Fundamental Principles of Value Creation

Most people think that a company's only job is to make money. While it is certainly important for a company to be profitable, there are several ways in which a company can create value.

Here we will discuss the four fundamental ways in which companies create value. We will also provide examples of companies that have succeeded by using these methods.

Companies can create value for their key stakeholders by doing the following: 1) providing a good or service that customers want or need, 2) reducing operating costs of their suppliers, 3) benefiting employees by making their workplaces more attractive, and 4) earning profit by deploying capital at rates of return that exceed its cost.

Key stakeholders

Stakeholders are the people who have a vested interest in your company's success. Key external stakeholders include customers and suppliers, while key internal ones include employees, founders, and other shareholders.

The best way for any business to be successful is by focusing on all of its key stakeholders.

Customers buy the company's products for their perceived value. This could be in the form of utility, price, or quality. A company that provides a product or service that its customers want or need is more likely to be successful than one that does not.

A company can add value for its suppliers by helping them increase their productivity and reduce their operating costs. As suppliers' costs go down they are more willing to accept lower prices for their goods or services which in turn benefits and creates value for the company sourcing those goods or services.

Employees provide their services in exchange for financial and personal benefits by working at a company. If they feel like their company is doing well and caters to them by providing attractive working conditions, competitive wages, or more career development opportunities, they will be more likely to stay and continue working hard. On the other hand, if they feel undervalued or less regarded at their workplace they are likely to start to look for other opportunities.

Founders are the people who started the company and have a significant ownership stake. They also have a lot of control over the company's direction. Like employees, they want to see the company doing well so that their shares will be worth more.

Shareholders are people who own shares in the company. They may be employees, founders, or outside investors. They want to see the company making money so that they can make a profit from their investment.

Value-based strategy

As we have seen, various stakeholders perceive value differently. Investors are focused on financial value and making financial gains from their investments, while customers, suppliers, and employees are focused on the perceived value that they draw from a relationship with a company. Only when a company can grow and sustainably deliver value for all these actors is a company also well positioned for long-term financial success.

Value-based strategy is all about simultaneously creating value for customers, employees, and suppliers. If a strategic initiative does not create value for customers, employees, or suppliers, it is not worth pursuing it. The management should focus on value creation, not profit itself. Profit will naturally come as a consequence of superior value creation.

A good way to demonstrate the concept is via a value-based strategy framework developed at HBS (see image below).

Value created = customer delight + company profit + employee satisfaction & supplier surplus

Customer delight represents the value captured by end customers. It equals the amount by which customers' perceived value of the company's products or services is greater than the price they paid. The higher the customer delight, the higher the perceived value that customers get when interacting with a company, and the higher also the price that customers are willing to pay (WTP). The best way for a company to increase customer delight is not by decreasing prices but by increasing WTP and creating additional value for customers through innovation, complements, or network effects.

Supplier surplus and employee satisfaction stand for the value that suppliers and employees extract when interacting with a company. Cost is what a company pays in total for its products and services, including material and labor. The higher the cost above the combined price at which the suppliers are willing to sell their inputs and employees are willing to provide their labor (such combined price is called willingness to sell (WTS)), the higher the delight of suppliers and employees. The best way for a company to maximize value for suppliers and employees is to lower their WTS by helping them achieve better productivity and by creating better working conditions.

Finally, the company's profit is the value captured by a company. It is the difference between the price it charges for its products and their cost. By setting the price, the company essentially determines how the value is shared with its end customers. It must always be a balancing act as enough value must be shared with customers if the company is to build brand loyalty and have them make repeat purchases.

Long-term horizon

To create lasting value for all of its key stakeholders, a company must have a long-term horizon. This means focusing on the future and not being solely driven by short-term metrics. Only then will the company be well-positioned to create lasting value for all of its stakeholders.

The evidence suggests that companies with a long-term mindset create more value than those with a short-term one. There are two primary drivers of long-term value creation: organic revenue growth and continuous investments in research and development. Both of these require a long-term focus to be successful. Focusing on the short term will only lead to fleeting gains that do not create lasting value.

Organic revenue growth

Organic revenue growth is the primary driver of value creation for companies. Companies need to focus on growing their top line to create more value for shareholders. Revenue growth can be achieved through several means, such as expanding into new markets, developing new products or services, or acquiring new customers.

Each of these takes time, effort, and money to accomplish. They also require a certain amount of risk. But the potential rewards are worth it for companies that want to create lasting value.

Continuous investments in research and development

Investing in research and development is essential for companies that want to innovate and stay ahead of the competition. It is also necessary for companies that want to create new products or services that customers will want to buy.

Research and development can be expensive, but the rewards can be significant. Companies that make continuous investments in this area are more likely to create value for shareholders over the long term.

Some examples

Some of the most successful companies in the world have been able to create value in multiple ways.

Apple, for example, is known for both its innovative products and its strong corporate culture. They provide products and services that are high quality and stylish, and they are always up-to-date with the latest technology. The iPhone and iPad are popular products that customers want and need, and Apple's retail stores are highly sought-after places to work. Apple has also been successful in deploying its capital at high rates of return. This focus on creating value has helped them become one of the most successful companies in the world.

Walmart is another company that has been successful in creating value for its stakeholders. They offer low prices on a wide variety of products, which has made them the largest retailer in the world. They also focus on creating a good workplace environment for their employees, which helps to reduce staff turnover and increase productivity. By doing this, they can keep their costs down, which in turn allows them to offer low prices to their customers.

Google is a company that has been successful by providing a service that customers want and need. They are the largest search engine in the world and handle billions of searches every day. They also offer other services such as email and maps. Google has been able to grow its business by expanding its customer base and increasing its market share.

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References / useful reading:

1. Felix Oberholzer-Gee: "Better, Simpler Strategy: A Value-Based Guide to Exceptional Performance", Harvard Business Review Press (20 April 2021)
2. Felix Oberholzer-Gee: "Eliminate Strategic Overload: How to select fewer initiatives with greater impact", Harvard Business Review (May-June 2021), https://hbr.org/2021/05/eliminate-strategic-overload