Enterprise value is built before it is measured
The following is a guest post from Kumar Rupesh, interim chief financial officer at FUTEK Advanced Sensor Technology. Opinions are the author’s own.
Organizations often begin assembling their valuation narrative and documenting evidence when a transaction or financing event approaches, treating valuation as a point-in-time exercise. Often the effort is focused on historical financial performance and future expectations. But much of what determines the credibility of economic results, past and future, was built years earlier.
The organization is built around a forward flow of decision architecture. Managers define strategy, make decisions, measure performance, establish causalities, optimize the actions and set future expectations. Capital providers look backward. They scrutinize the historical data, decipher organizational capability and strategy from the performance, make economic translations based on this assessment and then set future expectations.
Management: Strategy → Decisions → Performance → Causal Understanding → Actions → Expectations
Capital Providers: Performance → Drivers → Capability → Strategy → Expectations
Paradoxically, both parties eventually arrive at the future, but they reach it from opposite directions.
Therefore, the common ground of enterprise value between the internal and external parties is organizational strategy and capabilities and should become an integral part of the narrative.
The strategy and organizational capabilities accumulated, tested, refined and solidified over many years form the underlying foundation of value. An organization that only sells future expectations may struggle to establish credibility. One that focuses only on optimized actions may undersell the capabilities behind its performance. This is where the role of the CFO becomes critical in connecting historical and expected financial performance with the strategic and organizational capabilities that produced it.
Those capabilities extend beyond the products and services the organization offers or its objectives for revenue, growth and profitability. Before financial performance can be fully interpreted, there must be clarity about what the organization is trying to become; its intended value leadership position, product and service identity, target markets and channels. These choices determine which capabilities deserve investment and provide the context through which financial outcomes should be understood.
The credibility of organizational performance and confidence in its future improves materially when this clarity is defined and becomes the guiding force of organizational decision structure and organizational narrative.
A CFO’s commentary should hinge around an information framework based on business segments. Enterprise-level averages can conceal the underlying drivers of value when different parts of the business operate with materially different economics, capabilities, risks and capital requirements. Segmentation means separating the business into meaningful categories that share distinct economic and operating characteristics.
For example, for a manufacturing company that deals in multiple levels of transaction segments, a large volume of small, some medium and a few very large transactions can be a good baseline segmentation.
The information framework for each segment should contain:
Strategic alignment with the segment. This is where strategic clarity becomes of fundamental importance. The organization does not pursue the opportunities simply because an opportunity presents itself, but because it makes strong strategic sense to maintain, grow, and invest in.
Segment historical performance and performance drivers. The historical performance should reveal the trend, revenue quality in terms of repeatability and reliability, customer longevity and economics and margin behaviors. Equally important is explaining why the segment performed as it did, including the influence of its differentiating factors, competitive dynamics and broader industry conditions.
Segment operating and capital capacity. The credibility can be further solidified by charting out the operational capabilities that support the segment aligned with its strategic positioning. For example, an organization positioning as a cost leader should have the capabilities that support product standardization and modularization, optimized manufacturing, a robust supply-chain network and strategic outsourcing. Furthermore, presenting segment-specific capital requirements with historical baseline and underlying assumptions, including utilized and spare facility capacity, is important. Equally important is showcasing the depth of leadership and availability and accessibility of talent.
Segment risks and mitigation measures. The best narratives will not leave out risks; they rather, elaborate on sales, operational, brand and leadership risks and mitigating measures in action. Some sales risks originating from cyclicality, seasonality, customer concentration, customer-specific trends and economic trends require proper mitigation mentions as related to diversification, contractual safeguards and multi-application engagement with the customer. Similarly, the operational risks originating from equipment redundancy, supply-chain disruptions; the brand risks involving negative customer reviews, product failures, trademark infringements and regulatory limitations; and the leadership risks related to the flight of a few key members require careful presentation with mitigating measures.
Segment new initiatives, future performance and growth drivers. Once the baseline has been established for what works and why, setting up the future expectations becomes more acceptable and believable. The organization must certainly include new initiatives that strengthen the organizational capabilities which will drive future growth. This ensures not only confidence in growth but also in sustainability of the segment. As the segment offerings mature, the customer base stabilizes, the competition catches up and the alternatives present plausible solutions, eating away market share. The new initiatives should focus on elevating value proposition of offerings, cost containment measures protecting margins and new developments into new and adjacent products and applications.
The segment becomes critical if the business has suffered stagnation or decline. The analysis might reveal segment-specific factors, not a systemic issue. Furthermore, the synergy becomes more visible as each segment may attract different types of synergies.
Such a comprehensive narrative establishes why the business pursues the segment, what happened and why, what capability produced and sustained it, what could interrupt this, how this could be mitigated and where the organization goes from here. The organization not only builds credibility for presented numbers and metrics but may also drive confidence in the organizational strategies and systems. When causal relationships aren’t visible, uncertainty increases. And uncertainty gives the external party less basis for assigning value to claims about durability, scalability and future performance.
Valuation does not create the underlying organizational value. It assesses the evidence of value already created and forms an expectation about its future economic potential.
