The Key to Creating Shareholder Value Knowledge Begins with Simple "Cigar Box" Accounting

(TMA International Headquarters)

Building profitable businesses creates value. The board of directors and management’s primary responsibility is to increase company value and shareholder wealth. Shareholders invest in businesses seeking a significant return on their investment. They expect the reward to be appropriate for the business and financial risks of an unsure future.

What is value and how do you create it? A company is worth the present value of its expected future free cash flow. Free cash flow is the net operating earnings after taxes less any net new capital investments required for growth. Don’t let the accounting statements confuse you. You don’t need an MBA or a CPA to understand value. It’s simple "cigar box" accounting. You put all the sales receipts into the cigar box and you payout all expenses (income statement) and asset purchased (balance sheet). What remains is the free cash flow of the business.

The economic value of the company is determined by calculating each year’s free cash flow prospects over the planning horizon; capitalizing the final year free cash flow for a terminal value; and discounting the free cash flow stream back to the present using an appropriate discount rate that reflects the business and financial risk at hand. When the present value increases each year, you are creating value.

Making Something Happen

While corporate renewal professionals don’t create new businesses, we add value by rebuilding financially distressed and enhancing operationally under performing businesses. How do we add value? An astute investor once remarked "value is added when you see something others don’t or make something happen that others won’t." This statement succinctly summarizes the knowledge, experience and strength of the turnaround professional. It’s his or her skills at ferreting and recognizing something that others have missed coupled with outstanding leadership qualities to make things happen.

When boards of directors and investors are faced with a troubled, financially distressed company they should first ask—is the business worth saving? Should they kill it, sell it or fix it? Recognizing that often, even selling a company demands some degree of immediate fix to "stop the bleed" and ensure there is, in fact, something of value to sell.

How marginal are the company’s performance prospects? Would the shareholders be better off investing the company’s working capital in treasury bills? Does the company have:

• A defensible market position and customer base, . Critical mass of revenue and prospective cash flows,
• Reasonable product cost and capacity,
• A strong existing or identified management team, and,
• The support and patience of the companies various stakeholders.

Unless the answer to all of these requirements is comfortably "yes," the probability of accomplishing a successful turnaround is unlikely and little, if any, new value will be realized.

From the investor’s standpoint, an important consideration of investing includes looking at the company’s exit strategies. Determining when and if it is best to sell ultimately depends on the climate and rates of return desired by the current shareholders and lenders. Are they tired and want out or willing to hang in for the longer term if the plan and people are right? The most often asked question is "can we hold on without additional capital infusions?" When additional capital is required, consider if it will substantially enhance the company’s future value and facilitate a later private sale, recapitalization or IPO. The projected yield for any new money should be, at least, five times the risk-free interest rate on treasuries.

Examining Quick Fixes

Much of the emphasis in turnaround articles is focused on effective crisis management—the brinkmanship recovery from the edge of bankruptcy or liquidation. Crisis management results when financial distress places the company in imminent danger of failure. These are essential skills, often compared to a doctor’s efforts in the emergency room.

Initial turnaround efforts are of necessity focused upon regaining cost control, managing cash flows and repayment of delinquent liabilities. The future value of the business is evaluated and when prospects merit, resold to existing and prospective stakeholders.

The foremost goals of crisis management are to improve cash flows, maximize the turnover of assets and preserve current shareholder value. This involves some very basic steps, such as reducing inventories, collecting accounts receivables and when possible selling non-essential assets

This is a period of maximum stress that tests the strength and character of the turnaround professional and the entire company management team. It’s a time for outstanding leadership, experience and communications skills.

Occasionally, boards of directors, executive management and crisis management specialists view the recovery as complete. But is this realistic? They have doctored the symptoms and not fixed the underlying causes. Have they addressed creating value?

With the immediate financial crisis stabilized, it’s the board of directors’ and management’s job, often with a renewal professional’s assistance, to increase shareholder value the old fashioned way — by maximizing operating earnings, reducing excessive debt and filling the cigar box.

Creating value is a three-legged stool. To stand it requires:

1. A strategic plan focused on return on capital
2. A revitalized management team with modified corporate behavior, and
3. Value based products for its customers.

Increase Return on Capital

The strategic plan for the company should detail the specific actions and goals to be accomplished that will increase the value of the company. The most effective measure of periodic performance for a company is its rate of return on total capital. Rate of return measures how productively capital is employed. Companies capable of earning rates of return greater than their cost of capital create value, while those earning less than their cost of capital destroy value.

Net operating profit after tax

Rate of Return = Net operating profit after tax
Total capital

Capital is simply the total amount of cash that has been invested in the company over time. It is all the debt and equity of the company. Earnings are the net operating profits after tax. That is, sales less operating costs less tax payable in cash. Cost of capital is the minimum rate of return sought by investors to compensate them for the risks of investing in the company. It is the company’s "hurdle rate" for creating value. It is the weighted average cost of the target percentage of after tax debt and equity; where the cost of equity is the prevailing risk-free rate plus premiums for both business and financial risk.

Modify Corporate Behavior

Often senior management is fascinated and rewarded for sales growth, total gross earnings, and increased earnings per share; while too little attention is being paid to invested capital, cash flow and borrowing levels. Further, senior management may be ill-prepared and inexperienced dealing with financial and business adversity. To ensure company success, measure and reward management consistent with the overall policy of the board of directors and its shareholders desire for value enhancement.

When possible, make senior management feel as meaningful owners, either directly or indirectly, in the business. Equity incentive options help to extend senior managers longer term view of the business. And there’s no better way to control capital expenditures than when management understands part of each dollar spent is coming out of their pocket. In select situations ESOP ownership may be a useful employee incentive and financing alternative.

In addition, consider annual bonus awards for senior management based on pre-established, cumulative improvement goals for the company. Blend improvements of operating profit, debt reduction and return on capital to provide bonus opportunities of another 40 percent to 60 percent on base salary.

Deliver Customer Value

Wrap your products in value. Customers buy your products to solve their basic wants. They alone establish the worth of your products. They are willing to buy when value exceeds the price of your product. Customers buy the benefits your products provide not its features and functions. The more you can exceed their benefit expectations the greater the product’s value. Value is both real and perceived. Value is not only the physical product, it is also on-time delivery, service, and reliability. Reliability increases satisfaction and reduces overall cost. Satisfied customers are repeat buyers, recommenders, reference providers, and often unpaid salesmen. They also pay their bills on time.

Providing value to your customers directly increases the value of the company. When your product provides real and perceived value customers willingly buy your product generating greater sales, operating profits and free cash flow. Sales put cash in the cigar box, which improves free cash flow and results in a higher discounted present value. Improved market position, higher sales growth, greater product acceptance, and increased people productivity further reinforces the reliability of future earnings and free cash flow projections, generating greater net present value and increased stockholder value.