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What is value and How to measure it Published by: The Hauppauge Reporter, March 2009, Volume 28 - Issue 3, page 25 Written by: Frank Gallucci
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Value How Do We Create and Measure Value? To understand a business it’s critical to understand value. Exactly what is value? How do you create and measure it? When and how can we confiscate it? Ultimately, what destroys it? This is the second article in a series of four articles that attempts to address these concepts. The creation of value is a critical business concept that is often misunderstood and mismanaged. Its key elements are the assets that will provide the foundation from which income will flow, the time involved, the risk assumed and the cash available. A critical place to start a value creation analysis is with the asset foundation upon which the value creation process is built. This asset could be a small commercial building, a vendor’s food cart in front of the Metropolitan Museum of Art, or an investment in a fund managed by Bernard L. Madoff Investment Securities. When reviewing this asset foundation you need to ask yourself these questions: What supports this asset and its ability to provide you with a stream of cash over time? Is the foundation built upon a large amount of debt? What is the relationship between this debt and the equity which this asset requires? What goes into this business and what comes out of it? While these questions could be the subject of complex financial modeling, you don’t need to be a Nobel Prize winner or have an Ivy League MBA to understand how a business is creating value. You simply need to examine a business’s foundational components and apply basic logic and judgment. The core elements of great businesses are usually easy to understand. Ask any successful fruit vendor, in any market square, in any country in the world. They will tell you have if you have a good location, buy what your customer requires, manage your inventory, control your costs and don’t borrow what you can’t pay back, and you will create value. Let’s now move to the concept of time in the value creation process. Consider time in the context of how long it will take to provide positive cash flow. Every gardener knows different seeds have different gestation periods. You need to determine a rational gestation period for the value creation process you wish to analyze. Realize the longer the gestation period, the more risk you will assume. Also realize that you cannot harvest your garden, before it has been allowed time to grow. Be thoughtful in your use of time. It is a resource you cannot replenish. All of the things that can go wrong are reflected in the concept of risk. While there are mathematical ways of applying risk to a stream of cash flow over time, we will not discuss that here. Rather we will discuss risk at a gut and intuitive level. In the real world things go wrong. It is the responsibility of all business owners and managers to reduce or mitigate risk when they can. Do not make the mistake of assuming that risk is a macho virtue. And don’t confuse risk with courage. It should be thought of as part of a package that also contains reward. If the reward justifies the risk, and the foundation of the assets can support this risk/reward activity, you are likely to create value. Finally we get to everyone’s favorite: cash. You may have heard it said that “happiness is positive cash flow” or that “cash is king”. You may also have heard a movie character tell his agent to “show me the money”. While there is an element of wisdom in all these sayings, there is also an element of street mythology that needs to be put in proper context. Cash is simply a sterile storage unit of monetary value. Going back to our garden example cash is like fertilizer, it needs to be spread around in the garden so that the asset foundation can take root and grow. Unless cash is put to use it does not grow. In fact, inflation over time will diminish its value. The holders of cash are not necessarily virtuous, sexy or smart. What cash does do is measure and facilitates the value creation process. Sooner or later all elements of value creation, from a financial view, are expressed in cash. Consequently, “Cash is King”!
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