Shareholder Value Maximization

Statements on Management Accounting

B U S I N E S S P E R F O R M A N C E M A N A G E M E N T

C R E D I T S

T I T L E

This statement was approved for issuance as aStatement on Management Accounting by theManagement Accounting Committee (MAC) of theInstitute of Management Accountants (IMA). IMA appre-ciates the collaborative efforts of The Society ofManagement Accountants of Canada (SMAC) and thework of Dr. Howard Armitage, CMA, of University ofWaterloo, and Vijay Jog, of Carelton University, who draft-ed the manuscript.

Prior to his becoming a member of MAC, Randolf Holst,CMA, was a SMAC staff manager and, in that capacity,supervised and monitored the project, which was broughtto conclusion by SMAC staff manager Elizabeth Bluemke.MAC member Thomas E. Huff served on the focus groupthat provided significant assistance in shaping the finaldocument. IMA thanks the aforementioned individualsand members of the Management AccountingCommittee for their contributions to this effort.

Measuring and ManagingShareholder Value Creation

Published byInstitute of Management Accountants10 Paragon DriveMontvale, NJ 07645-1760www.imanet.org

Copyright 1997 Institute of Management Accountants

All rights reserved

Statements on Management Accounting


T A B L E O F C O N T E N T S

Measuring and Managing Shareholder Value Creation

I. Rationale . . . . . . . . . . . . . . . . . . . . . . . 1

II. Scope . . . . . . . . . . . . . . . . . . . . . . . . . 1

III. Defining Shareholder-Value and WealthCreation . . . . . . . . . . . . . . . . . . . . . . . . .2

IV. Determinants of Shareholder-Value Creation . . . . . . . . . . . . . . . . . . . . . . . . .3

V. The Role of the Management Accountant . . . . . . . . . . . . . . . . . . . . . . .5

VI. Techniques for Measuring Shareholder Value . . . . . . . . . . . . . . . . . . . . . . . . . . .6

Value-Creation Measures . . . . . . . . . . . .7

Economic Value . . . . . . . . . . . . . . . . . . . .9

The Equity Spread . . . . . . . . . . . . . . . . .11

Implied Value . . . . . . . . . . . . . . . . . . . .12

Cash Flow Return on Investment . . . . . .12

Wealth-Creation Measures . . . . . . . . . .14

Total Shareholder Return . . . . . . . . . . . .14

Annual Economic Return . . . . . . . . . . . .15

Hybrid Value/Wealth-Creation Measures 16

Market Value Added . . . . . . . . . . . . . . .16

VII. Additional Issues Related to Shareholder-Value-Creation Measurement . . . . . . . . .18

Stock Price . . . . . . . . . . . . . . . . . . . . .18

Uncontrollable Factors . . . . . . . . . . . . .18

Linkage Between Value- and Wealth-Creation Measures . . . . . . . . . . . . . . . .19

VIII. Managing for Shareholder Value . . . . . . .19

Ensuring Senior Management Commitment and Support . . . . . . . . . . .20

Creating a VBM Transition Team . . . . . .21

Aligning Incentives to Enable Change . .23

lX. Organizational and ManagementAccounting Challenges . . . . . . . . . . . . . 25

X. Conclusion . . . . . . . . . . . . . . . . . . . . . 25

Appendix A: Sample Calculations for Shareholder-Value-Creation Measures

Appendix B: From Earnings to OperatingPerformance to Value Creation

Bibliography

ExhibitsExhibit 1: Corporate Objectives and

Value Drivers . . . . . . . . . . . . . . . .3

Exhibit 2: Examples of Shareholder-Value-Creation Strategies . . . . . . . .4

Exhibit 3: Comparing Traditional and Value-Based Income Statements . . . . . . .8

Exhibit 4: Rate of Return on Net Assets (RONA) . . . . . . . . . . . . . . .9

Exhibit 5: Financial Drivers of Total Shareholder Return (TSR) . . . . . .15

Exhibit 6: Comparison of Shareholder-Value-Creation Measures . . . . . . .17

I . RAT IONALEMore than ever, corporate executives are underincreasing pressure to demonstrate on a regularbasis that they are creating shareholder value.This pressure has led to an emergence of a variety of measures that claim to quantify value-creating performance.

Why is creating shareholder value suddenlybecoming a credo in corporate boardrooms?There are many reasons for this renewed emphasison measuring and managing shareholder value,prominent among which are the following:l Capital markets are becoming increasingly

global. Investors can readily shift investmentsto higher yielding, often foreign, opportunities.

l Corporate governance is shifting, with ownersnow demanding accountability from corporateexecutives. Manifestations of the increasedassertiveness of shareholders include thenecessity for executives to justify their com-pensation levels, and well-publicized lists ofunderperforming companies and overpaidexecutives.

l Executives are concerned with self-preserva-tion. Well-publicized hostile takeovers haveserved notice to all levels of management thatweak financial performance is unacceptableand may precipitate a fight for corporate control.This potential loss of control has motivatedmany executives to better understand theimportance of measuring and managing share-holder expectations.

There is also considerable dissatisfaction withexisting accounting-based earnings and returnmeasures. Evidence is mounting that accountingmeasures such as earnings per share (EPS) andprofit or growth in earnings do not take intoaccount the cost of the investment required torun the business. Similarly, return-based meas-ures, such as return on assets, often motivate

managers to make short-term dysfunctional decisions that encourage underinvestment.Furthermore, neither earnings nor return measuresappear to correlate well with actual market values of companies.

I I . SCOPEThis Statement compares and contrasts variousmeasures that claim to quantify managementsshareholder-value-creation abilities and describesthe issues and challenges faced in order toimplement an operating paradigm resulting from these measuresvalue-based manage-ment (hereafter referred to as VBM1).

This Statement applies to all firms, private andpublic, large and small, whose managers areinterested in creating value for their shareholders/owners. It will help management accountants andothers to:l understand the fundamental concepts of

shareholder-value creation;l link value creation to shareholder-wealth

maximization;l unravel financial and operational drivers that

can lead to improved performance and therebyimprove shareholder-value creation;

l understand the differences among a variety ofmeasures that assess management perfor-mance within the context of shareholder-valuecreation and wealth maximization;

l appreciate the organizational and managementaccounting challenges in implementing VBM toimprove shareholder-value creation; and

l broaden shareholder and management awarenessof the importance of shareholder-value creation.

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1 VBM is an approach to management whereby the companys overall aspirations, analytical techniques, and man-agement processes are aligned to help the company maximize its value by focusing management decision makingon the key drivers of shareholder value.

The Statement recognizes that several philoso-phies exist with respect to how organizationsperceive the process of shareholder-value creation. The approach taken here places theshareholder at the focal point of all economicactivity within the firm, with maximizing share-holder value as the objective of the organization.This does not mean that, in its quest to createshareholder value, other stakeholders, such as employees, customers, suppliers, or the community, are ignored. Quite the contrary.Value-creating firms take decisions that maintaina proper balance between the competing interests of all stakeholders.

Nevertheless, the shareholder is the centralstakeholder. Placing the shareholder at the focalpoint of business activity is simply recognizingthe fact that firms that do not satisfy shareholderrequirements increase their risk of capital flight,higher interest rates, pressure from the board ofdirectors, takeovers, and lower productivity.Organizations that create long-term shareholdervalue simultaneously create relatively greatervalue for all stakeholders. Thus, value-creatingorganizations appear to operate with the followingobjective function in mind: Maximize shareholderwealth subject to satisfying remaining stakeholderrequirements.

III. DEFINING SHAREHOLDER-VALUEAND-WEALTH CREATIONFrom the economists viewpoint, value is createdwhen management generates revenues over and above the economic costs to generate these revenues. Costs come from four sources:employee wages and benefits; material, supplies,and economic depreciation of physical assets;taxes; and the opportunity cost of using the capital.2

Under this value-based view, value is only createdwhen revenues exceed all costs including a capital charge. This value accrues mostly toshareholders because they are the residual owners of the firm.

Shareholders expect management to generatevalue over and above the costs of resources con-sumed, including the cost of using capital. If sup-pliers of capital do not receive a fair return tocompensate them for the risk they are taking,they will withdraw their capital in search of betterreturns, since value will be lost. A company thatis destroying value will always struggle to attractfurther capital to finance expansion, since it willbe hamstrung by a share price that stands at adiscount to the underlying value of its assetsand by higher interest rates on debt or bankloans demanded by creditors.

Wealth creation refers to changes in the wealth ofshareholders on a periodic (annual) basis.Applicable to exchange-listed firms, changes inshareholder wealth are inferred mostly fromchanges in stock prices, dividends paid, and equityraised during the period. Since stock prices reflectinvestor expectations about future cash flows,creating wealth for shareholders requires that thefirm undertake investment decisions that have apositive net present value (NPV).

Although used interchangeably, there is a subtledifference between value creation and wealth creation. The value perspective is based on measuring value directly from accounting-basedinformation with some adjustments, while thewealth perspective relies mainly on stock marketinformation. For a publicly traded firm these twoconcepts are identical when (i) management provides all pertinent information to capital markets, and (ii) the markets believe and haveconfidence in management.

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2 Opportunity cost is often referred to as the cost of capital.It is an opportunity cost because it represents a foregonereturn on an alternative investment opportunity of equal risk.

IV. DETERMINANTS OF SHARE -HOLDER-VALUE CREAT IONTo create value, management must have a deepunderstanding of the performance variables thatdrive the value of the business. Called key-valuedrivers, there are two reasons why such an under-standing is essential. First, the organization cannot act directly on value. It has to act on thingsit can influence, such as customer satisfaction,cost, capital expenditures, and so on. Second,it is through these drivers of value that seniormanagement learns to understand the rest of theorganization and to establish a dialogue aboutwhat it expects to be accomplished.

A value driver is any variable that significantlyaffects the value of the organization. To be useful,however, value drivers need to be organized sothat management can identify which have thegreatest impact on value and assign responsibilityfor their performance to individuals who can helpthe organization meet its targets.

Exhibit 1 shows the linkage between corporateobjectives and four categories of value drivers.l Intangiblesl Operatingl Investmentl Financial

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Creating Shareholder Value (Shareholder Return)(Dividends, Capital Gains)

Cash Flow fromOperations

Cost of Capital

Cost of EquityCost of Debt

CapitalStructure

FinancialInvestmentOperatingIntangiblesManagementDecisions

ValueDrivers

ValuationComponents

CorporateObjective

Working CapitalFixed Capital

Sales GrowthProfit Margin

Income Tax Rate

AmountGrowth Rate

Duration

EXHIBIT 1: CORPORATE OBJECTIVES AND VALUE DRIVERS

Source: Adapted from Rappaport, 1986.

EXHIBIT 1. CORPORATE OBJECTIVES AND VALUE DRIVERS

Source: Adapted from Rappaport 1986

In the exhibit, the objective of management is toprovide consistent and positive shareholder value.Positive shareholder value results from improvingcash flow from operations and minimizing thecost of capital by making optimal capital structuredecisions. The cash flow from operations isdetermined by the value drivers and is affectedby operational and investment decisions takenby management.

Exhibit 2 shows the implications of this frame-work for value-creating strategies as they relateto the financial and operational value drivers.The second column shows the value drivers andthe third column shows the various underlyingstrategies that positively influence these drivers.3

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patent barriers to entry, niche markets,innovative products, etc.

scale economies, captive access to rawmaterials, higher efficiencies in processes(production, distribution, services) and labor utilization, effective tax planning, etc.

efficient asset acquisition and maintenance, spin-offs, higher utilizationrates of fixed assets, efficient workingcapital management, divesture of negative-value-creating assets, etc.

consistent and superior operatingperformance compared to competitors,long-term contracts, project financing, etc.

achieving and maintaining a capitalstructure that minimizes the overall costs, optimizes tax benefits, etc.

reducing surprises (volatility of earnings),designing niche instruments, etc.

consistent value creation

higher revenues andgrowth

To Achieve Value Drivers Strategic Requirements

lower costs and income taxes

reduction in capital expenditure

An increase in cash flow from operations

A reduction in capital charge

reduced businessrisk

optimize capital structure

reduced cost of debt

reduced cost of equity

EXHIBIT 2: EXAMPLES OF SHAREHOLDER-VALUE-CREATION STRATEGIES

Source:

EXHIBIT 2. EXAMPLES OF SHAREHOLDER-VALUE-CREATION STRATEGIES

3 It should be noted that reducing (and measuring the reduction of) the cost of capital is indeed a very difficult task and management should focus more on increasing operating cash flows than on reducing the cost of capital.

There are many examples of firms employing oneor many of these strategies to create shareholdervalue. The 3M Company does it by continuouslyintroducing new products; Corel does it by bringingquality products to market very quickly, usuallywith more functionality and at a cheaper pricethan its competitors; Sony does it by introducinghigh-quality products to the market for which consumers are willing to pay a higher price. Eachorganization uses its respective competitiveadvantages to dominate their product markets,so that as long as their operations and capitalcontinue to be managed effectively, incrementalshareholder value will be created. In reality,successful firms employ a combination of thesestrategies to achieve competitive advantages,which in turn create value for their shareholders.

However, not every strategy, although well-intendedand even well-executed, results in shareholder-value creation. For example, it may not be sufficientto simply introduce new and innovative productsat an attractive price. Although this may result inincreased market share and high revenuegrowth, unless there is sufficient competitiveadvantage to permit these new revenues toexceed the required additional investment andexpense, value may actually be destroyed.Similarly, not all total quality management (TQM)and customer satisfaction programs are success-ful in creating value. As has been shown by theexamples of the Wallace Corporation and FloridaPower & Light, winning the Baldrige or Demingaward does not automatically place the companysmanagement in the shareholder hall of fame.4

Quite clearly none of these strategies is likely to

successfully increase shareholder value unlessit is implemented in an area of a sustainablecompetitive advantage.

The linkage between strategy and value creationcan be summarized by two simple laws of valuecreation. The first law is that management mustcreate value for shareholders. The second law is that all other stakeholders should also be satisfied in a way that contributes to shareholdervalue. The companys ability to continue to attractcapital by providing incremental value to share-holders is exactly what will allow it to continue to provide attractive products to its customers,attractive employment to its staff, and opportuni-ties for its suppliers.

If a company can offer attractive and challengingwork to its staff, in a healthy and positive environment, perhaps it can lower the cost ofcompensation. If customers are always servedbetter but at no incremental cost, market sharecan be protected. These attributes also createcompetitive advantage, which in turn is a pre-requisite for creating shareholder value.

The key is to understand and manage the inter-relationships among what customers are willingto purchase, what employees perceive to beappropriate rewards, and, ultimately, what share-holders view as delivered value. The success ofVBM hinges on managements ability to balancethe sometimes conflicting notions of valuebetween the three principal partners: customers,employees, and shareholders.

V. THE ROLE OF THE MANAGEMENT ACCOUNTANTManagement accountants have, for years, beenconcerned with financial drivers like profit margins,capital utilization, and financing structures. Thisspecific knowledge, plus the broadening of man-

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4 The Wallace Corporation won the Baldrige award for outstand-ing quality in 1989. In 1991, it declared bankruptcy. FloridaPower & Light won the even more prestigious Deming award inthe early 1990s and was only saved from the same fate whenit realized that the costs of its quality efforts vastly exceededthe benefits shareholders were receiving from them.

agement accounting responsibilities that hasbeen taking place in the last decade, mean thatmanagement accountants play an important rolein the planning, implementation, and measurementof shareholder-value creation. While the degreeof involvement will vary, seven focal points seemparticularly pertinent.

l Assessing the Potential of VBM Managementaccountants can assess whether their organi-zations can successfully implement a VBMapproach. Characteristics that lead to a positiveenvironment include: a senior managementcommitment to maximizing shareholder value(a value-creation mind-set), a dissatisfactionwith accounting-based measures, a desire toalign performance objectives and value, andan interest in creating stronger links betweenpay and performance.

l Communicating the Fundamentals ofShareholder-Value Creation Managementaccountants fill an important role in educatingpersonnel on what VBM is, the strategies thatlead to value creation, the key drivers of value,the measures of value, and how an individualswork can support a VBM initiative.

l Measuring Shareholder Value Once particularshareholder-value-creation measures havebeen selected, the management accountantconsiders which adjustments to traditionalincome statement reporting formats may benecessary to make value-based calculations.Adjustments such as deferred taxes, goodwillamortization, research and developmentexpenditures, and unusual loses or gainscause value-based measures to differ fromaccounting-based statements.

l Linking Value Measures to Financial andOperational Drivers Management accountantsplay an important role in helping operationspersonnel develop measures that are linkedto, and promote, shareholder value. The task

of the management accountant is to focusthese measures so that everyone in the organ-ization is pointing in the same value-enhancingdirection.

l Assisting in Designing Performance MeasurementSystems Management accountants have animportant role to play in designing, explaining,and maintaining the performance measure-ment systems necessary to provide the rightvalue-creating signals to management. This isa critical area because in many organizationstraditional performance measurement systemsmay reward dysfunctional behavior behaviorthat leads to value destruction.

l Assisting in Setting Value-based CompensationPlans Increasingly, boards of directors andshareholders are requiring that compensation(particularly of senior managers and officers)be linked to value-based measures. Managementaccountants can provide valuable advice on thedevelopment and implications (what-if scenar-ios) of various value-based compensationstrategies that may be under consideration.

l Assisting in Evaluating Value-creatingStrategies Management accountants arebeing called upon more often not only to measure outcomes, but also to use theirexpertise to evaluate new and existing initiatives. By understanding the componentsthat lead to value improvement, managementaccountants are in the position to determinewhether new and existing projects lead to positive NPV.

V I . TECHNIQUES FOR MEASURINGSHAREHOLDER VALUEThe measures available to management andshareholders to gauge a firms value-creationperformance can be separated into three broadcategories. The first category includes thoseappraisals which rely mainly on the financialstatements produced by the firm, but require an

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estimation of the cost of capital and a variety ofother adjustments to traditional income state-ments and balance sheets to reflect operatingcash flows and an appropriate capital basethese can be termed value-creation measures.The second category of measures includesthose that rely exclusively on stock market dataand, thus, are mainly applicable to exchange-listed companies. These can be termed wealth-creation measuresthey concentrate onthe impact on shareholder wealth and use thatas an indirect measure of annual (or periodic)performance. The third set of measures arehybrid value/wealth-creation measures andrequire both financial statement and stock market data.5

Company differences in financial sophistication,internal reporting capabilities, and businesscharacteristics create a need for tailored value-measurement approaches. The techniques differalong a number of dimensions, including:l the simplicity/accuracy trade-off implied in each;l managements ability to understand and

control the measures; andl the complexity required for implementation.

The respective merits of these techniques have provoked a debate over and above discussion ofshareholder value generally. None of the alterna-tives is perfect; even the most sophisticated fueldebate.

Value-Creation MeasuresValue-creation measures require some rewritingof the financial statements to undo any adjust-ments made by the firm to satisfy externalreporting requirements for generally acceptedaccounting principles and to bring the reportedearnings closer to cash flows. Exhibit 3 comparesthe traditional income statement and value-based formats.

The traditional income statement provides noindication as to whether the earnings generatedby the firms met investor expectations based onthe firms business risk and leverage risk. It simply provides an earnings number, popularlycalled the bottom line. Typically, if the bottomline is positive, the firm is said to have done well.

Yet, firms that show a positive bottom line in atraditional sense may in fact have destroyedvalue. For example, a large Canadian integratedoil and gas firm showed a bottom line earningsof $514 million according to its published financial statements. However, its value-basedview indicates that it destroyed $492 million of economic value. Similarly, an analysis of 639Canadian firms in the nonfinancial sector in1994 shows that they earned $18.8 billion (traditional earnings) in total; however, the economic value amounted to minus $6.2 billion.6

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5 Value cannot be short term, but other measures can be.Earnings per share (EPS) or return on equity (ROE) are usually used in a myopic way by overly concentrating on theimpact of accounting earnings. Furthermore, earnings tend tofocus mainly on managing the income statement and placeslow weight on the actual amount and timing of cash flows.

Sufficient evidence exists to indicate that not only are thesemeasures theoretically inadequate, but, more importantly,there is an increasing body of empirical evidence that showsthat these measures have little relation to share prices or market value of the firm. (See Armitage and Jog, 1996.) All standard textbooks in corporate finance describe the theoretical inadequacies of these measures; empirical evidence is now available in the standard material of manyconsulting firms.

6 Internal Document. 1995. Ottawa, ON: CorporateRenaissance Group. (August)

The value-based view explicitly recognizes thecapital charge associated with the use of capital.The bottom line under this format is, therefore,quite different from that under the traditionalview. A positive bottom lineeconomic valuesignifies a superior performance because itaccounts for all four types of costs (see page 2)including that associated with capital.7

The value-based income statement concentrateson the operating performance of the firm byfocusing on cash flow from operations andaccounts for interest expense through capitalcharge calculations. Thus, it adjusts taxes as ifthe firm were all equity financed. This view isconsistent with the free-cash-flow10 view.

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EXHIBIT 3: COMPARING TRADITIONAL AND VALUE-BASED INCOME STATEMENTS

Source:

less: Cost of Goods Sold less: Cost of Goods Sold

equals: Gross Profit equals: Gross Profit

less: Depreciation, Sales & less: Depreciation, Sales & Administration, and Other Administration, and Other

equals: Profit Before Interest and Taxes equals: Profit Before Interest and Taxes (PBIT) (PBIT)

less: Interest less: Adjusted Taxes

equals: Profit before Taxes equals: Net Operating Profit After Taxes (NOPAT)

less: Taxes less: Capital Charge9

equals: Net Income equals: Economic Value Added

Revenues

Traditional Income Statement

Revenues

Value-Based Income Statement8

EXHIBIT 3. COMPARING TRADITIONAL AND VALUE-BASED INCOME STATEMENTS

7 It is noteworthy that current auditing or regulatory require-ments do not require a firm to produce such a value-basedview when, in fact, it is a more accurate assessment of firmperformance. Also, rarely in an annual report can one find avalue for the capital charge or a number for cost of equity andcost of capital.

8 This is a very simple view of the firm's income statement. Forthe time being, the issues of economic depreciation and thevariety of adjustments required to both income statement andbalance sheet to arrive at value-based NOPAT are ignored. SeeAppendix B for a discussion on these specific adjustments.

9 Capital charge equals weighted average cost of capital(WACC) times invested capital or capital base. This representsthe opportunity cost for using the funds provided by sharehold-ers and debt holders. In other words, it is the amount of prof-it investors require to compensate them for the riskiness ofthe business, given the amount of capital invested. WACC rep-resents weighted average cost of after-tax debt costs and esti-mated cost of equity weighted by their proportional impor-tance. Invested capital equals net fixed assets plus net work-ing capital, representing the total investment made by the firm's shareholders and bond holders. (See any standardcorporate finance textbook for a detailed example of how tocalculate WACC. The detailed discussion of WACC is beyondthe scope of this Statement.)

10. Free-cash flow is a company's true operating cash flow.It is the total net after-tax cash flow generated by the companyand is available to all providers of the company's capital, bothcreditors and shareholders.

The value creation measures considered are:l Economic Value; 11

l The Equity Spread;l Implied Value; andl Cash Flow Return on Investment and Value-

Creation Potential.

Economic ValueThe use of economic value (EV) as a measure ofbusiness unit and company performance hasbecome increasingly widespread in recent years.In North America, it has been adopted in variousforms by a number of large companies, includingCoca-Cola, AT&T, Kellogg, and Scott Paper astheir principal measure of profitability, replacingoperating income and net earnings as the focusof managements attention.

The origin of EV measures can be traced toRicardo in the mid-1800s who used the termsuper normal rent to describe EV. In the mid-1920s General Motors used a measure calledresidual income to indicate the amount of incomeleft over after paying for the various componentsof costs including a charge for capital. Althoughused by management accountants for manyyears, it was revived by the PIMS project and pop-ularized by Bennett Stewart12 who redefined it aseconomic value added and by Copeland et al. aseconomic profits. Since then this term has alsobeen defined as economic value creation andshareholder value added by others. 13

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13 The basic concept was first proposed by Alfred Marshallin the 1880s and was further mentioned by Peter Drucker in1964. Recently, it has also surfaced in academic accountingliterature and is known as the Edwards-Bell-Ohlson (EBO) orthe Feltham-Ohlson frameworksee Bernard (1995). Frenkeland Lee (1996) show the equivalence between the EBOmodel and the economic-value model.

11 Economic value measures include residual income,economic value added, shareholder value added, economicprofit, and economic value creation. These measures areexpressed in dollars. The rest of the Statement uses the termeconomic value (EV) to describe these measures.

12 See Buzzell and Gale (1996, 27) and Stewart (1991).

less

Revenue Gross Profit

ExpensesAfter Tax

Cost of GoodsSold

Current Assets Fixed Asset

WorkingCapital

Revenue

Net Assets

NetOperatingProfit After

Tax NetOperating

ProfitAfterTax %

AssetTurnover

RONA%

CurrentLiabilities

less plus

times

dividedby

dividedby

less

EXHIBIT 4: RATE OF RETURN ON NET ASSETS (RONA)

Source:

EXHIBIT 4. RATE OF RETURN ON NET ASSETS (RONA)

The key difference between EV measures and traditional measures of performance such asafter-tax rate of return on net assets (RONA) asillustrated in Exhibit 4 (see page 9) is that EVaccounts for the cost of capital and expressesthe value-creation performance in easily measur-able unitsdollars. Rather than saying thatRONA increased from 13 percent to 14 percentin a particular period and letting the reader inferits value-creation implications, it is much easierand intuitively appealing to state the firm created$100 of shareholder value.

In certain firms, managers' compensation is tiedto RONA and there have been instances wheremanagers have foregone investment opportunitiesthat had the potential to generate returns higherthan the cost of capital (i.e., value-creating decisions) to protect the minimum level of RONArequired to receive bonuses. Moreover, unless aspecific cost of capital is used to compareRONA, managers cannot know whether they havecreated value.

EV measures have some additional advantages:first, by explicitly recognizing the importance ofcapital and its associated costs, it motivates a capital-usage discipline. Second, it clearlyshows the linkage between the operating-marginperformance and capital intensity, and therebycan be used to better pinpoint opportunities for improvement as well as to assess the appro-priate level of investment to achieve theseimprovements. Third, it can easily link value drivers such as price and product mix to valuecreation. Fourth, it is consistent with the standard discounted cash flow (DCF) or the NPV framework. Fifth, and more importantly,since EV is an annual measure, it can be used toevaluate managerial performance and to provideincentives. 14

However, there are also some challenges in theactual calculation of all of the EV measures.These challenges arise because the actual calculations may require that precise estimatesof the cost of capital be derived and severaladjustments to the financial statements bemade.15 (See Appendix A for a discussion ofthese specific adjustments.)

The exact number and magnitude of adjustmentsrequired to convert the published numbers tovalue-based numbers depends upon the specificsituation. In general, four key principles shouldbe followed:l First, cash flow from operations must be

derived by making the necessary adjustmentsto reported earnings. Thus, any noncashcharges to reserves or write-offs affecting theincome statement (and balance sheet) mustbe reversed.

l Second, appropriate attention must be givento accounting for expenses that can be construed as investments in the future. Forexample, research and development expenses,which are usually treated as an expense of theperiod, can be considered as an investment inthe future. In such cases, only a portion of theR&D cost should be expensed in a given year;the rest may be capitalized and added to the asset base (and expected to earn the costof capital). Similarly, expenditures on largeconstruction projects or major research and

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14 From a present value context (i.e., for valuing a project or a firm), the DCF method provides an identical NPV to thatcalculated by discounting EVs. DCF is a well-known capitalbudgeting tool that is almost exclusively used at the projectlevel. Thus, it provides a one-time (today) value of an invest-ment to be undertaken. EV, on the other hand, provides anannual measure and can be used at the project/business/firm level.

15 Although many such adjustments may be required,experience indicates that not more than five to six adjustmentsmay be economically relevant. Examples of such adjustmentscan be found in Copeland, Koller, and Murrin (1996, 213) and Stewart (1991).

development initiatives generally have a longtime-to-market cycle and may not generateimmediate cash flow yet consume capital.

l Third, the asset base must reflect the replace-ment value of the capital and must not beaffected by goodwill write-offs, asset write-offs,or a highly depreciated fixed asset base whosebook values do not reflect replacement or mar-ket value, etc. The idea is to ensure that thecapital base used to calculate the capitalcharge reflects the true underlying capitalbeing used in the business.

l Fourth, and most important, all adjustmentsmust be material, transparent, and have animpact on managerial decision making.

In essence, the firm may well have three sets ofbooks: one to satisfy auditing and reportingrequirements, a second to satisfy the tax author-ities, and a thirdvalue-based booksto be usedin making value-creating decisions. It shouldalso be noted that this third set reflects an economic-value number that is different fromreported earnings and free-cash flow; some careis required in its derivation and interpretation.Fundamentally, there is a trade-off between simplicity and accuracy. A very complex calcula-tion with myriads of adjustments will failbecause of an inability to understand it.Managers will not abide by a measure that they cannot control or understand. (A detailedexample of how to calculate EV is provided inAppendix A.)

While EV is a better measure of financial gainthan the traditional income statement, it is stillsubject to malfunction. Experience shows thatfinancially oriented measures and incentivesbased solely upon these measures can result inpeople taking the shortest, most expedient pathto personal gain. This path often does notinclude such important initiatives as strengthen-

ing and building long-term customer relation-ships, protecting the companys brand image asa franchise or as an employer, or investing forfuture growth and potential. A careful alignmentof incentives to long-term EV creation is neces-sary to avoid this scenario (see Section VII).

The Equity SpreadAnother measure of shareholder-value creationis the one proposed by Marakon Associates the equity spread. This measure considers thedifference between the ROE and required returnon equity (cost of equity) as the source of valuecreation. This measure is a variation of the EVmeasures.

Instead of using capital as the entire base andthe cost of capital for calculating the capitalcharge, this measure uses equity capital and thecost of equity to calculate the capital (equity)charge. Correspondingly, it uses economic valueto equity holders (net of interest charges) ratherthan total firm value.

For an all equity firm, both EV and the equityspread method will provide identical valuesbecause there are no interest charges and debtcapital to consider. Even for a firm that relies onsome debt, the two measures will lead to identicalinsights provided there are no extraordinarygains and losses, the capital structure is stable,and a proper re-estimation of the cost of equityand debt is conducted. (A detailed example ofhow to calculate the equity spread is provided inAppendix A.)

A market is attractive only if the equity spreadand economic profit earned by the average competitor are positive. If the average competitorsequity spread and economic profit are negative,the market is unattractive.

11


Implied ValueThe implied value measure was popularized bythe Alcar Group and is similar to discountedfuture market value (DFMV) proposed by theStrategic Planning Institute.16 In this framework,the emphasis is not on annual performance buton valuing expected performance. The impliedvalue measure is akin to valuing the firm basedon its future cash flows and is the method mostclosely related to the DCF/ NPV framework.

With this approach, one estimates future cashflows of the firm over a reasonable horizon,assigns a continuing (terminal) value at the endof the horizon, estimates the cost of capital, andthen estimates the value of the firm by calculatingthe present value of these estimated cash flows.This method of valuing the firm is identical tothat followed in calculating NPV in a capital-budgeting context. Since the computation arrivesat the value of the firm, the implied value of thefirms equity can be determined by subtractingthe value of the current debt from the estimatedvalue of the firm. This value is the implied valueof the equity of the firm.

To estimate whether the firms management hascreated shareholder value, one subtracts theimplied value at the beginning of the year fromthe value estimated at the end of the year,adjusting for any dividends paid during the year.If this difference is positive (i.e., the estimatedvalue of the equity has increased during theyear) management can be said to have createdshareholder value.

The use of a change in the implied values as ameasure of value creation differs in at least twodistinct ways from the EV and the equity spreadmeasures of value creation. First, the impliedvalue measure is based on a longer-term view of

the business by using the estimates of futurecash flows. Thus, the change in its value acrosstwo years may be different from the economicvalue estimated under the first two methods.Since forecasts are used, it suffers from thesame problem as that of the DCF/NPV frame-work: forecasts can be manipulated to showdesired results.

Second, for exchange-listed companies, if capitalmarket participants have similar forecasts tothose of business managers, the implied valuemeasure should provide the same outcome asthe market value of the firms equity. If that is thecase, it may be easier to use the changes in themarket value of the firm as the measure of valuecreation and not worry about estimating futurecash flows. If that is not the case, the difference between the two values (value gap)may require further investigation.

However, despite these differences, the underlyinglogic behind the implied value measure providesan almost similar decision-making framework asthe one resulting from the EV and equity spreadmeasures. Value is created if managementsdecisions generate cash flows over and abovethe cost of capital and the firm is able to sustainthis performance over a long time period. (SeeAppendix A for a detailed example of the impliedvalue measure.)

Cash Flow Return on InvestmentMany investors are of the opinion that a companyis of little use to them unless it has the capacityto produce cash. These supporters of cash flowmeasurement and analysis claim that it makescompany managers think more like shareholdersbecause it concentrates their attention on theactual value of the company. Managers areforced to decide, for instance, whether they canreinvest the capital the company generates at a

12


16 See Buzzell and Gale (1996, 23-214).

level that adds value. If they cannot, they are likelyto either give it back to shareholders in the formof dividends or buy back the companys shares,which can be expected to raise the value of thosestill in circulation.

One method of measuring and analyzing companycash flow is the approach followed by the BostonConsulting Group and Braxton Associates calledCFROI (cash flow return on investment). CFROIrepresents the sustainable cash flow a businessgenerates as a percentage of the cash investedin the business.17 This cash flow on cash investedcan be expressed as an internal rate of return(IRR) over the normal economic life of the assetsinvolved. The difference between this return andthe cost of capital reflects the firms value-creation potential (the more positive the spread,the higher the potential). The changes in theCFROI across years can then be used as an indicator of the firms annual performance.

The appeal of CFROI and other metrics thatfocus on cash generation is that they help managers get a clear picture of a business unitscapital efficiency. Unlike traditional accountingmeasures such as return on assets, for example,CFROI looks at the true cash amounts invested.CFROI is not fooled by devices used to enhanceaccounting returns, such as operating leases,and it is not distorted by current or historicalinflation. This helps managers judge whether aunits ability to create value can be enhancedthrough expansion, reduced capital allocation, orassorted efforts to boost profitability.

Assessing the long-term cash flow that the company is likely to generate is not straight-forward. Calculating CFROI requires: convertingaccounting data (income statement and balancesheet) into cash in current dollars, calculating

cash flows in current dollars (accounting for infla-tion adjustments on monetary or near-monetaryassets such as inventories), estimating the normal life of the assets, calculating the value ofthe non-depreciating assets at the end of thehorizon, and then calculating the internal rate ofreturn. In addition, assumptions regarding thebusiness environment, industry trends, etc. willhave to be made. The expertise to develop suchlong-term scenarios may not be present in many companies, particularly smaller ones. Thedifference between this return and the real costof capital is termed the CFROI Spread; a positivespread reflects a positive expected value creation performance.

The CFROI methodology can also be used in valuing the firm by estimating annual CFROIsover the estimated period rather than estimatingthe CFROI value using current values. These estimates for a variety of industrial sectors areprovided by consulting companies, which usethis method in valuation. The changes in theestimated value across individual years (by re-estimating value at the beginning and at theend of the year) can be considered synonymouswith value-creation performance in that year.18

The period of cash flow that will need to beexplicitly forecast is industry specific, but it isunlikely to be much less than five years except inthe case of the most stable of environments.The cash flows should be forecast far enoughout of steady state to be a reasonable approxi-mation of forecast reality. This steady stateneeds long-run average economic conditions, soorganizations need to be careful that they arenot forecasting on the basis of either boom orslump conditions continuing indefinitely.

13


17 When inflation is a significant factor, both cash flow andcash invested are expressed in current dollars.

18 Boston Consulting Group also uses a modified version of CFROI called Total Business Return (TBR). Rather thanadjusting for inflation, current costs of assets are used in calculating TBR. For details, see Shareholder ValueManagement, booklet 2, The Boston Consulting Group, 1996.

Looking at cash flow is not the cure for all ills,however. It can become extremely complex andis probably way out of reach for ordinaryinvestors. But a large segment of the institutionalinvestment community now uses it as a matterof course, and management is more frequentlyperceiving a real value in looking at their businesses this way. (See Appendix A for adetailed example of how to calculate CFROI.)

Asking whether CFROI is better than EV is likeasking whether a Cadillac is better than aLincoln Town Car. There are trade-offs to eachapproach. CFROI provides a longer-term per-spective but is complex; EV is relatively easy touse but is an annual measure.

Wealth-Creation MeasuresWealth-creation measures rely entirely on thestock market and do not require any analysis ofthe firms financial statements for calculatingvalue-creation performance. Thus, they are primarily applicable to exchange-listed firms andare not useful for individual subsidiaries within the firm or for privately held firms.

The principle behind their use is simple: it is assumed that capital markets are, on average, capable of pricing all securities efficiently. The price of a common share of any firm is determined through the marketsexpectations about the firms (expected) value-creation abilities. The higher the potential, thehigher will be the share price relative to the capital invested. With that premise, a measureof the firms managerial performance can begauged by the rate of return earned by share-holders from their investment in the shares ofthe firm. Since changes in share price reflect the changes in investor expectations aboutfuture performance, these changes can be used

as a surrogate for the annual value-creation performance. Two wealth-creation measures con-sidered are:l Total Shareholder Return; andl Annual Economic Return.

Total Shareholder ReturnA useful summary measure for estimating theannual wealth-creation performance is the totalshareholder returns (TSR) concept that showsthe relative wealth creation of firms within a homogenous group. This return is simply therate of return earned by a shareholder through a combination of price changes and dividendsreceived.

The TSR measure allows managers to makeappropriate trade-offs among profitability, growth,and free-cash flows and to measure a units contribution to the overall company capital gainand dividend yield to investors.

Because it is possible that this return may beaffected by overall capital market conditionsrather than any specific decisions made by management, TSR typically is compared on arisk-adjusted basis with a peer group and/or a widely used benchmark (such as the TSE300or S&P500) for evaluating relative performance.If the relative performance is positive, one mayconclude that the capital market has respondedfavorably to managerial decisions made in thatyear, and, in turn, management has createdshareholder value. This measure is based entirelyon the markets perceptions about a firms futureperformance.

In Exhibit 5, a firms TSR is split into three component financial drivers. Its profitability (ROl)and growth in invested capital are the two key-value drivers of capital gains. Companiesgenerating high returns on their invested capital

14


(i.e., ROIs above investors required rate of return)achieve stock-price increases when they are ableto invest more capital at these high ROIs. Analternative strategy is exemplified by companiesthat increase their return on invested capital,which also drives relatively superior TSRs fortheir shareholders through capital gains perfor-mance. The third driver of a relatively superiorTSR is free-cash flow. (A detailed example of howto calculate TSR is provided in Appendix A.)

Annual Economic ReturnAnother wealth-creation measure is the annualeconomic return (AER).19 The AER explicitlyaccounts for both dividends and externally raisedcapital as well as the timing of these decisions tocalculate a firms annual wealth-creation performance. The rationale behind this measureis as follows: assume that at the end of each year,management has a choice of liquidating the firmat the market value of equity (net of any debt).Shareholders receive this liquidated amount andcan invest the proceeds in other investments.Alternatively, management may believe that it cando better by continuing to operate the business.20

In this scenario, management continues to runthe business, pay dividends, and raise externalcapital as and when required. The wealth-creatingability of management can be evaluated by comparing the return it generates with what itcould have accrued to shareholders under the liquidation scenario.

The AER method requires an estimation of theshareholders alternative investment rate, which,in theory, is the cost of equity capital corresponding to the riskiness of the firman estimationchallenge that is also faced by value-creationmeasures. Even the TSR method is not immuneto this challenge; ideally, the actual TSR shouldbe compared with the expected TSRtherequired rate of return by shareholders or, inother words, the cost of equity capital.

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TSR

Capital Gains

Profitability(ROI)

Growth(Investment)

Free-CashFlow

Dividends

EXHIBIT 5: FINANCIAL DRIVERS OF TOTALSHAREHOLDER RETURN (TSR)

Source: Boston Consulting Group Inc. 1996

EXHIBIT 5. FINANCIAL DRIVERS OF TOTAL SHAREHOLDER RETURN (TSR)

Source: Boston Consulting Group Inc. 1996.

19 See Jog and Halpern (1996), which shows a ranking ofCanadian firms based on this measure.

20 While debatable, readers who still remember their corporate finance textbooks can see that this description isthe Miller-Modigliani proposition on dividend policy

The main benefits of the AER measure over theTSR measure are that it accounts for the amountand timing of dividends and external capitalraised and also for the differences in opportunitycosts across firms. (See Appendix A for adetailed example of how to calculate AER.)

Hybrid Value/Wealth-Creation MeasuresHybrid value/wealth-creation measures requireinformation from both the financial statementsand the stock market. In essence, these measuresevaluate a firms performance by comparing themarket value of the firm (equity) with the investedcapital (equity). By comparing a companys currentvalue with the capital that has been invested inthe company since its formation, the investmentcommunity can tell if a firm is creating wealth orwasting iteven destroying it.

The difference between the market value of thefirm (equity) and the adjusted capital (equity) canbe thought of as a crude proxy for the net wealthcreation by a firms management. In efficientcapital markets, this difference represents themarket valuation of a firms investment opportunityset. The most common hybrid value/wealth-creation measure is market value added.

Market Value Added (MVA)MVA requires adjusting all capital (debt and equity)and reflects capital market expectations about thefirms future value-creation performance. Thevalue of capital can be adjusted to ensure that itreflects the cumulative capital invested by thefirms capital providers. For example, if the reportedbook value may have been affected by written-offextraordinary and normal losses, one must adjustthe book value upward accordingly.

A modification of this approach is to use the mar-ket value of the firms equity less the adjusted

invested shareholder capital. This is often usedsince the market value of debt is generallyunavailable. It requires adjusting for negativechanges to equity in the past and is affected byshare price and reflects capital market expecta-tions about the firms future value-creation performance. The market value of a firms equitycan be calculated by multiplying the number ofall outstanding shares times the price per share,and market value of the firm can be calculatedas the sum of the market value of all outstandingsecuritiescommon shares, preferred shares,and debt. The value of capital can be estimatedby ensuring that all relevant adjustments (seeAppendix B) are made.

Managements value-creation performance in aparticular period can be estimated by calculatingthe annual change in these two performancemeasures. This annual wealth-creation perfor-mance is simply the incremental wealth createdby management for its shareholders over a specifictime period. For investors, a crucial insight thatMVA offers is to beware of companies that pursuegrowth for growths sake. Unless the capitalemployed to generate earnings produces morewealth then it costs, MVA tends to stagnate andinvestors achieve no gain.

When comparing the performance of firms withone another using this measure, it is necessary toadjust for the differences in the size of the firms.This can be done by dividing the change in MVA bythe adjusted value of equity (capital) at the end ofthe previous year of each firm. This is referred toas a standardized value. These standardized values can be used to provide a performanceranking of firms relative to their peers.

MVA is not totally adequate when it comes to anatural resource industry like oil and gas, whereresources are not renewable and an asset base

16


can appreciate in value through timeunlikemachinery, factories and manufacturing inventoriesthat depreciate in value. (A detailed example ofhow to calculate MVA is provided in Appendix A.)

Exhibit 6 compares the various techniques formeasuring shareholder-value performance discussed in this Statement.

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EXHIBIT 6: COMPARISON OF SHAREHOLDER-VALUE-CREATION MEASURES

Source:

definition of operating economicprofit, capital base, and cost of capital

EconomicValue

Rate of Returnon Net Assets

The EquitySpread

CFROI/ValueCreationPotential/Implied or Plan Value

Total ShareholderReturn

AnnualEconomicReturn

Market ValueAdded

StandardizedMarket ValueAdded

none if accountingvalues are used

relies on forecasts future cash flows,

terminal value,current value ofcapital base

cost of equity and equity base

no estimation needed requires stock price

and dividend information

must know the amount and timing, external equity raised

requires adjustment of capital base

determination ofcapital-adjustedequity value

same as above same as above better for comparison

across firms

differentiating between expense and investment

requires a variety ofadjustments

supports the free-cashflow produced

can be used for compensation design

easy for line managers to grasp

can be used for comparisons with othercompanies

takes into account the costof the firms invested capital

is consistent with DCF no bias regarding new and

old business similar to IRR and NPV

metrics

does not requireaccounting data

directly related to shareholder wealthcreation

same as above for firmsraising capital frequently, thisis a better measure than TSR

accounts partially for opportunity costs

provides an indication of the investors expectationsabout future value-creatingperformance

can be used for comparisonswith other companies

easy for line managers to grasp

inter-divisional comparisonscan be difficult

since it is ratio based and ignores cost of capital, RONAprovides no explicit recognitionof value creation

since it is based on forecasts, itdoes not provide a directmeasure of performance

not useful for compensationdesign

complex and difficult for linemanagers to grasp

ignores capital structurechanges

since it is just a percentage, itprovides no explicit recognitionof value creation

not directly related to annualmanagerial performance

requires establishment of peergroup for comparison

not applicable for operationalunits or private firms


does not adjust for size differences for comparisons


ignores dividends can be biased against lower

return start-up investment; canfavor businesses with heavilydepreciated assets

adjusts for the size differencesfor comparisons

PerformanceMeasure

Key Challenges inEstimation

Limitations/Challenges

OtherComments

EXHIBIT 6. COMPARISON OF SHAREHOLDER-VALUE-CREATION MEASURES

VI I . ADDIT IONAL ISSUESRELATED TO SHAREHOLDER-VALUE -CREAT ION MEASUREMENT

Stock PriceBoth the (pure) wealth-creation measures and thehybrid measures are based on share price andassume that the share price reflects the marketsexpectations about the firms future value-creationperformance. A change in the stock price, andconsequently in MVA, is automatically attributedto managements value-creation performance.However, there are some major problems withusing the stock price as the only yardstick of managerial value-creation performance.

First, the overall level of stock market prices maychange simply because of macro-economic conditions (e.g., interest rates) in the economythat would affect the prices of all stocks. Thesechanges would have no relation to managerialvalue-creation performance.

Second, consider a situation where a firm hasconducted an exploration program that hasresulted in it finding economically provenreserves of oil. Fairly accurate estimates ofcosts associated with drilling and transportingare available. Based on current prices of oil andfuture uncertainty in oil prices, the stock markethas put a value of $100 million on the firmsequity at the year end. New management arrivesat the beginning of the year and decides to takea holiday for one year. During that year, the worldprice of oil increases and so does the uncertaintyabout future prices. Accordingly, the marketvalue of firms equity rises to $150 million, repre-senting a TSR and AER of 50 percent and changein MVA of $50 million. However, it is not clearwhat these changes have to do with managerialvalue-creation performance, unless one assumes

that managements decision to take a holiday(and not start production) was undertaken withgreat foresight.

The third problem with stock-market-basedmeasures is that they are unable to identify thevalue-creation performance of individual sub-sidiaries and business units. The market pricemay reflect the markets expectations of whatcorporate management would do with the overallfirm, but the market price cannot be used toassign a specific value to individual businessunits that may have wide variations in their value-creation performance. If the intent is to promotevalue-creating behavior within each businessunit, perhaps by linking incentive compensationwith wealth-based measures (e.g., stockoptions), then wealth-based measures based onthe share price of the overall firm are simplyinadequate. In this case, one must resort tovalue-creation measures.

Uncontrollable FactorsEV measures suffer some disadvantages inregard to uncontrollable factors. For example, arise in oil price may increase the calculated EVfor any given year. Considerable care must betaken to decide when managers get applauded(or blamed, if the reverse happens) for factorsnot under their control.

Similarly, in periods of rising prices there may bea tendency by management to overproduce inorder to benefit from the rise in oil price and toshow even higher EV. However, this implies thatthe firm has exercised the option of investingnow rather than later. The value of this exercisedoption must now be subtracted while estimatingeconomic value.21 Similarly, if proper incentive

18


21 See Dixit and Pindyck (1994, ch. 12).

mechanisms are not in place, and if the focus isonly on one years EV, then management maytake actions that may not be in the best long-term interests of the shareholders.

Linkage Between Value- and Wealth-Creation MeasuresBecause stock prices reflect capital marketexpectations about the firms long-term value-creation performance, it is not necessary thatthere be a one-to-one correspondence betweencurrent value-creation performance and wealth-creation performance as reflected throughchanges in stock price. The table above showsthat there are four possibilities.

The vast majority of firms will be found in the low-low and high-high quadrants. However, even iffirms are located in the other two quadrants, it isreasonable to assume that their positions thereare transient. In these situations, investors arelooking beyond existing EV and making anassessment that current EV will soon change toreflect longer-term market trends.

All three categories of measures can capture theessence of managements value-creation perfor-mance on an annual basis. The value-creationmeasures reflect the periodic operational perfor-mance of management, whereas the wealth-

creation measures reflect the periodic change ininvestor wealth arising from changes in the marketsexpectations due to managements decisionsduring that period. High MVA shows that a highexpected value-creating performance is beingrewarded by a higher market value of the firm.However, in all cases these measures quantifyperformance but do not create performance.

V I I I . MANAGING FOR SHARE -HOLDER VALUECompanies such as Disney and Coca-Cola aremanaged formally to create shareholder value.For these companies, the objective of value cre-ation is not simply a slogan appearing as thethird or fourth important goal in the missionstatement. It is the basis of all major decisionsthey make. In other words, these companieshave a value-creation mind-set in addition tomanagement processes and systems that arenecessary to translate that mind-set into action.As introduced earlier, this operating paradigm isoften referred to as value-based management.

Value-based management (VBM) is an approachto management whereby the companys overallaspirations, analytical techniques, and manage-ment processes are all aligned to help the company maximize its value by focusing manage-ment decision making on the key drivers ofshareholder value. VBM does not ensure that all

19


CURRENT EV-CREATION PERFORMANCE

Source:

Although the current value-creation performance is notadequate, the market expectssuperior performance in the future.

Low wealth creation reflectscontinued expected low valuecreation.

High wealth creation reflecting high and expected continuingvalue-creation performance.

Although the current value-creation performance is superior, the market expects inferior performance in the future.

Low High

High

WealthCreation

Current EV-Creation Performance

Low

of managements decisions will be perfect. It does, however, greatly improve the quality ofdecision making by improving the quality of thealternatives that management has to consider,as well as building into the organization a bias for choosing and implementing the bestavailable alternatives.

VBM may be introduced to an organization for avariety of reasons. There may be a mandate forchange because of a deterioration in marketposition, there may be increasing pressure byinstitutional shareholders for value-basedresults, or there may be a belief on the part ofsenior management that implementing a VBMinitiative is a way to focus the organization on aprimary objectivethe creation of shareholdervaluethat will permit the organization to develop or maintain a competitive edge. Oncethe notion of VBM has been introduced, varioussteps must be followed if effective implementa-tion is to occur.22 These are:l ensuring senior management commitment

and support;l creating a VBM transition team; andl aligning incentives to enable VBM.

Ensuring Senior Management Commitmentand SupportBefore VBM is introduced to the rest of theorganization, senior managers, including the CEOand the board of directors, must understand,accept, and be prepared to encourage the tech-nical, behavioral, and administrative changesthat VBM requires. As a new, and potentially disruptive, change-management approach, keypersonnel must familiarize themselves with howVBM concepts and measures can benefit theirorganization. This is not a trivial task. Despitethe popularity of a number of value-basedapproaches and measures, there have not been

a large number of value-creation implementa-tions in North America.23

For commitment at the highest level to beobtained, senior management and the board ofdirectors should feel confident that the followingkey benefits will pertain to their organization.

l a VBM framework will be able to create clearaccountable linkages between strategies,investments, operations, and stakeholder andshareholder values in the firm;

l incentive compensation can be tied to valuecreation rather than to accounting results orbudget negotiations;

l a VBM framework will permit value-based performance comparisons to be made betweencompetitors and between internal businessunits; and

l superior VBM performance will be demonstrablylinked to maximizing shareholder wealth.

While most organizations could benefit from theadoption of VBM principles, not all will be equallymotivated to do so. For example, centralizedorganizations, non-profit organizations that donot have the same profit-maximizing incentive asfirms in the profit sector, firms that can generallybe classified as followers rather than leaders,and firms that have senior management whomay not be motivated to see their compensation

20


22 The steps outlined are necessarily general in nature.Nevertheless, while each organization may differ on how eachis carried out, all are necessary conditions for success.

23 An example of this is provided by a recent survey of EVA(a value-based measure) knowledge and practice in Canada.The survey found that of 405 firms responding, only 6% or 24firms had implemented EVA. Of these, only four firms hadbeen using EVA for more than two years. See The Society ofManagement Accountants of Canada, (1995a). There is nosimilar survey from the United States. In general, however, itwould appear that adoption of new initiatives occurs morequickly in the USA than in Canada.

linked to value-based performance, will be lesslikely to be interested in, or mount, a successfulVBM initiative.

Creating a VBM Transition TeamManaging change means managing the commu-nication between the leaders of the organizationand those who will be affected by the change. It also means managing the organizational context in which the change to VBM is to occur.Organizations that are truly committed to VBMutilize what might generically be called a VBMtransition team.

A VBM transition team is a group of companychange agents, reporting to the CEO, who commitall their time to making the transition to VBM areality. While the CEO must provide the context andcommunicate the vision of the VBM change pro-gram, it is the transition team that translates thesehigh-level objectives and makes sure they areunderstood and implemented by divisional man-agers and employees throughout the organization.

Depending on the size of the organization, a VBMtransition team should consist of five to eight talented individuals who have the credibility andauthority to effect change. The minimum skillsset of the team includes information technology,management accounting, human resources, andprocess engineering. Team members come fromdifferent parts and levels within the organization.The head of the team should be an individualwho has the confidence of the CEO and one whois perceived by others as having the skill, integrity,and adequate knowledge of the business tomove the project forward.

Typically, a VBM transition team is charged withthe following responsibilities:

l providing context and guidance;l promoting dialogue;l coordinating and aligning;l ensuring top-to-bottom congruence; andl recognizing human relations issues.

Providing Context and GuidanceSenior management creates the strategic visionand long-run corporate objectives. However, thevision and goals need to be spread throughoutthe organization and explained to all levels ofemployees. The VBM transition team assiststhis transfer by holding organizational meetingsto explain the purpose of VBM and to help othersunderstand how they can align their efforts tosupport the overall organization initiative. Thismeans linking VBM measures such as EV to keyoperating metrics like cycle time or inventoryturns. To assist in transferring the VBM view, theteam should prepare printed (newsletter,brochure, communiques, and posters) matterand presentation and video materials thatdescribe the new initiative.

For example, Coca-Cola, one of the pioneers inmanaging with VBM principles, has an impressivecontext-generating brochure that is given out toall its employees. The brochure begins with aone page statement signed by Robert C.Goizueta, chairman, board of directors and CEO,that outlines how EVA assists the organization to achieve its mission of creating shareholdervalue and how each employee, in turn, must be accountable for the capital entrusted to, andthe net income generated by, his or her businessunit. In simple, straightforward terms the brochuredescribes the valuation measure selected by thefirm, why it is used, how it works, who is account-able, how the reporting process works, and howindividual employees can influence the value created by their own operating units.

21


Promoting DialogueIt takes time for people within the organization tobe convinced why VBM should be the primaryorganization paradigm, how it impacts on theirday-to-day activities, and why they should becomecommitted to the process. The VBM transitionteam plays an important role in encouraging andleading this dialogue. At Domtar, for example, over25 management presentations were conductedbefore implementation.

Coordinating and AligningPart of the role of the VBM transition team is tomanage the change process as it begins to takeshape throughout the entity. Education plays animportant part in ensuring that the ground rulesare well understood and that individual businessunits are pursuing a coordinated strategy ofvalue creation. Both Domtar and Husky offeredtraining to leaders, change agents, managers,and employees to get everyone focused on thereasons for pursuing VBM strategies, how valuewas calculated in the organization, the range ofbusiness unit-level strategies that could beundertaken to improve value, and the economicconsequences to both the firm and the employeefor successfully achieving value creation. Huskycalls this the Communicate, Communicatephase and it is the manner in which the VBMteam can ensure coordination and alignment ofmany disparate activities with the overall goalsof the organization.

Managers need to be involved in the analysisand not just educated in the results of the analysis. To reinforce this involvement, the coordination and alignment phase is the pointwhere, for example, accountabilities should be changed to provide managers with the authority to manage both cash flows and invest-ments, and interrelationships among businessunits should be determined and communicated

to highlight potential trade-offs at lower levels inthe business.

Equally important is the necessity to keep otherstakeholder groups, particularly investors,informed about key organizational changes andhow they will affect shareholder value.Organizations should identify a target group of influential shareholders and explain the companys actions and how they will contributeto changes in economic value. To gain credibility,this investor communication program requiresfull disclosure of relevant data. The goal shouldbe to avoid unnecessary surprises and minimizeuncertainty of the investing community.

Ensuring Top-to-Bottom CongruenceAdopting VBM means organization-wide changesin managerial philosophy. To be credible,management must be seen as both Talking theTalk and Walking the Walk. An important roleof the VBM transition team is to ensure that thiscongruence of goals at all levels is maintained,to be on the lookout for situations in which either management or business units appear to be straying from the course, and to take corrective action to remedy the gap.

Recognizing Human Relations IssuesAlong the way to VBM, there will invariably bechanged job descriptions, the potential of downsizing, re-engineered processes, and revisions to compensation structures. All ofthese can lead to heightened tensions, negativeeffects on morale, and natural human resistance. VBM transition teams should anticipate and be prepared for these issues. For this reason, the membership of the VBMtransition team should include individuals fromhuman resources.

22


Aligning Incentives to Enable ChangeA necessary final step involves incentive alignment.This has two elements. First, employees mustfeel internally committed to the VBM programand be willing to take personal responsibility for making VBM happen. Second, there must bean incentive-compensation system that rewardssuch behavior.

Because true VBM requires a change in mind-setfor decision makers at all levels, it usually takestwo years to achieve. During the first year,managers are trained and learn to use the toolsof VBM, especially value drivers. The secondyear solidifies their understanding, and whenthey become confident that VBM tools really dowork, they can accept a switch to value-basedcompensation systems.

While it is impossible to prescribe an actual compensation design that is applicable in all circumstances, it is possible to provide a frame-work for a VBM compensation scheme.Specifically, a scheme that meets the followingcriteria satisfies all the main components of aVBM compensation scheme.

The first criterion is that the performance measuremust be tied to shareholder-value creation. Thiscriterion rules out compensation schemes centered on earnings-based measures andthose that do not take into account the usage of capital; consequently, measures such as EPS,ROE and EPS growth are eliminated for compensat-ing executives. Also ruled out are measures suchas ROT and RONA because they do not account forpotential differences in the cost of capital.24

The second criterion is that the performancemeasure should be unambiguous and objectivelymeasurable. This criterion rules out measureslike CFROI or plan value (estimated value of

future cash flows based on estimates), whichdepend upon forecasted value and can bemanipulated.

The third criterion is that the performance measuremust be a measure that can be directly affectedby managerial decisions. This criterion questions,but does not rule out, compensation schemestied to the firms share price, such as the use ofstock options to reward management.25 Thereare at least two reasons for caution. First, it ispossible that as a result of an overall bull market,share prices of all companies go up, in spite ofthe performance of individual managers. If man-agers are compensated only on the basis ofshare price, they benefit even though the changein the share price may be lower than the requiredrate of return demanded by shareholders orlower than the required rate of return of industrypeers.26 One alternative to avoid such a conse-quence is to evaluate the increase in share pricein relative terms; relative to its peers in thesame industry rather than using an absolutenumber. Another would be to base it on AER anduse the estimated cost of equity rather than thet-bill rate as the reinvestment rate.

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24 This is especially relevant where the firm is engaged indiverse businesses. Inadequate attention to the differencesin the riskiness in the individual business segments and concentrating solely on RONA would imply that managers instable, low-risk business units would be adversely penalizedand vice versa. Accounting for the differences in the respec-tive cost of capital would alleviate this problem.

25 Under this arrangement, managers are given stockoptions with an exercise price close to the current marketprice. They benefit if the stock price goes up and get nothingif the stock price goes down. In this sense, this method isclosely tied to shareholder-wealth maximization.

26 There is another problem with this type of mechanism.Empirically, it has been observed that the exercise price ofstock options granted to the senior executives is fixed and notadjusted for the opportunity cost of capital. Moreover, in thecases where share prices go down, many firms simply adjustthe exercise price downward. These adjustments result in avery generous compensation mechanism for executives irre-spective of the performance of the firm's share price.

The second reason for not relying exclusively onthe firms share price is actually more important.Since stock-exchange-listed firms are generallylarger, the value-creation performance of a specificbusiness unit cannot be observed from thechanges in the share prices of the consolidatedfirm. Thus, linking compensation of managers ofindividual business units to the share price ofthe consolidated firm provides no incentive.

Linking the compensation of managers of individualbusiness units to the performance of their own unitand not to the firms share price is also consistentwith Porters ideas on role of business-unit man-agers. Porter claims that it is only at the business-unit level (not at the corporate level) that a firmcan create value, since this is where it can achievecompetitive advantage. If this is indeed the case,then compensation must be closely related to thevalue-creating performance of individual businessunits and not to the overall performance of thecorporation.

Thus, an absolute reliance on share price as themain determinant of the compensation mechanismmay not provide the right degree of motivation forvalue creation. Measures based on TSR, shareprice, AER, and MVA must be looked at carefully to ensure that they can actually separate value-creating managers from value-destroying managers.

A fourth criterion is that the measure be trans-parent and understandable. Managers need tounderstand what they are being measuredagainst. Some measures require many adjust-ments to the financial statements, making themdifficult to understand.

Other important characteristics of VBM-basedcompensation systems would include the following:First, managerial compensation should not bebased upon annual performance but on the

cumulative performance. This ensures that themanager has a long-term horizon and is referredto as banking or having a managers investmentin the firm. Second, since EV calculations requiredetermination of capital and cost of capital, it is necessary that both of these values be estab-lished at the beginning of instituting an EV-basedcompensation scheme. The value of capitalshould be close to the replacement (or market)value of the capital employed and a proper costof capital should be agreed on. This is especiallyimportant if the firm has multiple business unitsfacing diverse business and financial risk.27

Third, the exact definition of NOPAT needs to beagreed upon; treatments of R&D, training, reserves,bad debt losses, etc., require discussion and agree-ment. Fourth, in a cyclical business, there must be agreement on the horizon over which the EVperformance is to be evaluated. This is especiallycrucial if the compensation scheme is beingintroduced either at the peak or trough of thecycle. In some instances, a relative measure ofEV, relative to comparable companies, needs tobe created.28

No matter how the final compensation plan isdesigned and how much weight is given to the EVcomponent, it is clear that in the absence ofsuch value-creation-based incentive systems,there will be a misalignment of interests ofshareholders and managers. There exist manyexamples of managerial behavior that maximize

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27 Sometimes book value will be high relative to replace-ment value due to poor decisions undertaken by previousmanagement or decisions made by existing managementunder a different incentive scheme. In this case, there is a need to make an adjustment at the beginning of the imple-mentation period so as to encourage management's buy-in.

28 Many variations of this EV-based structure have beenemployed by firms in North America. A comparison of thesestructures for six firms - Ball Corp, Briggs and Stratton,CILCORP, Cincinnati Milacron, Clark Equipment, and NCR Corp(now a part of AT&T) is available in the ExecutiveCompensation Reports Vol. 12, 8, August 25, 1992.

current earnings because compensation isbased on the bottom line. A proper value-basedmeasurement implementation would require discarding these schemes and implementing aVBM compensation system.

Supporters of VBM sometimes underestimatethe problems of implementing this approach inpractice. Implementing VBM can be a long andcomplex process involving much trial and error.Nevertheless, a number of companies have gonethrough the process and have reaped the benefits.

IX . ORGANIZAT IONAL AND MANAGEMENT ACCOUNTINGCHALLENGESManagers would benefit enormously by adoptingshareholder-value creation instead of operatingincome or reported earnings as their basicmeasure of business performance. While it maybe disconcerting to discover that some businessunits in the portfolio are no longer profitableonce forced to recognize their full economic cost,this gives a much more reliable signal of the trueeconomic health of a business than that providedby conventional measures.

The great majority of companies do not have thecapability to generate reliable measures ofshareholder-value creation across and withinbusiness units. This means that corporate andbusiness unit managers are flying blind moreoften than not when it comes to knowing how or where to look for strategies to increase share-holder value. Changing the managementaccounting system and educating managers inthe use of these new measures may require considerable time and effort.

Managers must learn to discriminate carefullybetween good growth and bad growth. Goodgrowth results when the shareholders money

the equity capital supporting a business unit orthe companyis invested in strategies that earnconsistently positive equity spreads and, thus,positive economic profit over time. Bad growth isjust the opposite. It occurs when the shareholdersmoney is invested in strategies that produce aconsistently negative equity spread and, thus,economic losses over time.

Most companies must grow to create shareholdervalue, and achievement of the governing objectivewill require that the company constantly seek outand invest in new opportunities for good growth.If management does not at the same time controland eliminate bad-growth investments, much ofthe shareholder value created by its good-growthstrategies will be wasted or destroyed.

Management accountants need to understandthe various shareholder-value-measurementtechniques in terms of their strengths and weak-nesses, their impact on management behavior,and their potential fit with the business. As well,management accountants must analyze andapply professional judgment in selecting themost appropriate measure for the situation.

X . CONCLUSIONEvidence indicates that increasing shareholdervalue is the key to success in todays market-place. Increasing shareholder value does notconflict with the long-run interests of other stake-holders. Indeed, it supports these interests andmotivates organizational constituents to seekout, manage, and measure the drivers that leadto improving shareholder value.

Value-based management is an important toolthat links strategic decisions at the senior levelall the way down to the value drivers used byfrontline managers and employees. It is bestmeasured by metrics that link decisions to over-

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all economic value and that are correlated toshareholder wealth. The Statement hasdescribed the key features of the VBM paradigmand a number of measures that organizationscan adopt to measure the degree to which value is being created.

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APPENDIX A

SAMPLE CALCULAT IONS FORSHAREHOLDER-VALUE -CREAT IONMEASURESIn this appendix, sample calculations for theshareholder-value-creation measures describedearlier are provided for a fictional firm called XYZCompany. Because some measures require fore-casts, the calculations for these measures arebased on these forecasts. As such, the actualnumbers for these measures should be consid-ered as illustrative of the calculation methodolo-gy employed rather than as definite results.

The following measures are illustrated:

A) Economic ValueB) The Equity SpreadC) Implied ValueD) Cash Flow Return on InvestmentE) Total Shareholder ReturnF) Annual Economic ReturnG) Market Value Added

A) Economic Value (EV)EV is calculated as net operating income aftertaxes (NOPAT) minus the capital charge.

The first step in calculating EV is to calculateNOPAT; the second step is to estimate the capi-tal employed; the third step is to estimate theappropriate weighted average cost of capital(WACC); and the fourth step is to calculate thecapital charge and EV.

In this example, no adjustments are made to thetraditional accounting statements becausesome of these adjustments require an intimateknowledge of the firm's operations. However, ananalysis of the firm's annual reports indicatesthat the impact of any such adjustments wouldbe minimal; for example, the firm has no write-offs, no meaningful R&D or training expenses, nore-valuation of assets, no goodwi

Shareholder Value Maximization

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