Updated: Nov 23, 2020
Performance evaluation is important in Section E of ACCA Advanced Performance Management (APM) syllabus. In March 2020 APM exam, examiner told us that Value Based Management is one of poorest questions that not many students answered it well. We would like to explain this challenging topic here.
There are many different approaches to management that businesses take. These approaches are based on various management theories and target different aspects of the management process. Each of these approaches has some benefits and drawbacks. One particular management approach that we are going to discuss today is the Value Based Management approach.
What Is Value Based Management (VBM)?
Value Based Management (VBM) is a management approach that revolves around creating value for shareholders. Companies using a VBM approach will generally focus on projects and operations that maximize the wealth of their shareholders. The process involves creating and managing values for a company and then measuring those values.
However, VBM does not focus on increasing just the profits of a company. VBM involves making decisions that are beneficial for the long-term financial performance of the company. More specifically, it does not focus on the short-term earnings of the company.
In the VBM approach, instead of profits, the management of a company uses expected future cash flows. The company may discount these cash flows according to the cost of capital of the company to determine the present value of those cash flows. According to this approach of management, a company creates value when it invests in a project that provides returns above its cost of capital. Companies use this approach to management in strategic and operational activities.
Through the implementation of a VBM approach, a company does not only maximize the wealth of its shareholders but also ensures that the goals, operations and processes of the company are aligned.
VBM also focuses on the decision-making process of a company. Therefore, it may involve managers from different levels of a company in the decision-making process. In this approach, the managers of a company will use value-based performance metrics for better decision-making.
Targets should be both financial and non-financial. This will ensure that there is not too much emphasis on financial targets, which tend to be backwards looking, rather than relating to the present value of future cash flows, which is the focus of value-based management (VBM).
Why is VBM better?
A VBM approach is better for companies for many reasons. First of all, a VBM approach promotes the maximization of the wealth of shareholders. This approach can also assist the company in creating value for its shareholders consistently.
Furthermore, by promoting the maximization of wealth, the model also aligns the objectives of different departments and managers within the company with the interests of shareholders. This means that the approach helps all departments within a business to work towards achieving one common goal.
A VBM approach can also clarify the priorities of the management of a company. As we discussed above, all of their priorities will shift towards maximizing the wealth of the shareholders. Furthermore, a VBM approach can also facilitate open and transparent communications with shareholders and other important stakeholders of a company. Likewise, it can promote better internal communication within the company.
Through the use of different valuation models, a VBM approach also manages any uncertainties and risks involved for companies. Some valuation models can incorporate the risks of a company when making decisions to facilitate the management of a company in the decision-making process. Using these valuation models also encourages the company to select value-creating investments only.
A company can also use a VBM approach for an efficient allocation of its resources. Similarly, it can help the company identify any bottlenecks in different processes. This assists the company in different budgeting and planning needs. These needs may include capital budgeting needs, such as capital rationing.
Companies using VBM approach also ensure that their stock isn't undervalued. Furthermore, it facilitates the use of the stock of companies for mergers and acquisitions. Companies can also detect and prevent any takeover attempts through the use of a VBM approach.
Tool in VBM approach - Economic Value Added (EVA)
Companies can use the Economic Value Added (EVA) method to measure the profitability of particular projects or decisions based on the Residual Income technique. The model supports the idea that any project, or decision, that creates additional wealth in excess of the required cost of capital of a company is profitable for itself and its shareholders. The EVA model uses a straightforward formula to calculate the profitability of a company. This formula is as below:
EVA = NOPAT - (Capital invested x WACC)
In the above formula, NOPAT stands for Net Operating Profits After Tax while WACC stands for Weighted Average Cost of Capital. Capital invested can be calculated using the following formula:
Capital invested = Equity + Long-term debts at the start of the period
The EVA model can have many advantages and disadvantages within a VBM approach. However, since it supports the idea of maximizing wealth, it can be used as a valuation tool within the VBM approach.
The EVA model is also different from the Discounted Cash Flows (DCF) model. The main difference is that the EVA model does not require cash flows and does not consider the time value of money. On the other hand, the DCF model considers cash flows and the time value of money.
Pitfalls of VBM
The VBM approach has proven to be a successful approach for companies. However, does it have any pitfalls? To answer the question shortly, yes. The approach isn’t free from pitfalls. Let’s discuss a few of these below.
First of all, a VBM approach is based on an evaluation of different options and selecting ones, which can contribute to the wealth of shareholders. However, there is no such thing as a perfect valuation model. Every valuation will have its advantages and disadvantages.
If a company has not adopted a VBM approach, it may find it difficult to adopt the approach later. This is mainly because a VBM approach requires a culture change within the company. Similarly, implementing VBM at a large scale can be time-consuming for companies. Furthermore, while value creation may be sound straightforward, it requires companies to synchronize their strategic and operational activities to obtain the best results.
While VBM may be a useful approach for the benefits it provides to companies, it may often come at a cost for these companies. Companies have to measure the value created by different processes using different tools such as a balanced scorecard. The more the company goes into detail for these tools, the more accurate results it will get. However, to achieve more accurate results, companies may have to do a significant amount of research.
Similarly, companies must understand how the process of value creation works and what goes into the process. If the company takes any irrelevant information, it may end up destructing value rather than creating it. This may also require the company to have knowledgeable and skilful top-level management.
Finally, if a company does not have any prior experience with a VBM approach, it will need to train its management and employees. This may further add to the costs of the company related to adopting a VBM approach.
Value Based Management (VBM) is one of the many management approaches. VBM is an approach based on maximizing the wealth of shareholders in a company. The management of the company implements VBM by creating and managing values and subsequently measuring them. The VBM approach mainly focuses on the decision-making process of a business. There are many reasons why VBM is a better management approach. However, it may come with its pitfalls.
If you find this article is helpful and you want to help others too, just share it in any social media (such as Facebook, LinkedIn).