Is your business engineered to create wealth? Part 4: Planning

Most CEOs would prefer to create more wealth for shareholders than less.

But most companies are not ‘engineered’ to create wealth – internal processes often act to hinder wealth creation, rather than encourage it.

In this article we argue the planning process needs to be more than just a governance tool, it needs to produce an ambitious, clear strategy to deliver a step change in the value of the company.

Every large organisation needs a plan to coordinate the activities of its people, whose job is often just a cog in a much larger machine. And in any company, the objective of that plan should be to grow wealth. That is after all, the job of business in our society.

But plans and budgets in most companies are also used as governance tools, to hold managers responsible for performance. Not surprisingly, managers respond to this by putting forward highly conservative plans. This practice is so common it has a name, ‘sandbagging’.

The outcome of all this for shareholders is a high degree of accountability for a plan that often produces little gain in wealth.

But with care, this barrier to wealth creation can be turned into a powerful platform for the creation of it.

We’ll discuss the problem of sandbagging and how to remove it in the fifth article in this series, but let’s first look at how planning would be conducted if it was all about wealth creation.

If the job of business in our society is to create wealth, then the planning process should address the two key drivers of wealth and clearly address the questions:

  1. How is the business is going to achieve and sustain high returns on capital (quality); and
  2. How will the business find ways to put large amounts of capital to work at those rates (quantity)?

CEOs should not be responsible for changes in the value of their company in the short
term, but they should be responsible for changes in value over a three to five year time
horizon. And it is that horizon that the planning process should consider with questions
like, ‘How will high returns be achieved or sustained over the next three to five years?’
and, ‘How much capital can we put to work at those rates over that period?’

With that overarching goal, it helps then to break the planning process down by thinking
about each business unit in terms of fix, grow or sell.

Fix
Businesses with negative Economic Profit Spreads, that is over the past five years or over the forecast period suffer returns (ROCE) less than the cost of capital, need to be fixed. As we saw in part one of this series, for established businesses, negative EP Spreads are highly correlated with wealth destruction. If returns remain low, investing more capital in these businesses will only destroy more wealth.

The challenge for the managers of these business units is to develop credible plans to improve returns. For many, competitive forces are to blame for low returns. Where products or services are largely commoditised, profits and ROCE are driven down. Only those with a sustained cost advantage will be able to sustain high returns in a commoditised market.

In this instance, plans must either be about how to achieve a sustainable cost advantage
or how to differentiate the offering and achieve some pricing power.

Grow
Once a business has achieved high returns on capital (a positive EP Spread), it’s time to accelerate wealth creation by growing the business and finding ways to invest, without reducing returns below the cost of capital.

The challenge for the managers of these business units is to develop credible plans that show how high returns can be sustained. It is the nature of our competitive capitalist society that businesses that enjoy high returns attract competition. This is evident in the research summarised in part one of this series. Many low return businesses enjoyed at some stage in their history high levels of ROCE.

But competition brings with it lower prices and more benefits for customers, which usually come at the expense of margins and returns. As if that wasn’t enough, if the business is dependent on a key supplier (such as a landlord, or unique component supplier), they may be able to increase input costs to capture the wealth-creating high returns for themselves.

These businesses need to demonstrate a thorough understanding of the ‘moat’ around their business that will prevent competitors, suppliers and even governments from taking their high returns and in their plans, show how they will deepen and widen that moat, while all the time investing behind it.

Sell
We have discussed how high return businesses attract competition, usually driving down returns. Where industry returns are persistently low, the reverse process is often observed: low returns lead to a thinning out of competitors, allowing returns to rise for the remaining players.

If a business is not in a position to lead the rationalisation of the industry by buying out competitors, it can often create wealth by selling into it. These businesses usually trade at a discount to the amount of capital invested in them (ie their book value), reflecting investors’ belief that capital will continue to be invested at low rates of return.

In selling out, vendors can often achieve at least book value for their businesses, thereby creating wealth (taking a negative back up to zero).

Of course it is not just low return businesses that can be sold at a profit; a company that is engineered for wealth creation will also maintain internal valuations for each of its business units and be ready to sell at the right price.

Is your business engineered to create wealth? Part 3: Capital allocation

Most CEOs would prefer to create more wealth for shareholders than less.

But most companies are not ‘engineered’ to create wealth – internal processes often act to hinder wealth creation, rather than encourage it.

In this article we look at how capital allocation processes can fail shareholders and some simple steps that can be taken to drive greater accountability into investment decisions.

The big capital spends, be they investments in new markets, new products or acquisitions, often represent the signature, transforming achievements of a CEO. And for shareholders, they often have a transforming impact on wealth.

So when faced with these opportunities, CEOs need clear, reliable tools to assess investment opportunities. Unfortunately, the tools that they are most likely to use are anything but.

If wealth creation is the goal of the business, then for any investment evaluation tool to be of use it must address the quality and quantity issues we saw in part one of this series as the key determinants of wealth creation.

This rules out using EBITDA and EPS growth, which both fail to capture the funds invested in a business and say nothing of the quality of the business. Sophisticated investors know this and mark down businesses that trumpet EPS accretion, if the investment fails to deliver reasonable returns on capital invested.

Other, more sophisticated tools, like Internal Rate of Return (IRR) and Discounted Cash Flow (DCF) address the draw backs of EBITDA and EPS by forecasting all the capital required for an investment and all the cash that will be generated by it and boiling them down to a single number; a percentage in the case of Internal Rate of Return (IRR) which can then be compared with the company’s hurdle rate, and a dollar figure in the case of Discounted Cash Flow (DCF), showing how much wealth will be created from the investment.

But while IRR and DCF can be used to accurately calculate the wealth impact of an investment decision, they are only ever as useful as the forecasts used and this is where IRR and DCF analysis fall down.

The best users of DCF look to key drivers, such as margins, volumes and inventory turns to assess the reasonableness of forecasts. If the acquisition requires industry best results across all key drivers to create wealth it’s time to negotiate a better price, or walk away.

But one key reasonableness test every CEO should ask is, ‘What is the forecast ROCE of this investment, in each year of the forecast period?’ If ROCE forecasts are beyond reasonable upper limits then warning bells should sound.

As the chart below shows, drawing on our research into returns achieved by Australia’s largest companies and summarised in the table in part one of this series, only the top 25% of companies are able to sustain returns 5% or more in excess of the cost of capital over any given five year period. This analysis probably understates how rare high returns on capital are in the broader economy, given businesses that have failed or who are yet to be consistently profitable are excluded from our research.

Figure 1: Returns significantly above the cost of capital are rare

Returns above the cost of capital are rare

 

In my experience, when DCF analysis is recut to include ROCE and Economic Profit data on an annual basis it often forecasts ROCE starting low and gradually growing larger and larger, past the 75th percentile and eventually into the top decile of what companies have historically been able to achieve.

Few companies are able to generate let alone sustain these returns, due to the competitive forces they face. If one player in a market is able to invest and generate such attractive returns, others will follow and unless the investment is made behind, as Buffett would call it, a deep ‘moat’ of a hard to copy competitive advantage, returns will begin to fall, not rise, as time goes on.

Given 75% of companies fail to make returns more than 5% above the cost of capital, the default assumption for DCF analysis should be that returns will revert to the cost of capital over time, in the absence of a very clear and proven set of competitive advantages that will keep competitors, suppliers and even governments at bay.

Equipped with the forecast annual EP Spread of the investment and a thorough knowledge of the competitive forces of the industry in which the business operates, a CEO is in a much stronger position to make career defining capital investment decisions.

The second and important step in this phase is to close the accountability loop for investment decisions. And that comes back to the performance measure chosen by the CEO. EBITDA and similar measures ignore the capital invested in a business and send a signal to all managers that capital is free.

Economic Profit by contrast, constantly reminds managers of the funds invested in their business and the need to generate sufficient returns. By holding managers accountable for sustained gains in EP, the rigour of investment proposals increases: managers know while putting together their forecasts that unless the investment generates and sustains high returns, the Economic Profitability of their business will fall.

As one client put it, ‘EP is like DCF with a memory’.

Is your business engineered to create wealth?

Most CEOs would prefer to create more wealth for shareholders than less. After all, in our society, we create different institutions for different needs: governments to create and enforce laws, charities for good causes and businesses as places to store and grow our wealth.
The job of business is to create wealth.

But most companies also face barriers to that goal. Even if you are able to create a great product or service that will improve the lives of customers, competitors will do all in their power to steal those customers, suppliers will squeeze higher prices for their inputs if they can and even governments will sometimes impose special taxes on businesses deemed to be too profitable.

To take on these challenges, every CEO must ask themselves, ‘Is my business engineered
to created wealth?’

In the five articles that follow, we’ll examine the most common internal barriers that businesses
face in trying to create wealth and how CEOs can remove them and in the process,
engineer their business to create wealth.

Figure 1: Barriers to wealth creation

barrier_large

In the first article, we’ll look at research into why some businesses create wealth, while others destroy it.

The second article looks at the impact internal measures of performance can have on decision making and wealth creation.

The third article addresses capital allocation and what can be done to close the accountability loop for investment decisions.

The fourth article looks at budgeting and planning, calling for a greater focus on how the business will create wealth and less on governance and accountability.

Finally, the fifth article addresses incentive structures, outlining some of the most damaging aspects of the more popular plans before outlining a different approach that is engineered for wealth creation.