Traditionally companies pursued strategic goals such as capacity growth, market share growth, revenue growth or growth through vertical integration. Most of these goals are without doubt essential elements of long term value creation though not sufficient by themselves. The companies pursued those goals with out any conscious thinking about value creation. Till 1970s, the companies never needed to worry about value creation as they operated in an era where there was seemingly unending demand with virtually no competition. Shareholders had little risk in investing in such companies.

With emergence of competition, customers became central to a company’s strategies. This coupled with several developments like, globalization and ongoing deregulation of capital markets in countries all over the world, resulted in institutional investors who till then were mere passive investors, now had more options before them, and so begun to exert influence on managements to create more value for shareholders. Once leading companies adopted value as the long term objective, the peer pressure in corporate circles influenced other companies to make value creation central to their strategic plans.

Understanding value creation
Value creation is defined as differential of present value of future cash flows and present cash out flows. But how is it different from conventional accounting earnings? Value creation is a function of magnitude, timing (time value of money) and degree of uncertainty of future cash flows (risk). Where as conventional accounting earnings are insufficient indicators of time value of money and risk involved or risk taken to obtain the earnings. In other words conventional measures lack quality aspects of the earnings, which measures for value creation take care of.

That takes us one step closer to understanding value creation – measurement of value created. Value Based Management (VBM) is an innovation in financial practices, which represents a convergence between finance, strategy and even organization behaviour. Following VBM methods facilitate measurement of value created:

• Free cash flow method proposed by Mckinsey and LEK
• Economic Value Added (EVA) / Market Value Added (MVA) method by Stern Stewart and Company
• Cash Flow Return on Investment (CFROI) / Cash Value Added (CVA) method by Holt Value Associates and BCG

Though there have been arguments against and in favour of each of these methods of measuring value, EVA and CFROI methods have gained more prominence. What ever be the measurement adopted the underlying assumption of considering time value of money, opportunity costs and risks involved – cost of capital – remains valid. This means that there is a common broad strategic theme that can be associated with value creation.

Strategic imperatives of value creation
Since value of a company is present value of future cash flows resulting from both existing assets and future growth of assets, discounted at the rate equal to cost of capital (perception of risk and opportunity cost), the company must know what strategic actions it may have to take up to ensure value creation. In order to create value a company must weave its strategies around the activities that create value and guard against the activities pursued inadvertently which in fact are value destroyers or value neutral at best. Strategic theme of any company intending to create value must focus on:

• Increasing the cash flows generated by existing investments
• Increasing the expected growth rate in earnings
• Increasing the period of high growth
• Reducing the cost of capital

Increasing the cash flows generated by existing investments entails:

• Decisions on existing assets that generate less than breakeven returns (to continue, liquidate or divest)
• Strategies to improve operating efficiency like de-bottlenecking process constraints and adopting a pull system rather than a push system
• Initiating activities that minimize tax burden
• Reducing capital expenditure on existing investments, which in turn is a trade-off with life of an asset
• Reducing working capital requirements – importantly the non cash working capital which can be achieved by reducing cash to cash cycle time

Increasing expected growth, may entail growth in investments in such a way that expected rate of returns is considerably higher than cost of capital. Also enhancing capability to introduce new products and services, focusing on value proposition of profitable customers and creatively segmenting markets and customers to unearth the latent market potential helps in increasing expected growth rates.

Increasing the period of high growth may require a firm to consciously build unique brand image, acquire sustainable competitive advantages through product, technology and process patents- focused approach towards R&D and innovation, inducing switching costs for the customers, building loyalty through value innovation, eliminating smaller and inefficient competitors and creating barriers for new entrants using the efficient cost structure of the company.

Reducing cost of capital The cost of capital can be minimized by a flexible capital structure and minimizing operating risks (strong raw material linkages, capability to produce unique product mix for which there is no alternative in the market place and eliminating fixed costs by forging value creating alliances or outsourcing operations).