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A Management Seminar

A Management Seminar. The “Essence” of Value-Based Finance. Presented by: Roy E. Johnson Vanguard Partners Ridgefield, Connecticut. Discussion Topics. The “Essence” of Value-Based Finance ( VBF ) Page/s Overview of VBF 3 – 6 The “Accounting” Model 7 – 13

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A Management Seminar

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  1. A Management Seminar The “Essence” of Value-Based Finance Presented by: Roy E. Johnson Vanguard Partners Ridgefield, Connecticut

  2. Discussion Topics The “Essence” of Value-Based Finance (VBF) Page/s • Overview of VBF 3 – 6 • The “Accounting” Model 7 – 13 • Value “Indicators” 14 • The “Economic” Model 15 – 17 • Financial “Drivers” 18 – 21 • Value “Analysis” 22 • Market Value Added (MVA) 23 • The “Magnifier” Effect 24 – 28 • Allocating Resources – Based on “Value Creation” 29 – 31 • Summary 32

  3. “Overview” of Value-Based Finance (VBF)

  4. Overview Value-Based Finance (VBF) is a system to help management deliver value to “shareholders”. Focused on financial performance, VBF is part of an overall corporate management system that needs to “balance” the value delivered to customers with economic performance. Therefore, Value-Based Finance (VBF) needs to “fit” within the strategic direction, level of financial sophistication and cultural environment of the corporation.

  5. Overview One way to view VBF is as a sub-system of a larger value-based management (VBM) system, integrating the needs of customers and shareholders. Business Strategy Workforce Engagement Investment and Operations Performance Measurement

  6. Overview Within this framework, VBF coordinates key financial activities. Strategy “Evaluation” Corporate Goals Business Analysis “Alignment” … Managers to Shareholders “Hardwiring” Strategy to Budgets “Economic” Performance Financial “Drivers” “Value-Based” Metrics

  7. The “Accounting” Model

  8. The “Accounting” Model Most “accounting” analysis begins with a determination of “Gross Profit”. “Base Period” CO. ‘A’ CO. ‘B’CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Cost of Sales 200 500 800 Gross Profit - $ 800 500 200 - % 80% 50% 20% This analysis indicates major differences in the relationship of selling price(s) to product cost(s) among the three companies.

  9. The “Accounting” Model Most “accounting” analysis ends with a determination of “Net Profit”. “Base Period” CO. ‘A’ CO. ‘B’CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Cost of Sales 200 500 800 Gross Profit 800 500 200 Operating Expenses 650 350 50 Operating Profit 150 150 150 Taxes @ 33% 50 50 50 Net Profit - $$100 $100 $100 - % 10% 10% 10% Factoring in Operating Expenses essentially completes the analysis.

  10. The “Accounting” Model The “accounting” analysis can be summarized as follows: “Base Period” CO. ‘A’ CO. ‘B’CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Net Operating Profit [NOP] - $$100 $100 $100 - % 10% 10% 10% The Accounting (“Earnings”) model stops here. In this case, all companies are the same ... and, all are “profitable”.

  11. The “Accounting” Model The “Accounting” model does not do a good job, however, of explaining “Value”. Correlation of EPS to Market Value 5.5 GIS 5.0 K 4.5 4.0 CPB MSTR 3.5 Market Value / Invested Capital HSY 3.0 R2 = 1% 2.5 HNZ CPC SLE RAL CAG 2.0 OAT MCCRK 1.5 RAH TYSNA NA 1.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 EPS Growth Source: Credit Suisse/First Boston

  12. The “Accounting” Model …And, revenue growth alone does not create shareholder value. There must be a “return on capital”. Revenue Growth, ROI Spreads and Market Multiples • Revenue • CGR - % >16% 12 to 16% 8 to 12% 4 to 8% 1 to 4% > 1% Average Market Multiples – S&P Industrials 0.71.12.1 2.2 4.2 0.91.11.5 1.5 2.5 1.00.91.2 1.7 3.2 0.70.91.2 1.7 3.1 0.71.01.01.4 2.2 0.91.11.11.2 1.6 >-4% -4 to –2% -2 to 2% 2 to 4% >4% Return on Investment “Spread” … ROI less Cost of Capital Source: Hewitt Associates

  13. The “Accounting” Model Why? • From a financial perspective: • Accounting was not created to do value analysis … rather, its origins are in “credit” and “liquidation” analysis. • A true measure of value creation must factor in “risk” and “return” – which accounting does not do. Thus, two critical elements are missing in the “accounting” model. • Two key concepts that are critical in the understanding of “value creation” for investors will be explored, namely: • Economic Profit, and • Market Value Added.

  14. Value “Indicators”

  15. Value “Indicators” – Economic Profit “Base Period” CO. ‘A’ CO. ‘B’CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Net Operating Profit [NOP] - $$100 $100 $100 - % 10% 10% 10% -------------------------------------------------------------------------------------- Invested Capital [IC] $600 $800 $1,000 Cost of Capital [CCAP] 12% 12% 12% -------------------------------------------------------------------------------------- The “Economic Profit” model introduces the concept of Capital required to produce the “Accounting Profit” and the Costof this capital. We begin to see that all the companies are not the same.

  16. Value “Indicators” – Economic Profit “Base Period” CO. ‘A’ CO. ‘B’CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Net Operating Profit [NOP] - $$100 $100 $100 - % 10% 10% 10% Invested Capital [IC] $600 $800 $1,000 Cost of Capital [CCAP] 12% 12% 12% -------------------------------------------------------------------------------------- Economic Profit NOP [from above] $100 $100 $100 Capital Charge [CCAP] (72)(96)(120) Economic Profit [“EP”] $ 28 $ 4 $ (20)

  17. Value “Indicators” – Economic Profit We can restate “EP” as “ROC” by changing the formula within our framework. “Base Period” CO. ‘A’ CO. ‘B’CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Net Operating Profit [NOP] - $$100 $100 $100 - % 10% 10% 10% Invested Capital [IC] $600 $800 $1,000 Cost of Capital [CCAP]12% 12% 12% -------------------------------------------------------------------------------------- Economic Profit Net Oper. Profit [NOP] $100 $100 $100 Invested Capital [IC or C] 600 800 1,000 Return on Capital [“ROC”] ~17%~12%10%

  18. Value “Indicators” – Financial “Drivers” There are three major support measures for management focus. • Growth Rates • Invested Capital Intensity • Value Profit Margin These “drivers” provide a foundation for the Economic Profit and Market Value Added metrics, and give managers a simple, yet powerful, template for value creation. These support measures are also the ones to focus on when evaluating business strategies and major investment programs.

  19. Value “Indicators” – Financial “Drivers” • Growth Rates • “Relationship” of Revenue, Operating Profit and Invested Capital Growth .... CGR’s • Invested Capital Intensity • How much Capital to Generate One Dollar ($1.00) of Revenue (Sales) .... in total or incremental .... encompasses working and fixed capital • Value Profit Margin (VPM TM *) • Minimum Profit Margin to Create Value for Shareholders (Owners) * VPM is a trademark of Vanguard Partners

  20. Value “Indicators” – Financial “Drivers” Value Profit Marginis a very useful support measure. • What is it? • A “minimum” profit margin ... in essence, a beginning point for value creation • A pre and/or post tax financial performance benchmark • Why use it? • Allows for profitability comparisons for businesses of different size • Simple to calculate and easy to communicate ... especially to operating managers • Provides managers with a threshold ... generating a positive “spread” creates shareholder value • Effective for planning ... strategies, acquisitions, investments • ...And, provides an “earnings” measure linked to value.

  21. Value “Indicators” – Financial “Drivers” • How is VPM calculated ? • Pre Tax Basis -- multiply ‘ICI’ by ‘CCAP’ ... then, divide by ‘one minus the effective tax rate’ • After Tax Basis -- multiply ‘ICI’ by ‘CCAP’ • Example -- assume Co. ‘A’: • Revenue (Sales) = $1,000, IC = $600 [ICI = $.60] CCAP = 12%, and the effective tax rate = 30% • “VPM” -- Pre Tax Basis • .60 x 12% = 7.2% / 70% = 10.3% • “VPM” -- After Tax Basis • .60 x 12% = 7.2% ... vs. Actual NOP = 10% (Example)

  22. Value “Analysis”

  23. Value “Analysis” – Market Value Added • Economic Profit (‘EP’) translates into Market Value Added (‘MVA’) – closely related to Shareholder Value Creation – through a future financial forecast or outlook. Business strategy should “drive” the assumptions and rationale of a future outlook. • Assume the following assumptions for the ‘A’, ‘B’, ‘C’ Example: 1.All companies maintain same invested capital to revenue ratio. 2. All companies continue to earn same profit margin on revenue. 3. All companies increase revenue by 10% per year … for 4 years. The implications of these assumptions and the future outlook’s “value” is dramatic, depending on whether a business is an ‘A’, ‘B’ or ‘C’.

  24. Value “Analysis” – the “Magnifier” • Company ‘A’ Invest capital in growth-oriented strategies / programs ... with high return potential • “Go for Growth” -- instill growth as a driving force throughout the organization • Emphasize staying close to existing margins and capital intensity, with room for some deterioration if the opportunity is significant • ... Growth adds value -- “Bigger is Better” !

  25. Value “Analysis” – the “Magnifier” For Co. “A” -- More growth adds more value ! $ “MVA” (Discounted) +75% ILLUSTRATION $400 +51% $408 +MVA %.... (Cumul.) +29% $351 $300 +10% $301 $200 $256 $233 $100 $0 % Growth (Sales) 0% 5% 10% 15% 20%

  26. Value “Analysis” – the “Magnifier” • Company ‘B’ Earn more operating profit with the same capital • Squeeze additional profit from existing capital base • .... Selective pricing and/or cost cutting • Emphasize margin improvement • ... Growth is secondary -- adds minimal value !

  27. Value “Analysis” – the “Magnifier” • Company ‘C’ • Reduce the level of capital employed • Streamline / re-engineer / re-structure operations • Validate capital invested in major lines of business • ... Growth ‘destroys’ value !

  28. Value “Analysis” – the “Magnifier” For Co. “C” -- More growth destroys more value ! 20% % Growth - Sales / Earnings 15% ILLUSTRATION 10% 5% 0 -$ 75 -$167 -$183 -$150 -$215 -$251 -10% -$225 -29% -$291 -51% $ Value - “MVA” (Discounted) -$300 -75%

  29. Allocating Resources – Based on “Value Creation”

  30. Allocating Resources based on “Value” The “value-based” approach takes corporate and business unit evaluations to a new level. Assume a hypothetical company with four business units. “Market” Values $70 $60 $50 $40 $30 $20 $10 $70 ‘Total’ Value ‘Strategy’ Value ‘No Growth’ Value $35 Per Share Values $35 BU #1 BU #2 BU #3 BU #4 Total Co. $20 $20 $5 $15 $15 $15 $15 $5 $10 $10 $5 $5 -0- “Strategy” Values can be determined for the Business Units, and should be the basis for making investment decisions.

  31. Allocating Resources based on “Value” When “market values” and “cash flows” are integrated, corporate and business unit analysis is completed. Market Value / Cash Flow $70 $60 $50 $40 $30 $20 $10 $70 $35 Per Share Values $35 BU #2 BU #3 Total Co. BU #4 BU #1 $20 $20 $15 $5 $15 $15 $5 $15 $10 $10 $5 $5 -0- Negative Cash Flow Positive Cash Flow

  32. Summary: The “Essence” of VBF • “Economic” Profit incorporates income statement performance, balance sheet investments and a capital cost, making it more robust than “Accounting” Profit. • Operating managers can “drive” value creation by focusing on three key financial indicators: • The relationship of revenue, profit and invested capital growth • The amount of capital needed to generate one dollar of revenue • Margins (before and/or after tax) above a minimum level required for value enhancement. • The “economic” profit approach and supporting financial “drivers” provide a template to assess progress toward shareholder value goals. • Economic Profit translates into Market Value Added through a future outlook, providing a mechanism for valuing strategy and allocating resources. • Growth “magnifies” value creation (positively or negatively) depending on whether economic returns are above or below the cost of capital. • Resource allocation decisions should be based on “strategy value”.

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