The causes of value based management (Blog 1) 25.10.2019

The causes of value based management

Definition

Before we talk about what created the value-based management, let's take a look at what it is. Value-based management is the principle and method of corporate governance to ensure the consistent management of long-term shareholder value creation. 

At the same time, value-based management will judge some business projects through three aspects: first, how much money the company needs to invest in the project. Second, what is the rate of return on these investments. Third, what is the opportunity cost of this investment. This shows that the value management system will decide which business to create value to change the company's decision (Tang, 2017). 

For how to create value, it is very simple that the return is more than the cost of the business. Three points should also be paid attention to. First, the cost of the project. Second, compare the required rate of return with the actual rate of return on capital. Third, within a certain planning horizon. These can be calculated by accounting figures (Chandra, 2007).

Interesting debate

As for the value-based management, its emergence is due to the dispute between shareholder theory and stakeholder theory and some company scandals. Some experts believe that the value management system can coordinate the interests of shareholders and managers. The company's value is not obtained by falsifying the company's benefits through false accounting data (Simth, 2003).

There is a dispute about this. The theory of shareholders holds that shareholders should prepay capital to the managers of the company, and the managers should only use the company's capital in the way authorized by shareholders. As Milton Friedman (1970) wrote: "a business has only one social responsibility, which is to use its resources to engage in activities aimed at increasing profits, as long as... Participate in open and free competition without fraud or fraud. " However, according to stakeholder theory, managers are responsible for shareholders and "individuals and groups who voluntarily or involuntarily contribute to the company's ability and activities to create wealth, and therefore become its potential beneficiaries and / or risk bearers". Therefore, they believe that managers should ensure that there is no violation of ethical rights of stakeholders and balance stakeholders in decision-making. Legal interests. Its goal is to balance the maximization of profits with the company's long-term sustainable operation ability.

The fundamental difference between the two is that the stakeholder theory requires that the interests of all stakeholders be considered, even if it will reduce the profitability of the company. In other words, according to shareholder theory, non shareholders can be regarded as "means" to achieve the "purpose" of profit; according to stakeholder theory, many non shareholders' interests are also regarded as "purpose". But, historically, argued John Cassidy (2012) in the new Yorker, "many chief executives saw their main task as exceeding the welfare of their employees and customers. As long as the firm made A percent provide every year and raised the divided it paid its stockholders, this was considered good enough.

This is actually the reason for the emergence of value-based management, which enables shareholders and managers to clearly see the benefits and risks of various stakeholders, so that they can more clearly judge what decisions the company should make, and shift the focus back to the company's objectives.

Scandal about Enron

The Enron Corporation scandal describes a company that has reached a dramatic height but is facing a dizzying decline. The collapse of the doomed company has affected thousands of employees and shaken the core of Wall Street. At its peak, Enron's share price was $90.75; on December 2, 2001, when the company declared bankruptcy, its share price was $0.26. 

Such a powerful enterprise, one of the largest companies in the United States at that time, disintegrated almost overnight. The key point is that its leadership deceives the regulators with false stock ownership and off balance sheet accounting. This is the distorted use of shareholder theory and the use of illegal, fraudulent and false accounting data to create company value.

The minimum regulatory environment of the times allows Enron to flourish. At the end of the 90s, the Internet bubble was in full swing, and the NASDAQ index reached 5000 points. Revolutionary Internet stocks are being valued to ridiculous levels, so most investors and regulators simply accept the new normal of soaring stock prices.

But Enron's leadership fooled regulators with fake holdings and off balance sheet accounting. Jeffrey Skilling, chief executive, used mark to market accounting to hide financial losses from the company's trading and other businesses. This technique measures the value of a security based on its current market value rather than its book value. This can play a good role in securities trading, but it can be disastrous for the actual business. This led to Enron's significant exposure to the most volatile parts of the market during the 2000 recession. As a result, many trustworthy investors and creditors are finding themselves in the final stages of a gradual loss of market value.

Conclusion and author's opinion

The example of Enron company shows the distorted use of shareholder theory, which just proves that the emergence of value based management is to coordinate the contradiction between shareholders and managers and the contradiction between the two theories behind it. When risks and benefits are all placed in front of managers and shareholders, how to allocate company resources to achieve the company's goals is no longer a controversial thing.

References

Chandra, P. (2007). Financial management (7th ed., pp. 817-823). Mcgraw-hill.

Smith, J. (2003). The Shareholders vs. Stakeholders Debate. Retrieved 25 October 2019, from https://sloanreview.mit.edu/article/the-shareholders-vs-stakeholders-debate/

Tang, D. (2017). What Is Value Based Management (VBM)? | flevy.com/blog. Retrieved 25 October 2019, from http://flevy.com/blog/what-is-value-based-management-vbm/