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The new New Economy Analyst
Report – August 03, 2002
Juergen Daum’s new New
Economy Best Practice service
©2002 Juergen Daum. All rights reserved.
Approaching the next level of shareholder value
management – basics (part 1)
News categories: Enterprise and business
strategy, Finance and accounting,
Performance management and controlling, investor relations
- How does it work –
(traditional) shareholder value management?
- Why is
traditional shareholder value management falling short today?
- The building block #1 of the new corporate performance management system: a measurement systems which reflects company’s true business economics
- Focus on the
Management Dialog
- Summary
- Additional
resources
With
the raise of institutional investors in the 1980s and with their growing
investments in corporations, live for these companies and their executives
changed. An institutional investors, such as a fund, “collects” money from
private investors and invests it in the capital market – in recent years to a
large extend in the stock market. By optimizing continuously the portfolio of
all its investments it tries to maximize the returns of the total investment
sum and therefore the value of each individual investment of its customers, the
private investors. There is pressure to perform for institutional investors,
because each one is competing with others for private investors and their
capital.
Over
the last two decades the amounts of capital that many of these institutional
investors were managing, such as public pension funds, and the size of their
investments in the stock of individual corporations became so large, that they
had not been able any more to just sell the shares of a company that did not
perform. If they would do it and if they would go with such a huge number of
shares in the market, the stock price would immediately and dramatically drop.
Their only possibility was, to “influence” the company in order to improve its
performance. They started to exert pressure on management (“perform or leave”)
and financial analysts, investment bankers and consultants developed
performance management and valuation methods, that should align internal target
setting and performance management with the stock market view – the shareholder
value movement, which has started in the U.S. in the mid 1980s was born.
A
second phenomena in the 1980s was the one of the “corporate raiders”, investor
who identified undervalued companies, where the sum of the parts, that is of
the different business units, was larger than the actual market value of the
whole corporation. They then tried to get the majority of voting shares -
pursuing a so called “hostile takeover”. When they had succeeded, they split of
the company and sold the different parts separately, with the resulting value
added flowing into their own pockets. It was definitely not a very attractive
perspective for corporate executives to become a victim of such a corporate
raider. They therefore had been looking for ways to avoid it. The simplest
solution was, to increase the stock price of the own company, so that it not
risks to be undervalued. So also corporate executives, not only institutional
investors, became very interested in shareholder value management techniques that
allow to increase the stock price of a company and started to apply them.
How does it work – (traditional) shareholder value management?
Corporate
shareholder value management can be reduced to three main types of methods:
1.
Calculating an economic profit and
use it as the basis to judge the performance of a company and its business
units: Accounting based earnings are adjusted to an
investors perspective by capitalizing for example expenditures with an
investment character that are under GAAP not allowed to be capitalized, such as
expenses for research and development activities, marketing expenses for brand
building etc.. In subsequent accounting periods depreciation for these
“investments” is subtracted form earning. From this “normalized” profit cost of
capital are deducted. The underlying philosophy for this is, that an investor
is able to select in which share he is going to invest. If he his going to buy
shares of one company, he expects this company to earn at least the average
return he can expect from comparable investments in the stock market. These “weighted average costs of capital”
(WACC) represent therefore from an investor perspective “opportunity costs”,
costs for the foregone opportunity to invest in shares of other companies. Only
the part of the normalized earnings that exceeds the cost of capital creates
therefore value for an investor. The result, after deducting cost of capital
from normalized earnings, is called “economic profit” (in contrast to the
accounting or GAAP profit) or Economic Value Added (EVA – a trademark of Stern Stewart & Co.).
If the economic profit of one company is compared with the economic profit of
another company, investors are able to judge which company is better performing
from an investor perspective.
2.
Calculating the net present value
of future earnings / economic profit and use it for valuing the company: Based on a business plan or other
estimations, earnings of future years are discounted with the weighted average cost
of capital rate and a net present value is calculated – this is often called shareholder
value added (SVA). If this is done with estimated cash flows instead of
earnings (assumption: cash flows are not subject to different accounting rules
and provide therefore a more consistent view), the result is called discounted
cash flow (DCF). If it is done with economic profit instead of accounting based
earnings, its is called market value added (MAV). The underlying philosophy is,
that the expected return of a company is built into its actual share price.
Investors calculate the value of their investment by adding up the future
annual returns (profits, cash flows of the company) over the time span in which
they are holding the shares and by deducting for the future periods “interest
rates” (equals the cost of capital rate), because these future returns are not
available today for reinvestment. The result represents the total value of the
company. By dividing it through the number of shares, a “fair market value” for
the share is calculated and can be compared with the actual share price
(investor perspective). If this calculation is reversed, management can
evaluate, what future earnings / cash flow expectations are built into the
actual share price (management perspective). With this information management
can now define internal earnings and cash flow targets for the company’s
business units.
3.
Optimizing total corporate
shareholder value by optimizing the portfolio of its investments, each
represented through one of the company’s business units:
The underlying philosophy of this approach is, that a typical corporation today
is consisting of different business units which are acting in different market
segment, each with different opportunities and possibilities to maximize
earnings and cash flow. If corporate management is measuring the performance of
its business units from an investor perspective (see above topics 1 and 2) and
is constantly optimizing the whole portfolio (reducing investments in under
performing units and markets, increasing investments in over performing units)
it can maximize the total shareholder value of the company. Portfolio
management techniques are applied here, which allow to measure
earnings/economic profit/cash flow against capital employed. Often so called
waterfall charts are used to visualize the result.
Shareholder
value management in theory is therefore to link internal management targets and
actions with an external investor perspective.
Why is traditional shareholder value management falling
short today?
The
main problem with the traditional shareholder value management approach is,
that it is too focused on the financial figures.
Financial
analysts and investors are concerned too much with quarterly earnings of
corporations and always try to extrapolate from actual quarterly earnings the
future earnings – often for many future years. Because they use financial
results as nearly the only basis for the calculation of a company’s fair market
value, the risk is that they are paying too less attention to activities that
do not affect short term earnings but created future competitive advantage and
future earnings potential. This attitude of investors is animating managers and
corporate executives to do the same.
The
economic profit of a business unit is telling something about the economic
result of past activities in creating new products, entering new markets and
improving or destroying customer satisfaction. It does not tell much about how
successful the company will be in the future in a world and in markets, where
constant change will be the norm. Sure, economic profit makes the financial
investments in these areas transparent (by capitalizing them), but it does not
show how successfull a company is, in executing on these investments, for
example if product development is on the right track. The sustainability of a
company’s results and of the company’s business in general is at risk, if
investors, analysts and managers are focused too much on financial results.
Purely financials based shareholder value management and sustainability do not
make good bed fellows.
The
actual scandals about companies that reported inflated profits is a direct
consequence of this development and of the so called “earnings game”. Today we
are living in a knowledge economy. Most value is being created not any more
through capital investments and industrial value chains, but through activities
that involve the creation of knowledge and relationship assets such as through
product development, customer relationship building and constant business
process optimization. These activities typically require a constant adaption to
new market developments and competitor actions in order to maintain these
“assets” and the related benefits for the company. None of these new values and
nothing abut their actual status is reflected in financial accounts, but
building them costs money and short term profit. The risk is, that companies
sacrifice their future for short term profit, rising short term share prices
(and rising stock option values of their executives) in favor of the
sustainability of the company and of its future revenues and earnings. When the
business starts to decline (as a consequence of neglecting the business
fundamentals), executives are often tended to polish the numbers – first within
the legal boundaries / GAAP rules and later beyond them. According to a study
of Baruch Lev, professor for financial accounting at New York University’s
Stern School of Business, Enron has not invested a Dollar in R&D in the
past 5 years before it went bankrupt. They have not created any fundamental
value or real competitive advantage. Sure, a drastic example with a lot of
criminal energy behind it. But the essence of it – focus on short term,
sometimes “polished”, financial results plus a good investor relations /
capital market approach with an attractive “story” – applies today to nearly
every company with its shares trading on the stock markets.
The
merger and acquisition wave of recent years fit into this scheme: many of the
calculated “synergies” have never been realized and very often shareholder
value has been destroyed and not increased. This is because the forecasted
synergies of mergers in many cases are still based on traditional economies of
scale based on cost savings (assumption: overhead costs can be reduced and the
remaining overheads can be spread across more units sold – resulting in
increased profits). But these traditional economies of scale are increasingly
offset by the new business economics of the knowledge economy: realizing
synergies with knowledge assets for example, is far more complex than merging
successfully two production plants. It requires that knowledge workers feel
still at home in the new larger organization, that they are able to work
together with the new colleagues in a productive way, and it requires that your
customers and other stakeholders still see a value in working with the new
larger organization.
What
we need is therefore a new approach to shareholder value management, with major
consequences for the corporate governance and the corporate performance
management system.
The new approach: focus on the business fundamentals and on the enterprise’s total factor productivity (E-TFP)
The
times for short cuts in improving shareholder value are gone. Today, as
business fundamentals and credible accounting become the new touchstones by
which investors are starting to judge corporate quality, executives and
especially chief financial officers have to pay more attention to and have to
fully understand the performance of their businesses. Mergers can add
significant value under the right conditions (if one is aware of the knowledge
and organizational capital implied). But for most companies, shareholder value
comes from internally generated growth, through new products or services, from
improved customer relations, from entering successfully new markets, and from
cost, resource, and capital efficiencies.
But
many executives do not understand, how their business units create value and
they do not know much about the business economics that underpin their business
system. But only when management fully understands the internal logic of their
business system, positive financial results can follow. Only then corporate
executives and business managers are able to manage for sustaining financial
performance – exactly what investors and financial analysts expect today from
management.
This
requires not a generic financial shareholder value measurement system, but a
enterprise control systems and key performance indicators that reflect the
individual business system of an enterprise. Value and growth does not come
from the single components of the company’s value creation system alone, such
as from new production processes, from R&D results, new technologies that
are applied, or from new marketing concepts. In today’s information and
knowledge economy these techniques are in many cases also available to competitors.
Value is being created instead by the intelligent and unique combination of
various factors with the objective to create maximum customer value. Value
added resulting from the combination and recombination of a companies
production factors is the real source of shareholder value and of competitive
advantage. This requires executive to focus on an enterprise’s total factor
productivity instead on paying just attention to the performance of single
corporate activities and on the companies financial performance, which is only
an indicator for past improvements or deteriorations of total factor
productivity, but it does not provide much information to allow executives to
mange and optimize it for the future.
The
problem for executives and managers is, that they are missing the information
they need to understand the business economics of their business system and
that allows them to optimize them in order to improve the total factor
productivity of the enterprise.
The building block #1 of the new corporate performance
management system: a measurement systems which reflects a company’s true
business economics
An
empirical study from Juergen Weber, professor for controlling and
telecommunication at the Wissenschaftliche Hochschule fuer Unternehmensfuehrung
(WHU) in Koblenz, Germany, revealed, that more than 60% of the managers in the
sample are not satisfied with the measures they receive from their controllers:
the measures should be instead more balanced and not only financially oriented,
and there should be an understandable relation between the different financial
and non-financial measures.
The
problem is not that companies and their managers have not enough information
today, in fact the problem is that they have too much. This is not so much a question
of information technology, but first and foremost a conceptional challenge: how
do you select the right measures?
The
selection of the right measures has to be based on the underlying logic of a
company’s business system, on its business economics. These business economics
determine, how value creation in a specific company works and how managers are
able to increase for example return on capital employed in a sustaining way.
When the business economics are transparent and clear and determine also the
logic and concept of the performance measurement system, managers will
understand immediately the relation between the different measures and will be
able to use them much more effectively.
Many
pharmaceutical companies for example, do not effectively measure and manage the
value of their research, development, and product launch activities. But these
activities represent together one of their major value creation factors in
their business system. The first step therefore has to be, to provide better information
about the productivity and effectiveness of the entire product development and
market introduction process to enable management to learn, what the right
actions for optimizing the value of the product portfolio and of the product
pipeline are and what levers they have to pull. At the same time information
about the other components of the business system are required: about the
marketing and sales network consisting of the own sales force and of marketing
partners, about the supply chain and production activities, about human
resources effectiveness etc.. This should enable management to learn more about
the economics of the whole system and about the logic between the different
subsystems in order to optimize the combined value and the enterprise’s total
factor productivity.
This
corporate performance measurement system should not provide too much
information and should not be too complex, otherwise management will loose the
overview. But it has to provide enough insight into the business system as a
whole, so that management is able to optimize the different activities from a
holistic perspective in order to optimize total risks and returns and to
maximize cash flows in a sustaining way. I have described a conceptional
framework for such a measure system in my forthcoming book “Intangible Assets and Value
Creation” (John Wiley, 2002) [German version: “Intangible
Assets oder die Kunst, Mehrwert zu schaffen” (Galileo Press, Mai 2002)]
which is called a Tableau de BordTM, that combines strategic
measurement concepts (Balanced Scorcard) with modern operational measurement
concepts (Lev’s Value Chain Blueprint, Supply Chain Cockpit …) – see figure 1.
Figure
1: The Tableau de BordTM, a conceptual framework for
designing an individual business system specific corporate performance
measurement system
Focus on the Management Dialog
Good
management decisions are based on a good knowledge about the business. Measures
and Key Performance Indicators are not enough to create that knowledge.
Knowledge is being created through information and through
communication, that is through a good measurement system and through effective
dialogs in the management team and between corporate executives and business
managers.
This
requires, in addition to a good measure system, which creates a common
information platform, well structured management processes that help to
organize the performance management communication between different managers
and that help to reconcile their different views and perspectives in a way that
leads to optimal decisions and not to never ending unproductive conflicts that
often exist between the different economic subsystems in a company, for example
between product development and sales.
After
having solved the information problem by selecting the right measures and by
reducing unproductive information overflow in the company, the next level in
terms of management productivity that leads to increased total factor
productivity of the enterprise stems from improved management dialogs and
communication. This will be the topic of the second part of this article series
about the next level of shareholder value management.
Summary
The shareholder value movement, which has its roots in
the 1980s, when institutional investors were starting to exert pressure on
corporate executives to deliver better shareholder value and corporate raiders
forced them to take care, that their company is not undervalued, is approaching
a crossroad today. The extensive focus of investors and financial analysts on
quarterly earnings and the resulting “earnings game” has led to severe
exaggerations and resulted in an under-attention of both investors and managers
on the business fundamentals of enterprises. This is reinforced through the
actual scandals, where companies have inflated their earnings figures,
resulting in a severe damage of reputation and in a general mistrust in
corporations, their auditors and in financial analysts.
For
most companies, shareholder value comes from internally generated growth,
through new products or services, from improved customer relations, from
entering successfully new markets, and from cost, resource, and capital efficiencies.
But many executives do not understand, how their business units create value
and they do not know much about the business economics of their business
system. But only when management fully understands the internal logic of the
business system of their company, positive financial results can follow. Only
then corporate executives and business managers are able to manage for
sustaining financial performance – exactly what investors and financial
analysts expect today from management.
The
first building block of a new improved corporate performance management system
represents a measures system, that reflects the individual business economics
of the enterprise. It has to enable managers, to learn, how they can improve
total factor productivity of the enterprise, which is driving fundamentally
shareholder value by optimizing both the single factors and processes such as
in product development, sales, or supply chain management and by
optimizing the combination of all factors. A conceptual framework for such a
measures system, that I have described and developed in my book (see below) is
the Tableau de BordTM (see figure 1 above).
But
management knowledge is being created through information and through
communication, that is through a good measurement system and through effective
dialogs in the management team and between corporate executives and business
managers. How to organize effective management dialogs in an organization will
be continued in part 2
of this article series.
Additional
resources:
Intangible Assets and Value
Creation – a book from Juergen Daum, focusing on a new enterprise model and
on the new management system for the new knowledge and intangible assets based
economy of today, comprising many examples and case studies. It describes the
new environment and its consequences for businesses, the rules that can be
extracted from this understanding for the design of a new management system,
and it develops a framework for a new management system and describes its
elements, as well as how a company can set it up and bring it to live.
deutsche Version
Approaching the next
level of shareholder value management – the art of corporate performance
management (part 2) – article
by Juergen Daum
Enterprise Total Factor Productivity
(E-TFP) - The Fundamental Value Creator (Presentation
held by Baruch Lev at SAP's
European mySAP Financials Conference, June 2002, Strassbourg / France)
deutsche Version
Performance
Management and Business Controlling in the 21st Century (Presentation
held by Juergen Daum at SAP's
European mySAP Financials Conference, June 2002, Strassbourg / France)
deutsche
Version
Beyond
Budgeting – Fixed targets are a thing of
the past. In order to respond quickly to market developments in a
fast-paced economic environment, managers need tools that offer greater
flexibility – article by Juergen Daum
deutsche
Version
Why
today's accounting, controlling and management systems fail - in an
interview with sapinfo.net, Jürgen H. Daum explains the limitations of our
traditional management tools in our economies of today and why an overhaul is
necessary
deutsche
Version
Value Drivers
Intangible Assets – Do we need a new approach to accounting, controlling and
management systems ? – article by Juergen Daum
deutsche Version
Strategic Enterprise
Management and Value Based Management – A new generation of analytical
applications to support management processes – article by Juergen Daum
deutsche Version
Previous new New
Economy Analyst reports related to the topic of the new performance management
system:
June 11, 2002 –
Intangible Assets: a central topic at the mySAP Financials conference in
Strasbourg
March 06, 2002 –
Interview with Baruch Lev: Accounting, Reporting and Intangible Assets
Dec 28, 2001 - How to
create value with Real Options based innovation management
Nov 27, 2001 - Leveraging
e-Business Opportunities for Finance – Q&A with Juergen Daum
Nov 13, 2001 - Interview
with Leif Edvinsson: Intellectual Capital: the new wealth of corporations
Oct 16, 2001 - E-Business
requires CFOs and CIOs to redefine their roles and relationships
Sept 11, 2001 - The book
of the month: “Managing the Professional Service Firm” by David H. Maister
July 26, 2001 - How
accounting gets more radical in measuring what really matters to investors
July 18, 2001 - Interview
with David P. Norton: "Intangible Assets and the Balanced Scorecard"
May 22, 2001 - Beyond
Budgeting: How to become an adaptive sense-and-respond organization
March 28, 2001 – The book
of the month: “The Innovator’s Dilemma” by Clayton M. Christensen
Febr 26, 2001 - eXtensible Business Reporting Language
(XBRL) is moving forward
Nov 01, 2000: The Book of
the Month: “Meta-Capitalism” by Grady Means and David Schneider
Oct 03; 2000: The book of
the month: “Future Wealth” by Stan Davis and Christopher Meyer
I will continue in
future reports to report on new economy economics and issues related to
managing companies in our information and Intangible Assets based economy of
today. To subscribe for my free-of-charge e-mail newsletter click here.
The concept for a new
accounting, controlling, and management system for our knowledge and intangible
assets based economy, that integrates strategy management (strategic
innovation) and product and market development (product and market innovation)
with operations management (supply chain management, customer relationship
management) and resource management (finance, hr, alliances, IT) is described
in detail in my book "Intangible Assets oder die Kunst,
Mehrwert zu schaffen" ("Intangible Assets and Value Creation ") which is now available (German
version – English edition forthcoming).
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