Increasing the value of a company is perhaps the most important objective of any CEO or a Business Unit head.
However, neither is it easy to define “Value” nor to understand the levers that drive it in a business. In this post, I share with you a simple framework we use to help businesses understand their Value Drivers through the “EiValue Framework”. It will enable you ask the right questions so as to build the value in your business and set up the building blocks for continuous improvement.
Generally speaking, Value is equated to a financial metric such as EBIT, EBITDA, NPAT or Returns metrics such as ROE, ROI, etc., Whilst these are all appropriate measures, the financial outcomes almost always provide a great perspective in the “rear view mirror”. Let’s look at a framework to understand what drives these results looking forward, i.e. the levers that will create value in the future.
I define the fundamental Value equation as being:
Enterprise Value = Value Created + Value Retained
At first glance, it becomes immediately apparent that you need to do two things to build your enterprise value – Create it and then retain it. The relative importance of the activities that govern these may depend on your industry and the stage of your company.
Let me elaborate on each of these further:
There are two methods through which Value is created in an enterprise:
Value Creation = Active Value Creation + Paper Value Creation
Active Value Creation
This is the process by which “New Valuable Business” is brought into the Enterprise. There are two elements to this phrase:
- New Business — This is new business from existing customers (cross-sell & upsell) or new business from new customers
- Valuable Business — The new business that has been brought in should be Value accretive, i.e. the enterprise should be MORE valuable with the new business than it was before. This is an important concept which can be rather hard to grasp, measure, and monitor, but it can be summarised as
- New Business Value (NBV) > Acquisition Cost (CAC)
- If you have a business where the NBV < CAC then hopefully you have a long-tail business with recurring revenue from the client such that the Lifetime Value (LTV) of the Client is more than the Cost of Acquisition and the Cost to Serve (as covered below)
- Lifetime Value is defined as Discounted future revenues from a customer over the expected lifetime from the customer
Paper Value Creation
This is when value is released based on accounting practices, changes in exchange rates, interest rate fluctuations, etc. Though this is an essential part of the Value creation process, it’s rarely the sole reason a business is set up.
Value retention is a metric that reflects the quantum of business that was brought over from a “previous period”. This is applicable only to businesses who have an ongoing relationship with their clients such as insurance companies, subscription businesses, license based contracts, etc.
Value Retention = Passive Value Creation – [ Value Lost + Cost to Serve]
Passive Value Creation
This is the incremental value that is created from your existing book of business. An example of this is the Funds management industry where the Assets under Management will generate a yield on an ongoing basis irrespective of any new business that may come through the door.
In a given period is the business that you owned in the previous period that did not carry through to the current period. This can be further broken down into:
- Customer Churn – Losing a customer is the biggest contributor to Value Loss for most companies (a small caveat, if you lose “non valuable business”, you may be better off).
- Value Seepage – This is the value that is lost due to mismanagement of cost structures. For example: Auto payment of subscriptions, non-consolidation of suppliers, increase in travel or entertainment budgets, etc.,
Cost to Serve
This is the cost expended by an enterprise in servicing existing customers. This includes costs such as customer support, account management, drip marketing, etc.
The following diagram summarises the Value Tree that has just been described. We strongly encourage our clients to focus on the “Primary Focus Areas” as highlighted in Green below. These are the core activities of a business that will eventually drive Enterprise Value.
Now that you have an understanding of the framework, here are some of the questions you need to think through to define the precise metrics for your business:
- Which part of the Enterprise Value equation is most important for your business?
- What are the underlying activities that you need to measure and monitor on an on-going basis?
- What is the current baseline for your key metrics and what targets should you define for each of the measures?
- How can you cascade the corporate metrics down the chain to the people who are actually involved in Value Creation?
- Where would the data come from for such monitoring and how can you implement a system that will automate this for you?