This article was first published in the November/December 2012 International edition of Accounting and Business magazine.
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In this article we now dive into the seven strategic value drivers that drive the value of a business. These are the:
- Sales growth rate (SGR).
- Operating profit margin (OPM).
- Incremental working capital investment (IWCI).
- Fixed capital investment: the replacement fixed capital investment (RFCI) and the incremental fixed capital investment (IFCI).
- Corporate tax rate.
- Cost of capital.
- Competitive advantage period (CAP).
So what are the competitive drivers behind these? For the SGR we can represent the main ones as being:
SGR = a function of (macroeconomic growth + market-specific growth + shift in relative market share).
So there are a number of layers in what is a kind of an ‘onion’ of external demand for a company’s products which are interdependent.
In addition we can go behind ‘shift in relative market share’ to get:
Shift in relative market share = a function of (the shift in our competitive position relative to that of competitors and the relative fit of our products to customer needs).
So from the latter equation one needs to think about the way in
which sales volumes are influenced by one’s own relative competitive position over time.
In addition to sales volume effects, there are other secondary impacts that might need to be thought through, eg where there is a strong competitive position based on superior customer value, then this can enhance sales values through:
- price premia
- discounting avoided: through generally lowering prices and promotions.
Turning now to OPM, we meet a slightly different set of competitive drivers. These can be even more volatile in mature markets than fluctuations in SGR: sometimes called ‘price wars’.
OPM is a function of (changes in the level of ‘competitive pressure’ in a market + shifts in relative competitive position).
Here ‘competitive pressure’ is my more everyday term for Porter’s ‘five competitive forces’ or:
- buyer (customer) bargaining power
- threat of entrants
- rivalry between existing competitors
- bargaining power of suppliers.
Where even one or two of these are unfavourable this can have the effect of dampening OPM. Where three or more are strongly negative this can destroy OPM: one has to have a very cunning plan indeed to cope with a bad margin environment.
Having an excellent relative competitive position will mitigate that – and in a situation of low competitive pressure this will usually provide superior economic value added (EVA). All of this is liable to change over time and thus one needs to understand the future in terms of the future curve of ‘competitive pressure over time’, and ‘competitive advantage over time’.
One needs to understand the ‘competitive advantage period’ – see the seventh strategic value driver – not as a fixed duration but one of a curve of decline – unless there are new and revitalising strategies being brought in over the period.
So there is quite a lot to think about economically before plunging into making naive assumptions about the SGR and OPM, especially through simplistic extrapolation.
Turning next to the capital assumptions, these have the following competitive determinants:
- Incremental working capital investment can be affected by
the relative bargaining power that you have with your customers
- Replacement fixed capital may be affected by the extent to which your capital base has been eroded in quality – and putting it crudely you might have been milking the business to death – so that this is non-linear and is increasing disproportionately.
- Incremental fixed capital is very much going to be determined by the strategies for growth and change that you are embarking on: here there is a see-saw effect: the more ambitious and expensive these are the more cashflow in the medium term will be held back, and the more the long-term cashflow will be leveraged.
The corporate tax rate is something that is largely outside one’s control other than through tax planning. The cost of capital is partly within your control and partly outside of it. Broadly it is set as the ‘weighted average cost of capital’ (WACC) as being:
The cost of equity X its proportion of total capital + the cost of debt
(1 – the tax rate) X its proportion of total capital.
An example helps here of;
Cost of equity = 10%
Cost of debt = 8%
Tax rate = 25%
Equity is 60% of capital; debt is 40%:
WACC = 10% x 60% + 8% x 40% x (1-25%) = 6% +2.4% = 8.4%
Debt is thus cheaper as it is lower risk and also has a tax shield.
Once the seven value drivers have been set – bearing in mind their competitive drivers – we now calculate as in September’s article, All about EVA, the net cashflows and the terminal values discounted to present values.
To arrive at a final valuation of the business, one also needs to add in any cash that is on the balance sheet and also deduct the outstanding debt. Where the numbers of shares are known, one can easily then calculate the value per share.
One of the most important things to do here is to prioritise the seven value drivers – particularly for risk and sensitivity analysis.
In the final part we now look at the case of Tesco plc in terms of trends in performance and the impact of competitive drivers of economic value.
Tesco case study
In 1993 I ran a case study on the UK supermarket industry with my MBA students and out of that I did some scenarios of the industry anticipating the price war of 1994 – using Porter’s five forces. I gave one of my books, Breakthrough Strategies For Growth, with the case study in to Sir Terry Leahy (then CEO of Tesco).
Tesco’s amazing and profitable growth from then on was staggering – it breached the £1bn and the £2bn profit barrier and became a global retailer. This was based on some clever sub-branding of outlets, aggressive investment and related diversification, enormous drive, commitment and championing the customer and – for a period, better service.
Over more recent years it seems as if the pressure to drive productivity may have weakened service levels at a time when competitors were getting much better. Also Tesco’s dominance in the UK was resented by some customers. Perhaps too the success was a little taken for granted.
In the UK in 2011 there was slippage and Tesco responded by even more price discounting and £5 rebates for a £40 shop – more than their actual margins. Not only was market share in a tightening market squeezing SGR but price giveaways were hurting OPM too. The result: a share price under pressure and a drop off in the competitive advantage curve.
Here the SGR and OPM were the most important value drivers – and are competitively determined.
A profit warning was made in January 2012 and there was a 19% slump in share price in the six months to end April 2012 (underperforming the market by 25%). Tesco then announced a strategic plan for the UK of £1bn to turn it around.
In the next article I look at how EVA is generated as part of an overall business value system.
Dr Tony Grundy is an independent consultant and trainer, and lectures at Henley Business School in the UK