Value based management

Copeland et al. (1994: 127) define Value Based Management (VBM) as the process of continuously maximising the value of a firm. According to them shareholder value creation is the main objective when applying VBM techniques. They argue that VBM is based on discounted cash flow (DCF) concepts (Copeland et al., 1994: 93). The value of the firm is determined by the present value of its future cash flows. Investing in projects where the return exceeds the cost of capital results in value creation, while investing in projects with returns below the cost of capital destroys value.

Young and O’Byrne (2001: 468) indicate that it is important to realise that the value of a firm is eventually determined by capital markets’ perception of its ability to generate future cash flows. They point out that when a VBM approach is adopted the future cash flows, as well as the cost of capital, of all investment opportunities should be carefully scrutinised. The interpretation of cash flow figures when used to evaluate historical financial performance, however, should be carefully conducted. Negative cash flows are not necessarily an indication of poor financial performance but may be the result of large investments required to generate future cash flows.

According to Copeland et al. (1994: 97) VBM is a combination of two elements. On the one hand, it consists of adopting a value-creation mindset throughout a firm. Each employee should understand that the financial objective is to maximise the value of the firm. They should understand that all their actions should be directed towards achieving this objective.

They also indicate that this value-creation mindset should be combined with the necessary management processes and systems to ensure that the employees would actually behave in a manner that creates value (Copeland et al., 1994: 98). Important factors to consider include the performance measures applied to evaluate employees, targets set, as well as the necessary incentive systems. Employees need to know exactly what targets they are trying to achieve.

Furthermore, employees should know how their performance will be evaluated. It is very important that the performance measures adopted should support the targets declared by the firm. In order to ensure that employees focus on the creation of shareholder value their performance need to be evaluated and rewarded in terms of the shareholder value created. A VBM system should thus ensure that employee compensation is linked to value based financial performance measures (Martin & Petty, 2000: 6).

Martin and Petty (2000: 9) consider the following three elements to be decisive in order to successfully implement a VBM system:

o The program must be supported by the top management of the firm. Without the support of top management the implementation of a VBM system will prove to be difficult. Top management should ensure that the program is implemented at all levels and in all the divisions of the firm. They should also continue to focus on its objectives at all times.

o A link between the performance and compensation of managers should be implemented. In order to motivate managers to strive towards the objectives of the VBM system they should be rewarded for achieving it. Compensation systems should focus on the performance required under the VBM system and managers should be rewarded accordingly.

o The VBM system should be understandable to all levels of employees. To ensure that the VBM system is implemented successfully in all divisions of the firm it is of great importance that all employees should understand it. Performance measures should be developed that are understandable and suitable for the different divisions. This may entail translating the performance measures into divisional value drivers.

An important aspect with regard to the success of VBM systems is raised by Martin and Petty (2000: 200). Although VBM systems appear to be implemented successfully they argue that the following factors also need to be considered:

o The accuracy of share price estimates obtained from discounted cash flow models. Martin and Petty acknowledge that although DCF methods provided reasonably accurate share price estimates, large prediction errors do occur. Since VBM methods are based on DCF methods these methods may be exposed to the same inaccuracies.

o The ability of the VBM measures to predict the market value of a firm’s shares. DCF methods estimate the value of a firm by calculating the present value of the expected future cash flows. Most of the VBM measures applied, however, are single-period performance measures. Martin and Petty indicate that the ability of these single-period measures to estimate share values could be questionable.

o The effect of the implementation of a VBM system on the performance of a firm. Martin and Petty (2000: 201) also question the long-term sustainability of a VBM system. They indicate that although it could be possible to improve the financial performance of a firm over the short-term it could become increasingly difficult to maintain this improvement over the long-term. Amongst others they refer to studies that report no statistically significant differences in the performances of firms applying VBM systems and those that do not over the long-term.