Closing the value gap Syncing market value and strategy There has never been a more important time to look at how to manage market value. While this might sound like a broken record, value remains a question which CEOs cannot afford to ignore. Their success is judged by their ability to generate and sustain superior returns for their shareholders, a demanding challenge given the current market environment and disruptive forces of technology accelerating. How to drive value is a topic of considerable complexity, but the basic parameters are clear. There will be an explicit or implicit aspiration of where the share price should be in a few years time. Various strategies and initiatives are then put in place to close the resulting value gap. However, what often receives little attention is the economics of value creation. For example, a discounted cash flow (DCF) model estimating the intrinsic value of the company from an internal perspective is hardly ever available. Instead, reliance is placed on analyst reports and their share valuations, which are by their nature based on limited publicly available information. This is despite the fact that an internal value model will answer a number of important strategic questions. Taking known financial projections and planned strategic initiatives into account, would the resulting DCF value be consistent with the aspirational goals? Does the market already anticipate the expected results of a company s 5-year plan or will they actually move the needle in terms of share price performance? If not, can the resulting value gap be closed through a combination of additional efficiency and growth initiatives? Should the focus be on growth or would the share price be more responsive to cost reduction? What market expectations in relation to capital growth rates and returns are already built into the share price? The frequent omission of value analysis is ever more surprising if we consider that the economic foundations of value creation are straightforward. An economic profit model shows that market value is linked directly to two drivers: the quality of capital returns and the volume of capital investments.
Figure 1: Drivers of market value Market value* Invested capital (opening) Present value of future economic profit Economic profit Invested capital ( ) Return on invested capital Cost of capital Volume of 1 2 Quality of returns investment (*) Debt and equity In other words, in order to create additional value, capital should be invested at returns above the cost of capital with a growing volume of such investments (Figure 1). Future funding and capital allocation decisions therefore need to focus on business units generating superior returns and at the same time need to fund emerging opportunities that can be converted into businesses yielding excess returns in the future. Consequently, strategies to reach aspirational value targets should be founded on a sufficiently robust economic analysis, providing guidance on the value potential of current strategies and at the same time directing additional actions towards the aspirational goal. 2
A structured approach We have developed a three-step approach to help our clients assess their current strategies and progress towards their aspirational value goals: 1. Benchmark economic returns 2. Create a portfolio view of market value 3. Quantify the value of additional strategies. Benchmark economic returns The process should begin with the end-game in mind what are the current market implied growth rates and returns, and what is a potential value target? Here we have found it useful to benchmark a company s historical return on capital to understand the returns and growth rates built into the current share price and how these compare to peers or industry groups. An illustrative example is provided in Figure 2 where we benchmarked returns on invested capital (ROIC, calculated based on annual financial report data) and market implied growth rates (estimated based on a perpetuity formula at constant historical returns) for a target company against 20 selected large cap non-financial companies with positive economic returns. Figure 2: Benchmarking implied growth rates and capital returns. Implied growth rate % 8.0 7.0 7 6.0 21 17 5.0 4.0 19 16 14 15 12 10 9 11 6 4 3 2 1 3.0 2.0 5 1.0 20 13 8 18 0.0 0 5 10 15 20 25 30 Return on invested capital % Closing the value gap 3
Even this high-level analysis will already provide guidance on where the emphasis of future investment decisions should lie. If a company is already in the group of high ROIC performers, the strategic focus will most likely be on growth as further increases in returns will be difficult. Conversely, if returns are near or below the cost of capital an efficiency imperative is most appropriate. The order of magnitude of the value uplift achievable from accelerated growth and/or improved returns can also be quantified as part of this analysis. Create a portfolio view of market value The second step is concerned with assessing market value from an internal perspective. Business unit leaders have a wealth of knowledge about a company s projected future performance, which can be leveraged to estimate the intrinsic enterprise value in aggregate and the value contribution from individual business units. Rather than embarking on a stand-alone DCF business valuation we find it useful to directly link this valuation activity to the company s existing financial forecasting process. For example, a five year strategic forecast is undertaken by most companies. Integrating valuation and forecasting makes it easier to make the process repeatable and achieves a higher degree of commitment from business unit leaders. The result of the sum of parts portfolio valuation is an aggregate DCF-based enterprise value; a DCF implied share price; and a granular breakdown of enterprise value by individual business unit (see Figure 3). Figure 3: Enterprise value contribution by business unit and capital spend over forecasting period. EV AU$m 3,000 Illustrative 2,000 1,000 Enterprise value vs. future capital invested (Strategic business units) Important H2&H3 contributors Modest value contribution long tail Horizon 1 Horizon 2 Horizon 3 0-1,000 4
By disaggregating the portfolio in this manner, a company can develop a picture of how individual business units and segments are performing. It is not uncommon to find that a small number of business units contribute the majority of the value, that strong variations in capital efficiency exist and that the portfolio is overweight towards mature businesses, with emerging opportunities contributing much less even in the long run than previously thought. By contrast, at an aggregated level the DCF valuation allows a comparison of the DCF implied share price with the current share price. This provides guidance on how far market expectations deviate from the intrinsic value that is implied by internal forecasts and current strategies as perceived by the leaders of the firm. Even if the current share price is warranted by the internal DCF, it becomes clear through this process that even aggressive business unit forecasts do little more than underpin the current share price and have already been factored in by the market. In this case, future value creation and share price growth require additional initiatives beyond those already planned. Quantify the value of additional strategies Once the value contribution of existing forecasts, strategies and projects are known, additional initiatives to close the value gap are identified and quantified. This process is informed by the results from the market benchmarking and portfolio value analysis carried out in the previous steps. By utilising the DCF models already in place each initiative is evaluated in terms of its value potential. These fall into two areas: 1. Initiatives that improve the economic returns on capital (the quality of the investment) such as actions to reduce overhead costs, operating margins, capital efficiency and the cost of capital and 2. Initiatives that increase the volume of such investments, principally organic and inorganic growth. We find that as a result of this process, new initiatives remain firmly aligned to a value agenda (Figure 4). Conversely, the quantum of the remaining shortfall is quantified. This also creates a powerful platform to cascade strategy to business units and provides both, a strong sense of direction and a common overarching goal. Figure 4: Sources of additional value. Overhead cost reduction Quality Operational efficiencies (capex and opex) Cost of capital Value gap Accelerate organic growth Volume Inorganic growth/aquisitions Closing the value gap 5
Conclusion Any company must find new ways to improve market value creation. Taking a structured approach not only helps to create visibility and better governance of capital spend, but also ties strategic decision making back to a value agenda. By doing this, companies can improve strategic planning, optimise their capital spend and better manage market value creation and investor expectations. This is of relevance to any company wanting to drive the best outcomes from their portfolio of assets. Case study Supply chain logistics company When our client wanted to understand how to optimise the allocation of its capital across 50+ business units, Deloitte acted as a key advisor and developed a new process that allowed the client to improve its value creation strategies and its financial position over the next five years. The challenge The client is provider of logistics services operating across multiple industry supply chains, in more than 50 countries and a capital spend of approximately $1bn per annum The client has a mix of mature and emerging businesses, with different risk and return profiles depending on the maturity of the supply chain. The client wanted to optimise the allocation of capital over the upcoming five year planning period considering the capital needs, the long term value contribution of each business unit and the potential risks to the portfolio. Using this view the client wanted to set the overarching value creation strategy for the Group as a whole. How Deloitte helped Working with the corporate, regional and business unit finance teams, Deloitte developed a sound understanding of the internal economics of the various businesses. Detailed financial models for 50+ separate businesses captured projected value contribution, cash generation, return on capital and helped to identify the major strategic imperatives for all geographies and product lines The models were in turn linked into the annual budgeting and five year forecasting process. Particular care was taken to estimate capital requirements and value contribution of emerging markets, utilising scenario analysis to calculate risk adjusted valuations where possible Deloitte helped to synthesise the findings into an aggregated portfolio view, allowing management to assess the relative value contribution, growth rates and economic margins created by each of the 50+ businesses. Value delivered The blend of strategic and financial skills provided by Deloitte allowed the client to gain a much deeper insight into its economic performance. The work has already led to a re-assessment of the strategy that is required to improve shareholder value and achieve the value targets over the medium term Both the strategic planning and the budgeting process are now firmly based on a value creation agenda, and the framework has provided the client with the underlying fact base to define strategic initatives at a much more granular business unit level. 6
Contacts Jeremy Drumm Partner Consulting (Sydney) Strategy Deloitte Touche Tohmatsu Tel: +61 414 966 777 jdrumm@deloitte.com.au Dr Frank Decker Principal Consulting (Sydney) Strategy Tel: +61 414 777 602 fdecker@deloitte.com.au Angad Soin Director Consulting (Sydney) Strategy Tel: +61 2 9322 3231 asoin@deloitte.com.au Closing the value gap 7
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