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The path to higher shareholder value.


One of the realities of business today is that senior executives, CEOs in particular, must be content with snapshot views of how their companies are performing. Most of their time must be spent developing and managing the corporate strategic agenda - that is, charting the company's course, rather than steering it. And this is as it should be. Nothing is more important in the global economy than building the strategies and programs that frame superior, sustainable performance.

However, even if strategic leadership were not the senior executive's key job, other priorities might still take precedence over operations. This is because the belief exists at most companies that significant inefficiencies have been purged from their systems and that further economies should be subject to the Law of Diminishing Returns. Further, the Gospel du Jour states that the road to competitive advantage and market leadership runs through The Land of Increased Sales. To an extent, those beliefs are true. Today, far fewer companies are bloated or inefficient, and significant increases in shareholder value do require stronger focus on sales, marketing, and share. Nevertheless, operational excellence remains a far greater imperative than most companies and executives acknowledge.

Effective management of assets can increase a company's stock price by 20 percent or more by improving "free cash flows" and, hence, true stock valuation. A shareholder value analysis of more than 100 companies in several industries reveals that the market pays attention to asset management as well as to earnings and revenue growth rates. Stock prices do reflect the amount of capital that management invests to generate earnings and support growth. Operational excellence dramatically improves a company's capital efficiency and, hence, its stock valuation.

For the first time, quantitative analysis draws a direct and compelling connection between operational excellence and shareholder value creation. Operational excellence is the neglected driver of stock valuation.


Several factors determine a company's overall stock value. The five most critical drivers are: profitable revenue growth rate; operating income margin; effective tax rate; working capital efficiency; and fixed capital efficiency.

Over the past five years, most executives and companies have been working diligently - with measured success - to reduce costs. More recently, top management has focused its attention on growing sales by expanding into new markets, introducing new products, and/or by increasing existing market share [see chart at right].

While sales growth and cost reductions are critically important determinants of stock price and the underlying market value of a company, the true magnitude of value derived from capital efficiency is not well understood or widely appreciated. Growth must be profitable to be of value, profitable enough to generate healthy free cash flows - that is, the money left over after subtracting expenses, taxes, and capital investment from revenues.

Certain companies have learned the intrinsic value of managing their working capital investment rate (defined here, using quarter end data, as accounts receivable-trade plus inventory minus accounts payable-trade, all divided by four times quarterly revenue). Compaq Computer, for example, consumes about 10 [cents] in working capital per revenue dollar; competitor Dell Computer uses a remarkably low 1.5 [cents] in working capital per revenue dollar.

Compare these capital consumption figures to those of such prominent U.S. corporations as American Home Products, Hewlett-Packard, Kodak, and Rubbermaid - each of which consumes about 28 [cents] in working capital per dollar of revenue. Clearly, working capital efficiency has an enormous impact on free cash flow. The lower the capital or operating expenditure per revenue dollar, the higher the free cash flow and the higher a company's market capitalization.

When comparing stocks and assessing fair market value, financial analysts, especially sell-side analysts, apply several simple valuation models, the most common being price/earnings (P/E) ratio times the earnings per share (EPS) model. Stock analysts' preoccupation with short-term earnings, however, reinforces management's short-term focus on the quarterly income statement. The balance sheet, which reflects the capital efficiency side of the business, usually gets short shrift from both sell-side analysts and management. The balance sheet reveals fixed capital efficiency and working capital efficiency through metrics such as fixed-asset turnover, accounts receivable days-of-sales-outstanding (DSO), inventory turns, and accounts payable days-of-purchases-outstanding (DPO).

Working capital efficiency is heavily dependent on these factors. The longer the DSO, for example, the more money the company has tied up in assets for which customers have not yet paid, and the less money it has in free cash flow. One major manufacturer pays its suppliers in 15 days, but does not collect from its customers for 90 days. This company, as a result, requires additional working capital investment and suffers a lower free cash flow and, consequently, a reduced market capitalization. The solution is not for the firm to lean on its suppliers by slowing down payments - although the corporation may have some latitude in that respect - but rather to conduct a root cause analysis of the operational issues causing slow collections and then to fix the relevant business process.

Our analyses of 100-plus corporations indicate that an untapped 20 percent of market capitalization resides in the balance sheet, within those areas of operational excellence (such as inventory turns and Dso) that determine capital efficiency and free cash flows. A recent publication, "Cash Flow and Performance Measurement - Managing for Value," by the research affiliate of the Financial Executives Institute, indicates that a growing number of senior executives are beginning to understand that expectations about future cash flow drive stock valuation. Are a company's production costs likely to go up? Can management gain market share? Is inventory growing excessively? Such factors are good indicators of future cash flow.

Senior executives are learning to distinguish between cost drivers that are influenced largely by external factors - i.e., markets and competitors - and those determined by internal, operational factors. The latter lie within their control. Recognizing this, senior management can identify and implement a portfolio of high-impact operational improvements that are free cash-flow based.

Those executives who understand that a company must earn more than its cost of capital before it can create shareholder value have an advantage. Some of these executives have adopted financial statement-based ratios (such as return on capital employed) or economic measures (such as Stern Stewart's EVA[R]) as key corporate performance indicators. These are major steps in the right direction. They indicate a true understanding that the balance sheet matters. Indeed, some companies go so far as to link balance sheet performance directly to executive compensation.

Although financial statement ratios and economic performance indicators point management in the right direction, they don't translate directly into stock price. There is no immediate cause and effect relationship between stock price and such ratios and indicators. At best, these indicators are linked to stock price through a squishy statistical correlation. A more powerful approach is to link cash flows to operating variables, which allows us to calculate stock valuations directly from an operating executive's point of view. This methodology is patterned after the Bond Valuation Model, a mathematical equation that allows one to calculate what a bond is worth based on its future free cash flows - i.e., a stream of regular interest payments and the return of the principal amount upon maturity.

This approach makes stock valuation not only understandable, but also demonstrates its dependence on operations. The methodology is especially useful for identifying high-leverage improvement opportunities on a large scale - at either the enterprise or business-unit level.

Naturally, the greatest positive effect on stock price comes from implementing high-impact improvement programs on an enterprise-wide basis. Because the valuation model is based on cause and effect relationships, the effect of inventory turns and DSOs can be linked directly to stock valuation and market capitalization.

This approach gives management a powerful analytical tool that not only incorporates all the company's value drivers, but correctly captures their interrelationships. This tool is invaluable in helping top management analyze trade-off opportunities and develop a prioritized portfolio of operational improvements, ranked by their impact on stock valuation.

As it turns out, all cash flows are not created equal when it comes to boosting market capitalization. Cash flows generated by revenue enhancement and cost reduction are taxed. The U.S. government takes one-third or more of these additional cash flow dollars.

However, cash flows created from greater capital efficiency - through higher inventory turns or lower DSO - are untaxed. This means that 100 percent of these freed-up cash flow dollars go toward improving market capitalization.


Take a look at Rochester, NY-based Eastman Kodak Co., for example. based on a recent analysis of publicly available information, we know Kodak consumes about 28 [cents] in working capital investment per dollar of revenue. The figure on page 46 is a three dimensional graph of Kodak's Working Capital Investment Plane. This plane is analogous to a hiker's contour map of the side of a hill. The color bands represent 2[cents]-per-$1 changes in investment rate. Kodak's inventory turns are about 4.2 times per year and its accounts receivables run at about 75 DSO.

Kodak's working capital investment rate is the intersection of 4.2 inventory turns and 75 DSOs on the surface of the plane. Note that this intersection point lies at the boundary of the blue and green bands in the top left corner of the graph. Move to the left and follow the parallel lines to the left vertical axis. This puts you at about 28[cents]-per-$1.

Kodak can move down this plane - improve its performance - by increasing inventory turns and reducing its DSOs. The boundary between the green and red bands in the lower right corner illustrates the combination of stock turns and DSOs which result in a 14[cents]-per-$1 investment rate (e.g., eight turns and 45 DSOs).

We believe Kodak could reduce its capital consumption to at least a 14[cents]-per-$1 investment rate by focusing on achieving operational excellence, and through the judicious use of commercially available information technology.

This effort would require senior executives to commit to and be involved in concerted efforts to improve asset management. Without such top management commitment, particularly on the part of the chief executive, improvement efforts frequently fizzle out. Why? Because improving capital efficiency is difficult. It requires sustained effort and unprecedented cooperation among the senior management team and the operating managers.

The above left figure plots Kodak's stock valuation against the working capital investment rate. Kodak appears to have an opportunity to boost shareholder wealth by about 23 percent, or more than $5 billion, It is important to remember that the slope of the line in this graph is company specific. Also the size of the stock valuation impact depends on a company's starting point. If the firm's working capital efficiency is poor - and 28[cents]-per-$1 falls into that category - it has a huge opportunity to move downward along the Working Capital Investment Plane. Such downward movement translates into a significant boost in market capitalization.

We conducted a shareholder value analysis of Kodak's financial model to illustrate this methodology. But Kodak is by no means the only well-respected company with poor working capital efficiency.

Companies with higher growth rates can expect larger stock valuation impacts because of the compounding effect of revenue growth. This compounding of benefits derives from the fact that the relationship between stock valuation and revenue growth rate is not linear. Rather, the increase in stock valuation accelerates as revenue grows. If the revenue growth rate is increased by 5 percent, for example, stock valuation may increase 8 percent. This compounding growth explains the sky-high multiples of fast growing, highly profitable companies like Cisco and Microsoft.


There is substantial untapped opportunity, then, in virtually every company with a working capital investment percentage-of-revenue dollar higher than the industry leaders in its category, and/or leading practice companies, regardless of industry. This opportunity lies in achieving operational excellence. More specifically, it lies in optimizing the company's supply chains.

By now, most managers understand the concept of supply chain management - i.e., the management of the "flows" of materials and products across the enterprise (from raw material to customer) and among trading partners. Supply chain management also incorporates three other important flows: information, cash, and process/work. Operational excellence derives from a mastery of these four.

Globalization, competition, and demanding customer needs are creating new' objectives for companies today. By working these objectives, which are business unit-wide, cross functional, and/or enterprise-wide, managers gain a new perspective on their businesses and markets. Holding departments or functions accountable for internal results no longer assures that the company remains competitive. Cost, time-to-market, and value-added services associated with products and channels constitute the new rules of competition.

World-class supply chain management presents major challenges because of its complexity, scope of operations, and heavy dependence on teamwork - not only across the business, but also with trading partners. Companies with the highest performing supply chains (e.g., Compaq, Dell, P&G, Wal-Mart, Nike) also are among the highest performers in terms of stock valuation.

We believe a supply chain is truly optimized only when: customers are "delighted" with products and services; total supply chain costs and cycle times (to buy, make, move, and sell the product) are at lowest and fastest possible levels; the supply chain is contributing to profitable sales growth; worldwide effective tax rates are at lowest possible levels; capital efficiency (working and fixed) is at lowest possible levels; and the supply chain is able to respond to changes faster than its competitors.

These characteristics represent ideal goals that are attained by only a few of the best companies globally. Tangible progress toward any of them, however, will undoubtedly translate into positive results and increased shareholder value for any company.


Supply chain excellence requires effective strategies, sustained management commitment, and changes in attitude, culture, and organization. As a guide to realizing this corporate State of being, we offer the following principles of supply chain excellence:

* Formulate a differentiated supply chain strategy. For product categories, product channels and target customers, develop an operating strategy that, when executed, makes your supply chain different from the rest.

* Organize your business unit around major processes, not functions. Plan, develop, buy, make, move, and sell are much more important processes than organizational functions, departments, or other traditional "silos" that separate work and interrupt flows.

* Transform business processes into customer-driven, efficient processes that are integrated within your organization and with trading partners. As you reorganize, change the way work is viewed, performed, and measured. Manage across the business on behalf of the customer and work collaboratively with trading partners to establish seamless flow pipelines.

* Invest/reinvest in supply chain information technology to manage flows end-to-end. Update your information systems; acquire packages that support both the planning and execution of the supply chain. Such systems include decision support tools that help decide what, when, where, and how much to buy/make/move/sell, and then measure results.

* Invest/reinvest in supply chain knowledge, people, skills, and learning. No person, team, process, or company ever knows enough. Change is a constant, with innovations and problems always occurring. Organizations must invest in ongoing training, mentoring, education, and feedback systems to keep their people current with the latest thinking.

* Operate/manage by product/channel. Products are sold through channels, with each channel being different in terms of competitive needs. Supply chains should be set up and driven by the characteristics of the channels.

* Outsource elements of the chain for higher performance. In many cases, the operating functions of the supply chain can be performed better by third parties. Management time should be spent on innovations, new ways to excel, not on managing the mundane.

* Think globally, build regionally, operate locally. The best performing supply chains are managed with centralized planning, regional approaches, and local operations. Companies must design the right combination of these three elements, and then execute them better than their competitors.

Stephen C. Johnson is president and CEO of Komag, Inc., a San Jose, CA-based manufacturer of magnetic disk media.

Gene Tyndall is a Partner of Global Supply Chain Management at New York-based Ernst & Young, a multi-billion dollar global professional services firm, and co-author of Supercharging Supply Chains: New Ways to Increase Value Through Global Operational Excellence.

Gerry Marsh is the founder and a principal of Ernst & Young's High-Tech Analyst Group, a management consulting firm specializing in shareholder value analysis.
COPYRIGHT 1998 Chief Executive Publishing
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Copyright 1998, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:includes related article on principles of supply chain excellence; supply chain management
Author:Tyndall, Gene
Publication:Chief Executive (U.S.)
Date:Jul 1, 1998
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