The Quintessence of Strategic Management by Philip Kotler Roland Berger & Nils Bickhoff

Author:Philip Kotler, Roland Berger & Nils Bickhoff
Language: eng
Format: epub
Publisher: Springer Berlin Heidelberg, Berlin, Heidelberg

The shareholder value approach is similar to a net present value calculation and consists of three main components: first, the total of all future free cashflows (FCF) over a period starting from the present, discounted at the weighted average cost of capital. In practice, most forecast periods are no longer than 5 years in duration, beyond which the forecast uncertainty is too great. This is because the free cashflow is calculated on the basis of future balance sheets and profit and loss statements (P&Ls), and all items need to be furnished with detailed assumptions on the development of the business.3 This process is also frequently known as business planning, and it integrates both the SWOT analysis and all of the perspectives from the business strategy, since it is concerned with forecasting operating and strategy-induced business figures as precisely as possible. However, because companies are in business for longer than 5 years, the going concern value is calculated for the period beyond that. This is technically a perpetuity value: either the last free cashflow or the average of all free cashflows is divided by the weighted average cost of capital and then discounted. The sum of the accumulated and discounted free cashflows and the discounted going concern value equals the enterprise value. Interest-bearing debt is then deducted to finally arrive at the shareholder value.

It is essential for the free cashflow forecast to be very good, since that is what drives both of the value components.4 In practice, the going concern value normally makes up more than 70 % of the enterprise value.5 If the enterprise size then increases as a result of profitable investment activity, these investments lead to a positive earnings contribution, which generates sustainable growth in free cashflows and, thus, shareholder value.

This sustainable rise in shareholder value can be achieved through investment-based growth only; therefore, shareholders will not be satisfied with companies that do not show sustaining growth. Divesting parts of a company generates only one-time liquidity effects. While this does have a positive impact on cashflow, it has no impact whatsoever the following year, so it barely carries any weight in the formula. Nor does a constant enterprise size normally bring any growth in shareholder value—companies need to improve their return spread to improve shareholder value. The return spread is the positive difference between the return on equity and the cost of equity. The cost of equity is calculated based on a safe investment (such as government bonds) plus a company risk premium, which is specific to the particular company and the industry in which it operates. Both of these together mean that the cost of equity is usually 15 % or more. To create any real value, companies must earn this cost plus an additional return.

Figure 4.3 illustrates this link and also points out that an accounting profit can destroy value, representing an economic loss for shareholders. This knowledge is something of a revolution for the subject of companies’ strategic planning as mentioned above: it is not

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