Two divisions of the same Nigerian group each report a return of 15% on the capital they use. The group’s cost of capital is 12%. Division A has ₦360m of capital and Division B has ₦220m. Both look equally good on return. Yet A adds ₦10.8m of value to the owners in a year and B adds only ₦6.6m, because A earns its extra three points on a larger base.
A manager who looks only at the percentage would not see the difference, and a manager who looks only at profit would not see whether the profit pays for the capital. Value-based management (VBM) was developed to answer a simple question: is this business, and every part of it, earning more than the capital it uses costs, and what drives that?
This topic explains VBM, value drivers, economic value added and market value added as measures, how VBM differs from value for money, value added and value-based pricing, and the benefits and challenges of the approach. It builds on the earlier topic on social and ethical issues in strategy, which introduced stakeholders and long-term value. The next topic covers corporate failure and life cycle issues.
In 30 seconds
Value-based management is a strategic approach that aims to maximise the long-term value of a business, and so the wealth of its shareholders, by managing the customer base and every decision by the value created. It encourages managers at all levels to think and act like owners and to balance short-term and long-term goals.
Its measures include economic value added (EVA) = net operating profit after tax − cost of capital × capital employed, which is positive only when the return exceeds the cost of capital, and market value added (MVA) = market value of the business − capital invested. Value drivers are the factors that create value: customer satisfaction, operational efficiency, innovation, market share and expansion, sales growth, margin and capital use.
Benefits: alignment of strategy, operations and decisions; better decisions and resource allocation; common goals across stakeholders; adaptability and innovation; lower risk. Challenges: complexity, finding the true drivers, social and environmental factors, setting measurable long-term goals, reliance on non-financial measures, and neglect of other profitable opportunities. VBM is different from value for money (economy, efficiency, effectiveness), from value added (price less cost) and from value-based pricing (price by perceived value).
Full marks come from a clear definition, a measure with a calculation and a balanced view.
What value-based management is
Value-based management is a strategic approach that focuses on maximising the long-term value of a business by managing its customer base, its investments and its operations according to the value they create. The goal is to optimise profitability and so create value for shareholders. It works because a business that earns more than its cost of capital, for years, is worth more than the capital put into it.
VBM considers short-term and long-term goals but gives more weight to the long term, and it asks managers and their staff to think and act like owners.
The idea of value
A business creates value only when its return exceeds the cost of the capital it uses. Profit alone does not show this, because accounting profit is struck after interest but before any charge for the cost of the owners’ own capital.
A company with a profit of ₦20m on capital of ₦300m that costs 12% has not created value: the charge for capital is ₦36m. VBM therefore charges for all capital, debt and equity.
Measures of value
- Economic value added (EVA) = net operating profit after tax (NOPAT) − (cost of capital × capital employed). EVA is positive when return exceeds the cost of capital. In practice NOPAT and capital employed are adjusted for items that are treated as expenses but really are investments, such as research and development and advertising, and for non-cash and other accounting items. EVA is a measure for a division or a whole business.
- Market value added (MVA) = market value of the business (equity and debt) − capital invested. It shows the value the market thinks has been created in total, and exists only for listed companies.
- Other measures used in VBM include shareholder value added, cash flow return on investment and total shareholder return. Whatever the measure, the test is the same: does the return exceed the cost of capital?
Value drivers
Value drivers are the factors that make value, and that managers can change. Customer satisfaction, operational efficiency, innovation, and market share or market size are examples, as are the financial drivers: sales growth, operating margin, the tax rate, investment in fixed assets and working capital, and the cost of capital.
The first step in VBM is to find the real drivers for the business, then set targets for them at each level and reward the managers who control them. A driver tree breaks the aim of higher value into measures that a department can understand: for example, a cut in the time to deliver (operations) raises satisfaction (customers) and so sales, and a cut in stock lowers capital employed.
Benefits, challenges and related ideas
Benefits
- It focuses on value creation, aligning strategy, operations and decisions.
- It improves decision-making and the ability to adapt decisions to the need to create value in competitive conditions.
- It guides resource allocation: capital goes to units and projects that earn above their cost.
- It aligns the objectives of the stakeholders on a common goal of creating value.
- It encourages adaptability and innovation, which give a lasting competitive advantage.
- It helps decisions that reduce risk.
- It balances short-term and long-term goals and discourages short-termism.
Challenges
- Complexity. It is multi-faceted and hard to set up.
- Finding the value drivers. The key drivers, such as customer satisfaction or market expansion, are not always clear.
- Neglect of other opportunities. A narrow focus can shelve activities that could have been profitable.
- Social and environmental factors. A framework must allow for them, which is hard.
- Long-term goals. They must be clear, measurable and linked to value creation, which is not easy.
- Non-financial measures are hard to measure and to use.
- Adjustments and cost of capital. EVA needs many adjustments and an estimate of the cost of capital, both open to judgement; and EVA can still be pushed up in the short term by cutting investment.
Not to be confused with
- Value for money (VFM). VBM maximises shareholder value and uses measures such as EVA. VFM is a customer-centred or public-sector idea: making the best use of the money available through economy, efficiency and effectiveness.
- Value added. The difference between the price of a product or service and the cost of producing it. It is not the same as VBM.
- Value-based pricing. Setting the price by what the customer believes the product is worth, not by its cost.
Layouts for value calculations
- NOPAT. Operating profit × (1 − tax rate), after any adjustments the question requires.
- Capital charge. Cost of capital × capital employed.
- EVA. NOPAT − capital charge. Positive means value created.
- Return. NOPAT ÷ capital employed. Compare with the cost of capital.
- MVA. Market value of equity and debt − capital invested.
- Effect of a driver. Recalculate NOPAT and EVA with the changed driver and compare.
Money is in ₦ million to one decimal place, and each answer is rounded once, at the end.
Worked examples
Example 1: EVA and MVA. A company has NOPAT of ₦48.0m and capital employed of ₦300.0m. Its cost of capital is 12%. The market value of its equity is ₦380.0m and its debt ₦140.0m, and the capital invested is ₦400.0m. Required: the EVA and MVA.
- Capital charge.
12% × 300.0 = ₦36.0m. - EVA.
48.0 − 36.0 = ₦12.0m, positive: value is created.
The return is 48.0 ÷ 300.0 = 16.0%, above 12%. - MVA.
(380.0 + 140.0) − 400.0 = ₦120.0m. - Comment. EVA is a one-year result and MVA the market’s verdict on the future. Both are positive, so the company is creating value.
Example 2: the effect of a value driver. A company has sales of ₦1,200m, an operating margin of 8%, tax of 30%, capital employed of ₦500m and a cost of capital of 11%. A change in the delivery process is expected to lift the margin to 9%. Required: EVA before and after.
- Before.
Operating profit 8% × 1,200 = 96.0
NOPAT 96.0 × 0.70 = 67.2
capital charge 11% × 500 = 55.0
EVA = ₦12.2m. - After.
Operating profit 9% × 1,200 = 108.0; NOPAT 108.0 × 0.70 = 75.6; capital charge unchanged 55.0; EVA = ₦20.6m. - Change. EVA rises by ₦8.4m, from a one-point margin gain.
- Comment. A small change in one driver adds two-thirds more value. Managers should be given targets and rewards for the drivers they control, such as delivery time, and watched to see that the gain is not bought by cutting investment.
Expect variants: EVA with adjustments to NOPAT and capital, divisions of different size, or a question on which driver to target first.
Common mistakes
- Charging only for debt. EVA charges for the cost of all capital.
- Comparing returns only. Divisions with the same percentage return create different value if their capital differs.
- Using pre-tax profit where NOPAT is required.
- Confusing VBM with value for money or value added.
- Presenting EVA as free of judgement. Adjustments and the cost of capital are open to argument.
- Forgetting short-termism. A manager can raise EVA now by cutting investment.
Quick revision
- VBM: maximise long-term shareholder value; managers think like owners.
- EVA = NOPAT − cost of capital × capital employed. MVA = market value − capital invested.
- Value drivers: customer satisfaction, efficiency, innovation, market share; sales growth, margin, capital use.
- Benefits: alignment, decisions, resources, common goals, innovation, risk. Challenges: complexity, drivers, other opportunities, social factors, long-term goals, non-financial measures.
- Not the same as value for money, value added or value-based pricing.
How the marks are earned
- Define and explain: VBM, EVA and drivers, about two marks each.
- Calculate: NOPAT, capital charge and EVA with the layout.
- Discuss: benefits, challenges and a balanced conclusion.
Practice questions
These are original questions, written in the style of the Skills examination. Work each one before you open the answer.
Recall check: multiple choice
Question 1. Value-based management aims to:
- Maximise long-term value for shareholders
- Cut all costs
- Maximise this month’s sales
- Avoid tax
Show the answer
A. It balances short and long term.
Question 2. Economic value added equals:
- Sales less cost of sales
- Profit before tax
- NOPAT less the cost of capital times capital employed
- Market value less book value
Show the answer
C. All capital is charged for.
Question 3. A positive EVA means:
- A loss was made
- The return exceeds the cost of capital
- Tax was paid
- Debt is zero
Show the answer
B. Value has been created.
Question 4. A value driver is:
- An employee who drives vehicles
- A fixed asset
- A tax
- A factor that creates value, such as customer satisfaction or efficiency
Show the answer
D. Managers can change drivers.
Question 5. VBM differs from value for money because VBM:
- Ignores shareholders
- Is only for charities
- Maximises shareholder value, while value for money is about economy, efficiency and effectiveness
- Is the same thing
Show the answer
C. They have different aims.
Question 6. A challenge of VBM is that:
- It is complex and the true drivers are hard to find
- It is too simple
- It needs no data
- It has no benefits
Show the answer
A. Social and environmental factors add difficulty.
Question 7. Market value added equals:
- Sales less cost
- Market value of the business less capital invested
- Profit after tax
- Book value of assets
Show the answer
B. It exists only for listed companies.
Question 8. Value-based pricing sets the price by:
- Cost plus a fixed mark-up
- Competitors only
- Tax rules
- The customer’s perceived value
Show the answer
D. It is customer-focused.
Question 9. VBM encourages managers to:
- Think and act like owners
- Avoid targets
- Ignore capital
- Focus only on cost
Show the answer
A. This links decisions to value.
Question 10. Value added, meaning price less cost, is:
- Always the same as EVA
- The same as MVA
- Different from value-based management
- A tax
Show the answer
C. The terms are easily confused.
Section B style: written questions
Question 11 (10 marks). (a) Explain value-based management and describe THREE benefits. (6 marks) (b) State FOUR challenges of applying it. (4 marks)
Question 12 (15 marks). A group has two divisions and a cost of capital of 12%. Division A has NOPAT of ₦54.0m and capital employed of ₦360.0m. Division B has NOPAT of ₦33.0m and capital employed of ₦220.0m.
(a) Calculate the EVA of each division. (6 marks) (b) Calculate the return on capital employed of each, using NOPAT. (4 marks) (c) Comment on the results. (3 marks) (d) State which division creates more value. (2 marks)
Question 13 (20 marks). A company has sales of ₦1,500m, an operating margin of 7%, tax of 30%, capital employed of ₦600m and a cost of capital of 10%. Better stock control is expected to lift the margin to 8%.
(a) Calculate the EVA before and after the change. (8 marks) (b) Calculate the change in EVA. (2 marks) (c) Discuss the benefits and challenges of value-based management for this company. (10 marks)
Model answers
Show the model answer to Question 11
(a) Value-based management is a strategic approach that aims to maximise the long-term value of the business, and so shareholder wealth, by managing customers, investments and operations by the value they create; managers think and act like owners (2). Benefits, any three: aligns strategy, operations and decisions; improves decision-making and resource allocation; aligns stakeholders on a common goal; encourages adaptability and innovation; reduces risk (1 each, with explanation).
(b) Any four: complexity; difficulty finding the true value drivers; neglect of other profitable opportunities; social and environmental factors; setting measurable long-term goals; reliance on non-financial measures; judgement in adjustments and the cost of capital (1 each).
Show the model answer to Question 12
(a)
- A: charge 12% × 360.0 = 43.2
- EVA 54.0 − 43.2 = ₦10.8m (3).
- B: charge 12% × 220.0 = 26.4
- EVA 33.0 − 26.4 = ₦6.6m (3).
(b)
- A: 54.0 ÷ 360.0 = 15.0% (2).
- B: 33.0 ÷ 220.0 = 15.0% (2).
(c) Both earn 15%, above the 12% cost of capital, so both create value. The percentage return is equal, but A earns its three-point margin over cost on a larger base, so it adds more value (3).
(d) Division A creates more value: ₦10.8m against ₦6.6m (2).
Show the model answer to Question 13
(a)
- Before.
operating profit 7% × 1,500 = 105.0; NOPAT 105.0 × 0.70 = 73.5; charge 10% × 600 = 60.0; EVA ₦13.5m (4). - After.
8% × 1,500 = 120.0; NOPAT 84.0; charge 60.0 (stock control may also cut capital employed, which would raise EVA further); EVA ₦24.0m (4).
(b) 24.0 − 13.5 = ₦10.5m increase (2).
(c) Benefits: focus on value, with the drivers such as margin and stock; better resource allocation; managers who think like owners; link to rewards. Challenges: the drivers must be found and the data collected; adjustments and cost of capital are judgemental; managers may raise EVA in the short term by cutting investment; social and environmental factors are hard to include; complexity (10).
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