Projected free cash flow (NLG millions)

1999 446

2000 754

2001 800

2002 526

2003 910

There is not much interesting to say about this series of numbers. But now look at Heineken's performance from the perspective of growth and ROIC.

Actual 1994-98 Projected 1999-2003

(percent) (percent)

Revenue growth 8.5 5.6

EBITA growth 12.9 6.6

ROIC (after goodwill) 12.3 12.3

With this information, we can understand intuitively how Heineken is performing. We can assess its growth relative to the industry. We can evaluate whether its ROIC is improving or deteriorating and how it compares with other branded consumer products companies. Companies need to be cautioned, however, about shifting their focus entirely to ROIC and ignoring growth. An unbalanced focus on ROIC can lead to harvesting behavior, leaving a company out of the race for long-term growth.

Returning to the Sears and Wal-Mart comparison, Exhibit 4.9 plots the revenue growth and return on invested capital for Sears and Wal-Mart between 1995 and 1997. (Before 1995, Sears' performance was distorted by its ownership of Dean Witter Discover and Allstate Insurance.) Over the period, Wal-Mart's revenue growth averaged 12.6 percent a year compared with 7.7 percent for Sears, and its return on capital averaged 14.2 percent against Sears' 10.4 percent. Both companies' cost of capital was about 9 percent. Wal-Mart achieved higher growth and higher returns on capital.

How can it be that Sears earned higher TRS than Wal-Mart when its underlying performance was so much poorer? The answer goes back to the treadmill. Sears was not expected to do well, but did better than expected. Wal-Mart, on the other hand, was the victim of high expectations. It probably earned more economic profit than any other retailer in the world, while sustaining high growth. But the market expected even better.

We can also compare historical performance to the expected performance implied by the market. Exhibit 4.10 shows both the historical results of the two companies as well as a line showing the combinations of future growth and return on invested capital that are consistent with today's market value. These lines represent the level of performance needed to meet market expectations. If a company delivers this level of performance, its share price should rise in line with its cost of equity less the dividend yield (assuming the market as a whole moves in line with expectations). If it exceeds expectations, its share price should rise more quickly. Wal-Mart is expected to perform considerably better than Sears, and even better than it has done in the years to 1998. For Sears, the opposite is true. The market does not appear to expect it to perform as well as it has in recent years.

In addition to providing better insights into the economics of a business than cash flow, growth and ROIC can also be used to set short-term Exhibit 4.9 Underlying Financial Performance of Sears and Wal-Mart

Exhibit 4.10 Market Expectations of Sears and Wal-Mart

performance targets for a company or business unit. Looking back at the figures for Heineken, management can compare actual ROIC and growth to projections to see if its progress is on track. It can't do the same with free cash flow.

Value Drivers: Leading Indicators

The fourth issue that our framework raises is that market measures and financial measures are not sufficient to understand why a business performs the way it does. Short-term financial measures can be especially misleading. One could even argue that financial measures are inadequate by themselves because they can be manipulated.

Take the example of a packaged foods division of a major consumer products company as related by its chief financial officer. The division was a market leader and had shown steadily improving financial performance for years. Since its numbers were so good, no one at headquarters asked too many questions about the results. In fact, the division had achieved its stellar performance by raising prices. This encouraged new entrants and led to steady erosion of market share. As the competition got stronger, the business could no longer sustain its financial performance. A major restructuring was needed.

The important point is that companies should be as concerned about how a business achieves its financial results as about whether it meets its financial targets. Value drivers help companies to understand the reasons for their current performance and how their future performance will likely develop.

In addition, value drivers can serve as leading indicators of performance. Financial results (ROIC and growth) tell what a company has achieved in the past; they are ''lagging indicators." Management needs performance measures that tell it where it is going in the future, "leading indicators." Market share might be a leading indicator for a packaged food company. The R&D pipeline could be a leading indicator for a pharmaceutical company. As companies and the financial markets get more sophisticated, the emphasis is shifting to these leading indicators. The high valuations of Internet stocks and their behavior is important evidence of this shift.

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