Today, share buybacks and employee option schemes are headline news. However, many view them as a means of value extraction, not value creation, and for good reason. If the prime purpose of stock options is to get management and employees to walk in an “Owner’s shoes” — to think like a long-term shareholder, an exemplar being Warren Buffett, and then to behave like a genuine entrepreneur who puts customers first, then they don’t seem to work too well.
Buffett says: “I like businesses I can understand … that narrows it down by 90 percent … anyone can understand this.” He holds up a Coke bottle. “It’s a simple business, but not an easy one. I don’t want an easy business for competitors. I want one with a moat around a valuable castle and the Duke in charge to be honest, able, and hard working.”
“People buy a share, and they look at the price next morning to decide if they’re doing well or not … that’s crazy. You aren’t buying a share … you’re buying part ownership in a business. That’s what it’s all about.”
How many members of company share option schemes have that explained to them? Do they understand how valuable the free equity they’re given really is, let alone what the critical numbers are that build the moat and castle? As Buffett says, “I want a business with great economics, and then I can see in a general way where they’ll be ten years from now. If I can’t, I don’t want to buy it.” His one message for managers of companies Berkshire Hathaway owns or invests in: “Widen the moat!”
That means throwing crocs and sharks into it through brilliant business design, low costs, good service, high product quality, patents, and choosing carefully where to compete – to have a “Game Plan” that acts on the right tasks – opportunity and productivity-driven ones.
Productivity and profitability of assets drive a firm’s long term value. The only valid measures of management’s intent and results are productivity ratios – not a share price.
The Return on Assets Managed financial model below (ROAM), contains the most important of them. It is a simple but certainly not simplistic way to measure the “economic moat”.
The three most important measures of operating management are ATO, the ROS percent – both link to sales – and the ROAM percent. They are closely followed by the “Ready-for-Sale” Cost of Goods Sold (COGS) – usually about 80 percent or more of total cost and expenses (OPEX).
This chart shows the correlation between EBIT ROAM and value of the firm (VOF) measured as market cap ÷ total assets. The sample size is 142 firms on the JSE.
The link’s clear. You don’t need complex measures like EVA or Cash Return on Invested Capital to get the message across to people. Moreover, you only have to focus on the assets on the balance sheet and stop at operating profit, or earnings, before interest and tax on the income statement (EBIT).
The productivity moat and castle start with assets and their sales productivity. This prompts the first strategic marketing question: For each Rand of assets we own, how many Rands of sales do we generate? That’s ATO – the asset turnover number. Here’s a chart that shows how it is the foundation stone for building up the defensive productivity barriers …
To illustrate, let’s use a sample of one – PPC Cement, a highly asset intensive business and one that has faced many headwinds in recent years – not least one that blew away its, protective cement cartel umbrella.
The first measure, a hybrid one, is the “Capital Cost per Ton of Cement Sold”. If you need more production assets than your rivals to produce and sell a ton of cement this will hobble you before you even start to compete. — BizNews.com