Capital Ideas: Back to the Future of Valuation

The inventor of a new valuation model claims to have a roadmap for value creation that includes signposts on how to set, track, and meet growth goals.

The retention ratio, explains Abrams, is tied to the company’s growth rate and payout ratio (the percentage of net income that the company pays in dividends). When the growth rate increases, so does the retention ratio, which decreases the payout ratio. The equation thus shows that as the growth rate accelerates, the payout rate to shareholders drops.

The point, says Abrams, is that the combined effect of all the variables in the equation is what matters. The payout-ratio scenario illustrates that just growing sales as fast as possible doesn’t always ensure an increase in shareholder value.

A credit-policy decision is another example of how the equation can help set and track future goals. Say that a CFO gives customers two credit-term options: one to pay within 10 days, which comes with a 2 percent discount; the other to pay in full after 30 days. The 10-day term effectively costs the company interest expense, but it also accelerates the payment of a percentage of its accounts receivable (A/R).

Lower A/R translates into a lower retention ratio and higher payout ratio. Thus, by plugging appropriate variables into the equation for, say, a 10-year calculation, the equation will show that maintaining a lower level of A/R now will likely produce a higher payout for shareholders in 2015.

If that’s management goal, then the variables should be updated and monitored to make sure managers keep A/R at suitable levels.

The tail end of the equation — the ratio immediately following the last multiplication sign — is about managing risk. It represents the discount rate in some future year and the long-term growth rate associated with that point in time. An important idea that managers can glean from the equation is that whatever action senior executives take to reduce risk should not, on balance, restrict growth, Abrams says.

In the right side of the equation “we cross the border from pure valuation to management,” says Abrams. The valuation expert used Miller and Modigliani’s basic science as a foundation, then extended the mathematics to make the formula relevant to management. For his part, Abrams likes to encourage managers to use his equation as a compass to plot a course and check if they are headed due North as the future unfolds.

Abrams explains that the equation is about achieving balance. Ideally, a business should grow profitably — and as fast as possible — without unduly straining cash flow. That, however, is a neat trick, even if a company has the in-house talent to manage the strain that accompanies rapid growth, he adds.

Still, having a formula alone doesn’t assure success, reckons management consultant Linda Feinholz. The reason is mainly that executives often balk at making needed operational or organizational changes when a project is focused on growth that is five or ten years in the future — and especially when the decision comes down from on high.

To get managers to buy in to such changes, according to Karen Spaun, CFO of $270 million Meadowbrook Insurance Group in Southfield, Michigan, it’s easier for focus on value creation as a team sport. That strategy may have taken root while Spaun was a Division I swimmer for the University of Ohio, but it’s a management philosophy that serves her well.

Although Spaun hasn’t used Abrams’s methodology because she is not familiar with it, she agrees with its premise that management needs to take an active role in monitoring growth goals and adjust business decisions to stay on track. To that end, Spaun uses homegrown budget and forecasting models to figure out how management’s actions affect shareholder value.

Her models include balance-sheet totals, return on equity, and cost of capital, which get manipulated with “if/then statements,” says the finance chief. For instance, says Spaun, “what would happen to our capital expenditure outlays or return on capital if we expand our fee-based business?”

Spaun’s Excel-based models are used by all of Meadowbrook’s department managers, who test out growth strategies and tactics before presenting them to the management team. She says the models go a long way to boost communication between operations and the finance department.

Indeed, the mathematics falls short without the human touch, says Abrams: “What matters is that management understands the value consequences of its actions.”

Marie Leone’s “Capital Ideas” column appears every other Thursday. Contact her at MarieLeone@cfo.com.

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