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Accounting for value

Hosted by Drew Adamek

The definition of value continues to evolve in the knowledge economy. Finding new ways to measure, manage, and understand organisational value is a critical role for finance professionals and management accountants. In this episode, Paul Ashworth, FCMA, CGMA, previews his upcoming Financial Management articles on effective valuation, the challenges and benefits of different valuation methods, and why good value management can elevate the finance function within a business.

What you'll learn from this podcast:

  • How the definition of value is changing and growing.
  • How effective valuation approaches can improve strategic forecasting.
  • The first step in developing more useful valuations.
  • Common valuation mistakes and how to avoid them.
  • Why the finance function is the natural shepherd of organisational value.

Play the episode below or read the edited transcript:

To comment on this episode or to suggest an idea for another episode, contact Drew Adamek, an FM magazine senior editor, at Andrew.Adamek@aicpa-cima.com.

Transcript:

Drew Adamek: The definition of value is changing for many organisations. As the knowledge economy continues to grow, intellectual capital and other intangible assets are becoming an increasingly important part of an organisation's value. But measuring intangible assets like intellectual capital can be an ephemeral and dynamic challenge.

Paul Ashworth, FCMA, CGMA, has been conducting research on measuring and managing value for years, in order to effectively implement the concepts in practice. He is now writing about the insight he's gained over the years to share it with other practitioners.He has a wide range of finance department experience, and is currently the director at PA Strategic Insight.

In several upcoming FM articles, Paul will explore how organisations can measure their value differently, and how to build effective strategic forecasts using those measurements.

I'm FM senior editor Drew Adamek, and in a preview of his upcoming series, I spoke to Paul recently about the evolution of organisational value, the relative merits and challenges of different value measurement systems, and why understanding value can elevate the finance department within an organisation.

Adamek: Paul, thank you so much for joining us.

Paul Ashworth: It's a pleasure.

Adamek: In your mind, how is the definition of value evolving and growing?

Ashworth: I think the nature of value has changed significantly over say the last 30 years. Historically, the book values of the businesses tended to reflect the value of the business relatively closely.

But that was basically made up of financial capital. Over time things have changed and the component which is made up by intellectual capital has significantly increased. Now the majority of value in businesses is in intellectual capital, which will not be reflected in the financial accounts. Therefore the challenges that we're now facing have evolved very significantly.

Adamek: As these challenges evolve, what is the finance function's role in accounting for these changes in value, and this expansion in the definition and understanding of value?

Ashworth: It's been commented that finance's role has extended into becoming the custodians of organisational value; however, I'd challenge actually where businesses are at this stage. I'd say that their take up of this role at the moment is very limited, and this needs to change.

In terms of taking up that extended mandate, I think that a lot of the skills which are needed do exist within the finance function. They're used to dealing with large volumes of data in a structured, disciplined way, analysing that data, and identifying important findings from the data.

They're also already doing business partnering roles that relies on this data. However it shouldn't be assumed that they will become custodians of value, because I can see that there could be quite a bit of competition for this role. It's a very influential role in the business.

Finance functions need to earn the right to become custodians of value. In terms of understanding the significance of intellectual capital, it's just worth recognising that this has changed massively over the years. Back in the '70s, about 80% of a business's value was made up by financial capital. Now, it's at least 80% of business value is made up of intellectual capital.

Finally coming to the data, the finance functions is going to need to get used to dealing with various data types. They need look at both financial and nonfinancial data from internal and external sources. As mentioned, they need to deal with absolute numbers, but also ambiguous numbers. They need to also rely on data that is going to be outside of their normal areas of working. This will present lots of challenges in terms of understanding the internal data, but they've also got to look at external data. That will be a large challenge.

Adamek: Will you describe the importance of value measurement within an organisation, and how it can or does provide a competitive edge for organisations to measure their value correctly?

Ashworth: Value has always obviously been important within organisations. However, I think that historically it hasn't got as much focus as it's starting to get now. The main time people were talking about value was because maybe there's a mergers and acquisition event going on. Or they talk about value in terms of the market values from public companies. Talk about value within the finance functions has been, I think, relatively limited. A lot of the expertise was held outside organisations, and there's now need that this expertise still be developed within the organisations.

Finance functions, they're used to managing and measuring tangible assets and net working capital. But as mentioned before, there's an increasing reliance in businesses, in terms of what their value is made up of, of looking at intangible assets. This gives the greatest potential for value creation and destruction within business; the dynamics within this intellectual capital. We need to become experts within this area.

This is also accompanied by the fact you've got ESG, demanding organisations consider their long-terms societal impact, which will also impact the value of the organisation, and hence the masses that finance functions need to look at.

Adamek: How would you describe both the merits and challenges of the different kinds of value measurement systems that are out there?

Ashworth: It's complex because the best system will both depend on the individual organisation that we're talking about, and also what purpose the evaluation's going to be put to. For instance, if you only want to come up with a valuation, then some of the approaches will achieve this. If you want to use value management, as well, which I would think in most instances people will want to go on to that as the next step, then some of the approaches are more appropriate to that. But I describe the approaches in three main categories. You've got, first of all, component valuations. Then valuation techniques based on multiples, and finally, discounted cash flows.

In terms of component evaluations, these tend to work very well with businesses that the majority of that value is within tangible assets and working capital. It's a well understood approach. You're looking very much at a specific asset, for instance, and saying, what is the value of this asset? Such as a property.

When you're looking at intellectual capital, how do you do an evaluation of a system, for instance? Any piece of intellectual capital will have different values for different people. That's going to apply to everything, But in terms of looking at it specifically by itself on a component valuation basis, that then becomes very difficult to say what is the right valuation. Also, intellectual capital only tends to be of value when it's used in conjunction with other intellectual capital.

Moving on to the multiples approach. This can be based on precedent transactions, so other valuations that came out of similar mergers and acquisitions activity, for instance, or public company comparables. Finding a listed company and saying what multiple that is operating on, It's a very widely used approach, very common. But it is very difficult to find a comparable business. Most businesses are made up of a number of different businesses within them. Trying to find an exact match or take apart another business and understand its definite multiples for the different components makes that approach very difficult.

Also, you've got the fact that the multiples will vary over time with market conditions or various events such as listing, a full sell, or a takeover. Any multiples do take into account that there's intellectual capital within the business, and that is really by looking at approach of comparable situations. But it doesn't deal with the complexity and ambiguity of intellectual capital. It doesn't really, to my mind, give very much insight into how to then go on to manage that value.

We finally come to discounted cash flow valuations. This is the most complex approach, but I think the effort can be well justified because it can provide the most accurate valuations that are also justified by underlying business dynamics. In a loss situation, the quality of forecast the businesses have is insufficient to give a good valuation. What needs to be done on that? Also, the appropriate discount factor is not understood well enough. This work needs to go into that.

Finally, in terms of issues, too much reliance can be placed on the terminal value. It's important to make sure you're forecasting out to a point where you're providing explicit justification for the numbers, and they're different than the usual market dynamics. Once you've built this forecast and a discounted cash flow valuation off the back of it, you can use that forecast to then go on to do scenario modelling. All of this will give you a wealth of information to then go onto look at subsequent business management in order to maximise value or avoid value destruction.

Adamek: As finance departments and finance professionals are beginning to look at value in different ways, what are some of the common mistakes that you see people making?

Ashworth: One of the starter points is that I think a lot of people look at the completion of the measurement exercise as being an end in itself. I see the measurement is the start of the process. It provides you some insight, which you can then challenge and reassess whether that measurement is correct. The measurement has got to be underpinned by information that then goes on to inform the subsequent value management. This will necessitate people to work with a sufficient level of detail that they can make subsequent meaningful comparisons to actual data. Often, forecasts are done at too high a level to make this possible.

Another mistake is that the assumptions for value drivers that will lead to a valuation of business aren't actually aligned to the business strategy or there's no real plan as to how that level of performance will be achieved. Finally, I'd like to say that the time scale that people will build out their forecasts over to complete their valuation upon tend to be too short, and this will mean that in the instance of a discounted cash flow valuation, there's too much reliance put on a terminal value.

Adamek: For finance professionals and organisations that have been looking at value in a more traditional way, but want to start looking at it in a more expanded view, what's your recommended first step?

Ashworth: The first step I'd recommend is one that I tend to always take when I join any new organisation, and that is to get hold of the actual financial performance of the business, and start to look behind it to see where those numbers have come from. When you've understood some of the drivers of the actual numbers, you can then build a model that shows how those drivers work together to deliver the financial outcomes that are being seen. Having done this on the actual business, it then underpins any forecast going forward that will be used in the valuation and give you the justification for the valuation you've come up with.

Adamek: How does this process of measuring value, forecasting based on value, increase the finance functions value to an organisation? How does this empower finance within an organisation?

Ashworth: Understanding this game to building up a valuation before the underlying justification provides a high level of strategic insights into how the business currently works and could work going forwards into different scenarios. This is strategic insight that can increase the certainty for all parts of the business about how the organisation performs and also then increase the levels of agreement that can be achieved within the organisation about creating a strategic direction, which ultimately can then lead to more rational decision-making and value management within the business.

I've found that the insight that I've been able to gain from similar exercises that I've done in various businesses means that finance is always welcome to the table at various decision-making meetings and they become a valued partner to the business.

Adamek: Paul, thank you so much for joining us.

Ashworth: It's a pleasure. Thanks for your time.

Adamek: I'm FM magazine senior editor Drew Adamek, and you've been listening to my conversation with Paul Ashworth about measuring and managing organisational value. For more of Paul's insights, please watch the FM website for his upcoming articles.

Thank you for listening.