Saturday, June 04, 2011

Value – The Measure of Success

The last decade has demonstrated how no individual is immune to economic decimation. The Great Recession, as termed by many scholars, could be as devastating as the Great Depression of the 1930’s. It is undeniable that almost overnight shareholder value vanished. As we look in the economic rearview mirror, many contend that this economic pulse was the direct result of failure to manage risk. The result, a cascade of events that obliterated value as it made its way across the globe.

The cause of the Great Recession will probably be debated for years to come, as economies continue to rebuild. What did we learn from all of this? Depending how the economic dynamic of the day touched our lives, the lesson learned will be in direct alignment. If the impact was nothing more than a graze like that of a bullet – then we will continue along unaware of the breadth and depth of the economic devastation. Alternatively, the suffering of economic hemorrhaging will indelibly alter our behavior for years to come. These findings are beginning to pepper economic and psychology journals.

One article that caused me to stop and take note was Shareholder-Value Based Auditing by: Kevin Shen. Shen argues that the casualties of the Great Recession could be traced back to management’s failure to mange risk. Shen postulates that auditors may be too focused on risk and not enough on value, or rather the origins of value. Shen contends that shareholder value can be traced back to lines of activities and the audit process should focus on the risk of those lines of activities.

Shen draws on the derivation of shareholder value, along with the Gordon Constant Growth model and the Capital Asset Pricing model to derive a model that quantifies value. The model defines value (V) as the result of the quotient of earnings/profits (E) by the net of cost of capital (K) and growth (G).

V = E/(K-G)

Shen continues to refine the model from the corporate level down to individual activity level and contends that the audit should examine these value contributing elements to be effective in preserving shareholder value.

It is undeniable that the souvenir of the Great Recession is understanding and preserving value. The thought that immediately came to mind was how value is identified in organizations that have a completely different dynamic such as governments and non- profits. One could argue that they don’t have value and are simply an anomaly not to be test scrutinized.

I believe Shen’s model holds merit in the for-profit entities and also for the non-profit (NFP) entities. The transition for the model, however, requires an unpacking of the terminology. Shen proposes the basis of the model as the value accruing to shareholders. But who are the shareholders; those who have an investment in a nonprofit. I feel that the shareholders or better the stake holders in a NFP or government are the community which it serves. The community accrues value by virtue of the NFP, whether by feeding the homeless, aiding the needy or providing safety for persecuted. This value can be quantified by the easing of the burden on the community’s services.

This value is derived by extrapolating on Shen’s model. Earnings (E) cannot be managed in the usual sense as these organizations must expend all of their grants/donations in a specific time frame. However, the Earnings component could be more of savings derived by less demand placed on community and emergency services. Possibly a second tiered level of earnings could be the economic value derived from individuals who have been retrained to be economic contributors in society.

To a NFP or a government body there really is no cost of capital. Funds are either the result of grants, donations or taxation. However these funds do come with a cost. Grants and donations require considerable effort on the agency to attract these contributions. These costs can be hard, soft and opportunity in nature. Once quantified, these costs can be applied to the Shen model.

The last and possibly the most difficult to quantify is growth. Shareholder growth is easily quantifiable. However, how does one quantify the growth of a NFP or government? Maybe growth is not the correct term as it conjures up heavily bureaucratic organization that achieves volumes of red tape. Maybe growth represents the change in the social service the NFP is meant to address. By way of an example, if a NFP has undertaken to serve runaway teenagers in a community. The figure for growth would represent the annual percentage of runaway teenagers in the community year upon year. As the percentage increases (denominator) the value of the organization addressing the issue increases. Likewise as the NFP increases their service and lessens the injustice, their value decreases.

It is undeniable that value has become the new measure of success. Value must be a yardstick to quantify the contribution of every entity.

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