Value is in the Eye of the Beholder
Each company is unique and must develop its own definition of value by reconciling stakeholders' expectations.
Value creation. Value maximization. Value drivers. These are all catchy phrases that are overused in business. Yes, business owners need to design a road map to generate and measure intrinsic value in their business. The question is, what is value? This is difficult to define because what is valuable to one company may be worthless to another. That means companies must undergo a process of defining what value is to them and how they intend to measure it.
What drivers make a company more valuable than its peers? How can company owners ignite those unique value drivers? Companies need to answer those questions for themselves because value is not a "one size fits all" proposition. In this article, I examine some of the factors that business owners should consider when determining what's valuable to their own companies.
Value is in the Eye of the Beholder: The Stakeholder Model
Every company has different stakeholders. Each stakeholder may have different goals and expectations from the company, which, in turn, define value for them. The problem is that these expectations often conflict with each other. A good management team must weigh each expectation differently and reconcile all of them in order to find "value balance" for an organization. This is easier said than done, as you will see from a brief review of each stakeholder.
- The shareholders, or "owners," of the company
Almost always, shareholder objectives outweigh all other stakeholders. In owner-managed businesses, the main shareholder runs the business, so his/her expectations may all be related to driving personal profit. In a larger business, the board of directors has a fiduciary duty to increase value for the shareholders and value is almost always defined in financial terms. Value could, therefore, be defined as earning the highest return on invested capital, generating higher and predictable profitability, generating free cash flow and ultimately driving the intrinsic equity value per share as high as possible.
It is impossible to run a business without employees. Usually, shareholders attempt to align their financial goals with those of employees by offering stock options or employee ownership in the company. However, what most employees want from an organization is stability, the ability to do engaging work, a positive work environment and positive feedback loops. Employees see "value" in their companies when these requirements are delivered, which at times may conflict with owners' short-term return expectations.
- The Community
All companies exist within a community, which, in turn, demands certain things. "Being a good corporate citizen" is a phrase we hear often in business. What this means always comes down to doing the right thing. The community sees value in companies that follow the law, employ community members, are socially engaged and are environmentally responsible.
Like employees, businesses need customers to operate. For customers, value means what you can do for them. What is your value proposition to your customers and are they willing to pay a premium for it? For example, some customers may demand a high level of safety in the services you provide. Therefore, they equate value with a pristine record of safe operations. For a company, delivering on these expectations may mean incurring costs and, consequently, sacrificing some financial return.
Suppliers are sometimes the forgotten stakeholders. They are, however, a significant part of any business. Without them, it would be virtually impossible to provide services or products. Value to suppliers usually means following through on a contractual relationship, predictable and stable terms, and getting paid on time.
The Traditional Financial Value Measures
The financial needs of shareholders or owners will usually outweigh the goals of all other stakeholders. After all, most companies are for-profit enterprises. The end goal, and how value is ultimately defined and measured within a financial context, is a higher notional equity value per share. It follows, therefore, that value creation in companies is about maximizing the equity value while minimizing the number of shares outstanding. In order to maximize the equity value, enterprise value needs to go up and debt needs to be reduced.
Enterprise value improvement happens only by:
- Improving recurring earnings (i.e., EBITDA) from operation and/or free cash flow; and
- Improving — or at least influencing — the multiple that is applied to recurring EBITDA.
Conflict Resolution and Your Company’s Own Definition of ValueUnless your company is a nonprofit entity, you cannot avoid measuring value in financial terms. However, early on in your strategic process you should define how much you are willing to sacrifice your other stakeholders’ needs in exchange for short-term financial results. This becomes a tricky process because completely sacrificing your stakeholders usually leads to poor longer-term financial results. Consider the following examples:
- If you reduce fixed overhead, you will improve the company margins and returns (high value for the shareholders). Reduce it too much, and your remaining fixed employees may be overwhelmed and become discouraged (low value for the employees).
- You can improve free cash flow by managing accounts payable aggressively. Don't pay your suppliers in 30 days. Instead, manage them to 45 or 60 days. This strategy frees up cash flow, which can be used for debt reduction (high value for the shareholders). Take it too far, however, and you risk upsetting suppliers and potentially losing key supply contracts (low value for suppliers).
- If a manufacturing company cuts some corners with environmental compliance, its profitability will improve. However, in this case, the community suffers and, ultimately, no value is created for either the company or the community.
Value is RelativeValue is relative, and each company must develop its own value definition. A public company or a larger private company with sophisticated capital providers may be more financially driven. A smaller owner-managed business that is well regarded in the community may be more employee or community-driven. An owner may or may not be willing to sacrifice value in financial terms during a downturn by keeping employees, even if margins suffer.
Before "creating value," a company must first determine what it considers valuable and what it’s willing to sacrifice to grow that value. The companies I’m involved with are not willing to sacrifice safety, employee engagement or community involvement in exchange for better financial results. We are OK with sacrificing some equity value per share if we can build legacy companies that go beyond one generation. In fact, we build our key performance indicators to measure things such as safety and employee engagement. Every company must look in the mirror to determine their own definition of value, then align the company's behavior to drive this value.