The Value Creation Imperative

The world’s humans, otherwise known as "consumers", began to take over ownership of the world’s resources from the few old-world rulers approximately 400 years ago with the creation of the world’s first publicly traded company, the Dutch Vereinigte Oostindische Compaignie (VOC), whose first shares were issued on September 27, 1606. As of 2008, this capital market is valued at over $75 trillion and well over 1 billion consumers are now active owners of the world’s resources, compared to very few monarchs and dictators as recently as a few hundred years ago.

We, you and I and our fellow human beings, managed this transition by quietly, and without any organized leadership, transitioning the resources one company at a time into the capital market. By the time the old-world rulers started to understand what was happening, it was too late. Many are still fighting to stop the transition, but they will lose their battle. We will win.

While the objective of any individual human may be essentially to live happily (whatever pattern of individual consumption that might imply) and to control the way they die, it doesn’t make sense to talk of the ‘objective’ of an organization, such as a company. An organization exists because some collection of humans wishes for it to exist, and it is important to understand that organizations are simply a means to an end. As such, when it becomes a destroyer of net happiness, rather than a net producer of happiness, then the humans will wish to shut it down. Depending upon the different parties to the organization and the relative power of the winners and losers to its continued existence, it may take a long time to shut it down, however one thing is certain – any organization which remains a net destroyer of human happiness for a sustained period of time, will be dismantled by the humans eventually. This fate awaits every company, government, religion, or any other social institution. Thus, when we consider that value is just another word for happiness, then it is clear that the objective of any company is value creation. (What is the “value” of your house to you? What is the “value” of your partner or children to you? It is clear that “value” is not about money nor finance. It is about happiness, or, as economists refer to it, utility.)

Thus, as we, the consuming public, have taken ownership we have changed the rules. The managers of today are starting to feel this pressure from all angles. We, acting as consumers, want safer, more reliable, more feature-rich products and services and we don’t want to pay much for them. We, acting as employees, wish to be treated with respect, offered opportunities for development and autonomy and paid relative to the value we contribute. We, as shareholders, want to minimize the agency costs, inefficiency and waste in the system which prevents the efficient delivery of higher quality products at lower cost. We, as citizens of the planet, want our managers to treat our communities and planet with respect and consideration. The increased importance of Corporate Social Responsibility (CSR), far from being opposed by the capital market, is better understood as one of the creations of the capital market. As we have gotten control, we have demanded increased sensitivities of ‘our’ managers towards the impact they have on the communities and the planet we inhabit. As this movement sweeps the world, recognize that it originated where the capital market is most established and where we have taken ownership, and is least adopted in those parts of the world where the capital market is least present and where the “few” still rule over the local resources. .

Woe to the manager who misinterprets the capital market as the tool of the shareholder or debtholder to the detriment of the consumer. It is the consumer as shareholder who has taken control and in the consumer’s own mind, as both consumer and shareholder, it is the consumer role which takes precedence. Thus the trend to ever-higher quality products and services at ever lower cost, while it becomes ever more difficult to provide a good return to shareholders and debtholders. As long as we, the consumers, are in charge, we will privilege ourselves as consumers over ourselves as shareholders. Like the organizations we create, the capital market itself is simply a means to an end as is our role as shareholder. It is not our objective to simply have ownership – it is our objective to take ownership in order to direct those resources to those pursuits which best justify their use – creating and delivering happiness to us, otherwise known as value creation.

It is critical to understand that the manager’s performance at the center of the web of conflicting stakeholders is best measured by looking at the shareholder value metric. If the objective for each company (or institution) is value creation, then the metric which reveals whether a manager is successfully delivering on this challenge is shareholder value as the residual claim in the company. It is important to recognize that this in no way implies that shareholders are a more important constituency than any other group – quite the opposite. It is the fact that shareholders are the residual claimant that makes their claim the metric to assess how well management are doing their jobs. If this value is declining, then we know management are killing the company and in the long run, if they don’t reverse the trends, the companies’ employees, customers, suppliers, communities, etc. will all suffer as a result.

Measuring this shareholder value concept is difficult. A useful indicator is the company’s share price, which is easily observed when the company is publicly traded. However this is only an indicator of shareholder value, it is not the “truth”. Consider the famous catastrophe at Enron – those managers must have known full well that they were destroying value for years even while the share price was rising at the same time, demonstrating clearly that management can be destroying value and killing the company while the share price fails to reflect this. Thus, we, as shareholders, will demand that our managers deliver the products and services we want, while using resources as efficiently as possible, and managing the company’s various relationships in a way to ensure its continued delivery into the future.

How will we know if they are succeeding, if the share price is only an indicator? What is the “real objective” if it isn’t share price? The true measure of shareholder value is the present value of expected future cash flows generated by the company. While each of us may have our own view of what those cash flows might be, the phrase “the expected future cash flows” does not leave room for opinions. To see this, note that each decision taken by a manager will, in fact, either create value or destroy value. The fact that the manager may not know which it is does not change the fact that it happened. Thus, when we say “the expected future cash flows” we are not referring to any given person’s expectations, but rather the true “expected” cash flows which may be unknown to all humans. Thus, the job of management is to simultaneously study the consumer’s interests and trends, the employees’ motivations for working which will help management to get the most from them, the competitive landscape, any technological innovations and developments, the changing regulatory environment, the relationships with present and potential future suppliers, etc., so as to understand what the impact might be of each of his/her decisions, at least in terms of what is reasonable to expect. If the objective is value creation, then we, the owners of the world’s resources, can summarize any manager’s job as simply: accept the value creating ideas and reject the value destroying ones. The manager who is unable to put together a forecast of the cash flows which are reasonable to expect as a result of a given decision, and thus is unable to assess the value impact of his/her decisions, and thus is the wrong person for the job.

The capital market is absolutely clear, and brutal on this point. In the old world it was more important to know the right person, attend the right school, be born to the right parents, kiss the right butts and pull the right strings in order to succeed in business or politics. In the new world where we have taken ownership of the world’s resources via the capital market, the only way to be sure to survive as a company, and keep your job as an employee, is to create value – Value creation is all we care about and we’re very serious about it. Indeed, as employees, we are sick and tired of the ‘old-world’ approach to management in which it is more important to know the right people, or to kiss the right butt or to lie most successfully in order to get promoted. We each have a “fairness-meter” implanted in our brains at birth, and we will never consider these “fair” reasons for someone being promoted instead of ourselves. We also have a “value-meter” implanted in our brains at birth, and it turns out that the two meters, the “fairness-meter” and “value-meter” are inseparably connected to one another. The one determinant that we will accept as “fair” is value – as long as it is those who create the most value who enjoy promotions and success, we will not revolt, but when it is value destroyers who enjoy the material success in the company or in society, we will fight the system in an effort to correct this “unfairness”.

The shareholder value metric is the measure to aspire to deliver, yet try as you might, our shareholding in the world’s companies is simply a means to an end – it is what enables us to take control of our lives away from the old-world rulers. As such, maximizing the shareholder value will remain the metric, but it will be like the pot of gold at the end of the rainbow. The closer a company gets to it, the more competition will rise to challenge the value creators in an effort to get some of their own, the more employees will react to capture more for themselves, and the more consumers will respond by demanding still higher quality products and services at better prices, making maximization of shareholder value a very elusive target with self-regulating forces to ensure it remains so. This is simply the lesson of Adam Smith’s Invisible Hand, first offered to the world in 1776 in “The Wealth of Nations”, which is alive and well today as it always has been and always will be. It is rather shocking and unfortunate that this lesson has been misunderstood and underappreciated by so many since its first release. No doubt, for the old-world rulers and corporate executives who stand to lose their control the world’s resources, they have worked hard to prevent dissemination of this understanding. In our self-regulating world, driven by us for our benefit, the providers of capital will neither earn more nor less than the opportunity cost of their capital. We will see to it and the evidence from the capital markets is already fairly clear on this point. We are moving toward a world where we all share in the ownership of the world’s resources and we direct their application toward the individual happiness of each of us, whatever that may entail, rather than toward the happiness of the few rulers. It is a form of pure ‘communism’ – it is called capitalism.

And we are only just beginning…

What are the five “need to knows” which will enable every manager to lead more effectively without destroying value.

1. Consumers come first – always ask how your decisions will benefit consumers, either by delivering higher quality products/services with the features they will value, or by enabling more efficient use of resources to drive down the cost to the consumers of the high quality, feature-rich products/services you provide to them.

2. Value-driven – ask always how your decisions will enable the organization to create, deliver and capture more value to enable it to survive another day in order to try again.

3. Integrity is critical to management and leadership – we do not accept any determinant for promotion as “fair” other than value creation. Those organizations which are able to see past the traditional criteria for promotions, such as who went to what school, who knows whom, who is more effective at “politicking” inside the organization, who lies the best, etc., and instead promote simply based upon who is best able to understand, create, deliver, and capture value with be accepted as “fair” and thus respected by all employees resulting in higher morale and effectiveness and leading to better performance on points 1. and 2. We will refer to such organizations as “having integrity”. Those organizations in which it is the traditional criteria which determine who gets promoted will be referred to as “lacking integrity.”

4. Indicators are not objectives – the objective is value creation. There are many indicators in business, just as there are indicators in a car – the speedometer indicates the speed you are traveling while the fuel gauge indicates the level of fuel remaining – don’t look at the fuel gauge if you wish to know how fast you are traveling. Many organizations mistakenly give their managers performance objectives based upon the indicators with the result that they manage the indicator directly. The result is they do not manage for value creation. This results in two negative results – (1) any indicator target can be obtained through either value creating methods or value destroying methods (e.g., attain 30% market share by spending only €1 million, or attain 30% market share by spending €1 billion) – of the two, delivery through value destroying methods will almost always be easier. As a result, managers who are focused on performance objectives based on indicators will very often deliver on these by destroying value, but will be rewarded with promotions and bonuses – resulting in a situation all will consider unfair which demotivates other employees and does not serve the objective of the organization, which is value creation. The second negative result is, (2) because the managers are “managing” the indicators, they are no longer reliable indicators. Thus, all we know about such organizations is: (1) they are not focused on value creation and (2) the indicators are almost certainly not indicating what we think they are indicating and (3) all of the employees are probably demotivated by the lack of integrity in the organization.

5. Value creation is about expectations – value cannot be assessed after the fact. When a manager takes a decision, the value impact is based upon whether the expected cash flows are positive in present value (not the cash flows the manager expects, but rather “the” expected cash flows which are not a matter of opinion but are those cash flows which are truly expected based upon all of the random elements which will drive the eventual outcome). After the fact, one of the infinite potential outcomes which might have occurred will be the one we actually observe as the outcome which happened. This outcome cannot help us to assess whether value was created or destroyed – it simply tells us what happened. To understand whether value was created or destroyed we need to know what was expected at the time of the decision. Due to this, management must be sufficiently knowledgeable and courageous to be able to recognize that some “good ideas” (those which are value creating) may turn out badly and some “bad ideas” (those which are value destroying) may turn out well, but that these outcomes must not be used to determine promotions or bonuses in the organization. As GE’s Jack Welsh liked to emphasize, good ideas which turn out badly will not mean “career damage” in a value-driven organization. The pressure this puts on management to be able to have the knowledge to distinguish good ideas which turn out badly from bad ideas which turn out badly is enormous. This will require the full effort of a “learning organization” focused entirely on understanding value and value creation and built from top to bottom on a system of integrity. A company with integrity will be one which is in fact value focused, simply having the intention of being value focused isn’t good enough – in addition to having the right “character”, the organization and its management need to have the “competence” to know the difference between value creating and value destroying decisions, even if the value creating ones sometimes turn out badly or the value destroying ones sometimes turn out well.