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The Future of Strategic Risk Management

 

 

Despite growing sensitivity to shareholder value, most VBM initiatives fail. They simply fail to be integrated into day-to-day decision-making.

This is not a new insight.  Several advisors, including our former colleagues, recommend compelling behavioral change through incentives.  Others, including ourselves, weave the concepts of free cash flow and Economic Value Added into corporate strategy, by making EVA -based targets a vital part of long-term planning.  Both initiatives add value. Yet they sometimes just scratch the surface.

The Model is Inherently Static

We believe the gulf between line activities and corporate goals stems from corporate finance models which view the world as a static collection of best, worst and most likely case scenarios. The static case-oriented model of financial performance is simply inconsistent with a world that has come to accept orderly chaos as the norm.

In most companies we call on, operating managers have a feel for their business, but they often cannot quantify the likelihood or dispersion of probable outcomes. Senior managers, on the other hand, seek hard annual targets plus periodic updates to ensure hitting those targets. For the former, the ritual may seem burdensome and far removed from daily brush fires. For the latter, it is often the only connection to what is happening in the field. Comments we've heard include the following:

  • We're still getting bad numbers;
  • If managers have to add or multiply to find out how they're doing, the measures are too obscure; and
  • The model does not address company-specific factors.

The result is frequently tension — tension between operating managers who deal constantly with random events and corporate managers who evaluate their business on the basis of narrow tolerances around budget. Instead of being constructive, this tension impedes successful implementation of value-based planning initiatives.

How to Make Shareholder Value Succeed

We believe value-based initiatives succeed when they incorporate real-world uncertainty explicitly into the planning process. By real world uncertainty, we do not mean what if operating scenarios where one or two assumptions are modified, and the model is allowed to recalculate.  Such procedures work well in a world of constant margins, constant inflation, constant politics, constant growth, and constant faith. Unfortunately, we do not belong to such a world — except for death and taxes.

Traditional forecasts are doomed from the outset to be in most instances more wrong than right.  That is why it is so difficult, at present, to discuss financial prospects candidly and openly with line managers. And that is why, in our opinion, there is often a credibility gap between line managers and the corporate office.

Uncertainty Must be Measured Explicitly

The reason for constructing a bottoms-up probabilistic model is that it concentrates attention on those components of performance where randomness can be measured historically, and where it is thus easier to generate consensus among line managers as to bounds (receivable days on hand, inventory turns, etc.). The alternative approach is to assign weights to arbitrary best and worst scenarios. Although quicker, the approach does not distill from historically verifiable relationships those factors over which management has influence, and is thus more prone to error. It is often impossible to explain the chosen weights to line management, appearing instead to be a black box rationalization.

The better approach is to rebuild the forward plan from the ground up, assigning verifiable parameters to those variables which are uncertain, and then running the model hundreds or thousands of times to see how aggregate measures like cash flow, ROE and EVA are distributed. Only then will you get a solid sense of how difficult certain goals may be to achieve, and a solid sense — six or even eighteen months out — of how difficult it will be to get back on track.

The Model Must Be Dynamic

The key distinction between a probabilistic and a traditional modeling approach is that the probabilistic approach is dynamic. On any day after generating the forward plan, there will be a subset of scenarios which fit existing circumstances, and which paint a realistic, probability-weighted mural of subsequent outcomes. Those scenarios which offer the greatest promise of stockholder return can then be distilled into line-by-line guides for re-focusing management attention, and for reevaluating corporate expectations. Management's focus would thus be shifted to beating the odds it faces, given circumstances to date, rather than surpassing static, out-of-date targets.  This is closer to the perspective of your stockholders, who make extraordinary returns only if your company's stock outperforms market expectations — expectations which adapt constantly to emerging circumstances.

Strategic risk management is fast becoming the next hot topic in corporate finance, one which will — for the first time — facilitate seamless integration with corporate strategy.  Just as manufacturing processes are being reshaped on the basis of technology available today, so too should corporate finance.

To learn more about Finegan & Company’s services in this area, select the Obtain Information option on the sidebar.


http://www.shareholdervalue.com

Illustrations: Warren Gebert
Photography: Wayne Takenaka

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