Report of the NACD Blue Ribbon Commission on Performance...

Report of the NACD Blue Ribbon Commission on

Published by the National Association of Corporate Directors

The NACD Center for Board Leadership

Heidrick & StrugglesKPMG’s Audit Committee InstituteOliver WymanPearl Meyer & PartnersWeil, Gotshal & Manges LLP

SUPPORTED BY

AND ITS PARTNERS

Performance MetricsUnderstanding the Board’s Role

Report of the NACD Blue Ribbon Commission on Performance Metrics i

Report of the NACD Blue Ribbon Commission

on

Performance Metrics:Understanding the Board’s Role

2010

A Publication of theNational Association of Corporate Directors

and The NACD Center for Board Leadership and its Partners:

Heidrick & StrugglesKPMG’s Audit Committee Institute

Oliver WymanPearl Meyer & Partners

Weil, Gotshal & Manges LLP

National Association of Corporate Directors1133 21st Street, NW

Suite 700Washington, DC 20036

202-775-0509www.nacdonline.org

Report of the NACD Blue Ribbon Commission on Performance Metricsii

The NACD “Blue Ribbon Commission”Report SeriesFor two decades, NACD has issued Blue Ribbon Commission reports on a variety of topics, updating them asnecessary. Reports have covered the following topics (listed in order of original publication).

Executive Compensation:Guidelines for Corporate DirectorsJean Head Sisco, Chair

Evaluation of the Chief Executive, Board, and Directors Boris Yavitz, Chair

Director Compensation:Purposes, Principles, and Best PracticesRobert B. Stobaugh, Chair

Director ProfessionalismIra M. Millstein, Chair

CEO SuccessionJeffrey Sonnenfeld, Chair

Audit Committees:A Practical GuideA.A. Sommer, Jr., Chair

The Role of the Board in Corporate StrategyWarren L. Batts andRobert B. Stobaugh, Co-Chairs

Board Evaluation:Improving Director EffectivenessRobert E. Hallagan andB. Kenneth West, Co-Chairs

Risk Oversight:Board Lessons for Turbulent TimesNorman R. Augustine andIra M. Millstein, Co-Chairs

Executive Compensation and the Role of the Compensation CommitteeBarbara Hackman Franklin and William W. George, Co-Chairs

Board LeadershipJay W. Lorsch andDavid A. Nadler, Co-Chairs

Director Liability Justice E. Norman Veasey,Chair

The Governance Committee:Driving Board PerformanceJohn A. Krol, Chair

Board-Shareholder CommunicationsDennis R. Beresford andRichard H. Koppes, Co-Chairs

Risk Governance: Balancing Risk and Reward Adm. William Fallon andDr. Reatha Clark King, Co-Chairs

The Audit Committee Dennis R. Beresford andMichele Hooper, Co-Chairs

Performance Metrics:Understanding theBoard’s RoleJohn Dillon andWilliam White, Co-Chairs

Report of the NACD Blue Ribbon Commission on Performance Metrics iii

Commission MembersWith Primary Affiliations and Current Board Seats*NACD Board Member

Co-ChairsJohn T. DillonInternational Paper (Ret.)Caterpillar, Inc.E.I. DuPont de Nemours & Co.Kellogg Company

William J. White*Northwestern UniversityBell & Howell (Ret.)Context Media, Inc.

Comission MembersPeter Clapman*Governance for Owners, LLPAARP Mutual Funds; iPass

Betsy CohenRAIT Financial Trust

Kenneth DalyNACD

Theodore DysartHeidrick & StrugglesWorcester Polytechnic Institute

Charles ElsonUniversity of Delaware, Weinberg Center for Corporate GovernanceHealthSouth

The Honorable Barbara Franklin*Barbara Franklin EnterprisesAetna, Inc.; American Funds; Dow Chemical Company

Peter GleasonNACD

Holly GregoryWeil, Gotshal & Manges LLP

Robert E. HallaganKorn/Ferry InternationalBerkshire Life Insurance Co; Bush Industries

Karen Hastie Williams*Crowell & MoringContinental Airlines; Chubb Inc.; Gannett Company; SunTrust Bank; Washington Gas

Michele Hooper*The Directors CouncilAstra Zeneca; PPG Industries, Inc.; UnitedHealth Group; War-ner Music Group

Reatha Clark King*General Mills Foundation (Ret.)General Mills, Inc. (Ret.)

Jannice KoorsPearl Meyer & Partners

Gregory E. Lau*General Motors Company

Patrick A. LeeKPMG’s Audit Committee Institute

Mary Pat McCarthyKPMG’s Audit Committee Institute

Bruce NolopE*Trade FinancialMarsh & McLennan

John F. OlsonGibson, Dunn & Crutcher LLP

Charles TharpCenter on Executive CompensationNational Academy of Human Resources Alex WittenbergOliver Wyman

Christianna WoodInternational Corporate Governance NetworkH&R Block; International Securities Exchange

Report of the NACD Blue Ribbon Commission on Performance Metrics v

About the Publisher and Sponsors

National Association of Corporate Directors (NACD), an independent nonprofit it organization founded in 1977, is the country’s only membership organization devoted exclusively to improving corporate board performance. NACD conducts educational programs and standard-setting research, and provides information and guidance on a variety of board governance issues and practices. Membership comprises board members from U.S. and overseas

companies ranging from large publicly held corporations to small, over-the-counter, closely held, and private firms. With chapters in many major cities providing educational programs and networking opportunities, NACD operates at both a national and local level.

In response to growing demand for information and guidance on effective board leadership issues, Heidrick & Struggles International joined with NACD to form the NACD Center for Board Leader-ship. Heidrick & Struggles International is now joined by four other partners to support the activities of the NACD Center for Board Leadership. This organization, which is internationalin scope, is focused primarily on defining, establishing, and refining “best practices” to en-hance board performance. To accomplish this, the NACD Center for Board Leadership engages in substantive research projects on critical board topics and holds CEO and director roundtable dis-cussions to help organizations continuously improve boardroom performance.

Partners

Heidrick & Struggles International, Inc. (www.heidrick.com) is a leading executive search firm, specializing in chief executive, board of directors, and senior-level management assignments. Contact Ted Dysart at (312) 496-1860.

KPMG’s Audit Committee Institute (www.kpmg.com/aci) was established by KPMG in 1999 as a resource for audit committees and senior management. ACI’s main mission is to communicate with audit committee members to enhance their awareness of, commitment to, and ability to implement effective committee processes. Contact Caryn P. Bocchino at (201) 505-2012, or ACI at (877) 576-4224.

Oliver Wyman (www.oliverwyman.com), is the leading management consulting firm combining deep in-dustry knowledge with expertise in strategy, operations, risk management, organizational transformation, and leadership development. Oliver Wyman is part of Marsh & McLennan Companies. Contact Alex Wittenberg at (212) 541-8100.

Pearl Meyer & Partners (www.pearlmeyer.com) is a leading executive compensation consultant to senior management and board compensation committees, creating custom designed executive and board pay pro-grams in support of the goals and strategic plans of each client. Contact David Swinford at (212) 644-2300.

Weil, Gotshal & Manges LLP (www.weil.com), an international law firm, has been at the forefront of corporate governance developments for more than two decades. Under the leadership of Ira M. Millstein, the corporate governance practice draws from the firm’s corporate, securities, litigation, tax, and restructuring practices. Contact Holly J. Gregory at (212) 310-8038.

Report of the NACD Blue Ribbon Commission on Performance Metricsvi

Table of ContentsNACD BRC Report Series . . . . . . . . . . . . . . . . . . . . . . ii

List of Commissioners . . . . . . . . . . . . . . . . . . . . . . . . iii

About the Publisher and Sponsors. . . . . . . . . . . . . . . . .v

Letter from the Co-Chairs . . . . . . . . . . . . . . . . . . . . . .1

Chapter 1Understanding the Board’s Role . . . . . . . . . . . . . . . . 3

Chapter 2Selecting and Using Metrics . . . . . . . . . . . . . . . . . . . 7

Chapter 3Compensating Executives . . . . . . . . . . . . . . . . . . . . .12

Chapter 4Communicating to the Marketplace . . . . . . . . . . . . . .16

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17

Appendix AMetrics Categories: Samples . . . . . . . . . . . . . . . . . . 19

Appendix BExamples of Performance Disclosures . . . . . . . . . . . .22

Appendix CHybrid Techniques for Valuation . . . . . . . . . . . . . . . .28

© Copyright 2010National Association of Corporate Directors

All rights reserved. No part of the contents hereofmay be reproduced in any form without the prior

written consent of the National Association ofCorporate Directors.

This publication is designed to provide authoritativecommentary in regard to the subject matter covered. It is provided with the understanding that

neither the authors, nor the publisher, the National Association of Corporate Directors, is engaged in rendering legal, accounting, or other professional services through this publication. If legal advice or

other expert assistance is required, the services of a qualified and competent professional should be sought.

ISBN 978-0-943176-53-6

Report of the NACD Blue Ribbon Commission on Performance Metrics 1

Directors are expected to oversee corpo-rate and executive performance, but this is not always easy—especially in large,

complex companies. To fulfill their oversight re-sponsibilities, directors require clear and focused metrics to measure and communicate the finan-cial and non-financial criteria that are critical to the success of their enterprise. A clear under-standing of corporate and executive performance will empower boards to excel in these important responsibilities. Establishing the appropriate metrics to determine executive progress in achieving stra-tegic goals and competitive success is a critical board task, yet given the company-specific nature of such decisions, little helpful guidance is avail-able in the governance literature. This is the issue our Commission was formed to address. As directors, we see a lot of numbers—mostly historical data from financial reports. While this information is critically important, there is much more at work in an organization. Directors rarely receive regular reports on other critical issues, such as executive development, workplace safe-ty, or product innovation. While many companies are now enhancing their reporting on these areas, more can and should be done. Directors must focus on the information needed to understand what the company is truly accomplishing in core areas. In an effort to create more efficient methods of measurement, accountants, consultants, and regu-latory agencies have devised and circulated scores of metrics, both financial and non-financial. In turn, this has led to a great quantity of evaluation tools without a true sense of quality and priority. Boards may receive too much data without evalu-

ating what impact it has on the achievement of corporate goals. The lack of meaningful metrics is only one obstacle to overcome; director com-prehension of the board’s role in metric selection and monitoring also needs improvement. In addi-tion, directors have an affirmative duty to oversee performance for both the short- and long-term health of the enterprise. Yet, directors often defer to management to establish the metrics by which the board will judge the success of the manage-ment team. Improving director understanding of met-rics is likely to improve the board’s ability to link pay to performance. While this report does not focus specifically on compensation, the Commis-sion recognizes that metrics are indispensable for determining executive pay. With an improved un-derstanding of both the board’s role with respect to establishing the metrics by which performance is assessed, and the types of metrics that can be used to track the critical elements that contribute to corporate performance, boards and compensa-tion committee members are better positioned to create meaningful incentives and to identify pay practices that may be misaligned. In order to properly understand metrics, the board must first put a spotlight on three areas: the board’s role in selecting metrics, the relation of metrics to compensation, and how to effectively communicate the metrics structure to sharehold-ers. To this end, in the chapters that follow, we recommend six imperatives to guide boards as they consider the performance metrics used by their company:

1. Understand and agree on the company’s key performance metrics. These key metrics, set

Letter from the Co-Chairs

Report of the NACD Blue Ribbon Commission on Performance Metrics2

for both the enterprise as a whole and for major business units, should be used to track progress against the company’s strategy.

2. Establish company performance metrics to cascade throughout the entire enterprise. The board should ensure that management has used the metrics to establish more robust and detailed metrics at lower levels.

3. Track company performance against metrics on an ongoing basis. Metrics need to be set annually and monitored over time.

4. Establish consistent and appropriate executive performance metrics. These measures should be used not only for compensa-tion of top officers, but also for managers through-out the organization.

5. Reward executives based upon performance as measured by appropriate metrics. Deter-

mine compensation payments based upon an as-sessment of performance, including consideration of risk, for top officers and other levels of man-agement.

6. Communicate with shareholders regarding how the company has paid for performance. Use clear language to convey the reasons and re-sults of pay.

This report seeks to provide guidance in these areas. Undertaken with care, the effort to improve performance metrics will empower corporate di-rectors to help build stronger corporations. We hope that directors will find that this report is valuable to them in working with their manage-ment to develop and use appropriate metrics for their companies.

John DillonWilliam WhiteOctober 2010

Letter from the Co-Chairs


Providing oversight of corporate performance lies at the heart of the board’s role. This responsibility has increased dramatically

over the last several years due to increased busi-ness complexity, board activity, and commitment expectations. Additional regulatory and legislative changes have also prompted keener attention to governance issues at the board level. At the same time, shareholders have placed a sharper focus on financial results and executive pay. Therefore, pri-ority must be placed on understanding corporate performance metrics, engaging in dialogue with the senior leadership team, and providing the se-nior leadership team with feedback on their perfor-mance relative to the established goals. Understanding corpo-rate performance requires information well beyond the traditional financial metrics. This additional in-formation, based on value drivers and strategic objectives, can help a board add value to boardroom discussions and reinforce a corporation’s competitive advantage. Receiving additional corporate information alone, translated into metrics, is not sufficient. Corporate leaders must select metrics that encap-sulate the company’s strategy, the balance of risk and reward, and the milestones along the way. Consequently, metrics should result from a robust dialogue between management and the board. This dialogue is critical to implementing a winning strategy. When used prospectively, metrics help establish goals to propel corporate strategy. Directors must understand that metrics do not merely reflect what a

company has done, but also how individuals intend to carry out and accomplish a corporate strategy. So how does the board add value to metrics discussions with management? Both the board and management should engage in a conversation re-garding how the company actually makes money and what differentiates it from competitors. This is essential in educating the board, and often manage-ment, about the kinds of performance targets that need to be set, measured, rewarded, and eventually communicated. At a basic level, the board must review and ap-prove management’s selected metrics. But a board’s role goes deeper than this: it must emphasize the importance of value-drivers and the reward system

used to motivate employee behaviors; both are critical to the success of the com-pany. We recommend six im-peratives to guide the

board in the application of performance metrics for their company: Imperative #1: Understand and agree on the company’s key performance metrics. A director’s responsibility is to oversee and aid corporate growth and positive performance relative to competitors. Essential to this role is the board’s duty to monitor corporate performance. Boards typically consider stock prices, revenues, and cash flows in order to accomplish this. While these are indispensible measures of performance, they do not capture all the factors that will drive sustain-able profitability. There are countless ways to approach corporate valuation. It would be impossible to list all of the

Understanding the Board’s RoleChapter 1

Metrics should result from a robust dialogue between

management and the board.


metrics and tools used in the marketplace today. Management and the board must first agree on the “key” corporate activities that they will monitor to track performance both in the short and long term. These areas are the “value drivers” that propel a corporation’s strategy and ultimately its long-term success or failure. Company value drivers may be seen as “enablers,” which are necessary to achieve the short- or long-term corporate objectives. Often these enablers are based on human talent, intellectual capital, product innovation, or superior execution. Some may argue that financial outcomes are the result of these matters. However, historic financial metrics often will not provide an early indication of progress or problems; thus corporate leaders should not wait for bad results to address these issues. Management and the board should create a scorecard of metrics with a balanced mix of finan-cial and nonfinancial measurements. Boards should determine the critical number of metrics in a scorecard that allow for a comprehensive mea-surement of the company while still concentrating on its particular key value drivers. Generally, the scorecard will contain between five to ten metrics, but may contain more as determined by the board. No particular side of the metrics, financial or other-wise, should dominate in any overall performance scorecard. Imperative #2: Create company performance metrics to cascade throughout the enterprise. The use of metrics must go beyond management and senior executives. All employees need to un-derstand their responsibilities toward accomplish-ing the strategic objectives. The setting and meet-ing of metrics then becomes a cultural asset for the company. Senior managers should consider their own per-formance metrics, as monitored by the board, and use them as a basis to establish more robust and detailed metrics cascading throughout the entire

enterprise. There should be perhaps hundreds of metrics tailored to the specific functions or depart-ments of a company and to the roles and responsi-bilities of successively lower levels of leadership. Each metric would be intended to further the goal of corporate strategic objectives. However, all em-ployees in leadership positions should share a small set of metrics—two to five—tied to enterprise-wide performance, whether financial or otherwise. Incentive compensation would then be delivered or not delivered to all managers as the enterprise-level metrics are achieved or not achieved. While management would not be expected to have comprehensive knowledge of all the data from every division, it provides an excellent inventory of information to track performance at different levels and different business units of the company. It is

also crucial that man-agement communicate to employees the im-portance of achieving metrics for driving cor-porate performance.

This approach provides a broader selection of metrics to track progress at different levels of the organization. This may also reveal metrics that can be used as early indicators of risk. Using data as an early warning system allows for correction, or imitation, when needed. Where early indicators are not apparent, management should look “up-stream” and place metrics around activities seen as the building blocks for the successful outcome of a strategic objective. Such activities may appear minor, but are nonetheless foundational for a cor-poration’s success. For example, weakening safety performance signals a failure to follow operating procedures which will soon be expressed in pro-duction or quality problems. Similarly, declining employee engagement may be a foreshadowing of less innovation.

TYPES OF METRICS Management is responsible for developing company appropriate metrics. The board decides

Using data as an early warningsystem offers advance signs of

progress or problems.

Chapter 1: Understanding the Board’s Role


whether the metrics are appropriate to establish long-term competitive advantages and sustained creation of shareholder value. There are several things to consider when making this determination, including the use of “hard” or “soft” data, whether to focus on long- or short-term goals, and measur-ing performance against industry peers.

Qualitative vs. Quantitative A meaningful evaluation of corporate perfor-mance is impossible without the right mix of quan-titative and qualitative metrics. Qualitative met-rics, or “soft” data, may not always allow for easy measurement. Consequently, management must determine methods to extract quantifiable “hard” information by defining subjective measurements with objective data. To do so, it may be helpful to look at collateral evidence. For example, it may be difficult to monitor employee development but good “bench strength” may be evidence of effec-tive training programs. This approach permits greater flexibility with qualitative metrics, but the Commission recom-mends that all metrics be reported quantitatively. Reporting of soft, or undefined, metrics can pos-sibly be used as a justification for failure. Boards

should make every attempt to base performance assessments, and eventually executive incentive compensation, on data that is not subjective.

Absolute vs. Relative The selection of metrics also includes the con-sideration of both absolute and relative perfor-mance. Boards often believe they must measure performance against peers, rather than setting and meeting an absolute goal. Those who favor measurement against peers point out that the mar-ketplace is a relative world where outperforming your competitors is a corporate necessity. This ap-proach, however, is not without problems; reward-ing executives in poor economic climates can be-come difficult. By contrast, absolute goals provide clear mea-surements of performance and are easier for em-ployees to understand. They can also be useful for determining progress against long-term corporate strategies. While the use of absolute goals has its advantages, this approach requires some flexibility to be practical. Economic realities can often pres-ent the impossibility of meeting pre-established and concrete goals. Therefore, a balanced system of both relative and absolute goals is the most ap-


Relative Performance Measurement Considerations*Advantages Disadvantages

Can address difficulty of setting goals in highly vola-tile markets or cyclical industries

Highly dependent upon the ability to define an appropriate peer group

Provides an important market perspective to an often internally focused budget process

Timeliness and comparability can be challenging

Can reinforce and validate the “pay-for-performance” alignment

May result in high payouts for being “the best of the worst”

Recognizes that companies compete for capital by shareholders

Can muddy the “motivational” aspect of incentives, since it is hard to track relative performance during theperformance period

Provides a useful standard for assessing how com-petitive the company is versus peer companies

Can result in lack of innovation

* Pearl Meyer & Partners



propriate approach. Companies are encouraged to find the right mix of metrics as appropriate for their particular indus-try. No single metric, absolute or relative, should dominate in any measurement of corporate perfor-mance. It may be helpful to use absolute goals for internal, non-financial metrics while relative goals are used primarily to measure financial perfor-mance. When measuring performance against peers, a key consideration is the accuracy of information. An annual review must be conducted to ensure that management’s choice of peers is appropriate and the data is reliable and comparable. This requires a substantial discussion between management and the board regarding peer companies. The board adds value by discussing management’s choices along the lines of corporate size, complexity, in-dustry position, and strategic direction.

Short vs. Long Term The establishment of goals naturally follows the creation of a corporate strategy. Sustainable cor-porate growth, by definition, cannot develop with-out careful coordination between a strategy and the company’s short- and long-term goals. While boards must oversee both sets of goals, they should

place their attention on long-term performance. When approving metrics for managers, directors must consider the implication of management’s ac-tions on the long-term corporate strategy. Short-term performance cannot be ignored, but it should be considered in the context of the overall corporate strategy and management of risk. Each short-term goal should align with the strategy of the organization or position the company to achieve long-term objectives.

What Does “Long Term” Mean? “Long term” means different things to dif-ferent companies. Many companies view “long term” as between three and five years.* Nota-bly, the SEC proxy access rules set a three-year holding period as a key differentiator between a company’s long-term owners and those who are holding stock for the short term. By con-trast, some industries view “long term” as ten years or more, while others consider it to be any period of more than one year. Despite this debate, the duty of directors is to focus on the health of the corporate enterprise as a continu-ing entity.

*2010 NACD Public Company Governance Survey


Corporate metrics exist to capture a tremen-dous amount of information and present it in the most meaningful and concise way.

Of course, not all metrics are relevant to the board of directors. As part of its oversight responsibility, the board monitors corporate performance against a strategic plan. Therefore, board-level metrics must have a clear correlation to a strategic objective. Imperative #3: Track company performance against metrics on an ongoing basis. The basic selection of metrics should remain con-sistent over several years along with strategic plans and incentive compensation programs. Metrics used for board decision-making should, however, be re-viewed for effectiveness on an annual basis. Many organizations have created a “balanced score-card,” based on the original created by Robert Kaplan and David Norton, to quickly assess the performance of an organization. This original scorecard features four perspectives: financial, customer, internal busi-ness processes, and learning and growth. While this approach may be appropriate for some companies, boards are encouraged to select the metrics most relevant to understanding the value drivers of their organization. There are three considerations a board must make when approving metrics. First, desired performance outcomes must be defined to delineate success or failure against goals. Therefore, each metric should have a defined range of acceptable outcomes identi-fied by a minimum, target, and maximum. The mini-mum is the threshold of acceptable performance; failure to meet this goal does not warrant incentive

compensation. A target is the expected level of per-formance necessary to carry out the strategic objec-tives of the organization. The maximum indicates the level at which performance has greatly exceeded expectations, but incentive compensation will no longer escalate. These performance levels serve a dual purpose: they enable directors to monitor prog-ress while offering a basis to reward executives. Compensation structures also should be de-veloped to include “stretch goals,” by establishing a goal—and corresponding rewards—beyond an expected performance level. This may incentivize management to pursue greater results. Second, consideration should be given to adjust-

ment of the performance levels. As the saying goes, a rising tide lifts all boats, but the opposite is also true; a corporation’s performance will naturally change due

to external factors, typically in times of economic boom or bust. Directors may determine, in their dis-cretion, whether it is appropriate to condense time frames and place greater emphasis on short-term goals and performance. Boards should carefully consider the ramifications of such changes, and have conviction that there is no resulting misalignment between short- and long-term goals. Finally, various metrics may be weighted ac-cording to importance, with the heaviest weights as-signed to areas deemed most critical to the company. The weights may be considered for the purposes of a general performance assessment as well as for com-pensation. No particular metric should be weighted so heavily that all other measurements become inef-fective or unimportant.

1

2

Selecting and Using MetricsChapter 2

Metrics must have a clear correlation to a strategic

objective.


NONFINANCIAL METRICS There are advantages and drawbacks to every metric and it is crucial for boards to understand how measurements are created. Directors add value to boardroom discussions by “getting behind the data” and constructively challenging its appropriateness and then applicability. The Commission has identified several broad nonfinancial categories that directors can incorpo-rate into a scorecard. Each category contains a non-exhaustive list of the available metrics to be used. It is not the role of the board to monitor every single metric; the key is to select metrics that are best for understanding and measuring the value drivers in the organization. The following are potential nonfi-nancial categories to incorporate into a scorecard:

NONFINANCIAL METRICS CATEGORIESBusiness Development• Community Engagement/Corporate Social • ResponsibilityCompetition/Market Share• Corporate Culture• Customer Satisfaction• Environment, Health, and Safety • Ethics•

Executive Talent Management/Succession• Human Capital• Innovation/Innovative Culture• Legal/Regulatory Compliance• Logistic Capabilities• M&A Execution and Integration• Operations• Product Quality• Reputation• Risk Management• Tone at the Top•

The nonfinancial metrics categories listed above are merely a starting point; some companies may wish to expand and reward other performance areas, such as leadership. The Commission recommends monitoring the five nonfinancial areas below and adjusting as appropriate. Each nonfinancial metric below contains examples of measurement. There are additional examples in Appendix A.

Community Engagement Corporations large and small have an enormous impact on their local communities. Engaging with the community and helping improve quality of life for employees and local constituents should be

Chapter 2: Selecting and Using Metrics

Frequently Used Nonfinancial MetricsWhich nonfinancial corporate metrics do you analyze for the purposes of senior executive compensation?

Nonfinancial Metrics ResponseCustomer satisfaction 53.7%

Legal compliance 40.5%Employee morale 37.4%Product quality 29.6%

Workplace safety 29.6%Employee turnover 19.3%Workplace diversity 13.6%

Other 23.6%

Source: 2010 NACD Public Company Governance Survey


done as part of business strategy and a driver of shareholder value. The following metrics should be considered when evaluating communityengagement:

contributions to local charities • HR policies encouraging employees to • volunteer in the communityenvironmental impact•

Customer Satisfaction with Products and Services Understanding the customer’s wants and needs is an essential, elemental need for a company. Quality determines the viability and sustainability of a business, and, therefore, metrics intended to provide a continuous picture of customer satisfac-tion with a product is crucial to the measurements a board receives. When customer satisfaction and product quality surveys are used, it is important to have inde-pendent third parties verify or conduct the data collection. The following metrics may be useful for measuring customer satisfaction:

sales figures• number of product recalls and returns• market share• customer service performance (e.g., “first call • resolution”)

Executive Talent Management Identifying the internal talent available to replace senior executives should be a top concern in every company. The board needs to ensure management is developing talent and building up the company’s “bench strength.” Special concern should be given to finding potential in individuals and to groom leadership candidates early in their careers to develop a robust pipeline of talent. The following metrics may be useful for measuring progress with executive talent management:

turnover of executive positions• number of candidates eligible to succeed • current C-suite executivesnumber of diversity candidates• effectiveness of programs created to educate • and develop candidates

Innovation Companies cannot rest on their laurels. The need to improve and compete is a constant busi-ness imperative. Boards should keep a keen eye on the business’s ability to meet, exceed, and change customer expectations and experiences. The fol-lowing metrics may be useful for understanding a company’s ability to innovate:


When linking pay to long-term corporate performance, how do your [company] pay plans define “corporate performance”?

Profits 66%Sales (revenue) 41%

Cash flow 36.3%Ratios such as EPS 30.7%

Stock price 30.6%Hybrid measures such as EVA or CFROI 16%

Assets 9.6%Other 24.2%

Source: 2010 NACD Public Company Governance Survey



number of new patents, copyrights, and/or • trademarks spending in research and development (growth • rate, comparison to peers) number of new products to market• innovation share vs. competition•

Tone At The Top Few responsibilities are as important or im-pactful as “tone at the top.” Establishing a culture of ethical behavior and goal achievement must be promoted and dutifully monitored. Quantifying and judging a corporate culture can be difficult, but there are certain indicators, such as workplace sat-isfaction or employee productivity, that work well. These areas should be routinely monitored and considered with the highest priority. The following may be useful metrics to evaluate tone at the top:

“perception” surveys of key senior executives • and investors to judge the corporate “tone”workplace satisfaction statistics• employee engagement• ethics violations•

FINANCIAL METRICS The valuation tools below are the most com-monly used for measuring short- and long-term financial performance. Wall Street analyst re-ports are also frequently used to understand cor-porate performance from an external perspective. Additionally, there are a host of hybrid measure-ments that are gaining in popularity and preferred by many institutional investors. (See Appendix C for descriptions of several valuation hybrid tech-niques.) Nearly all financial metrics have multiple methods of calculation or sources of data. Directors should not take any metric at “face value;” rather, directors should look at collection methods and ascertain whether the data is credible

and accurate. This Commission does not endorse any particular financial metric, as all are widely used and measured. Rather, consistent reporting and year-over-year comparisons are critical for un-derstanding each of the following metrics:

profits/margins• return on investment (ROI)• working capital• revenue growth• cash flow• capital expenditures• earnings per share (EPS)• earnings before interest, taxes, depreciation • and amortization (EBITDA)total shareholder return (TSR)• working capital•

PRESENTATION OF METRICS When directors meet, they have a finite amount of time to discuss a seemingly infinite amount of information. Board members receive an ongoing flow of information from various parts of the orga-nization, but not all of it may require examination. Therefore, when presenting to the board, manage-ment should focus on fewer metrics and report on them more frequently. Boards may find it helpful for management to provide the entire scorecard of metrics but should highlight five or six for in-depth analysis and discussion. These highlighted metrics should then be presented to board members with sufficient regularity between board meetings, as de-termined by the directors. The highlighted metrics should focus on those areas where a deviation or variance (either positive or negative) from the expected performance level occurs. The board may also choose to ask manage-ment what metrics they are closely monitoring and what they think is challenging or changing in the business.

3


RED FLAGS There are certain practices to avoid when estab-lishing metrics. The Commission has highlighted several practices that should be clear “red flags”:

metrics that may incentivize excessive risk • taking or unethical behaviormetrics that are not easily verifiable• metrics which the management team has little • or no ability to influence

Reporting of NonfinancialsPresentation of nonfinancial metrics such as environmental impact and community engagement can present a challenge to some companies. Boards may wish to consult the Global Reporting Initiative (www.globalre-porting.org) on methods to provide informa-tion to boardroom members as well as other external stakeholders.



Appraising executive performance and es-tablishing executive compensation are functions of the whole board, not just the

compensation committee. However, the committee should provide strong support to the board by fo-cusing on the more detailed aspects of executive compensation. CEO input is also a critical compo-nent of determining pay. The board and the CEO should discuss and agree on the performance met-rics to be used in setting incentive compensation. Imperative #4: Establish consistent and ap-propriate executive performance metrics for all levels of management. Corporate leaders often wrestle with finding the best pay mix to motivate and reward senior management performance. Executive incentive com-pensation should be rea-sonable and flow from the accomplishment of critical objectives or initiatives that improve the performance of the enterprise. As stated in the Report of the NACD Blue Ribbon Commission on Executive Compensation, pay packages should be both fair internally and ex-ternally. This includes the consideration of cumula-tive compensation over the periods of years. Often boards fail to realize the full amount of successive yearly payouts. Compensation that continues over a period of years needs to be reasonable and not misalign with actual corporate performance. Imperative #5: Reward executives based upon performance as measured by appropriate met-rics. As established in Chapter 2, achievement of performance as defined by a minimum, target, or maximum, should have corresponding levels of in-

centive payouts. The minimum performance level provides the lowest threshold for which perfor-mance is expected, and executives should not re-ceive incentive compensation for failing to reach this level of performance. Reaching the target goal should not result in rewarding executives with the highest payouts; that is reserved for reaching the maximum performance level. Additional stretch goals can be used to incentivize performance past the target. Directors should avoid plans that tie incentive payments to performance indicators such as stock price without establishing target levels. Situations may arise where external events lead to corpo-rate windfalls that result in inequitable rewards

for executives. If the maxi-mum performance levels in a compensation package are not determined, boards need discretion to imple-ment “collars,” (also known

as “escape clauses” or “circuit breakers”) to stop unreasonable payouts. It may also be helpful to look at the probabil-ity of CEO payouts by comparing the current per-formance target with previous goals and the cor-responding compensation over the last ten years. This offers information on how many of the payouts were at, above, or below target and thus provides guidance on the reasonableness and appropriate-ness of performance targets for senior executives. Compensation packages should be developed with the intent of reaching strategic goals in an eth-ical manner with the proper identification of—and controls around—risk. To help ensure the quality of metrics and avoid incentivizing improper behavior, compensation committee collaboration with audit

Compensating ExecutivesChapter 3

Emphasis on ethical practices will likely reduce manipulation

of the metrics system.


committee members and internal auditors (and/or risk committee members, if applicable) can be use-ful. The audit committee is well suited to assist in the determination of whether incentive compensa-tion has the potential to encourage unintended be-haviors, and boards may wish to consider having members of the audit or risk committee also serve on the compensation committee. Reaching goals in an ethical manner also de-pends on a company’s “tone at the top.” With any incentive system, “gaming” can occur to manipu-late results for increased rewards. Boards should insist on the highest standards of integrity, and an emphasis on ethical practices will likely reduce manipulation of the metrics system.

BENCHMARKING The regular updates to the board on the key performance areas require metrics and bench-marks to measure and compare performance. The terms "metrics" and "benchmarks" are sometimes used interchangeably, but they are not the same. In terms of compensation, metrics usually refer to performance indicators used to set the level of com-pensation, such as revenue, earnings, cash flow, and returns. These figures may be used to measure an organization’s or an executive's performance. A benchmark takes this one step further and helps a company set performance thresholds by comparing levels for the same metrics in peer companies. Compensation decisions should be made with the consideration of peer companies used in the an-nual report. Selecting peer groups and benchmark-ing pay, whether performed by the compensation committee or a human resources department, should be done with advice from consultants. Boards must familiarize themselves with the process for select-ing peer companies, and be wary of inappropriate choices. For many companies there are no direct comparables. In these cases, a peer group must be determined based on important attributes such as size (as measured by market capitalization or rev-enues), business characteristics (for example, ser-vice companies or manufacturing companies), and

other factors (such as multi-business companies, global operations). Boards should also consider business complexity as a factor in selecting peers. Corporations that compete for talent may also serve as useful peer companies. Peer groups should be of sufficient size to make adequate comparisons. A peer group should be big enough to avoid having any one “peer” company skew results in benchmarking, yet small enough to maintain close similarity of features among com-panies. A typical range is between 15-20 compa-nies based on comparable industries, size (market cap or revenue), and complexity.

RETAIN DISCRETION FOR COMPENSATIONPURPOSES Any one scorecard of metrics cannot capture the entire scope of an organization. Boards need the freedom to go beyond a scorecard when circum-stances require. Board judgment is, therefore, an important part of evaluating the performance of an executive and determining pay. Boards may award incentive compensation even though the executives have missed set goals due to circumstances that are beyond their control (positive discretion). The board may use positive discretion to award the payouts if the circum-stances warrant such an adjustment. This use of discretion is appropriate in certain circumstances, but the opposite must also be true. As a matter of fairness, boards, by prior agreement with manage-ment, should be able to use either positive or nega-tive discretion. Discretion may be especially useful when compensating for nonfinancial metrics. Awarding achievement of some nonfinancial metrics on a discretionary basis can help to avoid overly formu-laic compensation plans. This should only be done af-ter a thorough discussion between the board, man-agement, and experts, such as compensation con-sultants. It may also be practical to use discretion when compensating for achievement of smaller goals unrelated to the corporate strategy.

Chapter 3: Compensating Executives


It is important to communicate the board’s use of discretion to the marketplace. In some cases, companies have decided to define a certain percent-age of executive pay that will be discretionary. For example, 20 percent of the annual bonus is based upon board discretion. This method is acceptable as long as the percentage of discretion as related to the entire compensation is disclosed, as well as the general reasons behind the reward. This practice may be helpful for compensation plans that include the consideration of operational and short-term goals, as well as resource development that enables the achievement of longer-term strategic goals. On the other hand, discretionary compensation, either positive or negative, should be used with caution. Incentive payments disconnected from discernible objectives can cause unease with investors. There-fore, every effort should be made to make discre-tionary payments as transparent as possible.

SPECIAL CONSIDERATIONS OF THE COMPENSATION COMMITTEE There are many factors to consider when relat-ing incentive compensation with short- and long-term metrics. Compensation committees, chiefly responsible for this activity, should review some of the following questions:

Do the chosen performance metrics support • the basic strategy? Do they measure the key value drivers?Does the required performance fall within the • scope of industry performance and economic projections?Are the performance metrics incentivizing • team work or individual merit?Have we reviewed performance metrics as dis-• closed in our competition’s proxy statements?What are the weights of varying business • units? Have we placed too much emphasis on one particular unit?Have we placed too much emphasis on a par-• ticular individual performance factor? Have we ensured no one metric dominates?


Principles from the NACD Report on Executive Compensation and the Role of the Compensation Committee (2007)Past Blue Ribbon Commissions have at-tempted to tackle the difficult issue of incentivizing executives through appropriate pay packages. This Commission builds upon the foundation laid out in the 2003 Report of the NACD Blue Ribbon Commission on Executive Compensation and the Role of the Compensation Committee.

Principle 1: IndependenceMake independence a bedrock of compen-sation committee philosophy. Ensure that committee membership, processes, and ap-proaches are entirely independent from the CEO and management.

Principle 2: FairnessFairness is not readily defined or measured. Different companies may define fair pay in different ways. Nonetheless, each compen-sation committee should try to create pay packages that will pass the test of scrutiny for fairness, both internally and externally.

Principle 3: Link to Performance In selecting performance measures, commit-tees should link pay to desired outcomes that the individual can affect rather than to stock price alone.

Principle 4: Long-Term Value for Share-holdersCompensation committees should design pay packages that encourage long-term commitment to the organization’s well be-ing. Tying bonuses, stock grants, or other incentive compensation to an increase in the company’s long-term value can help align a CEO’s personal financial interests with those of shareholders. (Continued on page 15)



Are the metrics able to be communicated • externally with respect to legal issues and confidential information?Are the short-term bonus metrics supportive • of and consistent with long-term metrics?What are the pros and cons of using relative • performance measures?Should there be a payout if performance is • negative but beats peers?Is there sufficient confidence in the integrity • of the numbers and the measurement process of the metrics, whether financial or nonfi-nancial, to be sure that fraud or erroneous reporting would not subject the payments to clawback provisions required under the Dodd-Frank Act. Can the performance metrics be skewed • inappropriately by non-recurring or non-operating performance?

3

(Continued from page 14)

Principle 5: TransparencyCompensation committees should embrace a philosophy of transparency—meaning full and clear disclosure. Compensation commit-tee members need to learn the important facts about compensation arrangements, and then let shareholders know these facts in a timely manner.


Communicating to the MarketplaceChapter 4

Shareholders vary in their investment goals and philosophies. Nonetheless, it may be fair to say that these goals can generally be cat-

egorized into three main objectives: stock price in the short term, stock price in the long term, and the company’s ability to optimize these through lead-ership, innovation, strategy, and risk management. Disclosures should include material information that would both enable the marketplace to make in-formed investing decisions and aid shareholders in voting on key matters. Communication of metrics, especially the non-financial ones, should be as transparent as possible without providing competitive information. The disclosure of metrics should tell a story about what the organization values and what directors are will-ing to incentivize. For example, if a company val-ues having a deep talent pool, the company should explain how employee development and bench strength are measured, and how they relate to cor-porate results. Imperative #6: Communicate with share-holders regarding how the company establishes and measures performance. Communication is not just an obligation; it is an opportunity. Face-to-face dialogue with major shareholders can be extremely effective, but many times it is not feasible. The annual proxy state-ment’s compensation discussion and analysis sec-tion (CD&A) remains an effective way to transfer information to the marketplace and portray the company’s story. Conveying the board’s focus on performance objectives and resulting executive pay will help to reinforce the understanding of the board’s role in enforcing pay-for-performance. Moreover, the SEC rules compel such disclosure in the absence of competitive harm.

As companies grow more comfortable in disclos-ing corporate performance metrics used for the year past, boards may wish to proactively convey the measurements to be used for the future. This Commission recognizes that this may cause some concern, but boards should endeavor to disclose metrics without unveiling strategic objectives or sensitive information. This may be easier for com-panies that provide guidance to the marketplace and their compensation goals align with such guidance.

PROXY DISCLOSURE OF NONFINANCIAL METRICS The proxy statement can be an excellent vehicle for explaining the board’s definition of performance and how it is measured. It is an opportunity for the board to demonstrate its commitment to the devel-opment of the corporation’s value drivers. In the future, the Dodd-Frank Act will compel some form of this disclosure. To effectively report nonfinancial metrics, the proxy statement can list the relevant metrics cate-gories and include measurements. Additionally, the company can disclose whether management met, exceeded, or missed the target performance level for each measurement. Therefore, shareholders un-derstand the importance of a particular area without alerting peers as to how the company is specifi-cally achieving goals. For each named executive officer, SEC staff has been requiring disclosure of each individual’s objectives; achievement of such objectives; and how the level achieved affects the compensation paid to that executive. In communicating incentive targets and perfor-mance metrics, the company should take care not to disclose information that is nonpublic and which, if known by competitors, could cause competitive harm to the company.


COMMUNICATION OF COMPENSATION As with many issues in corporate governance, transparency is crucial. With greater attention fall-ing on CEO pay packages, public company boards must be prepared to explain and justify executive pay structures, compensation metrics, and the re-spective links with corporate performance goals, and, if necessary, justify practices that are not con-sidered gold standard. At an absolute minimum, all directors should be literate on the topic of compensation. This in-cludes the ability to explain the compensation metrics used, as well as the current and long-term performance as measured against those metrics. Additionally, directors should be able to explain the philosophy behind compensation, as described in the CD&A in the proxy statement. Board members should know the “best” and “worst” case scenarios for pay outcomes. This requires understanding the formulas that produce the potential outcomes. Knowing best case and worst case scenarios re-quires an understanding of the potential final com-pensation if a CEO exceeds or fails to meet the goals set in a compensation plan (and/or what compensa-tion could be owed the CEO based on contractual provisions unrelated to performance). Directors

should also be prepared to explain their rationale for any exercises of discretion to alter compensa-tion awards above or below target amounts.

CONCLUSION As part of the board’s oversight role, the moni-toring of performance against a company’s strategy must be a constant activity. Directors must develop a deeper understanding of the company’s perfor-mance beyond the traditional financial metrics. A board’s understanding of enterprise risk, company ethics, human resources development, product quality, and safety performance can be as critical to success as the more traditional focus on financial results. The board need not tally results from metrics or calculate formulas. This Commission does call for directors to improve their approach to performance metrics, but the board’s true value lies in its judg-ment. The board has an essential duty to analyze the data supplied by metrics and make informed decisions about corporate plans, initiatives, and compensation. The metrics they use are merely markers, they are not a path. They must not sup-plant the board’s discretion and wisdom.

Endnotes

1 Robert Kaplan and David Norton, “The Balanced Scorecard: Measures That Drive Performance,” Harvard Business Review, 1992.

2 This tool has evolved. See “Strategy/Execution.” http://web.hbr.org/se/index.php?cm_mmc=email-_-news-letter-_-business_bookshelf-_-bb71310&referral=00215&utm_source=newsletter_business_bookshelf&utm_medium=email&utm_campaign=bb71310

3 Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law No: 111-203, Sec. 954. The Dodd-Frank Act requires public companies to recover, or “clawback,” compensation from any current or former execu-tive officers in the event of an accounting restatement due to material errors in financial reporting. Companies must adopt or modify a policy to retrieve incentive compensation during a three year period preceding an accounting restatement.

Chapter 4: Communicating to the Marketplace


Appendices

Appendix A: Metrics Categories: Samples . . . . . . . . . . . . . . . . . . . . . . . 19

Appendix B: Examples of Performance Disclosures . . . . . . . . . . . . . . . . 22

Appendix C: Hybrid Techniques for Valuation . . . . . . . . . . . . . . . . . . . . 28


Metrics Categories: SamplesAppendix A

In general, metrics vary in nature and in order of complexity. There are basically three ways to ac-count for measuring anything:

Ratio.• One type of metric is a ratio: A ratio takes one number from a company, compared to another number from the same company at the same time and gets a percentage—for ex-ample, “We have a 40 percent renewal rate.” Increase/decrease. • Another metric takes one number or one ratio and compares it over time (company in present vs. in past)—for example, “We have doubled our renewal rate to 80 percent.” Competitive comparison.• Yet another metric compares the company’s metric to a competi-tor’s metric—for example, “Our 80 percent renewal rate is ten points above that of our competitor, which is only 70 percent.”

This Appendix will use all three kinds of ratios. But bear in mind that for any simple ratio, there are at least two more varieties: increase/decrease in the ratio, and comparison to a competitor. If desired, these same numbers can be com-pared to peers. For example:

Average Company Result 1. Company Result as Percentage of Average 2. Result of Peers (can be used for any metric where peer results may be obtained)

Metrics Categories

Business DevelopmentSuccess in diversifying into a new field,• Growing new businesses or product lines • Expanding in targeted geographies (e.g., • emerging markets)

Community EngagementCash contributions to local charities• In-kind contributions to local charities • HR policies encouraging employees to volun-• teer in the communityAppearance by company leaders at events • promoting local charitiesCompany sponsorship of local charitable • causes

Competition/Market ShareMarket share for a membership organization • focusing on a “market” as a defined group of people. For example, “all police officers” can be measured as the number of members in an organization (the Fraternal Order of Police)/total number of individuals in the group (all police officers). The territory can be local, state, national, or global, as defined. Market share for a manufacturer producing a • product. For example, “frozen desserts” can be measured as # of products (frozen desserts) sold by company in a defined period x /total number of products (bar coded frozen dessert packages) sold in that same period.

Customer Satisfaction and Loyalty Customer satisfaction

Average (mean) scores of a survey intended to • measure level of satisfaction, along with com-mentary on how the scores were distributed statisticallySignificant increases or declines in customer • satisfaction scores over time Percentage of customers who say they will • recommend the product/service to others Results of customer satisfaction surveys•


Low number of product recalls and returns• Customer loyalty

Repeat business (customer buying the same • product or service multiple times) can be measured as the number of customers who buy company products or services more than once/total number of customers who buy products or services from the company, in-cluding those who buy only once Retention rate (customer renewals) can be • measured as number of customers who renew a periodic service/total # customersNumber of customers who intend to repur-• chase/reuse our product/service.

Environmental, Health, and SafetyEnvironmental Positive environmental accomplishments can be measured by:

Reduced carbon count • Percentage of products with life cycle envi-• ronmental concerns built into the designZero or reduced government citations for • environmental law violations Increased financial investment (e.g., per-• centage of expenses) in technology, ser-vices, or staff pertaining to environmental improvement

Health Percentage of employees regularly participat-• ing in early screening testsZero, reduced, or comparatively low health • department citations locally (for restaurant chain) Zero, reduced, or comparatively low employ-• ee sick days Significant, increased, or relatively high • spending in a public service health campaign that relates to the company’s products, such as responsible drinking from a liquor company

SafetyIncident of unsafe practices• Zero, reduced, or comparatively low work-• place accidents

Increased spending in safety training •

Executive Talent ManagementPercentage of executives who have individual • development plansAverage time in last career level for high • potential candidatesNumber of candidates for key executive posi-• tions who are considered “ready now” and “ready in two to three years”Compensation of bottom executive perform-• ers versus top executive performersNumber of programs created to educate and • develop executive leadership capabilitiesLength of time critical executive role remains • openPercentage of roles filled internally versus • externallyPercentage of identified high potentials in • development programsDifference in retention rates between high and • low performersPercentage type of executive separations • by category: regrettable, non-regrettable, retirement, transitions

Human CapitalRecruiting success• Low employee turnover • High sales per employee (# in sales or # of • employees) Positive results in surveys of employee • morale Zero lawsuits from employees • Zero strikes or other labor disputes •

Innovation Number of projects successfully passing early • test gatesNumber of new patents, copyrights, and/or • trademarks (growth rate, comparison to peers) Spending in research and development • (growth rate, comparison to peers)

Appendix A: Metrics Categories: Samples


Legal/Regulatory ComplianceZero, reduced, or comparatively low number • of pending lawsuits Zero, reduced, or comparatively low expendi-• ture on legal fines and settlements Zero accounting misstatements • Zero material weaknesses found in • Sarbanes-Oxley Act, Section 404 review •

M&A Execution and IntegrationNumber of companies acquired and retained • for more than two years times total sharehold-er return (TSR)

OperationsAcceleration of product life cycle (time it • takes to move from design/research and de-velopment to roll out)Positive return on investment for projects • Positive return on investment for acquisitions •

Note: The company could create other metrics for operations based on a combination of other items in this list (weighted score for human capital, product quality, etc.)

Product/Service QualityPercentage of early stage rework • Zero or low rate of errors or flaws in product • Zero or low level of complaints about product • or service Number of nationally recognized awards won • for products

ReputationNumber of positive mentions in press/Internet • search engine results Number of awards won from organizations • active in social issues

Risk ManagementFrequency of the board receiving reports from • the chief risk officer (or other person with responsibility to oversee overall risk) about enterprise risk management (ERM) Percent of annual revenues spent on ERM• Annual outside advisor expenditures by risk • committee (or other committee with responsi-bility to oversee overall risk)

TechnologyComputer system/website downtime per year/• monthZero, reduced, or comparatively low inci-• dence of IT malfunctions due to cybercrime, human error, or other problems Average time to resolve downtime or other • problems

Tone at the TopQuality and frequency of written and oral • communications to employees on ethical and legal principles Opinions of the external and internal auditors • concerning the tone set by top managementPercentage of board meeting time spent on • interactive full board discussion (rather than presentations) What is the nature of top management’s • relationships with governmental officials, regulators, etc.Number of regulatory or legal complaints/ac-• tions against the companyResults of a 360-degree review of senior • officers by subordinates; comparison of such results over a period of years

Appendix A: Metrics Categories: Samples


Examples of Performance DisclosuresAppendix B

Many public companies have attempted to explain their performance objectives in relation to CEO compensation. The following excerpts from the 2010 Home Depot, Pfizer, and Pitney Bowes proxy statements are good examples of how to frame a company’s disclosure around performance metrics. These examples are starting points and boards are encouraged to expand upon them with the recom-mendations found in this report.

2010 Home Depot Proxy Statement (Excerpt)Fiscal 2009 Company Business Objectives and PerformanceOur Fiscal 2009 business strategy focused on three principles aimed at driving shareholder return and a sustainable competitive advantage:

Passion for customer service;• Being the product authority for home improve-• ment; andDisciplined capital allocation driving produc-• tivity and efficiency.

By executing against the strategic initiatives that support these principles, our business performed exceptionally well in a challenging economic envi-ronment. Highlights of the Company’s Fiscal 2009 performance include the following:

$1.55 in diluted earnings per share from con-• tinuing operations;$4.8 billion in operating profit;• $66.2 billion in total revenue;• $485 million reduction in inventory;• $5.1 billion in operating cash flow; and• 10.7% return on invested capital.•

As a result of our significant cash flow from opera-

tions and disciplined capital allocation,we were also able to return value to our shareholders through a 30% increase in our stock price during Fiscal 2009, share repurchases and dividends.

Compensation Philosophy and ObjectivesOur compensation program aligns pay with per-formance with a goal of enhancing associate per-formance and morale, which in turn drives superior customer service. This philosophy applies to the compensation programs for all of our associates.

The principal elements of our compensation pro-gram for management-level associates are base sal-ary, annual incentives, long-term incentives, and benefit programs. The amount of incentive com-pensation paid, if any, is determined by our perfor-mance against our Fiscal 2009 business plan, a plan we be lieved to be challenging in light of prevailing economic conditions, yet attainable if we performed well against our core principles. Fiscal 2009 perfor-mance targets were overall enterprise and business unit financial results, achievement of specific stra-tegic goals and share-price performance.

Pay for Performance. The following features of our compensation program for executive officers specifically illustrate our philosophy of making compensation performance-based:

100% of annual incentive compensation un-• der our Management Incentive Plan (“MIP”) is tied to performance against pre-established specific, measurable goals for the fiscal year, including both financial and strategic perfor-mance goals. The financial goals are based on sales, operating profit and inventory turns, and the strategic goals are related to our supply


Appendix B: Examples of Performance Disclosures

chain, merchandising, customer service and market share;20% of annual equity compensation is a three-• year performance share award with payout contingent on achieving pre-established aver-age return on invested capital (“ROIC”) and operating profit targets over the three-year pe-riod;Our performance-based restricted stock • awards, which comprise 40% of annual equity compensation, are forfeitable if operating prof-it is less than 80% of the MIP target;Approximately 87% of our CEO’s total target • direct compensation is tied to the achievement of corporate performance objectives and share-price performance; andWe do not provide tax reimbursements, also • known as “gross-ups,” to executives.

Elements of Our Compensation ProgramsOur compensation programs consist of the follow-ing principal elements:

Base Salaries. We provide competitive base salaries that allow us to attract and retain a high-performing leadership team. Base salaries for our named executive officers are reviewed and gener-ally adjusted annually based on a comprehensive management assessment process. In light of the difficult economic environment, Company officers did not receive an annual increase for Fiscal 2009, so officer base salaries remained at 2008 levels. For our non-management associates, however, we provided a 2.5% merit increase budget for Fiscal 2009.

Annual Incentive. All named executive officers participate in the MIP, a cash-based annual incen-

tive plan. Seventy percent of the MIP payout is contingent on the achievement of financial perfor-mance goals, and 30% is contingent on the achieve-ment of specific, measurable strategic performance goals. The Committee sets goals at the beginning of the applicable performance period, which was Fiscal 2009 for both portions of the MIP for the named executive officers. The annual target payout levels are determined as a percentage of base sal-ary: 200% for the CEO, 125% for the CFO, 100% for other EVPs and 75% for SVPs.

Performance Goals• : The Committee chose the following financial performance measures with the following threshold, target and maxi-mum achievement levels for the Company for Fiscal 2009. (See chart at bottom of page.)

The Committee chose these specific measures

to drive achievement of our business plan. The operating profit threshold must be met for any financial metric payout to occur. The potential payout for achievement of the financial perfor-mance goals was weighted 20% to sales, 35% to operating profit and 15% to inventory turns. The relative weighting among these goals was determined by the Committee with input from the CEO and the EVP-HR to reflect the Com-pany’s strategic priorities. The relative weight-ing on operating profit also reflects our belief that operating profit and the expense control inherent in that measure provide a more ef-fective means to drive bottom line results for shareholders in a difficult economy than sales, which are more subject to macroeconomic factors outside of our control. The pre-estab-lished definitions of sales and operating profit under the plan provided for adjustments for the impact of acquisitions or dispositions of

Sales Operating Profit Inventory TurnsThreshold $61.4 billion $3.6 billion 3.41Target $64.6 billion $4.1 billion 3.79Maximum $67.9 billion $4.3 billion 3.98



businesses with annualized sales of $1 billion or more and, for operating profit, nonrecurring charges and write-offs exceeding $50 million in the aggregate for specified types of strategic restructuring transactions in Fiscal 2009. The Committee adopted these definitions for plan purposes because these strategic decisions support the long-term best interests of the Company and therefore should not adversely affect incentive opportunities.

For target achievement of the financial perfor-

mance goals, executive officers receive 100% payout for this portion of the award, and at threshold and maximum achievement, the payout is 10% and 110%, respectively. The Company uses interpolation to determine the specific amount of the payout for each named executive officer with respect to the achieve-ment of financial goals between the vari-ous levels. The threshold performance level encourages incremental performance when achievement of the target appears to be unlike-ly. The target performance level was consis-tent with our 2009 business plan and the fore-cast disclosed at the beginning of Fiscal 2009. The maximum performance level rewards par-ticipants for above-target performance while avoiding windfall payouts due to a better than expected external environment. The Commit-tee does not have discretion to increase the MIP payout but may decrease the payout even if the performance goals are achieved.

The payouts for the financial performance

goals component of the MIP for Mr. Blake and Ms. Tomé are based on overall Com-pany performance. For the other named ex-ecutive officers, payouts are based upon the level of achievement of the portion or subset of the corporate financial performance goals that corresponds to the portion of the Com-pany’s annual business plan for which they were accountable. The specific performance levels that correspond to specific portions of

the Company’s annual business plan are not critical to an understanding of the Company’s compensation program, and we do not believe disclosure of this information would be mean-ingful to shareholders since it would not be ap-parent how this information correlates to our consolidated financial statements.

For Fiscal 2009, the Committee also selected

the following strategic performance goals:A specified increase in the percentage of • stores and annualized cost of goods sold serviced by our Rapid Deployment Cen-ters;A specified year over year increase in • our voice of the customer “net promoter” score; In-sourcing a targeted percentage of mer-• chandising maintenance services in a specified number of departments, while maintaining or increasing vendor satisfac-tion survey scores; andIncreasing market share, as measured by • an independent source, in five specific merchandise categories.

The strategic performance goals were deter-mined by the Committee with input from the CEO and the EVP-HR to reflect four of the Company’s pre-established strategic initiatives for Fiscal 2009. Each goal is equally weight-ed. Specific, measurable success criteria were set at the beginning of the year for each of the goals. The Committee expected that they would be achievable with strong execution, but not automatically achieved. Achievement of the specified criteria for each strategic per-formance goal is required for any payout with regard to that goal, with no partial payment for incremental performance.

2010 Pfizer Proxy Statement (Excerpt)

Setting CEO Performance Objectives The Committee establishes Mr. Kindler’s perfor-



mance objectives based on its judgment as to where it believes Mr. Kindler should focus in achieving Pfizer’s strategic plan. The Committee selects and weights Mr. Kindler’s goals, taking into consid-eration Pfizer’s current financial and strategic pri-orities. The Committee recognizes that increasing total shareholder return should be emphasized; however, the Committee also acknowledges that performance against this objective may not be re-flected in a single 12-month period. For 2009, Mr. Kindler’s objectives were asfollows:Shared Objectives: These objectives reflect col-lective goals applicable to all members of the ELT (including Mr. Kindler) and are intended to ensure continued financial strength, to generate revenue growth, to increase shareholder value and to en-sure strong leadership of an enaged workforce. For 2009, the Shared Objectives were:

Financial Objectives: 50% weighting • Total Revenue • Adjusted Diluted EPS• Cash Flow from Operations•

Enhancing the Product Portfolio: 10% • weighting

Actions to enhance Pfizer’s product pipe-• line (representing the Committee’s quali-tative assessment of Pfizer’s performance in improving its product pipeline).

People Management: 10% weighting• Improving colleague engagement, in-• creasing diversity and reducing the inclu-sion gap between senior-level men and women.

Strategic Corporate Objectives: These objectives reflect Mr. Kindler’s key accountabilities at the enterprise level. For 2009, the Strategic Corporate Objectives were:

Strategic Corporate Performance: 30% • weightingImplement a new global “go-to-market” model • driven by fully accountable business units. Close the Wyeth transaction and proceed with • the prompt integration of operations, process-

es, and people.Advance global policies to preserve the biop-• harmaceutical business model and protect pri-vately funded innovation.

The Committee selected these annual strategic goals based on its judgment that they represent areas on which Mr. Kindler should focus to drive Pfizer’s strategic plan and shareholder value during 2009. Mr. Kindler’s progress against these goals was periodically reviewed during the year.

CEO Performance Assessment The Committee is responsible for evaluating Mr. Kindler’s performance against his objectives, with input from the other independent members of the Board, and for determining his compensation. Early in 2010, the Committee reviewed Mr. Kin-dler’s performance against his objectives, as well as other key factors, and determined his compensa-tion, which was ratified by the independent mem-bers of the Board. The Committee believes that Mr. Kindler’s leadership was a significant factor in the continued progress made by Pfizer in 2009 in strengthening the foundation for future growth and long-term success. Financial Results: Despite the unprecedented challenges in the global macroeconomic environ-ment and other challenges, the Company exceeded the target goals for 2009 set by the Committee for annual incentive purposes (Total Revenue of $45.0 billion, Adjusted Diluted EPS of $1.90 and Cash Flow from Operations of $10.5 billion) by achiev-ing Total Revenue of $45.5 billion, Adjusted Di-luted EPS of $1.98 and Cash Flow from Operations of $11.2 billion.

* * * * * * * * * *

Enhancing the Product Portfolio: Under Mr. Kin-dler’s leadership and oversight, during 2009 we im-proved the product portfolio (early stage through late stage), resulting in enhanced pipeline delivery, rationalization of projects considered to be “first wave” and/or “best in class,” with over 100 projects



strategically terminated, and reduced cycle time on early stage key projects by 3-12 months.

People Management: In 2009, we met or exceed-ed each of our people management goals, includ-ing: a statistically significant improvement (as de-termined by an independent survey organization) in colleague engagement; increased percentages of senior-level women of 2.3 percentage points (glob-ally) and senior-level minorities of 1.0 percentage point (U.S. only) in our workforce; and a statisti-cally significant reduction in the inclusion gap be-tween senior-level men and women.

Strategic Corporate Performance

Business Model Implementation: During 2009, the Company also modified the global business unit model, announced in 2008, to accommodate the addition of the Wyeth businesses. This model aligns the Company’s valuable resources with the individual businesses and drives decision-making closer to its customers and the markets in which they operate. In addition, the Company prioritized its research and development efforts to focus on the greatest opportunities for scientific, medical and commercial success, and the Company remains on track to meet the various research and develop-ment goals announced in March 2009. Mr. Kindler also further strengthened the Company’s leadership team through strategic hiring and the redeployment of key senior leaders across the Company. Wyeth Transaction: During 2009, we devoted significant attention to the acquisition of Wyeth. Under Mr. Kindler’s leadership, we finalized ne-gotiations, gained regulatory approval and closed the $68 billion acquisition of Wyeth, all in an ex-pedious manner. During the year, Mr. Kindler oversaw a detailed review of Wyeth and its busi-nesses and the development of an integration plan, including the modification of the new business unit structure, to facilitate the timely and smooth inte-gration of the Wyeth businesses following comple-

tion of the acquisition. Specific accomplishments included: implementation of an integrated sales force in three of our major biopharmaceutical busi-ness units within 10 days following the closing of the acquisition; a fully operational research and de-velopment organization comprised of two distinct groups, with the announcement of six site closures and significant downsizing of four additional sites within one month after the closing; and integrated people management processes in over 50 countries promptly after the closing. With the completion of the acquisition under Mr. Kindler’s leadership, Pfizer is one of the largest biopharmaceutical com-panies in the world, as well as a more diversified company in the health care industry. The Com-mittee believes that as a result of the acquisition and other achievements, Pfizer is well positioned for improved, consistent and stable growth, with sustainable shareholder value in both the short and long term.

Industry Leadership: During 2009, Mr. Kindler was actively involved, through both Pfizer and external organizations, in developing and advanc-ing U.S. and global public policies that serve the overall interests of our Company and our share-holders, as well as doctors and patients. These ef-forts included constructive participation in the U.S. legislative process to advance Pfizer’s goals of achieving a more rational operating environment; improving Americans’ access to quality, affordable health care; preserving the doctor/patient relation-ship; and enhancing policies that promote innova-tion. Also, through both Pfizer and external organi-zations, he has sought to ensure the availability of safe medicines by opposing legislation that would allow for importation of prescription drugs that could jeopardize the integrity of the drug supply chain in the U.S. In addition, under Mr. Kindler’s leadership, Pfizer undertook efforts to protect its in-tellectual property by supporting legislative initia-tives on patent review, patent challenges and patent infringement. In view of Mr. Kindler’s accomplishments noted



above and the fact that he achieved all of his objec-tives and exceeded most of them, the Committee believes that Mr. Kindler successfully led the Com-pany toward the achievement of its strategic goals during 2009 – a year filled with opportunities and challenges, particularly given various Company-specific and macroeconomic factors. To reward Mr. Kindler for his performance and leadership of the Company, the Committee determined to increase his expected total direct compensation, consistent with the plan, at the time he was promoted to CEO, to align his compensation with other CEOs in our pharmaceutical peer and general industry compara-tor groups after a short period of time, dependent upon his success in the role.

2010 Pitney Bowes, Inc. Proxy Statement (Excerpt)

2009 Annual Incentive Payout In applying negative discretion in determining the awards for 2009 performance, the Committee measured the company’s financial and strategic performance against objectives that were set by the Committee in the first quarter of 2009. The payouts for named executive officers are predominantly tied to these objectives, with some discretion for individual performance. The 2009 financial objectives, which were each weighted at 17.5% at target, are shown in the chart below. The 2009 strategic performance objective was weighted at 30% at target and consisted of creat-ing new business opportunities, sustaining profit growth in mail-related businesses, expanding be-yond the core business, and creating efficiency and

scale through innovation and transformation. In applying negative discretion the Committee also considers factors such as customer loyalty, tal-ent and leadership development, and other signifi-cant accomplishments.In February 2010, the Committee determined 2009 performance. The company exceeded its perfor-mance target for adjusted free cash flow and the strategic performance objective. The Committee compared actual performance to the predetermined targets to determine the resulting performance fac-tor. The resulting performance factor of each metric may be between 0-150% of the applicable target. Given the challenging environment in 2009, organ-ic growth, adjusted earnings per share and adjusted earnings before interest and taxes did not meet tar-get expectations and there was no payout for those objectives. The performance factor for free cash flow, which was weighted at 17.5% at target, was 150% result-ing in a payout factor of 26%. The Committee de-termined that the company exceeded target with respect to the strategic performance objective re-sulting in a performance factor of 35%. Based on these results, the Committee approved annual in-centive awards in 2009, for the named executive officers other than Mr. Monahan, at approximately 61% of amounts they would have received had all the factors been achieved at target. The Commit-tee determined that Mr. Monahan’s annual incen-tive award would include an additional amount of $50,000 in connection with his leadership role in the strategic transformation initiatives. The perfor-mance factor of 61% of target represents a decrease of 36% from the performance factor in 2008.

Financial Objectives TargetOrganic Growth 0%

Adjusted Earnings Per Share $2.67Adjusted EBIT $1.093 billion

Adjusted Free Cash Flow $745 million


Hybrid Techniques for Valuation*Appendix C

Valuing a company requires appreciation for what the company owns (assets minus liabilities), for how the company can generate future funds (via earnings and cash flow), and for how the capital marketplace perceives this wealth-creating poten-tial (stock price). Careful analysis of any one of these aspects of value can improve an investor’s sense of a company’s worth and hence the possible price ranges for buy, sell, and hold decisions. But valuation need not stop there. These elements can be even more powerful as valuation tools in combi-nation. But how? It starts with the effort to obtain a useful model for valuation. Here is a simplified list of the approaches, along with the general valuation terms —e.g., “earnings”—for the elements they add, subtract, divide, and/or multiply. (See the following section for the specific terms used by each approach—e.g., “operating surplus” in the cash-value-added ap-proach.)

Cash Flow Return on Equity™ (uses cash flow, 1. equity).Cash Flow Return on Investment® (uses as-2. sets, cash flow, invested capital).Cash return on gross investment (uses cash 3. flow, invested capital).Cash value added (uses cash flow, invested 4. capital).

Discounted free cash flow (uses cash flow, 5. invested capital).Economic Margin Framework6. Economic Value Added™ (uses earnings, in-7. vested capital).Economic value management (earnings, in-8. vested capital).Enterprise value (uses liabilities, equity [pre-9. ferred stock], market cap, cash equivalents).Market Value Added® (uses invested capital, 10. market value).Return on capital employed (uses earnings, as-11. sets, liabilities).Return on net assets (uses earnings, assets, in-12. vested capital).Shareholder value added (uses liabilities, cash 13. flows).Total shareholder return (uses stock price ap-14. preciation plus dividends paid).

The following sections provide more details on these common approaches to corporate valuation.

CASH FLOW RETURN ON EQUITY™ Cash Flow Return on Equity (CFROE) measures how well a company is doing with its shareholders’ capital. It was created for use by financial services firms, but it is also in use at some other types of

*Excerpted with permission from Corporate Valuation for Portfolio Investment: Analyzing Assets, Earn-ings, Cash Flow, Stock Price, Governance, and Special Situations, by Robert A. G. Monks and Alexandra Reed Lajoux (New York/Hoboken: Bloomberg/Wiley, 2011).

1 “The annual bonus plan for the CEO and CFO was comprised of a combination of cash flow return on equity (CFROE), achievement of operating profit targets in the individual business units and meeting personal objectives. CFROE. We believe that CFROE, which focuses on the company’s generation of cash flow against the equity capital employed, is an important measure in assessing our financial performance. We make adjustments to the CFROE cal-culation to focus the calculation on the actual financial performance of Torstar’s operations.” (Information Circular. Torstar Corporation, March 1, 2009, http://www.torstar.com/pdf/informationcircular.pdf.)


service firms, such as media.1 The approach is similar to cash flow return on investment (CFROI), which some use to value industrial firms. The basic formula is

The cash flow measured is for a particular period. If it is for a future period, it will be discounted to present value and is hence a discounted cash flow (DCF) measure. Credit Suisse First Boston, which owns a valuation company called CSFB Holt, re-leased a valuation model based on CFROE in 2005 with great fanfare. As of mid-2010, this measure still appears to be less popular than its older sibling, CFROI.

CASH FLOW RETURN ON INVESTMENT® Cash Flow Return on Investment (CFROI®) was developed by Bart Madden at Holt Value As-sociates (now part of Credit Suisse First Boston). It is used for industrial firms, such as aerospace com-panies.2 Madden calls this metric “a proxy for the firm’s economic return.” He explains that it is “an inflation-adjusted (real) ROI metric constructed from annual financial statements to approximate the average real ROIs being achieved on the firm’s portfolio of on-going projects.” 3 This metric has two main variables: cash flow and investment. The figures used are gross figures, and one is divided into the other. Hence, very sim-ply,

Gross cash flow is current dollar annual cash • flow. These are the inflation-adjusted gross cash flows available to all capital owners in the company.Gross investment is defined as net asset value • plus cumulated depreciation on assets plus current dollar adjustment. Another way of expressing this is:

Current dollar gross investment= In-flation-adjusted total assets – Non-debt li-abilities and intangibles 4

This is the inflation-adjusted gross investment • made by the capital owners.

The approach then converts this ratio into an inter-nal rate of return (IRR) by recognizing the finite economic life of depreciating assets and the resid-ual value of non-depreciating assets. The CFROI of the investment must exceed a hurdle rate, which is the total cost of capital for the corporation. This is calculated as the cost of debt financing and the equity investors’ expected return on equity invest-ments. An investor can adjust the formula to ac-count for depreciation. 5 In the end, the CFROI® result approximates the economic return produced by the firm’s projects. The standard CFROI calculation is a five-year projection. Over time, cash flow return on invest-ment drops, depending on the stage of growth, from a high innovation stage with high CFROI to “fading,” “mature,” and “failing” phases when the CFROI is progressively lower. The CFROI analyst includes “fade” in the valuation for the company. The rate of the fade is based on where the company is in its life cycle, as well as past performance and future prospects.

Appendix C: Hybrid Techniques for Valuation

CFROE =Cash flow from operations

Shareholder’s equity

2 For example, Northrop Grumman, 2009 Annual Report, p. 36, http://www.northropgrumman.com/images/annual_report/2009_noc_proxy.pdf.3 J. Bartley Madden, “Maximizing Shareholder Value and the Greater Good,” white paper, 2005.4 This formula assumes current dollar value of non-depreciating assets, inflation-adjusted treatment of current assets and land asset life, and uses an average depreciation term for all assets5 Michael J. Maubossin quoted an analysis by CSFB, that, measured by CFROI, the performances of companies tend to converge after five years in terms of their survival rates (Michale J. Maubossin, More Than You Know: Find-ing Financial Wisdom in Unconventional Places (New York: Columbia University Press, 2006)).

CFROI =Gross cash flow

Gross investment


According to Credit Suisse First Boston, the CFROI approach corrects many common distortions found in traditional accounting measures of perfor-mance, such as inflation, depreciation method, as-set mix, asset life, deferred taxes, pension account-ing, research and development, off-balance-sheet items, inventory accounting, asset holding gains or losses, acquisition accounting, investments, and revaluations. Thus, true economic wealth creation or destruction can easily be assessed to determine a company’s warranted value.

Cash Return on Gross Investment Cash return on gross investment (CRGI) involves both earnings and invested capital. The formula is

(EBITDA is earnings before interest, taxes, de-• preciation, and amortization.)

This is a good metric for companies in the indus-trial sector because the key number includes inter-est, depreciation, and amortization, which can dis-tort earnings. 6 At the same time, these factors can correct earnings; so this ratio should never be used as a central metric of corporate value.

Cash Value Added The cash value added (CVA) approach is calcu-lated as follows:

Operating cash flow • 7 = Operating surplus + Change in working capital – Nonstrategic in-vestmentsOperating surplus = Sales – Costs• Operating cash flow demand = operating cash • flow needed to meet the capital costs of the company’s strategic investments—the op-portunity cost of capital (expressed as a cash amount; not as a percentage)

As one expert put it, 8 CVA represents the cash flow needed to meet the investors’ financial re-quirements of the company’s strategic investments. Interestingly, despite its name, this is not consid-ered a discounted cash flow method; rather, it is considered to be a residual method. The CVA metric seems appropriate for a con-sumer products company because so much of the consumer products business depends on the effi-cient movement of products. Also, consumer prod-ucts companies—and industrials in general—have a wide variety of significant stakeholders. The CVA metric can be presented to show what cash value each group of stakeholders receives, enhancing a company’s corporate responsibility profile. 9

Discounted Cash Flow (DCF) Discounted cash flow is as simple as it sounds. Take the cash flow expected in the future, and cal-culate its present value, using a discount rate based on the cost of capital for the firm. Depending on the perspective of who’s expecting the money, the cash can come from dividends (dividend discount model), from operating cash flow (present value of operating cash flows), or from free cash flow (pres-ent value of free cash flows to equity). In the case


6 CROGI is used as a key metric by the Norwegian fertilizer and fertilizer byproducts company, Yara. http://www.yara.com/doc/Financial%20review%202008.pdf.7 Operating cash flow is synonymous with Earnings before Depreciation, Interest, and Tax (EBDIT). See Buctaru Dumitru, “Analysis Model of Company Treasury in the European Theory and Practice,” http://steconomice.uoradea.ro/anale/volume/2008/v3-finances-banks-accountancy/017.pdf.8 J. H. M. de Jonge, an analyst based in the Netherlands, at http://www.valuebasedmanagement.net/methods_cva.html.9 Brown-Forman, “Corporate Responsibility,” http://www.brown-forman.com/responsibility/priorities/economic-contribution.aspx.

CRGI =EBITDA - tax

Gross invested capitol

CVA = Operating cash flow - Operating cash flow demand



of earnings-based cash flow, DCF is calculated by taking projected annual earnings over some future period, getting its present value according to a dis-count rate, which is the weighted cost of raising capital by issuing debt or equity. One kind of DCF involves free cash flow, that is, cash flow net of taxes. Another term for this is net operating profits after taxes (NOPAT). For any period of time (past, present or future), the calcula-tion is

Change in capital employed = percentage by • which capital employed (Capital employed = Equity + Long-term debt) changes for the period

The DCF methodology is helpful to companies that may not have strong current revenues but project strong revenues, such as pharmaceuticals compa-nies. 10

The discounted cash flow model typically proceeds in two periods: a known forecast period and some terminal value. For each year in the known forecast period, there is an individual forecast of free cash flow. By contrast, all of the years in the post-hori-zon period are represented through one continuing value formula, being the steady-state value of the firm’s producing assets at the horizon. Continuing value is typically derived by applying the so-called Gordon formula to a simple extrapolation of free cash flow at the end of the explicit forecast period. Continuing value at the end of the DCF attempts to project value well into the future. It gives a two-stage formula in which the first part is a known period of investment, and the second part is after the known period. Breaking returns into two parts enables two things. First, because the first part of the formula is short term, the analyst can include detailed assumptions that would be difficult to fore-cast far into the future. Second, by adding the sec-ond tier, it extends the usefulness of the formula.

* * * * * * * * * *

Free cash flow = NOPAT - Change in capital employed

10 “Precedent Transactions Analyses to estimate potential acquisition value. Using base case financial forecasts pro-vided by our management, which assume positive I2S clinical trial results as well as the successful commercialization of all other pipeline programs, SG Cowen estimated our company’s potential acquisition value, based on precedent acquisitions in our industry. SG Cowen arrived at an acquisition value range of $15.78 to $28.27 per share. . . . Again using management’s base case forecasts, and again assuming positive I2S clinical trial results and the successful com-mercialization of all other pipeline programs, SG Cowen performed a discounted cash flow analysis of our company as an independent entity which yielded a range of standalone value for our company of $21.56 to $36.76 per share.” (“Board of Directors Urges TKT Stockholders to Vote ‘FOR’ Shire Transaction,” press release of July 12, 2005, http://www.shire.com/shire/NewsAndMedia/News/showtktshirepress.jsp?ref=2&tn=3&m1=8&m2=36.)

11 The Gordon formula states that the real return from buying and holding a stock forever and consuming the divi-dends is equal to the dividend yield plus the real rate of dividend growth. See Kenneth S. Reinker and Edward Tower, “Predicting Equity Returns for 37 Countries: Tweaking the Gordon Formula,” July 12, 2002, http://www.econ.duke.edu/Papers/Other/Tower/Equity_Returns.pdf. See also L. Peter Jennergren, “Continuing Value in Firm Valuation by the Discounted Cash Flow Model,” presented at the 32nd meeting of the EURO Working Group on Financial Model-ing, London, April 2003.

11



12 The third quarter 2009 report for US Concrete states, for example, “The estimated fair values of the Company’s reporting units were based on discounted cash flow models derived from internal earnings forecasts and other market-based valuation techniques” (http://www.faqs.org/sec-filings/091105/US-CONCRETE-INC_8-K/v164900_ex99-1.htm).13 Daniel J. Obrycki and Rafael Resendes, “Economic Margin: The Link Between EVA and CFROI,” in Value-Based Metrics: Foundations and Practice, Ed. by Frank L. Fabozzi and James L. Grant (New Hope, PA: FJF, 2000).14 For a description of why and how Allianz uses EVA, see https://www.allianz.com/en/investor_relations/share/ value_based_management/page1.html.

WACC is exactly what it says: the cost of capital. If the capital is in the form of debt, it is the interest rate charged times whatever time period and com-pounding may apply. If the capital is in the form of equity, it is the expected return. The weighted aver-age part pertains to a portfolio. WACC is the ex-pected return on a portfolio of all a firm’s securities. The weights are determined by the distributions of the securities (equity and/or debt). DCF is often combined with other approaches. By itself, DCF may not be robust enough to value a complex company. However, it is very appropriate to value a company unit. 12

Economic Margin Framework Economic Margin Framework, a proprietary mod-el of the Applied Finance Group is calculated as:

Its creators believe that it combines the best of CFROI and EVA, because it calculates an econom-ic value (like EVA), while at the same time incor-porating a fade rate (like CFROI). 13

Economic Value Added™ Economic Value Added™, developed by Joel Stern and trademarked by Stern Stewart & Co., enables investors or lenders to determine the value they will receive for the funds they loan or invest. EVA es-timates the amount that future earnings will differ from the required minimum rate of return (against comparable risk) for providers of capital. The for-mula is

r = return on invested capital = NOPAT/K• NOPAT = net operating profit after tax,• c = weighted average cost of capital (WACC)• K = capital employed•

This model, like cash value added, is considered a residual model, rather than a discounted cash flow model. It’s also called an “economic measurement” to distinguish it from market-based measures. The vendor of this approach, Stern Stuart, offers more than 150 ways to customize it, although users re-portedly make only a few adjustments.Because this is one of the more widely accepted approaches and because of the ability to custom-ize it, this metric is particularly suitable for a large, diversified company. 14

Economic Value Management (EVM) Economic value management, developed by El-eanor Bloxham, is a valuation approach created for managers, rather than investors; so it is in a class by itself. Nonetheless, it is worthy of inclusion be-cause it shows the narrowness of some of the other concepts. EVM is broader than shareholder value because it examines economic value management from the perspective of all the potential constitu-ents of an organization and their roles. Many people have written about stakeholders, but Bloxham makes a significant contribution by ana-lyzing them by role: she sees a central role for in-ternal and external suppliers. Internal suppliers are board, management, and employees. Externally, on the one side, we have providers of capital (equity and debt) and on the other we have consumers (cus-tomers). Other important stakeholders are citizens and regulators who represent them, as well as ob-

(Operating Cash Flow - Capital Charge)

Invested Capital

EVA = (r – c) × K = NOPAT – c × K



servers (critics, the media). Bloxham sees value as a function of all these relationships. Although this approach does not easily lend itself to simple for-mulas and models, it can be very useful for running company or, in the case of investors, for evaluating how well a company is run. In some applications, the theory of EVM em-phasizes economic profit, which says the value of a company is the amount of capital investment plus a premium equal to the present value of the value created in each year going forward. The main for-mula for this is:

Enterprise Value The enterprise value formula is a financial rather than a strategic concept, and its value is close to liquidation value. Therefore, company manage-ments don’t often use it. This measure seems to be more common in academic and investor circles. 16 This metric assumes that the worth of a company is the sum of all outstanding obligations (stocks, bonds, and debts) minus the cash the company has on hand. The formula is as follows:

Market capitalization = Shares of stock out-• standing x Current stock price

Preferred stock = Value of preferred stock (as • found on the balance sheet)Debt = Long-term debt + Short-term debt (all • debt from the balance sheet)

This is considered a residual value measure, rather than a cash flow measure.

Market Value Added Market value added (MVA) is the difference be-tween the equity market value of a company (to-tal shares outstanding multiplied by current stock price) and the sum of the adjusted book value of debt and equity capital invested in the company. The simplest formula is

Or, expressed more mathematically,

MVA = market value added• V = the market value of the firm, both equity • and debtK = the capital invested in the firm•

Total market value is the sum of the market values of debt and equity, while total capital supplied is the sum of the book values of debt and equity. Some analysts use the book value of debt as a proxy for the market value of debt. 18 However, when they do this, the formula becomes simply market value of equity minus book value of equity (because the debt cancels out).

15 An alternative formula is Net Operating profit – Adjusted taxes.16 See, for example, the discussion of enterprise value in Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions (Hoboken, N.J.: John Wiley & Sons, 2008).17 A more expanded formula is:

18 “The purpose of the analysis is to assess the addition to shareholders’ wealth; determining the market value of most corporate debt issues is difficult because they are not actively traded; debt market values are usually relatively close to book values; and the market value of an organization’s debt is more closely tied to interest rate movements than to managerial actions that influence shareholder wealth. Essentially, the assumption is made that the market value of debt equals its book value.” (Louis C. Gapensky, “Using MVA and EVA to Measure Financial Performance,” Healthcare Fi-nancial Management (March 1996), http://findarticles.com/p/articles/mi_m3257/is_n3_v50/ai_18193961/. Monks and Lajoux comment that it is important to calculate the market value of debt in the MVA formula; otherwise the two debt values cancel each other out and the formula is less robust as a valuation measure.

MVA = V - K = 0 Σ ∞ EVAt

(1+c)t

Enterprise value = Market capitalization + Preferred stock + Debt – Cash equivalents

Economic profit = Invested capital × (Return on invested capital –WACC)15

MVA = Market value – Invested capital 17

MVA = V - K



19 “Manage: The Executive Fast Track,” http://www.12manage.com/methods_mva.html.20 Toromount, http://www.toromont.com/company.asp.21 Northrop Grumman, http://www.northropgrumman.com/images/annual_report/2009_noc_proxy.pdf.22 John Deere, http://www.deere.com/en_US/compinfo/speeches/2009/090225_lane.html.

MVA is equivalent to the present value of all fu-ture expected EVAs. Positive MVA means the value that management’s actions have contributed to the company are higher than the value of that capital markets have contributed. (See Chapter 7 for more thoughts on management genius.)The drawback of this approach is that it cannot be used for a company unit. Also, it does not take divi-dends into account. 19

Return on Capital Employed (RCE) Return on capital employed is calculated as fol-lows:

EBIT = earnings before interest and taxes• Capital employed = total assets – current li-• abilities

Based on one example, a positive return is in the order of 18 percent. 20

Return on Net Assets (RONA) This measure’s formula is:

Enthusiasts of this approach point out that it is sim-pler than some measures (such as CFROI). 21

Shareholder Value Added The shareholder value added (SVA) approach, de-veloped by valuation expert Alfred Rappaport (see also Chapter 4), attempts to measure what a com-pany is worth to shareholders. SVA estimates the

total net value of a company and divides this figure by the value of shares. This metric has gained wide acceptance and is used by a number of blue chip multinational companies. 22

The value-added part says a company adds value for its shareholders only when equity returns ex-ceed equity costs. Once the amount of value has been calculated, targets for improvement can be set, and shareholder value can be used as a measure for managing performance. (The management of shareholder value requires more complete informa-tion than traditional measures.) A company’s share-holder value can be calculated as follows:

The value given to shareholders is found by sub-tracting the market value of any debts owed to the company from the total value of the company:

If total business value is greater than 1, then the company is worth more than the invested capital and value is being created.

Total Shareholder Return Total shareholder return (TSR), also called total business return in a more generic sense, is a simple valuation measure that can be used as a check point for an investment. It is a forward-looking internal rate of return.

RCE = Earnings before interest and taxesCapital employed

x 100%

Profit after tax/( Fixed assets + Working capital)

Shareholder value = Total business value – Debt

Total business value = Present value of future cash flows

+ Residual value of future cash flows



TSR, or holding period return (HPR) as it is some-times called, is the return a shareholder earns over a specified period of time. It is derived using the following formula:

SP1 = share price at end of period• SP0 = share price at beginning of period• D = dividends paid during the period•

Total business return = Terminal value for end of period

– Gross cash investments at beginning of period

+ Gross cash flows between periods

TSR= x 100%SP1 - SP0 + DSP0

Two Lafayette Centre1133 21st Street, NW Suite 700 Washington, DC 20036Phone 202-775-0509 Fax 202-775-4857NACDonline.org 9 780943 176536

ISBN 978-0-943176-53-6

Report of the NACD Blue Ribbon Commission on Performance...

Documents

Transcript of Report of the NACD Blue Ribbon Commission on Performance...