What’s it: Value creation is about producing something or making something more valuable. We can use it to refer to many meanings.
For example, creating value could be by adding value. Businesses create value by turning inputs into more valuable outputs. It makes consumers willing to pay more. And, the difference between the selling price and the dollars spent buying the inputs is the value they add. In this case, the business creates value for the customer.
In other cases, the business creates value for shareholders. It does so by generating more wealth for shareholders. For example, suppose the company is public. In that case, it is reflected in the dividends distributed and the increase in its stock price. To do so, the company must have a sustainable competitive advantage to generate returns above the average competitor.
Let’s discuss two types of value creation: customer value creation and shareholder value creation.
What is customer value creation?
Customer value creation means offering a valuable product for which the customer is willing to spend more. It requires companies to add value to what they offer. It doesn’t just focus on what’s inherent in the product, like features and quality. But, it also requires the company in other aspects such as customer convenience when interacting with salespeople. Branding is another aspect.
The importance of creating customer value
Businesses produce goods and services by adding value to the inputs they use. For example, a tire manufacturer converts cheap rubber latex into tires and sells it many times.
Creating value allows companies to differentiate their products from those of competitors. By doing so, they can secure their customers in the long run, allowing the money to continue to flow to them.
Three reasons why creating value for customers is essential for companies.
First, the company makes a profit with it. By adding value, they can charge a price higher than the dollar they pay suppliers. The higher the positive difference between the selling price and the unit cost, the greater the company’s profit for each product sold.
Second, the company differentiates its products from competitors’ products. Added value does allow businesses to generate profits. However, adding value alone is not enough. They must differentiate their products by which customers have reasons to prefer their products over competitors’ products.
Third, value creation encourages loyalty and strong long-term relationships. When customers are loyal, they continue to buy products from the same company. So, it keeps the customer’s money flowing to the company.
In addition, loyal customers are usually also willing to recommend products to others. So, the company can save its promotion costs.
Examples of customer value creation
To create value, companies must know who their customers are and understand what they want. It usually requires market segmentation to define the targeted market.
The company then develops a customer profile in which information about the target consumer is clearly defined. They then develop the appropriate marketing mix. Finally, they have to decide what products to sell, at what price, and how to promote and distribute them to consumers.
Another key aspect is developing a unique selling proposition. In the market, companies have to compete with competitors to sell goods. So, they must attract customers and encourage them to continue to buy their products over competitors’ products.
Companies must build differentiation by which consumers have reasons to choose the company’s products over competitors. And, if their differentiation is successful, competitors’ customers may also switch to the company’s products.
There are several ways to create value for customers. They will vary between businesses. Here are some examples:
- Additional features or functions. For example, smartphone manufacturers are embedding high-resolution cameras to create value.
- Quality. Customers prefer quality products over those that are not because, for example, they are more durable.
- Design. When people buy furniture or wooden furniture, design aspects are considered in addition to, for example, the quality of the wood used.
- Convenience. For example, a company saves customers time through its products as fast-food restaurants do.
- Ease of use. For example, consumers like easy-to-use software rather than having to write programs to execute commands.
- Customer service. For example, companies provide a delivery service or offer product installation in the customer’s home.
- Branding. It is about influencing consumers in perceiving the company’s products to create strong brand equity.
What is shareholder value creation?
Creating shareholder value is identified with increasing shareholder wealth. How is it done?
When investing in a publicly-traded company, shareholders have the potential to earn money from two sources:
- Dividend
- Capital gain
Dividends are the portion of net income distributed by companies to their shareholders. Some companies usually routinely pay dividends. Others may not, may hold it as retained earnings to strengthen internal capital.
Capital gain is the shareholder’s gain when selling the stock price higher than the purchase price. Thus, the higher the stock price rises after they buy, the bigger their profit.
Value creation is usually associated with a sustainable competitive advantage. If successful, the company provides higher returns to shareholders than the industry average. Experts use return on invested capital (ROIC) as an indicator to measure it.
The importance of creating shareholder value
Shareholders supply equity capital to the company. It becomes one of the sources of funding to grow the company’s business in the long term. Thus, the company must create value for shareholders to ensure investment capital is available in the future. Happy shareholders are also willing to inject new capital when company management needs it.
Take public companies as a case. By creating value, the company’s share price eventually follows. An increase in the share price allows the company to raise more funding in the future. For example, when they need additional capital, they can issue new shares. Because the stock price is high, the company can raise large funds.
Linking shareholder value with ROIC and competitive advantage
Return on invested capital (ROIC) is often used to measure a company’s ability to create value. It tells us how much return the company makes for every capital invested in the company.
When posting a higher ROIC than the cost of capital – measured by the weighted average cost of capital (WACC), the company creates shareholder value. Therefore, the company invested money optimally from a management perspective because it generated a higher return than the costs incurred to raise capital.
On the other hand, shareholders – stock investors – view the cost of capital as the risk they are willing to tolerate to invest money in the company. So, because of the higher ROIC, they get a higher return than the risk they take.
Then, before investing in a company, shareholders have several alternative companies to choose from. They can choose a company or its competitors, depending on how high the potential returns are offered. And, of course, they will choose the company with the highest ROIC.
The highest ROIC is usually associated with the company’s success in gaining and maintaining a competitive advantage. And, to gain a competitive advantage, it can choose two alternative competitive strategies: cost leadership and differentiation, as Porter suggests in his generic strategy.
Then, in the theory of resource-based view, competitive advantage is supported by the company’s core competencies. It is formed from the company’s resources and capabilities in using them to create value. Besides being valuable, core competencies must be rare, difficult to imitate, and non-substitutable.
Finally, competitive advantage can come from many aspects of a business. For example, it could be from the cost advantage of having an efficient logistics system. Technological capabilities can be another source. Then, providing superior value to customers by offering uniqueness is another example.
