296 The Marketing Book
present value of the cash flow at the end of the
planning period. This is estimated by the
standard perpetuity method and has a value of
£55.5 million. Adding any non-operating
investments the firm owns and deducting the
market value of any debt leads to the share-
holder value of £57.6 million. If there were 20
million shares outstanding, this would produce
a predicted share price of £2.88. The 5 per cent
sales growth creates additional shareholder
value of 5.6 million, just over 10 per cent
enhancement in the value of the share price.
This could well be an underestimate of the
value created, since the calculation assumes a
constant operating margin. In practice, over-
heads might not increase proportionately and
other scale economies in costs may occur. For
example, if 20 per cent of costs were fixed, the
shareholder value added would jump from £5.6
million to £34.4 million as the pre-tax operating
profit margin grows from 10 per cent to almost
14 per cent of sales. The difference between £5.6
million and £34.4 million emphasizes the
importance of not allowing growth to be at the
expense of margin erosion through propor-
tionate cost increases or price erosion.
Higher prices
Higher prices increase the operating profit
margin and cash flow, so long as these are not
offset by disproportionate losses in volume.
Here, in particular, one sees the advantage of
value analysis over short-term profitability
criteria for evaluating pricing. In the short term,
raising prices commonly increases profits
because many consumers do not immediately
switch. Over the longer term, however, com-
petitive position is often lost, leading to deteri-
oration in cash flow and especially in the
continuing value of the business.
The only sure way of achieving price
premiums is developing products that offer
customers superior value. This may be in terms
of greater functional benefits (e.g. Intel, Micro-
soft) or through offering brands with added
psychological values (e.g. Coca-Cola, Nike). If
premium brands can be created, the value
effects are very substantial. Table 11.1 can be
used to simulate a 5 per cent price increase. If
sales volume is unchanged, the 5 per cent price
increase creates £33 million additional value –
i.e. almost six times more than 5 per cent
annual volume growth. This is, of course,
because a price increase normally incurs no
additional operating costs or long-term capital
requirement, so that the revenue increase falls
straight through into additional free cash
flow.Lower costs
Cutting costs, as long as it does not lead to
offsetting declines in customer patronage,
increases cash flow and the value of the
business. Variable costs can be reduced by
better sourcing, fixed costs by taking out
overheads, and the development of more effi-
cient sales and marketing channels. There is
much evidence that companies with a strong
customer franchise need to spend less on
marketing and promotion (e.g. Reichheld,
1996).
Table 11.1 can also be used to simulate the
effect of a 5 per cent cut in costs. Again they are
very significant, adding £31 million to share-
holder value. As with a price increase, cost cuts
should fall out straight into free cash flow,
unlike volume growth, which involves addi-
tional capital.Reducing investment requirements
Though this varies across businesses, typically
every £1 million of added sales may demand
£500 000 of additional working and fixed capi-
tal (Rappaport and Mauboussin, 2001, p. 27).
Clearly, cutting investment requirements can
have a major impact on the free cash flow
generated and consequently the share price.
Again, there is increasing recognition that
effective customer relationships enhance cash
flow by reducing the level of working and fixed
investments. The trend towards relationship