM-focused approach may also cause you to lose sight of social or non-financial measures of corporate success. Being a good corporate citizen can be a factor that adds significant value. Costly projects that reduce the impact on the environment may not appear to add shareholder value in the strictest of terms. However, when you analyze these projects with a broader view of social value, they can actually contribute to long-term, sustainable value. Likewise, decisions that put shareholder needs above those of other stakeholders like employees and customers, can quickly backfire in some industries.
It is important therefore, to use an approach like VBM with a scope and perspective that matches your organization's overall mission and goals.
Jack Welch, a strong advocate of maximizing the value of an organization, was notoriously quoted in a 2009 interview as saying, "On the face of it, shareholder value is the dumbest idea in the world." However, what wasn't included in the sensationalized headlines was that Welch went on to say, "Shareholder value is a result, not a strategy..."
Welch's point was that you can't tell people that your strategy is to maximize organizational value. He doesn't feel that is a tangible outcome that energizes or motivates people. What he does believe is that to provide value, you must implement successful strategies, and VBM can be a part of that implementation.
Implementing Value-Based Management
There's no one set of steps for introducing VBM to your organization. As we said, it's a mindset and a method. As such, you'll need a formal change program to implement it, and this will drive an organizational journey that starts and ends with a commitment to creating value.
However, to launch and sustain this journey, there are four key stages for success:
- Understanding your value drivers.
- Developing a strategy to maximize value.
- Setting long-term and short-term performance targets.
- Developing performance measurements that support value-based targets.
We'll discuss these in more detail below.
1. Understanding Your Value Drivers
To create and maximize value, you need to understand the source of value. Simply saying that you want to create value isn't descriptive enough, so you must define how you intend to do it. Essentially, value is created when the return on capital exceeds the cost of capital.
Start by looking at all of the ways that you invest resources in your organization, and then assess the value of those resources. Some of these value investigations are purely financial. For instance, before making capital investments, do a thorough financial analysis of future cash flows, and ask yourself how this investment will benefit your shareholders in the long run.
Your organization also creates value in many other places that you can't measure as easily. For example, when you create value for your customer, you may also, ultimately, create value for your shareholders and your organization.
Use value chain analysis to identify and measure key areas within your company where you can maximize total value.
- How can you deliver better service?
- Where can you become more efficient, and generate a greater return on your investment?
- How can you use your resources (people and capital) to create the most value?
2. Developing a Strategy to Maximize Value
The value mindset is essential to a successful VBM program, and this mindset must start at the top and continue through every level of the company. With a clear and well-defined value-based strategy, you can show that the value of the organization is more important than other success measurements, and you can help direct people's actions and decisions toward creating value.
Ultimately, VBM provides a framework for analyzing every decision made within an organization.
When developing a VBM strategy for your organization and its various units, do the following:
- Assess how you defined the value behind each strategy that you're considering. Note the assumptions that will impact the value of the organization, and use these to analyze other strategic options.
- Weigh the value of each strategic option. (Conventional project analysis, Decision Tree Analysis, Decision Matrix Analysis and the Analytic Hierarchy Process can be useful for doing this.)
- Define the resources (investment) required for each strategy. Look at financial as well as nonfinancial resource commitments.
- Analyze how your expected value returns compare with your competitors' value returns. You probably want to provide more value to your customers and shareholders than your competitors do.
- Look at your alternatives in terms of the effect on your competition, and how they'll place you in your industry. These are important elements of overall organizational value.
3. Setting Long-Term and Short-Term Performance Targets
When you start with a strategy that supports VBM, you can then set performance goals to ensure that everyone within the organization works toward that common objective. This is how a culture of VBM spreads. When each person is accountable for value-based results, eventually the idea of organizational value becomes a "shared value" throughout the company.
To promote this idea, communicate how the performance goals relate to the value of the organization. Make a direct connection between the 10-year plan, the three-year plan, and the one-year plan, for example. When you link performance and outcome clearly, it's much easier for people to understand. Management By Objectives is a useful system for making this clear.
You'll also need solid action plans for people to follow. These plans break your strategy down into the smaller action steps required to reach the goal of boosting the value of the organization. Value as a goal is not very easy to measure, so the action plans provide the day-to-day structure for VBM to be successful.
4. Developing Performance Measurements to Support Value-Based Targets
Ensure that your performance management system reinforces the ultimate goal of maximizing organizational value. When something gets measured, it's more likely to get done. Therefore, you need specific performance metrics to motivate and encourage everyone to work toward the value-based strategy. Again, it's critical to link everyone's performance to the long-term strategy - and to communicate this link clearly.
Remember these guidelines:
- Look beyond financial measures of performance.
- Make sure that people who are accountable can influence the measures you set. People must see that their efforts directly impact their targets and performance.
- Develop metrics that will show when you aren't creating value. Build in warning measures so that you have time to make changes before your customers and shareholders respond negatively.
- Use compensation and incentive plans that are linked to the value that's created. By rewarding value-based activities, you'll increase those activities.
- Push value-based performance measures to all levels of the organization.
Value-based management (VBM) is a mindset that views the value of an organization as the ultimate measure of success.
Successful VBM depends on highly effective strategic planning, supported by a performance management system that drives the value mindset into the organization's overall culture.
Applying VBM effectively can create a cycle of increased awareness and recognition of the elements that create long-term and sustainable profitability. With the resulting investor confidence, your company will be able to endure market downturns and economic pressures better.
However, VBM is not suitable for all situations and organizations. If you apply any of the strategies or ideas behind VBM, make sure it fits with organization's overall goals and objectives.
Apply This to Your Life
Think about what drives value for your organization. What do you do on a daily basis that leads to long-term profitability? Look beyond short-term solutions that save money or increase revenue, and concentrate on efficient longer-term uses of resources that will result in long-term success.
Make a list of things you're doing currently - like capital investments and projects designed to improve customer satisfaction - that contribute to long-term value. Make another list of actions and decisions that are (or were) short-sighted, and that could potentially decrease long-term value. For example, cutbacks may save money in the short term, but they may reduce productivity, and therefore damage the organization's ability to attract and retain talent in the future.
Set one or two value-based performance goals for yourself and your team. Start with a strategic objective to create value in a way that you can directly influence. Then develop specific goals and performance measures that you can monitor. Discuss what you're doing and why, with your team as well as your colleagues and top executives. Although VBM requires support from the top, that doesn't mean it has to originate there!