I spend a lot of time talking about where the value lies in businesses. One reason is the influence of the first half of my career in high risk corporate lending. It leads me to tie what I see back to financial value. The other reason is the shifts that have occurred during my career in our overall economy. As we laid out in Intangible Capital, the shift to a knowledge-based economy has dramatically changed the sources of value in business. And it has increased the awareness of the external costs of corporate actions.
These shifts are easy to illustrate by comparing and contrasting the concepts of value creation and valuation.
Valuation is a well-known concept. There is actually a whole industry with several certifying bodies built around providing financial valuations of individual assets, portfolios of assets and entire businesses. The discipline uses a number of different approaches (market value, cost or intrinsic value) and scenarios (like whether it’s for tax purposes, a liquidation scenario, or evaluation of an asset like production equipment in place). It’s a sophisticated process. But one that can produce large differences of analysis as I outlined a couple years ago in Valuation Failures.
The purpose of valuation is to put a monetary value on something. So it’s no surprise that the process of producing a valuation is largely based on a financial analysis of that something. Seems simple enough. But it’s not simple and it becomes less so all the time. Because the drivers of the financial results are shifting.
That’s where the concept of value creation comes in. Value creation is often called the purpose of a business. A company is formed to solve a problem. To solve that problem, it accesses resources. It must provide value (monetary or nonmonetary) in exchange for those resources. It will be able to create some value that it retains in the form of money or assets. But many other resources will always be attracted based on mutual value creation. This is pretty abstract but it’s deadly practical when you’re trying to understand what’s driving the valuation.
If we look at the example of the pot being thrown in the photo above, it’s easy to illustrate the financial elements. The resources used include labor, the pottery wheel, electricity to turn the wheel and the clay that is the raw material of the pot. We can’t see but can infer that there is a kiln where the pot is fired. If this were a business, additional resources would be needed to market and sell the pot and generate revenue. Each of these resources has a cost to them. A valuation would weigh the costs against the revenues. The monetary value creation process seems straightforward up to this point.
However, the analysis of these numbers will not depend on what the business does right now but on its productive capacity going forward. This is because, unless it’s a liquidation, the buyer would want to use the assets and/or company for the same purpose going forward. The higher the expectation that the business can continue to do what it does successfully, the higher the value.
This is where value creation becomes a subjective matter. The expectations and judgment of the valuator or buyer come into play. Their judgment is going to be influenced not just by the numbers but by many other factors. Here are some of those factors using the integrated model:
- The financial resources of the company (financial capital)
- The equipment and facilities (manufactured capital)
- The potter’s capabilities, creativity and motivations (human capital)
- The designs of the pots (intellectual capital)
- The clay quality and availability (relationship capital with the suppliers)
- The demand for this kind of pot (relationship capital with customers)
- The safety of glazes, fumes from the firing process and the sustainability of the sourcing of the clay (natural capital)
The outlook and sustainability of each of these capitals will influence how the overall company is valued. The mechanics of a valuator’s job involve creating projections of future cash flows and discounting them back based on a risk-adjusted rate. Both the projection process and the setting of the discount rate require judgment by the valuator. So the better you control the conversation about the value creation, the more accurate the valuation.
How does your company create value? Smarter-Companies provides an open worksheet to help you answer that question. You can use it to identify and measure the key elements of your value creation system. If you want to control the conversation about the valuation of your company, you’ll want to dominate this information set. Download the Value Creation Worksheet to get started.
Photo credit: Sarah Vaughan at FreeImages