Saturday, June 6, 2020

The Value Tree, Part 1: A Corporate Strategy Framework Inspired by a Popular Valuation Technique

Let’s talk about shareholder value.

More specifically, a simple and practical strategic framework (The Value Tree) adapted from a popular enterprise valuation heuristic, which can be used to identify, coordinate and prioritize initiatives and investments that create shareholder value.

This article is Part 1 of a two-part series. Here, I introduce the Value Tree framework. And in Part 2, I delve into its elements to showcase its application. This series is not about valuation methodologies. Rather, it’s about adapting the simple valuation formula into a strategic framework that isolates the principal drivers of shareholder value, and using it to organize, prioritize and even quantify different strategic initiatives based on their potential to deliver measurable shareholder value growth. It’s a handy, and universally applicable, tool for strategy professionals to tie together the numerous, and often disconnected, corporate initiatives into a cohesive and coordinated portfolio. And tie everything back to (what should be) the number-one goal of every corporate executive: creating shareholder value.

As I suggested in my recent article on the value of the strategy function, and the capabilities needed to realize it, the main purpose of the Chief Strategy Officer (CSO) and the strategy group is to provide the rest of the organization a compelling and consistent north star. And to realize that purpose, they must deliver:
  1. Clarity of values, vision, mission, objectives, and near-term execution plan; and
  2. Coordination of narratives, agendas, initiatives, KPIs, processes and execution activities

The challenge most companies (and their CSOs) face is that corporate initiatives are often born reactively in different corners of the organization, without necessarily being unified by a common vision, narrative or overarching plan. An M&A deal led by one business unit, a new product development led by another unit, a PR campaign led by marketing, a cost optimization effort led by finance may all be happening at the same time and appear to be of equal strategic importance. How does the CSO tie them together in a cohesive story? And how does the leadership team determine if they are indeed of equal importance?

In addition, as strategy is seen as less ‘formulaic’ or structured of a discipline than, say, finance, HR or even sales, a newly hired CSO often starts from scratch, without a universal playbook or a set of standard tools and processes. After all, shouldn’t the strategy be unique to the company, the industry, the moment in time, the leadership team? And therefore, should be a tabula rasa and developed de novo each time, without a preestablished formula, method or process? The answer to the first question is, of course, ‘yes.’ But I believe the answer to the second question is ‘definitely no.’

There’s one thing that is fundamentally and universally true of all companies and their leadership teams, in any industry circumstance and any moment in time. A sort of a ‘first principle’ of corporate strategy. And that is that everything corporate teams do should be creating incremental shareholder value – that is, making their company more valuable in the eyes of investors. Conversely, creating shareholder value should dictate everything they do.

Regardless of the project or initiative, and who sponsored it, how complex it is, whether it aims to deliver ‘hard’ numbers or ‘soft’ qualitative results – if it can deliver meaningful shareholder value, then it should be prioritized. If it cannot, then why are scare corporate resources expended on it? Even initiatives that help a company advance its strategic story in qualitative ways can, and should, be held to the same standard.

Anyone who has worked in investment banking or private equity, or has ever bought or sold a business, which includes trading shares on the public stock markets, is (or should be) well familiar with valuation multiples – one of the more simplistic, yet disarmingly useful, techniques for determining what a company is worth. The simple formula of “Enterprise Value = EBITDA x Multiple” is a nifty black box that combines various factors – both quantitative and qualitative, objective and subjective, measurable and mysterious – to provide a quick answer that otherwise financial analysts derive from massive and complex financial models.

The Value Tree framework I propose (see Figure 1) makes use of the popular valuation formula: Value = EBITDA x Multiple to create a universal recipe for identifying, prioritizing and connecting corporate initiatives into a cohesive strategic story.

Figure 1. The Value Tree - a Strategic Framework for Managing the Corporate Initiatives Portfolio

The multiples-based valuation method simply postulates that a company’s worth is equal to the operating profit it generates times a subjective factor of how attractive investors believe these operating cash flows to be (compared to, say, another company that generates the same cash flows). One (EBITDA) is based on objective, measurable reality; the other (multiple) on subjective, ambiguous perception.

The power of this methodology is in its simplicity and its universality. It reflects how things generally work in life and nature. A blend of seemingly clashing, yet mutually reinforcing, dichotomies – science vs. art, rationality vs. emotions, right brain vs. left brain, evidence vs. judgment, facts vs. beliefs... The answer inevitably is: it’s a combination of these diametrical factors.

This framework, especially below its second tier, is not completely set in stone – it can be customized and adapted to be even more relevant to a particular business. The top two tiers will always be the same, based on the ‘Value = EBITDA x Multiple’ formula. But how CSOs choose to decompose EBITDA or isolate what drives the multiple is somewhat open to creative interpretations and analytical adaptations. My version here is what I believe is the most universal, easily understood, and broadly applicable adaptation of the framework. It is also my best attempt are making it a mutually exclusive and collectively exhaustive (MECE) construct – as all good strategic frameworks should be.

In Part 2 of this series, I'll dive into the Value Tree framework one tier at a time, and demonstrate how it can be applied by strategy executives to organize all corporate initiatives into a cohesive portfolio and assign them priority based on their potential to generate measurable shareholder value. 

1 comment:

  1. This is a smart blog. I mean it. You have an excellent knowledge about this topic. Thanks for sharing such a great blogs to us. Heavy Machinery Valuation


Current Feature

The Value Tree, Part 2: Using Shareholder Value to Unite and Prioritize the Corporate Portfolio of Strategic Initiatives

Let’s talk some more about shareholder value. More specifically, applying The Value Tree strategic framework, which I adapted from ...

Most Popular