Equity value with new growth opportunities




• Finding growth opportunities, to build off EG's strong brand name and to develop new skills, although this would probably have to wait until everything else was under way.

• Developing a strategy for communicating with investors about the restructuring plan and its potential impact on the value of EG.

Ralph and his team were confident that their plan would work well. Since they could take immediate steps, they also expected to get a quick and favorable response to the program.

Exhibit 2.15 EG Corporation—Value Buildup

Historical Business Business Restructuring extrapolation plans initiatives and new growth

Ralph As Value Manager

EG's restructuring plan resulted in an increase in the price of the company's shares. EG's price jumped immediately when the plan was announced. Then, when investors saw that EG was taking the actions it had promised, the stock price rose further. Over the first six months of 1999, EG's shares increased more than 40 percentage points above the stock market average increase. The analysts who followed EG stopped talking about takeovers and applauded the ''transformation" of the company.

Needless to say, Ralph and his team were pleased with the results. Ralph regretted having had to reduce the corporate staff and sell some of EG's businesses, but took some comfort from the knowledge that he did it in a more orderly and humane way than an outsider would have. Despite the successes, Ralph knew he had a lot more work ahead to see the restructuring plan through to completion, and needed to begin building an orientation toward managing value into the company. Otherwise, he feared that employees would become complacent about EG's performance, and the accumulation of untapped value potential would begin anew. He wanted to build on the fragile momentum he had established.

Ralph planned to take six steps to build EG's ability to manage value:

1. Focus planning and business performance reviews around value creation.

2. Develop value-oriented targets and performance measurement.

3. Restructure EG's compensation system to foster an emphasis on creating shareholder value.

4. Evaluate strategic investment decisions explicitly in terms of impact on value.

5. Begin communication with investors and analysts more clearly about the value of EG's plans.

6. Reshape the role of EG's CFO.

Ralph's plans and thinking in each of these areas are set out next. (Chapter 6, Making Value Happen, provides a systematic approach to carrying out these ideas.)

Put Value into Planning

Ralph was convinced that one of the main reasons EG had gotten into trouble was a lack of focus on value creation in developing corporate-level and business-unit plans. Likewise, evaluations of the performance of the businesses had only a vague focus on value. Ralph firmly believed that it was the responsibility of all senior managers to focus on value creation. Ralph would ensure that company plans included a thorough analysis of the value of each of the businesses under alternative scenarios. He would also make sure that EG used the restructuring hexagon approach on an annual basis to identify any restructuring opportunities within EG's portfolio.

This new focus on value would also require some changes in the way EG thought about its corporate strategy. For the next year or so, EG had to focus on restructuring. In the longer term, Ralph would need to develop a plan for sustaining EG's advantage in the market for corporate control. To do this, he would need to better understand the company's skills and assets and in which businesses they would be most valuable. Most important, he would have to ensure that the value of these skills could be identified in terms of higher margins, growth rates, and the like before building action plans around them. Too often, Ralph was convinced, EG had done a perfunctory analysis of its capabilities and entered businesses without a clear idea of how and why EG would be a better owner and able to create value for its shareholders. As a first step, later in the year Ralph would establish a task force to compile an inventory and do an analysis of EG's skills and assets compared with its competition, as well as ideas for new businesses EG might enter.

At the business level, EG's new focus on value would require some changes too. The restructuring review had pointed out a number of specific strategic and operating actions that the various business managers would need to take. Beyond this, management in the business units would need to think differently about their operations. They would need to focus on what was driving the value of their businesses—whether it was volume growth, margins, or capital utilization. Everyone was accustomed to focusing on growth in earnings, but what would matter in the future would be growth in value and economic returns on investment. Sometimes this would mean foregoing growth in the business that would have been accepted in years gone by. At other times, managers would have to get more comfortable with the idea of reporting lower earnings when investment in research and development or advertising with a longer term payoff made economic sense. Ralph knew that these changes would be difficult for his management group, because it had not been encouraged to think this way in the past. To help bring about change, he decided to share with the management group the results of the corporate restructuring analysis and to develop a series of training seminars for senior division management about shareholder value.

Develop Value-Oriented Targets and Performance Measures

Ralph knew that his managers needed clear targets and performance measures to track their progress. While the stock price performance was the ultimate measure, he needed something more concrete and directly manageable by his managers,particularly his business unit managers. He also knew that traditional accounting measures like net income ignored the opportunity cost of the capital tied up to generate earnings. Return on invested capital (ROIC), on the other hand, ignored value-creating growth. So he turned to a measure that incorporated both growth and return on invested capital, called economic profit (EP). EP is the spread between the return on capital and its opportunity cost times the quantity of invested capital:

EP = Invested c,i|)¡L,il x f ROIC - Opportunity cost of capital)

Ralph chose this measure because he knew that the discounted value of future economic profit (plus the current amount of invested capital) would equal the discounted cash flow (DCF) value (see Chapters 3 and 4 for a more complete description). In other words, EG could maximize DCF value by maximizing economic profit. Ralph asked that all strategic plans and budgets include economic profit targets for each of the business units.

Knowing that lower level managers also needed targets and performance measures that they could directly influence, he asked his business unit managers to translate economic profit targets into specific operational performance measures for their operating managers. For example, the manufacturing manager might be measured by cost per unit, quality, and meeting delivery schedules. Sales might be measured by sales growth, price discounts of list prices, and selling costs as a percent of revenues.

This integrated system of target setting and performance measurement required a new mindset for Ralph's accounting group, which was accustomed to dealing with accounting results. The accounting group resisted but Ralph convinced it of the benefits of integrating financial results with operating measures and with moving toward more economically relevant financial measures.

Tie Compensation to Value

Ralph believed that one of the most powerful levers he could use in building a value-creation focus throughout EG was the compensation system. At present, the package contained relatively little performance-based incentive for top managers. They did receive a bonus, but it was a relatively modest proportion of total compensation. They also received stock options, but few viewed these as significant in terms of their ability to build capital for doing a good job. It was clear to Ralph that the top-management incentives did not focus on value creation. Bonus payouts were geared toward achievement of earnings-per-share targets, which as he knew did not always correlate well with creating value. In addition, the compensation of business-unit managers was tied more closely to the performance of EG as a whole than it was to the fortunes of their particular business unit.

Ralph figured that several schemes were capable of meeting his objectives. He asked his human resources executives to consider phantom stock for each of the divisions; a deferred compensation program structured around the economic profit targets that the businesses were adopting, and using the attainment of goals on particular value drivers as a basis for compensation awards.

Assess Value of Strategic Investments

Injecting a value-creation focus into EG's planning and performance review process would make a big difference. Ralph also knew he needed to make changes in the way the company looked at major spending proposals.

To evaluate capital spending, EG had been using discounted cash flow analysis for at least five years, as had most other companies. This was fine, but Ralph saw two problems. First, capital spending was not linked tightly enough to the strategic and operating plans for the businesses. Because of this, capital spending proposals were out of context and difficult to evaluate. Second, EG had been using a corporatewide hurdle rate to assess capital investment proposals. From the restructuring review of EG, Ralph knew that each of the EG businesses involved a different degree of risk, so the hurdle rates for assessing capital investments should be different, too. To make matters worse, the hurdle rate was too high, having been set in an attempt to smoke out unrealistic operating projections. The result was an ineffective capital spending process. Ralph figured that many investments that earned about the cost of capital were being passed up because they did not meet EG's extremely high hurdle rate. On the other hand, major capital investments were not evaluated as closely as they should be since the whole process had degenerated into a numbers game about assumptions. Ralph intended to tie capital spending closely to strategic and operating plans to ensure that its evaluation was realistic and fact-based. He would also ensure that the finance staff developed appropriate hurdle rates that would differ by division to reflect the relevant opportunity cost of capital.

Ralph knew that one of EG's biggest problems had been the evaluation of acquisitions. He knew they had paid too much for the Woodco acquisitions in the 1980s. In the restructuring review, he had seen the impact of paying too much on the company's share price. Fortunately, as CEO he would have direct control over the decision to pursue acquisitions. He would insist that when proposing an acquisition, the relevant operating manager and CFO do a thorough valuation analysis based on cash flow returns for the transaction. He would not make the mistake his predecessor had of believing that just because he could make the accounting earnings and dilution figures look good in the first year or two of an acquisition, it made sense from a value standpoint.

To Ralph it was really quite simple. Either the cash flow value to EG's shareholders of an acquisition would be higher than the price eG would have to pay, or Ralph would not make the acquisition. And he believed that value could be assessed much more systematically than in the past.

First, EG management would evaluate the target's business on an ''as is" basis, just as the team had done for EG. Next, management would use the restructuring hexagon approach to identify improvements that could be made to the value of the company on a stand-alone basis. The management of the target company might or might not be capable of making these improvements on its own. Third, EG management would evaluate the potential for synergies with other EG businesses on a systematic basis. These synergies would be evaluated in concrete terms for their impact on value. Finally, EG management would think about the strategic options the acquisition would create. These would be difficult to evaluate and value, but could nevertheless be important. For example, an acquisition might give EG an option on a new technology in one of its businesses, or access to a new market, both of which could have substantial value under the right conditions.

Armed with this information, Ralph would be much better able to evaluate the logic of any acquisition, certainly much clearer than EG management had ever been. He would know how much EG could afford to pay. Equally important, he would know more specifically what to do with the business after it had been acquired. Before entering negotiations, Ralph would also have his team assess the value of the target to other potential acquirers; in this way he could be sure that he would not enter into a fruitless bidding contest or end up buying the company at a price higher than he needed to. He certainly did not want to fall into the trap of giving all the potential value of the candidate to the selling shareholders. After all, why should EG do all the work and the sellers receive all the rewards?

Acquisition proposals would be subjected to a new test. EG management would no longer presume that the best way to pursue a new business idea was by acquisition. Ralph would ensure that management considered entering a business in other ways, such as through a joint venture. Such approaches might be alternatives to the ''big bang" acquisitions that seem like easy solutions at the time, but afterward cause endless problems for the company's stock market performance.

Develop Investor Communications Strategy

Ralph planned to continue working hard to build the company's credibility with Wall Street analysts and investors. It would be essential for EG to track analyst views on its performance and prospects on a regular basis. Ralph wanted to do this for two reasons. First, he would be able to ensure that the market had sufficient information to evaluate the company at all times. Second, Ralph knew that the market was smart. He could learn a lot about the direction of his industry and competitors from the way investors evaluated his shares and those of other companies. He did not believe that he could, nor would he try, to fool the market about EG. He was convinced that it was sound strategy to treat investors and the investing community with the same care that the company showed its customers and employees. Had previous management taken the time to understand what the market was saying about EG, the company might have avoided the difficult position in which it found itself.

In addition to tracking the analysts' opinions and meeting with them regularly, Ralph thought EG should be more active and clearer in communicating with investors. Henceforth, communications with the market at securities analyst meetings and in press releases would focus on what EG was doing to build value for shareholders. He even thought it might be a good idea to have a section in the annual report entitled "Perspective on the Value of Your Company" that would discuss the company's strategy for creating value.

He thought that EG could go as far as publishing estimates of the value of the company, as long as the assumptions were spelled out clearly. Ralph knew that this communications strategy would be a break with the practices of many companies and with eG's recent past. However, Ralph did not really think investors got much benefit from the mechanical—and usually vague—explanations of changes in year-to-year performance typically found in annual reports. Likewise, the glossy photographs and glowing language in the front sections of many annual reports did little to give investors a clear sense of where a company was going and what the status of their investment was.

Reshape CFO's Role

Critical to the success of Ralph's efforts to build a value-creation focus into EG was the need to upgrade the role of the CFO. It was clear to Ralph that the link between business strategy and financial strategy was becoming tighter. Corporate strategies, which are designed to create an advantage in the market for corporate control and financial markets, are by definition intertwined with financial considerations. Furthermore, it was going to take a lot of work to make managing value an important element of EG's strategy and management approaches. Ralph would need a strong executive who would be able to help him push this through.

EG financial officers had been focused on running the treasury operation, producing financial reports, and negotiating the occasional deal. Ralph needed much more, and since his current CFO was due to retire at the end of the year, he felt this was a perfect opportunity to redefine the role. Ralph's concept was to create a position that would blend corporate strategy and finance responsibilities. The officer would act as a bridge between the strategic/operating focus of the division heads and the financial requirements of the corporation and its investors. Ralph drafted a job description for this position, which in EG's case would carry the title of executive vice president (EVP) for corporate strategy and finance (Exhibit 2.16). The EVP would act as a kind of ''super CFO" and take the lead in developing a value-creating corporate strategy for EG, as well as to work with Ralph and the division heads to build a value-management capability throughout the organization.

Exhibit 2.16 Job Description: Executive Vice President for Corporate Strategy and Finance, EG Corporation

Job Concept

The EVP will act as key advisor to the CEO and division heads on major strategic and operational issues and will manage EG's financial and planning functions. Responsibilities will include:

• Corporate strategy.

• Financial strategy.

• Budgeting and management control.

• Financial management.

Corporate strategy The EVP will take the lead role in coordinating the development of a value-maximizing overall corporate strategy for EG:

• Ensuring that plans are in place to create maximum value for EG from its current businesses.

—Assessing the value creation potential of plans on an ongoing basis. —Ensuring that plans focus on key issues by challenging important assumptions and the rationale for changes in performance, and providing external reference points for value-creation opportunities (for example, value of the businesses to alternative owners). —Acting as a sounding board for the CEO and division heads on critical proposals. —Establishing financial measurement standards and developing systems to monitor performance against goals.


• Supporting the development of corporate expansion strategies to create additional shareholder value.

—Developing perspectives on market opportunities in businesses closely related to current businesses.

—Assessing EG's skills and assets in place for pursuing opportunities and suggesting programs to build skills to fill gaps.

—Conducting business and financial evaluations of specific proposals.

• Planning and executing major transactions required to carry out EG's strategies.

Financial strategy The EVP will have responsibility for developing, recommending, and executing an overall financial strategy for EG that supports its business strategies and captures maximum value for its shareholders:

• Developing value-creating capital structure and dividend policy recommendations.

• Designing and managing a strategy for communicating the key elements of EG's plans and performance to investors and the financial community.

• Negotiating and executing all major financial transactions, including borrowing, share issuance, and share repurchases.

Budgeting and management control The EVP will design and carry out processes to ensure that EG managers have the right information to set goals, make decisions, and monitor performance:

• Coordinating preparation of short-term operating budgets.

• Developing key performance measures for each business unit.

• Ensuring that business units have adequate management controls in place.

• Evaluating business-unit performance in conjunction with the CEO and division heads.

Financial management The EVP will ensure the effective and efficient management of EG's financial operations:

• Ensuring that all external reporting and compliance obligations are fulfilled.

• Establishing controls to safeguard EG's assets.

• Ensuring the integrity and efficiency of cash, receivables, and payables management.

• Filing and paying all tax obligations.

• Pursuing opportunities to reduce EG's tax burden.

• Maintaining strong day-to-day relationships with EG's banks.

• Managing EG's pension fund.

• Managing EG's risk management programs.

Success Criteria

If the EVP is successful: One year from now:

• A well-defined corporate strategy will have been created, and early phases of execution will have been completed.

• A clearly articulated financial strategy will have been developed and implementation will have begun.

• Division heads and key managers will think in terms of shareholder value creation when developing their plans and evaluating proposals.

• The financial management functions will be operating smoothly.

• Securities analysts wll understand EG's strategy and evaluate it as a strong operating company rather than a breakup candidate.

Three years from now:

• EG will have provided shareholders with superior returns.

• EG will have begun pursuing several value-creating expansion initiatives (most likely through internal investments).

• Securities analysts will view EG as a leading-edge value manager of its businesses. Major Resources

The EVP's staff will include the treasury, controller, planning, and tax departments. In addition, the financial staffs of the operating units will have dotted-line reporting relationships to the EVP. The EVP will have broad discretion in organizing the staff.

Key Organizational Relationships

The EVP's integrating role will require close working relationships with all the other key executives at EG:

• CEO: The EVP will provide recommendations and analyses to the CEO on all major issues. The EVP will carry out the financial policy decisions made by the CEO.

• Operating-Unit Heads: The EVP will work with the operating-unit heads to ensure the smooth functioning of the planning, reporting, and control systems, and to resolve conflicts between corporate and business-unit priorities. The EVP will also counsel the operating-unit heads on finance-related issues and provide analytical support for special projects.


The EVP and staff will manage the relationships with important outside groups, including:

• Investors, securities analysts, rating agencies, and the financial press.

• Financial institutions (banks and investment banks).

• External auditors.

• Regulators and tax authorities.

Critical Skills/Requirements for the Job

The EVP should bring a broad business perspective and should possess the following characteristics:

• Seasoned business judgment and superior analytical abilities, particularly in strategic business and financial analysis.

• Ability to take an independent stance and challenge the ideas of the CEO and operating managers while maintaining their respect and confidence.

• Presence to deal with the financial community.

• Ability to lead/orchestrate negotiations in major transactions.

• Strong administrative and people management skills.

In addition, the EVP should have familiarity with the following:

• Financial markets.

• Financial and managerial accounting.

• Treasury operations.

The EVP would also be responsible for managing the normal financial affairs and financial reporting of the corporation. But his or her success would be measured mainly by how well EG made the transition to a corporation that managed value in a superior way. If the EVP were successful, in a year or so EG would have a first-draft corporate strategy in place, a clearly articulated financial strategy that supported it, and leading managers who were acting in terms of value creation when submitting plans and proposals. Securities analysts would also have a much clearer understanding of EG's strategy and the reason why it would not make sense to view the company as a breakup candidate. Longer term, the EVP's success would be measured as part of a team that would provide shareholders with superior returns, assist in launching value-creating expansion opportunities, and establish EG with a reputation in the financial community as a leading-edge, value-managing company.

Ralph Demsky expected that his six-part plan for building a sharper focus on value into EG could take as long as two years. It would require the recruitment of the new EVP and substantial time and attention from Ralph himself. Focusing planning and performance measurement on value creation, evaluating all major decisions in terms of impact on value, redesigning the compensation system for senior management, and communicating more clearly and consistently with the stock market would help to ensure that EG maintained an advantage in the market for corporate control and produced outstanding value for shareholders. Moreover, by following this much more integrated approach, it would be easier for EG to set corporate priorities, since major decisions would be brought back to the common benchmark of their impact on the value of the company.


The ability to manage value is an essential part of developing sound corporate and business strategies— strategies that create value for shareholders and maintain an advantage in the market for corporate control. As the case of EG Corporation shows, managing value is not a mysterious process. Valuation techniques and approaches can be complex in their details, but are relatively straightforward in their objectives and applications. Our objective in the balance of this book is to demystify the approaches needed to carry out value management in most companies.

As in the EG case, managing value consists of three broad steps: taking stock of the value-creation situation within the company and identifying restructuring opportunities; acting on those opportunities, which usually involves major transactions such as divestitures and acquisitions as well as reorganization of the company, and instilling a value-creation philosophy in the company.

A managing-value focus does not create value through financial manipulations. Rather, it creates value through developing sound strategic and operating plans for a company's businesses. The link between sound strategy and value creation is a tight one. As many CEOs have learned, financial manipulation on its own seldom works.

Many companies are not in as desperate a condition as we outlined for EG. Most companies, however, would benefit from a thorough review of restructuring opportunities. Perhaps it is because many companies that have gone through massive restructuring believe that it will only happen once. As we discussed in Chapter 1, we believe that restructuring and an active market for corporate control are now facts of corporate life. Consequently, managers need to ensure that they identify and act on value-creation opportunities regularly— not just once when they are a takeover target. This is best done through fundamental changes in the way their businesses are structured and operated. By acting now, value managers can avoid the need to react under duress.

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