Chapter 1
Why is Value Management Important?

CFOs and CROs have significant potential to influence the value of their firm through three channels.

• First, by providing better information in the form of RAPMs,1 which link management actions directly to shareholder value.
• Second, by challenging businesses to higher levels of performance through better insights, including segment-specific strategies and management actions.
• Third, by taking better decisions in their own areas of responsibility, especially corporate strategy, capital allocation, balance sheet management and risk management.

This chapter motivates the importance of these three levers in managing the value of the company from a CFO and CRO's perspective.

Better Information

The first objective of this Handbook is to develop a value and performance measurement framework which can be used by managers at all levels to set strategy and steer risk-based, capital-intensive banking and insurance businesses. The valuation framework, illustrated below, splits the value of the firm between its current net asset value (or the market value of its current assets less its liabilities) and its franchise value (reflecting future, profitable new business).

Figure 1.1 is used throughout the Handbook to represent the three value levers available to CFOs and CROs - better information, better insights and better decisions.

Figure 1.1 Better information - What gets measured, gets managed

The top part of the figure represents better information in the form of a valuation framework suitable for risk-based, capital-intensive businesses. This framework explicitly links management actions to both traditional value drivers - including profitable growth and operating efficiency - and value drivers unique to banking and insurance - including underwriting effectiveness, capital efficiency and financial returns from asset/liability mismatches. Better information is covered in Part II of the Handbook.

The rows in the figure represent better insights, representing the strategies and core skills needed to create value in each business segment. It suggests, for example, that sales effectiveness and operating efficiency are critical for all segments, but that managing "alpha" through asset/liability management is core only for Life and Health (LH) insurance and banking. Better insights is the theme of Part III of the Handbook.

The columns in the figure represent better decisions taken by the finance and risk functions, focusing on strategic planning and capital allocation; risk management and underwriting; balance sheet and liquidity management; asset/liability management. The topic of better decisions is covered in Part IV of the Handbook.

Why It is Important

There is an old saying, "What gets measured, gets managed." It is colorfully illustrated by the story of the chandelier factory in the old Soviet Union, where the Party had set production targets in gross tons of chandeliers. What did they get? Consistent with the incentives, the factory produced a dozen chandeliers, each weighing the equivalent of a small bus and capable of pulling down the roof of any building were they ever to be installed. The result: many tons of chandeliers, all twelve of them, but no light.

If we want to manage shareholder value and performance, we first need to measure it. If a company measures performance in terms of market share or sales growth then, guess what, market share and sales growth will be what it gets if successful. But does higher market share or growth create value? Not always. The international expansion of Japanese commercial banks and German Landesbanken in the 1990s illustrates strategies which arguably focused on growth but sacrificed shareholder value.

Similarly, a company focusing on risk-adjusted returns will achieve a higher return on capital if successful. But do higher percentage returns always translate into higher shareholder value? Even if the capital deployed is decreasing? Returns below the cost of capital obviously destroy value, but investing less and less capital at marginally higher risk-adjusted returns also represents an opportunity cost to shareholders.

Growth without adequate returns or risk-adjusted returns without growth. Both are bad strategies. Ultimately, the trade-off between growth, risk and returns needs to be understood and evaluated so that the right path can be taken. Providing clarity is one of the key levers that CFOs and CROs can "pull" to help create value.

Why It is Challenging

Measuring the performance of financial services firms is inherently difficult given the duration, complexity and risks inherent in their products. How to measure the value created by products with highly uncertain cash flows far into the future? Although the standard corporate finance mantra "Cash is King!" works well for industrial corporations, anyone who has had to wade through the complexities of insurance and bank financial accounts knows how difficult it is to go from financial reporting to cash and from cash to value.

In response, banks and insurers have converged on internal RAPM and Economic Profit (EP) frameworks, which make the returns and risks of very different, highly complex financial businesses directly comparable. Unfortunately, RAPM frameworks can be complex, reflecting the complexity of the business, and in spite of the complexity, not all of them provide the "right" answer.

In addition, the inherent complexity can make the link between RAPMs and shareholder value seem so tenuous to senior managers that they revert to a simpler paradigm to manage value - one of accounting earnings, earnings growth and P/E (price/earnings) multiples - even though, by ignoring capital and risk, the simpler approaches will lead almost certainly to the wrong decisions.

I remember a conversation that I had with the CFO of a large bank in North America while conducting a survey on the role of the CFO and CRO (OWC, 2003). We quickly established that the bank used RAROC to evaluate individual credits and business unit strategies, that RAROC was accepted by management and used to set targets and incentivize performance.

"At last!" I thought to myself. "Here is the poster child for value management that I have been searching for!" And so, with growing enthusiasm and great expectations, I (naively) asked my final question of the interview, "So, RAROC has had a strong influence in terms of shaping your corporate strategy?"

The answer was dumbfounding: "Shaping corporate strategy? But why? The CEO and I drive strategy by looking at earnings, earnings growth and a P/E multiple - from a shareholders' perspective, isn't that all that we need to set the strategy of the bank?"

A lot of questions ran through my head: If the bank's internal metrics don't link to value and are not used to set corporate strategy, then why go through the effort? Looking at it from another angle, if P/E or M/B (market-to-book) ratios accurately reflect value, then what determines them? Why do some firms enjoy an M/B multiple of 2× tangible equity and others only 1× or less? And finally, isn't ignoring risk and capital, as P/E and M/B multiples seem to do, asking for trouble when managing risk-based, capital-intensive businesses?

During the remaining interviews, I asked the same question of other CFOs and CROs. A consistent picture emerged: even in the most "advanced" institutions, senior management relied more on a combination of revenue and earnings growth and market multiples to set strategy, ignoring internal performance metrics which were developed over many years and with great effort. This is not to say that RAPMs and EP didn't have an impact at the tactical and transaction level, just that they more often failed to impact the strategy of the firm.

The reasons cited most often were the complexity of the internal metrics, combined with lingering concerns regarding stability and accuracy. From my experience, however, the real issue was simpler: most CEOs, business unit heads and CFOs saw no clear link between the complex internal metrics and the external valuation multiples used in practice. During my career, I have seen more CEOs sketch their corporate strategy on the "back of an envelope" for equity analysts using P/E multiples than I have seen using RAPMs and EP!

Fortunately, there is a way to salvage RAPM frameworks, correcting the flaws and allowing them to be understood and more closely aligned with value creation. These are the themes developed in the more technical Part II of this Handbook.

Better Insights

Better information is necessary but not sufficient; ultimately, strategic and operational decisions have to be taken, including the allocation of capital, and this requires an in-depth understanding of the marketplace as well as business strategies, core competencies and management actions which can be implemented. See Figure 1.2.

Figure 1.2 Better insights

Why It is Important

An interview with the CFO of a mid-sized European bank illustrated the importance of better insights in terms of both business challenge and capital allocation. Like many of his peers, the CFO's role had evolved over time from the Head of Accounting and...