Surviving the Barrage of Value Metrics

We saw through Fred's story in Chapter 3 how companies create value and how it can be measured. In the real world, managers have been bombarded with advice about performance measures: TRS, DCF, economic profit,1 EVATM, CFROI, ROIC, EPS, profit margin, and many others. But we think that the debate over which metric to use has come unstuck from the real purpose of metrics: to help managers make value-creating decisions and to orient all company employees toward value creation.

Attempts to compare metrics that have different goals just lead to confusion. DCF and economic profit, for example, are not alternatives. DCF collapses performance across time into a single result and is used for strategic analysis. Economic profit is a short-term financial indicator.

Some metrics are indeed better than others. We prefer economic measures (such as economic profit) to accounting-based measures (such as earnings per share). First, empirical research suggests that cash flow, not accounting earnings, is what drives share price performance. Second, it's easier to understand short versus long-term tradeoffs when you use an economic measure. Finally, you can better understand the sources of value if you use economic measures.

However, there is no perfect performance measure. As a result, we use a framework that links various economic measures to describe different aspects of performance (Exhibit 4.1). The framework describes which combinations of measures are useful for each aspect and also explains how different measures relate to each other.

1 Economic profit is a generic term synonymous with Stern Stewart's metric EVATM.

Exhibit 4.1 Comprehensive Value Metrics Framework

Exhibit 4.1 Comprehensive Value Metrics Framework

Reviewing Exhibit 4.1 starting from the left, the ultimate output measure is shareholder value creation in the stock market. Since it is an output measure, managers cannot use it for decision making, but they can set shareholder value creation targets.

Shareholder value creation in the stock market must be linked to some measure of intrinsic value. Intrinsic value is ultimately driven by the long-term cash-flow-generating ability of the company. Hence, intrinsic value can be measured by discounted cash flow (DCF). Intrinsic value based on DCF can be used to evaluate specific investment opportunities or the strategy of a business unit or an entire company.

While a valuable tool for strategic analysis, DCF values cannot be used to evaluate historical performance because they are based on projections. Another drawback of DCF values is that they are difficult to assess in the abstract. But DCF value can be linked to important financial indicators. The financial drivers of cash flow and DCF value are growth (in revenues and profits) and return on invested capital (relative to a company's cost of capital).

Because short-term financial measures may signal changes in value creation too late, we also need to use operating and strategic measures, called value drivers. Monitoring these drivers helps avoid sacrificing long-term value creation for short-term financial results. The value drivers are also helpful in identifying value creation opportunities and focusing the organization on these high priority areas.

Referring again to Exhibit 4.1, each class of measure has a role in management decision making and performance management:

• Corporate management can set long-term value creation targets in terms of the market value of the company or total returns to shareholders (TRS).

• Alternative strategies and opportunities and the value of the business units or the entire company can be evaluated in terms of intrinsic value (DCF or option value).

• Intrinsic values can be translated into short- and medium-term financial targets and targets for operating and strategic value drivers.

• Performance can be assessed by comparing results with targets on both financial indicators and key value drivers. Managerial rewards (compensation and others) can be linked to performance on both financial measures and key value drivers.

Stocks and Shares Retirement Rescue

Stocks and Shares Retirement Rescue

Get All The Support And Guidance You Need To Be A Success At Investing In Stocks And Shares. This Book Is One Of The Most Valuable Resources In The World When It Comes To

Get My Free Ebook


Post a comment