aggregate
capital valuation & management model (acvmM):
a blueprint for business management in the xxi century
Ó Oleg Cheremnykh, 2004. All rights
reserved cheremnykho@cnt.ru
T A B
L E O F C O N T E N T S
Intended Audience of the Article
& Methodology
Introduction: Need for Aggregate
Capital Valuation Model
Graham & Dodd - Formal Theory of Measuring
the Value of Companies
Revolutionary Changes in Business Environment
From production-oriented to
service-oriented economy
From dominance of tangible
(functional) to dominance of intangible (emotional) needs & values
From production/operations
management to product management and brand management
From labor to human resources to
human/intellectual capital
Transition to knowledge/oriented
(intellectual) economy
CRM technologies and the increased
importance of client relationships
Concept of stakeholders and
stakeholders’ relationships management (SRM)
Emotional objectives of shareholders
and importance of corporate culture
Increased importance of corporate
technologies (corporate know-how)
Resulting Fundamental Problems in Business
Valuation & Management
“Islandization” & incompatibility
of functional business management technologies
Lack of financial value management
technologies
Problems in cross-industry
comparison (comparative valuation) of business entities
Need for financial value – based
integrating technologies
‘Back to Basics’ – the Core Idea
& Concepts of ACVMM Methodology
Types of Financial Value in ACVMM
Fundamental Types of Company Capital
in ACVMM
General Classification of Capital/Assets
Detailed Classification of Capital/Assets
Valuation & Balancing in ACVMM
Key ACVMM Equations (Balances)
ACVM-based Business Valuation
Formula/Sequence/Process
Business valuation process (ten
steps of ACVMM valuation)
Business valuation formula in ACVMM
Three Approaches to Intangible Capital
Valuation
Capitalization of Incurred Costs
from the Inception of Intangible Capital
Estimating Value-Generating Capacity
of Intangible Capital (ACVM approach)
ACVMM and BSC/KPI Tools &
Parameters
ACVMM and Business Engineering
Structure of Aggregate Capital
Valuation & Management Model
Functional components of ACVMM Package
Standard and customized components of ACVMM
Package
ACVMM Software: Platform & Functional
Structure
Building a comprehensive business
valuation model
This
article/brochure presents a comprehensive business valuation and management
model which breaks down a fair (‘intrinsic’) value of the business enterprise
into a comprehensive set of different types of capital – tangible, quasi-tangible
and intangible – and creates a
methodology and framework for an efficient and reliable valuation and
management of key business elements and objects directly linked to the most
basic objective of business management – maximization of financial, functional
and emotional value of the company (including stock price management for public
companies).
ACVM
methodology has two aspects/components – valuation
per se and management of aggregate value
(and its components). Therefore, its valuation component has a ‘universal
application’ and can be profitably utilized by both the investment community
(investment bankers, brokers, investment managers and analysts) and managers of
real sector companies. Its value management component is naturally intended for
owners and top company managers (first of all, for CEOs and CFOs) as well as
for company employees involved in the technical aspects of measuring and
managing aggregate company value and its individual components.
It is
believed that this article can be useful for consultants and educators
specializing in financial or strategic business management as well as for MBA
and BBA students and for Ph.D. students majoring in financial and/or strategic
business management disciplines.
For many
decades (in fact, until very recently) business management was essentially financial management (i.e. management of
corporate finances) with other aspects of business management being of a
somewhat secondary importance.
Chief
Financial Officer (CFO) was second-in-command in the corporate hierarchy and
most (if not the overwhelming majority) of professional Chief Executive
Officers (CEO), with natural exception of owners/managers of small and
medium-size companies (entrepreneurs) were former CFOs. The shortest (and often
the only) path to the top slot in the corporation was climbing a career ladder
in the corporate finance department.
Business
management system and structure (including those of the corporate information
system) were built around four fundamental and by far the most important
corporate information statements: income
statement (often referred to as profit & loss statement – or P&L
for short); balance sheet, statement of retained earnings (which in
most cases was just one more component of P&L) and statement of cash flows.
These ‘classic’
financial statements formed the core of the two almost universally adopted
accounting systems – Generally Accepted Accounting Principles (GAAP) and
International Accounting Standards (IAS) – the former being the system of
choice in North America, the latter – in the European nations.
Therefore,
managing a business essentially amounted to maximizing
values of the two fundamental financial parameters – capital (shareholders’ equity) and the stream of dividends paid to
company shareholders. In addition, both capital and the stream of dividends
were expected to constantly grow in absolute terms on a year-to-year basis.
These fundamental financial parameters can be viewed as components of a financial value function (FVF),
maximization of which is the primary goal of managing a business enterprise.
Naturally,
maximization of capital & stream of dividends required optimization of other components
of financial statements – P&L
(revenues, fixed & variable costs, etc.) and balance sheet (cash, accounts
receivable, inventories, other current assets, accounts payable, short-term and
long-term liabilities, etc.) as well as of certain financial ratios (between components of the same or different
financial statements) – liquidity (‘credit’) ratios, per share ratios, price
ratios, profitability ratios, etc. Naturally, these components and ratios can
be rightfully referred to as key
financial components and ratios of business management system.
Another
important element of finance-based business management was budgeting – development and maintenance of cash budget for all
functional units and sub-units of the company – strategic business units (SBU),
marketing, sales, human resources, information technologies (IT), etc.
Naturally, the
structure and contents of functional budgets were supposed to optimize values
of key financial components and ratios (which, in turn, required optimization
of certain key parameters and ratios of functional budgets).
Such
finance-centered business management paradigm was essentially the legacy of an
industrial society where this paradigm was born. It was based on the following
principles, explicitly or implicitly believed to be true:
Unfortunately
(or fortunately, depending on the perspective), the business reality of the
past several decades proved to be very
different from these assumptions.
The first
major blow to the above-mentioned assumptions (but not yet to the
finance-centric business management paradigm) was dealt in mid 30‘s of the past
(XX) century by Benjamin Graham and David Dodd – authors of a groundbreaking
book Security Analysis (originally
published in 1934, it is still widely and successfully used by stock market
professionals worldwide).
Approach to
company valuation developed by Graham and Dodd stood the test of time and
allowed quite a few professional investors (the most widely known of which was
undoubtedly Warren Buffett) to amass huge personal fortunes and to consistently
(for decades!) achieve investment returns significantly exceeding those of the
stock market as a whole (the S&P index) – something that was simply
impossible, according to the traditional view of stock markets and business
management. According to the book Buffett:
The Making of an American Capitalist by Roger Lowenstein, from 1950’s to
the 1990’s “as the major stocks averages advanced by 11% or so a year, Buffett
racked up a compounded annual gain of 29.2%” (almost triple the ‘market return’).
The most
important principles of Graham and Dodd’s approach to company valuation proven
to be true (many believe, well beyond reasonable doubts) are the following:
DCF
approach to company valuation (i.e. estimating financial value of the company)
makes complete sense (unlike many other approaches to valuation). It is only
natural to state that an entrepreneur or investor invests into certain business
ventures or stocks to make money (in other words, to receive free cash flows
from the investment).
It is also
natural that the larger are these cash flows, the more financially valuable the
company is to its investors/owners/shareholders; the later these cash flows are
received by the investor, the less valuable are they to the investor (due to
the time value of money) and the riskier is the business, the higher is the
probability that actual cash flows received by the investor will fall short of
the estimated free cash flows (which naturally, makes business and the
investment less valuable to the investor).
The only
fundamental problem that Graham & Dodd’s theory (including its subsequent
additions and enhancements) did not address was the problem of managing the intrinsic financial value
of the company. It gave only the paradigm, methodology and tools to measure this value (a must for stock
market and investment professionals and a useful tool for company managers and
employees) but there were still no tools for managing and maximizing this value. Which naturally created an
enormous gap (still very much in existence) between the investment community
and management.
But there
was more to come. Enormous (almost revolutionary) changes in business
management technologies that started in 1970’s and 80’s and progressed into the
90’s and into the first years of the XXI century gave rise to fundamentally new
problems and challenges (and opportunities!) in measuring and managing the values
of business enterprises.
Probably the
most important change in domestic and international business environment was
transition from industrial to post-industrial society (in other words, from
production-oriented to service-oriented economy) that took place in the second
half of the 21st century.
This
transition meant that in the economically developed nations[3]
(with the only exception of oil-rich Persian Gulf countries) the bulk of GDP
was created by providing intangible services, rather than tangible products.
Naturally, intangible services were produced using mostly intangible assets
(i.e. those not reflected on a classic balance sheet) rather than classic
‘production equipment’.
Which,
naturally, meant that the importance of tangible assets as financial value
drivers was going down and the importance of intangible assets (not yet adequately structured by business
accounting systems) as financial value drivers was going up. Which, in turn,
for the first time in business management history created the need for proper
valuation of intangible assets (and, to balance the new, more adequate balance
sheet), of intangible capital.
But the
universe of tangible products not only shrank (relative to the industrial
society levels), but underwent radical
changes as well.
In the
industrial society financial value of the tangible product was determined
chiefly by its functional value to its consumer (in other words, by its ability
to satisfy practical functional needs of the customer – individual, business
enterprise, government entity, NGO[4],
etc.). This fact was probably best of all expressed by Henry Ford successfully
producing his famous Fort-T model exclusively in black color (as long as it
provided the functional value of transporting his owner from point A to point B
in reasonable comfort at an affordable and acceptable purchase price, color,
i.e. non-functional aspect of the car did not matter).
However,
things have changed since those ‘golden times’ and changed significantly. Such
‘functional’ philosophy worked well in the first half of the past century,
where inevitable large-scale wars and economic crises affected production
facilities (supply side) far more significantly than the demand side which led
to the market dominated by suppliers whose primary objective was to satisfy
purely functional needs of the population which arose again and again after the
products intended to satisfy these needs were destroyed by the next war or
economic crisis.
After the
enormously devastating World War II and the invention and proliferation of even
more devastating nuclear weapons and other weapons of mass destruction large
scale wars became a thing of the past. With most of economically developed
nations united in the Cold War against Communism they very quickly found tools
for prevention of large-scale economic crises (which could easily lead to the
destruction of the Western society and to the rapid worldwide victory of
Communism – with disastrous economic, political and social consequences).
Hence, large-scale economic crises became a thing of the past as well.
Which, in
turn, led to the end of periodical large-scale destruction of production
facilities and assets and ‘turned the tables’ in domestic and world markets –
which from that time on became the ‘consumer-dominated’ (or demand-oriented)
markets, as in the post-industrial and post-WWII society supply exceeded demand
(in the pre-war industrial society demand exceeded supply).
Consumer-oriented
market delivered another powerful blow to ‘classic’, finance-oriented business
management paradigm. First, very quickly basic functional needs of the
population of economically developed nations have been met (transition from
‘chicken in every pot’ to ‘car in every garage’, the latter implicitly stating
that each household owned an apartment or a house) took only a few decades. Which
was not very surprising as the universe of purely functional needs of a human
being is much more limited and much less diverse than the universe of emotional needs.
Which
automatically meant that the principal area of competition shifted to meeting
the emotional needs of consumers and
competency and competitiveness in the ability to satisfy the emotional needs of
the customer rapidly became the key success factor for a business enterprise.
As now the customer was paying primarily for having his/her emotional needs
satisfied and these customer expenditures on company products and services
being the only source of financial value of the company to its owners, the
ability of the company to satisfy the emotional needs of its customers quickly
became the primary financial value driver for the business.
Second,
advances in production and engineering technology (reverse engineering,
commercial/competitive intelligence – both legal and illegal, etc.) and the
emergence of powerful computer hardware and software made duplicating a
functional value a much easier task than it had been in the industrial society
era (an excellent example is competition between Intel and AMD in the
microprocessor business). Another good example is the personal computer market
where additional functional value created by a brand-new model of the industry
leaders is almost instantly duplicated by other market players.
And
duplicating purely the functional side of services in most cases was even
easier than duplicating the functional aspects of products (as duplicating
services usually required much smaller capital expenditures than duplicating
tangible products).
In other
words, due to its tangible (and, therefore, easily duplicable nature)
functional value created by company products, as a rule, could stay unique only
for a very short time and, therefore, could not help to differentiate the
company from its competitors (and hence to create a stable long-term
competitive advantage). Therefore, ‘functional capital’ of the company (its
ability to produce products and services that satisfied functional needs of its
customers) was becoming less and less valuable and important for the business.
On the
other hand, emotional value created by company products was much more difficult
to duplicate (due to its intangible nature) and, therefore, could be
successfully used to differentiate the company from its competitors (and hence
to create a stable long-term competitive advantage). In other words, ‘emotional
capital’ of the company (its ability to produce products and services that
satisfied emotional needs of its customers) was becoming less and less valuable
and important for the business
Unlike in
the industrial society, when commercial enterprises competed primarily on
functional value (their ability to satisfy the functional needs of its
customers), in the post-industrial society businesses compete primarily on
emotional value (their ability to satisfy the functional needs of its
customers)
And again,
financial and material assets did not have the ability to satisfy the emotional
needs of the customer (and therefore, could not create an emotional value which
now was the major driver of the financial value of the company). Which meant
that in order to stay competitive, the company had to develop and manage some
other kinds of intangible assets/capital that did have such an ability. And,
naturally, these assets/capital have to be properly accounted for and managed.
But more
was to come as both manufacturing and service companies were forced to shift
focus from production/operations management to product and brand management.
In the
industrial society with supplier-dominated markets dominated by standard mass-market
products with relatively long life cycles product management was pretty much
reduced to production/operations management and design of purely functional
features of the product.
All other
aspects of product management – design of emotional attributes, packaging,
pricing, promotion & distribution – were much less important as, again, the
primary objective of a business enterprise was to satisfy rather standard,
purely functional and not very sophisticated needs of its customers.
In
addition, production facilities typically resided in the same country and even
area where corporate headquarters were located and the company identified
itself primarily with its production facilities.
With the
transition to post-industrial society the situation has changed radically. More
sophisticated customers demanded customized, individualized products, services
and solutions heavily focused on the emotional needs of the consumers. And with
the radically accelerated pace of change in society product life cycles began to
shrink at a radical pace as well.
Satisfying
more sophisticated and individualized customer base required much more
sophisticated distribution, pricing and
promotion systems. Which meant that now these – intangible – kinds of capital
were becoming more and more important for the financial value of the company
than its production facilities – tangible assets.
In
addition, with globalization of business more and more companies in
economically developed countries began to move their production facilities to
the developing nations and in many cases (especially due to rapidly shrinking
product life cycles and the need for flexible, customized production) it became
profitable to outsource production facilities to companies specializing in
producing products according to supplied specification (‘third-party
manufacturing’). This trend was further expanded and reinforced by the
proliferation of licensing and franchising as very popular and highly effective
and efficient tools for business expansion.
As the
result, production of products (and often services as well) became separated
from production facilities which led to the recognition of fact that it was the
portfolio of products (product capital) rather than the portfolio of production
assets that determined the bulk of financial value created by the business
enterprise. And again, this intangible – product – capital (including both
individual products and the synergy
between products) had to be properly accounted for, valued and managed.
However,
there was one significant problem with corporate product portfolio – rapidly
shrinking product life cycle made life span of the product portfolio also
rather short which, in turn, made it rather unstable which increased business
risks and reduced the financial value of product portfolio and product capital.
Management needed another concept, another entity – far more stable than the
product itself but still closely related to the concept of product/service
which could not only add stability (and, therefore, value) to the product
portfolio, but to create additional financial value for the company.
Not
surprisingly, such a concept quickly emerged. It was the concept of brand. Two fundamental reasons
contributed to the origination, development and proliferation: (1) that
customers wanted emotional value and emotional attributes of products to stay
relatively stable compared to rapidly changing functional attributes of
products (human beings are known to crave stable long-term emotional
attachments and involvement) and (2) that they accepted new products or changes
in existing products more eagerly if these new products or features were
associated with certain ‘emotional entities’ inherited (derived) from products
and companies that customers got used to.
Brand is
exactly such an intangible ‘emotional entity’ that can relate to either a
product, a product line (product group), product category, business unit or a
company as a whole and thus creates additional financial value for the company
(as customers were willing to pay a premium price for a ‘branded’ product
compared to ‘non-branded’ or agreed to buy only ‘branded’ products). Which
immediately meant that brands (a collection or a portfolio of brands developed
and maintained by a company) constituted a new king of intangible capital – brand capital (or ‘brand equity’) which,
like other kinds of intangible capital (such as product capital) had to be
properly accounted for, evaluated and managed.
BuildingBrands (www.buildingbrands.com)
defined a ‘brand’ as “a collection of perceptions in the mind of the consumer”
which adds emotional (and, therefore, financial) value to companies, products,
product lines, etc. that it is applied to. This definition makes it absolutely
clear that a brand is very different from a product or service or a company
that it is usually originally derived from.
A brand is
intangible and exists in the mind of the consumer, adding intangible –
emotional - value to an underlying product, service or other entity. Naturally,
brand equity (or brand capital) is the difference between assets and
liabilities associated with an individual brand (or a portfolio of corporate
brands).
Due to much
more stable nature and its ability to be applied to new products and services
(even belonging to totally different industries) and to constantly shrinking
product life cycles brands, and not products, form the foundation of
value-creating capacity for each and every business. Recognizing that fact and
also the proliferation and growth of outsourcing, licensing, franchising and
similar business development technique, many well-established and distinguished
companies (even transnational corporations) are currently positioning
themselves as being primarily in the brand development business, outsourcing
even product management (including R&D, design, production, distribution,
logistics, etc.) to the ‘third parties’ specializing in the corresponding
business activities.
As the
result, for most companies ‘brand assets’ and ‘brand equity’ are now far more
important than the proverbial ‘property, plant and equipment’ (PPE) section on the balance sheet or than
current assets (or net working capital); the fact that traditional, finance-centered
approach to business management failed to recognize, adding one more driving
force for its eventual demise and inevitable replacement with other, more
adequate business management paradigm.
In the
industrial society, production was organized according to the famous (and in
the beginning, highly efficient) ‘division of labor’ principle. According to
this principle, each worker in the production process accomplished highly
specialized and typically rather simple activities which ‘fit into a bigger
picture’ (an assembly line or a similar production process). Such activities
required little professional skill and, as a result, each worker (including
several layers of supervisors) could be easily and quickly replaced and, therefore,
had little ‘intrinsic value’ compared to the value of equipment (material
assets) used in the production process.
Office work
was organized in a similar fashion; business management system (which at that
time was little more than production/operations management system) consisted of
specialized functional areas (departments) where relatively simple operations
were carried out by low-skilled workers (‘white-collar rank-and-file-employees’
or simply clerks) controlled by almost equally low-skilled supervisors.
Naturally, these clerks and their supervisors could also be easily and quickly
replaced and, therefore, had little ‘intrinsic value’ compared to the value of
equipment (material assets) used in the production process.
Only a
handful of top managers and professionals (engineers, financiers, etc.) were
difficult to find and replace and, therefore, provided a noticeable amount of
‘intrinsic financial value’ for the company. Therefore, the total value of
‘human capital’ in the industrial society was so much smaller than the value of
tangible capital that the former was practically immaterial from the standpoint
of financial accounting.
With the
advent of post-industrial society, things have changed radically. With most of
the menial, basic production and operations activities being mechanized and
computerized, practically all business activities in modern factories now
required much more skilled, intelligent and professional labor making finding,
securing and replacing suitable employees a far more difficult endeavor.
Transition
from productions/operations management to product and brand management also
required a much more skilled, creative and professional employees, further
increasing the importance of each and every employee and dramatically boosting
the value of human/intellectual capital relative to the value of fixed assets. And
with production of intangible services becoming the dominating force in the
economies of developed nations labor-intensive, not tangible capital-intensive
enterprises became the norm.
In
addition, ‘traditional’ corporate organization structures (based on functional
division of labor a-la manufacturing enterprise) started to give ways to
team-based or processes-based structures – far more efficient than their
‘functional predecessors’ (in a traditional organization structure up to 90% of
time, effort and financial resources was wasted ‘at the borders’ of functional
areas).
These new
structures radically changed the nature of labor in modern corporations – from
simple jobs combined into highly complex business processes to complex jobs
combined into simple business processes. Which, in turn, that as a rule, most
of business jobs and activities were now ‘intellectual’ rather than ‘menial’ an
thus required highly skilled, intelligent and intelligent employees, further
increasing the importance and financial value of human/intellectual capital.
Which, naturally, needs to be properly accounted for, evaluated and managed.
In the industrial
society business environment was relatively simple and stable. In than
environment efficient and effective decision-making required knowledge which
was rather narrow, simplistic and shallow. Corporate information systems were
also rather simple and shallow and the financial value of knowledge – both tangible – contained in various
documents and intangible – contained
‘in the heads’ of corporate employees was practically immaterial compared to
financial value of material and financial corporate assets.
The world
of post-industrial society is very different. The constantly increasing
complexity of business environment – both external and internal (the increasing
complexity of the former automatically causes constantly increasing complexity
of the latter) and often lightning-fast pace of change requires from
decision-makers and from other corporate employees ever-deeper and broader
knowledge. Now, in order to survive and prosper, business needs to ‘know what
happens well before it happens’.
Data and information
are no longer sufficient for successfully running a business. Business needs knowledge. And the difference between
these concepts is substantial.
Data is the elementary piece (‘atom’) of
information, such as the last or first name of an employee, zip code, etc. Information
is a structured collection of data that has a distinct meaning, such as
employee or transaction record. Knowledge is information that allows to
make decision and/or perform action which creates additional value –
functional, financial and emotional – compared to decisions and actions
possible without this knowledge.
In other
words, information and knowledge management system of a business enterprise has
to be structured along the following line (sequence of steps):
Data ® Information ®
Knowledge ® Decision/Action ® Additional Value
With an
enormous increase in the importance and value of each business decision the
value of corporate knowledge (‘common body of business knowledge’) possessed by
the company also increased dramatically compared to the value of productive
assets. Which means that now knowledge capital is a significant factor in
creating and maximizing financial value of the company and, therefore, needs to
be properly accounted for, evaluated and managed.
In the
industrial society, businesses competed primarily on functional attributes and
functional value of their products. Therefore, the primary objective of
business enterprise was to satisfy purely functional needs of its customers –
consumers of the product. A product that did satisfy functional needs of its
consumers, did sell well, the one that did not – did not sell well.
Relationship between the company and its customer was pretty much of the
sell/buy nature – and that was all to it.
In the
post-industrial society businesses had to shift focus to satisfying primarily
emotional needs of their customers and, therefore, to providing emotional value
to the consumer. And, not surprisingly, an important part of the emotional
value of the product came from the quality of relationships between the
business and its customer, which explained emergence, rapid proliferation and
growing in importance of Customer Relationships Management (CRM) technologies.
And rapid
shrinking of product life cycle in the post-industrial society caused a
corresponding shift in the importance of value drivers and of the company
capital – from production (productive assets) to client base (a portfolio of
significant and loyal customers).
In the new,
more competitive environment (and especially with the advent and rapid
proliferation of Internet technologies – up to de-facto emergence of an
‘electronic society’), consumers now have a much wider choice of product or
service vendors. On the other hand, each change in vendor involves so-called
‘switching costs’ – both financial (direct and indirect) and emotional.
Therefore,
the company which managed to develop a significant portfolio of clients and to
create high switching costs for each client in the portfolio, achieved high
customer loyalty from a significant portion of its clients and thus secured
stable and significant incoming cash flows from these customers.
Which, if
business managed to keep costs of creating and maintaining such a portfolio of
loyal customers under tight control (and thus achieving a high return on
investment in CRM technologies) creates significant financial value for the company
shareholders.
Therefore,
such a portfolio of loyal and
significant clients represents a special kind of intangible capital – client capital (or ‘client equity’),
which, needs to be properly accounted for, evaluated and managed.
Industrial
society had a relatively simple and straightforward structure. Relationships
between the company and its primary stakeholders[5]
(at that time, mostly customers, suppliers, employees, creditors, government
entities) were also rather simple and straightforward (see above). The only
relationships that had to be properly established, structured and managed were
those with powerful politicians (decision-makers) in the executive, legislative
and judicial powers – and with those ‘shadow cardinals’ that exercised a
significant influence over how those important (for the company) decisions were
made and executed and with company creditors (primarily, commercial banks).
In the
post-industrial society (and especially in the information era) things have
changed dramatically. Democratization of societies, empowerment of individuals,
globalization of business operations and emergence of a large number of
special-interest groups dramatically increased both the number of company
stakeholders and their influence on its business (and, therefore, on its
financial value) – individual and collective (combined).
Which
caused emergence, proliferation and development of another set of business
management tools - Stakeholders relationships management (SRM) technologies.
Depending on the quality of these relationships, the portfolio of company
stakeholders could either add or subtract a corresponding amount of company’s
financial value.
Naturally,
this portfolio of stakeholders and corresponding relationships constituted
another kind of intangible capital - stakeholder
capital (or ‘stakeholder equity’) which needed to be properly accounted
for, evaluated and managed. And, like any other kind of intangible capital (or
even tangible, for that matter), stakeholder capital could be either positive
or negative.
In the
industrial society both shareholders and their employees worked for the money.
Owners did business to make money to satisfy their mostly functional needs and
their employees worked for their employers also almost strictly for the money
that they used to satisfy their mostly functional needs. And the needs of both
employers and employees (even the emotional ones) were satisfied outside of the
company (‘corporate territory’). Relationships between employees and employers
were strictly financial and almost strictly financial were compensation
packages (salary + bonuses + financial or other material benefits).
In the
post-industrial society things again changed dramatically. With emotional needs
and emotional value of products and relationships becoming more important for
clients and consumers (those two categories of stakeholders not necessarily
being one and the same thing) emotional needs and emotional value was becoming
more and more important for company owners (entrepreneurs) and employees as
well. Which was absolutely not surprising as it simply reflected movement of
these categories of human being ‘up the ladder’ in the Maslow hierarchy of
human needs (one of the most important models developed by social and
individual psychology).
As most of
the adult population spends a significant portion (if not the most) of its
daily life in the workplace, entrepreneurs started to design and develop their
businesses to satisfy not only their financial needs, but emotional needs as
well. And prospective employees (job seekers) began to look not only at purely
financial and functional offerings of the prospective employers (financial
compensation package, opportunities for career development, etc.), but also at
the ‘emotional environment’ of the prospective workplace (‘corporate culture’,
including values, beliefs, emotional objectives, principles and basic
procedures of company operations and ‘corporate life’ in general) developed and
maintained by shareholders and top management of the company.
In
addition, studies have shown that emotional factors and emotional influence of
the workplace as a whole and the individual events provide a significant
influence on the productivity of company employees (and, therefore, on the
financial value created by the company). For example, a significant portion of
so-called ‘corporate downsizing’ projects popular in the 1990’s failed
miserably, because the fall in productivity caused by negative emotional
feelings generated by layoffs and increased level of stress more than
‘compensated’ for savings from personnel and related expenditures.
Also, it
became widely known that success or failure of a large number of businesses and
business projects was determined squarely by the amount and quality of
‘emotional drive’ (typically supplied by corporate culture and corporate
leadership) behind these businesses and projects.
Significant
financial value added (or subtracted) by the corporate culture and emotional
aspects of the workplace (internal company environment) created another
important kind of intangible capital - emotional/cultural
capital, which needed to be properly accounted for, evaluated and managed.
In the
industrial society, with long product life cycles, simple and unsophisticated
functional needs of customers and simple relationships with major stakeholders,
the only technologies that really mattered, were production/operations and
financial management technologies. The former were determined by the productive
assets (during production engineering) and the latter were pretty much standard
and obtained from GAAP and basic financial management courses. And with pace of
change being relatively slow there was always time for adaptation, including
making and executing business decisions.
With the
transition to the post-industrial, globalized, high-speed society (and
especially with the advent of ‘information era’ and the ‘electronic business
community’), things have changed drastically. “Speed is God, time is the Devil”
– this motto of Hitachi – a giant
Japanese industrial conglomerate – can (and should!) be adopted by practically
any business enterprise in any developed nation.
Now there
is no time to think – those who make and execute business decisions have to know precisely (or almost precisely)
what to do and how to do it. Therefore, the quality and sophistication of
corporate technologies (internal corporate know-how) became a decisive factor
in competitiveness (now companies compete to a significant extent on corporate
technologies), efficiency and prosperity of the company, and, therefore,
created (or subtracted) a significant amount of financial value.
Hence, technological capital became another
important kind of intangible capital and, as such, needed to be properly
accounted for, evaluated (measured) and managed. Naturally, corporate
technologies have to take into account the inevitable degree of chaos in
business operations and, therefore, have to be sufficiently flexible (possess
efficient tools for ‘chaos management’).
Different
companies in different industries have slightly different structures of
technological capital but it is still possible to list probably the most common
components of this kind of intangible capital:
·
Financial
Management Technologies
·
Client
Relationship Management (CRM) Technologies
·
Stakeholders
Relationship Management (SRM) Technologies
·
Brand
Management Technologies
·
Product
Management Technologies
·
Human
Resources Management Technologies
·
Corporate
Culture Management Technologies
·
Knowledge
Management Technologies (including Hardware/Software/Information Management)
·
Corporate
Technologies Management
·
Production/Operations/Logistics
Technologies
·
Distribution
Channel Management Technologies
·
Corporate
Communications Management Technologies (internal & external, marketing, PR,
etc.)
·
Risk
Management & Security Technologies
·
Planning
& Control Technologies
·
Project
Management Technologies
·
Business
Processes Management Technologies
·
Corporate
Structure/Organization Management Technologies
·
Ideas
Management Technologies
The
most important problem that resulted
from enormous advances in business management technologies (BMT) during the
transition from industrial to post-industrial society to the information era
and the ‘electronic business community’ was the ‘islandization’ of business
management system and functional business management technologies.
In other
words, as corresponding BMT have been developed by narrow professionals in
corresponding functional areas (client management, product management, brand
management, production/operations management, etc.) they became incompatible
with each other. Each functional department or group was speaking its own
highly specialized language which representatives of other functional areas
could barely understand and this situation very quickly turned businesses into
proverbial Babylon with the resulting highly negative impact on business
operations and company value.
To put it
simply, while the business community and business management professionals
(managers, consultants and educators) managed to successfully create, enhance
and develop BMT for separate functional areas and aspects of business
management (and even for vertical and horizontal integration within that functional area –
intrafunctional integration), they completely failed to develop the
technologies for integrating separate functional management technologies into a
single coherent picture – business management system as a whole (integration between separate functional areas –
interfunctional integration).
But lack of
horizontal interfunctional integration was not the only one problem. Another
problem was lack of vertical
interfunctional integration of separate functional management technologies with
the DCF-based company valuation model. In other words, while the goal of measuring financial value of the company
was successfully achieved, the tools for managing
& maximization of financial value were nowhere in sight.
DCF-based
valuation model and functional management technologies remained two totally
independent and incompatible subsystems of the total business management system
and thus maximizing financial value of the company remained an art rather than
a solid and transparent science.
The
beautiful idea of ‘key financial value factors’ remained just that – an idea
and an objective and two modern and popular approaches to establishment and
measurement of business indicators/parameters – Balanced ScoreCard (BSC) and
Key Performance Indicators (KPI) were tied to non-financial aspects and
objectives of business management rather than to financial value of the company
(probably due to the fact that these methodologies
have been developed by non-financial corporate managers as a protest against
the traditional finance-centered business management paradigm – a temporary
‘pendulum shift’ from strictly financial to strictly non-financial business
management paradigm).
Transition
from industrial to post-industrial society created one more problem for
measuring and managing financial value and financial performance of the company
– the problem of in cross-industry comparison (cross-industry comparative
valuation) of companies (very important for managing holding companies,
conglomerates and investment portfolios comprised of investments in companies
belonging to different industries).
One of the
most common indicator of financial efficiency – Return on Invested Capital
(ROIC) (NOPLAT[6]
divided by net assets – adjusted for current liabilities and
depreciation/amortization) became practically meaningless (for example,
application of ROIC to well-managed manufacturing company and poorly managed
services company will yield results totally contradicting common and economic
sense).
These three
fundamental problems in contemporary business management create the need for a
new business management paradigm/model and a set of new BMT that could provide
the tools, techniques and methods for both integrating – vertically and
horizontally – separate functional BMT and for enabling cross-industrial
valuation and comparison (creating a common platform for cross-industrial
comparison and comparative valuation of business entities).
In other
words, this new integrating model/paradigm had to be able to achieve the
following objectives:
·
Create
a common platform/approach for describing and structuring individual functional
management technologies (based on the concept of financial value created in
each functional area)
·
Create
an effective and efficient instrument for managing the total financial value of
the company by breaking it down into components directly determined by
individual functional areas and integrating with the specific technologies for
managing the corresponding functional areas
·
Create
an effective and efficient instrument and platform for cross-industrial
comparison and comparative valuation of business entities through the uniform
concept of “aggregate capital” that can be compared across different industries
(new concept of shareholders’ equity of the company)
The
remaining part of this article/brochure will be devoted to presentation of
exactly the required business management model/paradigm which (not
surprisingly) was labeled by its author the ‘Aggregate Capital Valuation Model’
(ACVM) or, more precisely, ‘Aggregate Capital Valuation & Management Model’
(ACVMM). Another name for the same concept can be ‘Comprehensive Capital
Valuation & Management Model’ (CCVMM) which means exactly the same thing.
The most
important idea and requirement of ACVMM is that the fair (intrinsic) financial
value of the company (of shareholders’ equity), as it was supposed initially by
authors of ‘classic’ corporate financial statements has to be seen clearly on the balance sheet of the company (which
required development of new concepts of shareholders’ equity and of the balance
sheet). Naturally, this financial value has to coincide with the intrinsic
value estimated using the DCF-based valuation model of the company.
The
intrinsic financial value of the company when placed on the balance sheet
according to the ACVMM methodology is labeled aggregate financial value (shareholders’ value) of the company as
it is created by aggregate capital
(or aggregate equity) of the company – another key concept of ACVMM.
Aggregate
capital includes not only ‘classic’ financial (tangible) capital defined and
calculated using GAAP or IAS accounting principles and standards, but also all
above-mentioned kinds of intangible capital, measured using ACVMM principles:
·
Client
Capital
·
Brand
Capital
·
Product
Capital
·
Stakeholder
(‘Relationship’) Capital
·
Human/Intellectual
Capital
·
Cultural
& Emotional Capital
·
Technological
Capital (‘Corporate Technologies’ or ‘Corporate Know-How’)
·
Knowledge
Capital (‘Corporate Knowledge’)
These kinds
of intangible capital (doe to reasons presented above) are assumed to be
mutually exclusive (to eliminate ‘double count’) and collectively exhausting
kinds of intangible capital and thus are both necessary and sufficient for
estimating the complete (aggregate) financial value of the company.
Naturally,
as in the ACVMM the balance sheet contains aggregate financial value and aggregate
capital, it is called an aggregate
balance sheet.
ACVMM uses
the following types of financial value for optimization of business management
system:
·
Book Value (value
of tangible capital) – ‘classic’ book value of shareholders’ equity calculated
using GAAP/IAS financial accounting principles & standards
·
Liquidation Value – difference between the current market value of tangible assets and
liabilities of the company; shows the amount of money that company shareholders
would received if the company is liquidated (assets are sold off and used to
pay off company liabilities)
·
Fair (‘Intrinsic’) Value – financial value of the company calculated using DCF methodology
originally developed by Graham & Dodd
·
Aggregate Capital Value – aggregate financial value of total corporate capital (tangible &
intangible) calculated using principles & standards of ACVMM methodology
·
Comparative Value – financial value of shareholders’ equity estimated by comparing the
company with public companies of a similar size and structure (using the system
of ‘adjustment coefficients’)
·
Current Market Value (Stock or M&A Transaction Price) – either the current price of
company stock multiplied by a number of shares (for public companies) of a
price of an M&A transaction (if the company is being purchased by a
strategic investor)
ACVMM
offers three categories of capital & assets; the difference between
categories being capital valuation methods:
·
Tangible Assets/Capital
(TA/TC) – ‘classic’ assets & capital defined in the traditional financial
management paradigm according to GAAP/IAS financial accounting principles &
standards
·
Quasi-Tangible
(Semi-Tangible) Assets/Capital (QTA/QTC) – assets that can be valued using
specially adjusted or developed DCF models and, therefore, can be viewed as
certain virtual ‘objects’ (hence the label ‘quasi-tangible’ or ‘semi-tangible’)
·
Intangible Assets/Capital (IA/IC) – assets that require special
valuation models and, therefore, can not be viewed as certain virtual ‘objects’
(hence the label ‘intangible’)
·
Financial
(Tangible) Capital – in this context, label ‘financial’ refers to all capital
placed on the ‘classic’ balance sheet regardless of whether it is represented
by financial or material (PPE, etc.) assets
·
Client
Capital
·
Brand
Capital
·
Product
Capital
·
Stakeholder Capital
·
Human/Intellectual
Capital
·
Cultural
& Emotional Capital
·
Technological
Capital (‘Corporate Technologies’ or ‘Corporate Know-How’)
·
Knowledge
Capital (‘Corporate Knowledge’)
‘Classic’
balance sheet, naturally, has to be ‘balanced’; in other words, the following
fundamental financial equation have to hold true:
Assets – Liabilities = Capital [1]
or
Assets = Liabilities + Capital (‘Shareholders’ Equity’) [1.1]
As ACVMM
includes (and expands) classic financial statements, the same basic financial
equation holds true in the ACVMM paradigm as well. The only difference is in
terminology (as ACVMM includes not only ‘classic’ – tangible – capital, but
also two categories of intangible capital – quasi-tangible and intangible
proper). Therefore, the ‘classic’ balance sheet equation on the aggregate
balance sheet in the ACVMM paradigm has the following form:
Tangible Assets – Financial Liabilities = Financial (‘Classic’) Capital
[2]
For
quasi-tangible assets and capital, a similar equation holds true:
Quasi-Tangible Assets = Quasi-Tangible Capital [3]
[3] is
acceptable in most cases as typically financial liabilities can not be
attributed directly to quasi-tangible assets; however, if some corporate
financial liabilities can be allocated directly to certain categories of
quasi-tangible assets, the following equation will be true for QTC:
Quasi-Tangible Assets - Quasi-Tangible Liabilities = Quasi-Tangible
Capital [4]
For
intangible assets and capital, a similar equation holds true:
Intangible Assets = Intangible Capital [3]
[3] is
acceptable in most cases as typically financial liabilities can not be
attributed directly to intangible assets; however, if some corporate financial
liabilities can be allocated directly to certain categories of intangible
assets, the following equation will be true for intangible capital:
Intangible Assets - Intangible Liabilities = Intangible Capital [4]
ACVMM
allows to streamline business management sequence (business management process)
compared to alternative business management methodologies. In ACVMM, the first
step (objective) in business management is maximization of aggregate capital
(tangible + quasi-tangible + intangible) which allows to maximize its aggregate
value (financial + functional + emotional) which, in turn, maximizes its
intrinsic value which allows to maximize the stock price of the company and,
therefore, the wealth of its owners:
Max aggregate
capital => Max aggregate value => Max intrinsic value => Max stock
price [5]
1. Evaluate
current financial (‘tangible’) capital using balance sheet structure and
contents developed within GAAP/IAS standards, procedures & guidelines
2. Develop
(using basic templates supplied with the ACVM package) models for valuing
quasi-tangible assets/capital (using DCF approach):
·
Client/Partner Capital
·
Brand Capital
·
Product Capital
·
Stakeholder (‘Relationship’) Capital
3.
Evaluate
quasi-tangible assets/capital (using models developed at step 2):
·
Client/Partner Capital
·
Brand Capital
·
Product Capital
·
Stakeholder (‘Relationship’) Capital
4. Develop
(using basic templates supplied with the ACVM package) models for valuing
intangible assets/capital:
·
Human/Intellectual Capital
·
Cultural/Emotional Capital
·
Technological Capital
·
Knowledge Capital
5. Evaluate
intangible assets/capital (using models developed at step 4):
·
Human/Intellectual Capital
·
Cultural/Emotional Capital
·
Technological Capital
·
Knowledge Capital
6.
Sum
all assets/capital values obtained at stages 1, 3 and 5 to arrive at a fair
(‘intrinsic’) value of the company (shareholders’ equity)
7.
Estimate
a fair value of the company using ‘classic’ DCF approach and generally accepted
business valuation principles (GABVP)
8.
Reconcile
company valuations obtained using ACVM & classic valuation
approaches/models
9.
Estimate
current market/deal conditions
10.
Estimate
fair market/transaction value of the company (shareholders’ equity)
+ Tangible (“Traditional”, “Material”) Assets
- Financial Liabilities
= Financial Capital (book value of shareholders’ equity)[7]
+ Quasi-Tangible Assets/Capital:
Client assets/capital
Brand capital
Product Capital
Stakeholders’ capital
+ Intangible Assets/Capital:
Human/Intellectual
assets/capital
Cultural/Emotional
capital
Technological Capital
Stakeholders’ capital
+ Synergy Effect[8]
= Fair (‘intrinsic’) Value of Shareholders’ Equity
+ Influence of Specific Market/Deal Conditions[9]
= Stock/Transaction Price (market/transaction value of shareholders’ equity)
[6]
Company
value = sum of all NPVs associated with individual capital components + BV[10]
of tangible capital.
·
Estimate
revenues generated by intangible capital/assets (IRRCLR model – Increase
Revenue, Reduce Costs, Lower Risks or all of the above)
·
Estimate
additional costs incurred by intangible capital/assets
·
Estimate
additional working capital & other investments required by intangible
capital/assets
·
Estimate
additional free cash flows generated by intangible capital/assets
(revenues – costs –
additional investments)
·
Estimate
discount rate associated with intangible capital/assets
·
Estimate
discounted cash flows (DCF) generated by intangible capital/assets (free cash
flows discounted at the rate estimated above)
·
Sum
of the DCF gives the Net
Present Value (NPV) of intangible capital/assets
·
Sum of all NPV generated by individual
components of intangible capital gives the total value of intangible capital
Pretty much
self-explanatory and sometimes used in intangible capital valuation. The only
fundamental problem with this approach is that it focuses on costs incurred in building a certain
infrastructure of an intangible capital while common economic sense suggests
that one should focus on value (revenues/savings – costs – additional working
capital – additional fixed assets). However, this valuation method can still be
used as an addition to more realistic methods and tools.
This
approach is based on estimating the ability of a corresponding category of
intangible capital to increase the value of ‘tangible’ (financial)
quasi-tangible and intangible capital
Two
fundamental mechanisms for increasing TC & QTC through ‘support’ of IC:
·
Adding new capital (clients, brands, products, shareholders, etc.), i.e. ‘new’ DCF
generated by ‘new’ assets/capital
·
Increasing the efficiency of the existing capital (clients, brands, products,
shareholders), i.e. increasing DCF generated by existing assets/capital
QTC &
IC are structured as investment projects or business processes
(continuous projects); the former assuming finite and the latter – infinite
life cycles and evaluated using two basic financial measurements (parameters) –
Net Present Value (NPV) & Internal Rate of Return (IRR).
Therefore,
two sets of tools are used in building valuation models for intangible capital:
project management tools (both operational and financial) embodied in
specialized project management software such as Microsoft Project of business
processes modeling tools linked to various methodologies such as SADT, IDEF,
SA/SD, ARIS, etc. and contained in corresponding software tools (such as BPWin,
ARIS Toolset, etc.)
As any true
valuation model is based on the future
values of financial and non-financial quantitative and qualitative parameters,
ACVMM is essentially a long-term financial
plan for the company developed on a 10-year (for most developed nations) or
5-year (for other countries) bases.
However, in
order for this financial plan to manifest itself in tangible financial results,
it has to be stated not only in general terms (as it is done in ACVMM and in a
‘classic’ DCF-based valuation model), but also translated in specific
measurable objectives at all levels of the corporate hierarchy – up to the
level of rank-and-file employees.
And here
the combination of ACVMM that breaks the total (aggregate) value of the company
into functional components (categories of intangible capital) comes very handy
as it allows (for the first time in the history of BMT) to tie up operational
(non-financial) planning & control technologies (such as BSC or KPI) to
financial value of the company, maximization of which is the most fundamental
objectives of business management. In addition, ACVMM is an ideal instrument
for both vertical and horizontal balancing of the BSC/KPI system, thus solving
the previously insurmountable problem that plagued effective and efficient
implementation of such systems.
As the
ultimate objective of business engineering[11]
is building the business structure that maximizes the financial value of the
company (and, therefore, maximizes aggregate capital), development of ACVMM
model can be viewed as the first step in business engineering process (or as
business pre-engineering phase of the
BE process).
ACVM => Business Engineering => BSC/KPI Implementation =>
Feedback & Control => Adjustment/Correction
Aggregate
capital valuation & management model consists of the following basic
components:
·
‘Classic’ financial statements (P&L + statement of retained earnings,
statement of cash flows, balance sheet expanded by adding intangible capital
and thus transformed into an aggregate
balance sheet)
·
Additional tables containing historical information and forecasts of parameters (accounts) of classic
financial statements (with the exception of intangible capital)
·
Quasi-tangible and intangible capital valuation tables (core and supporting tables)
according to ACVMM and other methodologies (cost capitalization, etc.)
·
“Classic” (DCF-based) company valuation model (tables for computing NOPLAT, ROIC,
WACC, economic profit[12]
and company value)
·
Other company valuation models (liquidation, comparison, etc.)
ACVMM
package includes the following standard and specialized components (modules):
·
General
(‘Transnational’) Components/Modules – the Core of ACVMM
·
Industry-Specific
Components/Modules
·
Country-Specific
Components/Modules
·
Company-Specific
Components/Modules
Naturally,
in order to become an efficient and valuable tool for investors and corporate
managers, ACVMM has to be implemented as a software tool (software package).
Initially, ACVMM components can be easily implemented using Microsoft Office
platform – Microsoft Excel as the primary tool with an addition of certain
files in Microsoft Project and Microsoft Visio format.
However, in
order to become a truly indispensable business management tool, ACVMM has to be
implemented as a stand-alone, ‘off-the-shelf’, ‘shrink-wrapped’ software
package developed using one or more of software development tool.
Such a tool
(tentatively called ACVMM Portal) has
to include the following functional components:
·
Business Investigation Questionnaire (BIQ) – for collection and structuring of
information necessary for development of ACVMM (formation of aggregate capital
knowledge base - ACKB)
·
Full set of ACVMM templates (see above)
·
Operational Planning Toolbox – an instrument for developing operational
plans (activities and their parameters) for various business components
(business units, departments, other functional units, teams, workgroups,
individual employees, etc.)
·
BSC/KPI system development tools
·
ACVMM Methodology Guide (self-explanatory)
·
ACVMM System Guide (an extended online help system)
·
ACVMM Presentation (an introduction and online tutorial)
ACVMM can
be best used for improving the efficiency and effectiveness of business
management system if used in the following sequence of steps:
·
Formation of Aggregate Capital Knowledge Base (ACKB) – Information Gathering
·
Analysis/Audit
(“as is”) of the existing business management system from the standpoint of
aggregate capital of the company
·
Design (“to
be”) of business management system with an objective to maximize the aggregate
capital of the company and thus financial value and market price of
shareholders’ equity
·
Planning
(“transition plan”) from ‘as is’ (existing system) to ‘to be’ (optimal system)
·
Feedback, control and adjustment/correction of financial & operational plan
The three
most important sources for building a comprehensive business valuation model
are (1) corporate documents (external and internal); (2) corporate personnel
(owners, managers and employees) and (3) corporate stakeholders[13].
Required information is gathered using ACVM questionnaire (BIQ) and ACVM forms
by means of interviewing corporate personnel and stakeholders and by analyzing
corporate documents (extracting required information from corporate documents
in various formats).
Financial
parameters are then transferred directly to ACVMM tables; quantitative
non-financial parameters are either transformed into financial or linked to the
latter; while qualitative parameters are first quantified (transformed into
quantitative) and than processed as other (original) non-financial quantitative
parameters.
[1] In other words, in the
‘traditional’, finance-centered business management paradigm financial and
other tangible assets are the main (and practically the only) drivers of the financial value of the
company
[2] Companies which stocks are
publicly traded on a major stock exchange
[3] Nations with the high level
of gross domestic product (GDP) per capita
[4] Non-government organization,
typically also non-commercial (belonging to the so-called ‘third sector’ of the
economy)
[5] Individuals and organizations
that have certain interests in the company activities – financial, functional
or emotional - clients/customers, consumers, suppliers, employees, partners
(e.g. participants in the distribution channel), creditors, stock market
participants, mass-media, government entities at the federal, provincial
(state, regional), municipal and local levels (domestically and
internationally), non-government organizations, etc.
[6] Net Operating Profit Less
Adjusted Taxes – one of the key indicators of operational profitability of the
company
[7] Calculated using GAAP/IAS
principles and standards
[8] Between components of
aggregate capital/assets/equity
[9] Can be either negative or
positive, depending on a specific situation
[10] Book value
[11] See the article on this
subject from the same author
[12] Difference between ROIC and
WACC multiplied by invested capital. ACVMM has similar paramenters but they
take into account aggregate capital, rather than strictly tangible capital in
classic valuation model
[13] A list of most important
corporate stakeholders can be found in the section on stakeholders relationships
management and stakeholder capital