Marwaan R. Karame
Direct: 212-248-0866 mrk@ev-advisors.com
www.ev-advisors.com
All rights reserved. No part of this report may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage and retrieval system, without the written permission of Economic Value Advisors.
Copyright © 2003-2009 Economic Value Advisors
Presentation objective:


Applying the concepts of Economic Value (also known as Economic Valued Added or
Economic Profit), so that we can maximize the long-term wealth of shareholders, by motivating managers to think, act, and get paid like owners.
Demonstrate how to create an effective executive pay for performance incentive plan using
@Risk.
Introductions …
Economic Value Advisors, based in Manhattan, is a Value Based Management consulting firm that focuses on maximizing the long-term value of businesses and the wealth of shareholders through a fundamental concept of applied corporate finance and economics, known as Economic Value (also known as Economic Value
Added or Economic Profit).
In each of these services we assist companies to do one or all of the following:
 Improve - Enhance the existing operations of a business by doing more with less
 Divest - Sell a business when the alternative of keeping it is less profitable.
 Invest - Invest in profitable growth opportunities through new initiatives or acquisitions.
Our full VBM implementation extends beyond adopting a measure of performance
(Economic Value), but rather it instills a Value Based Management business philosophy that aligns the interests of management and shareholders.
As a result, we help to create a shareholder centric culture that encourages a corporate mindset of management ownership and shareholder accountability across all levels and functions of an organization.

Copyright © 2003-2009 Economic Value Advisors


When discussing executive pay for performance we need to start from the very beginning by clearly defining our ultimate objective and determining how to measure performance against that objective.
In order to answer this question, we need to introduce the business philosophy of Value
Based Management.




1. Defining Value Based Management
The economic meaning of value
Value Based Management defined
Why maximize long-term shareholder value?
How to measure value creation



2. Economic Value
Calculating Economic Value – simple case
Shortfalls of traditional measures
Putting Value Based Management to practice
3. Executive pay for performance


Motivating managers to think, act, and get paid like owners.
Using @Risk to calibrate an executive incentive plan that pays for creating shareholder value
4. Shareholder / Management Alignment

Wealth Leverage – a shareholder / management alignment index is used to determine how strongly management incentive is aligned to shareholders.

Sections:
1.
2.
Defining Value Based Management
Economic Value - creating value
3.
Executive Pay for Performance
4.
Shareholder/Management alignment
“Price is what you pay, value is what you get."
- Warren Buffett
1.
Defining Value Based Management
Learning Objectives:
 Define value based management
 Understand why maximizing long-term shareholder wealth is in the best interests of all stakeholders.
 Identify a company’s sole objective
 Determining the source of value and wealth
Copyright © 2003-2009 Economic Value Advisors

To define a Value Based Management business philosophy we draw from …
… key economic principles of human behavior.
The rational-actor paradigm is a fundamental concept of economics that simply states that people act:
Rationally Maximize Value Self-Interest
When people make mistakes, or are fraudulent, or are perceived to act irrational, the problem can be traced to not having either:
The Right People
The Right
Information
The Right
Incentive
Copyright © 2003-2009 Economic Value Advisors
Source: Managerial Economics, A Problem Solving Approach by Luke M. Froeb and Brian T.
McCann, pg 4-5.
4

The objective of any company is dictated by the invisible hand principle
Corporate social responsibility is, simply, to maximize long-term shareholder wealth
“... But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society.
… By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”
- Adam Smith, An inquiry into the Nature and Causes of the Wealth of Nations (New
York: Modern Library, 1937), p. 423
Forbes: The World’s Billionaires 2009
(Ranking by Net worth)
1. Bill Gates - $40 billion
2. Warren Buffet - $37 billion
Source: ww.Forbes.com
Owners of companies, by necessity, must contribute to society in order to promote their own self interest.
The best way for owners to maximize their own selfinterest is by taking into account the self interest of others and to exchange something of value.
Anecdotal evidence
Rated #1 and #2 as the wealthiest men in the world, Bill
Gates and Warren Buffett provide anecdotal evidence that the best way to maximize shareholder wealth is by serving society in a meaningful and beneficial way.
The poorest countries tend also to be the most corrupt. This year's report brackets together New Zealand, Denmark and
Finland as the least corrupt countries.
Somalia and Myanmar suffer from the most corruption, defined as the abuse of public office for private gain.
- The Economist, Sep 27th 2007
From a macro perspective, wealth and healthy functional societies go hand in hand.
Honest free societies create the greatest level of wealth per capita.
Copyright © 2003-2009 Economic Value Advisors
5

How can managers impact society when maximizing shareholder value?
“Our mission is to create value over the long haul for the owners of our Company.
That’s what our economic system demands of us. That’s what allows us to contribute meaningfully to society. That’s what keeps us from acting shortsighted. As businessmen and businesswomen, we should never forget that the best way for us to serve all our stake-holders – not just our share owners, but our fellow employees, our business partners and our communities – is by creating value over time for those who have hired us.
That, ultimately, is our job.”
- Roberto C. Goizueta (Former CEO of The CoCa-Cola Company)
Who did he impact?
Nick Smith
Whitehead
Woodruff & Evans
Foundations
Emory University
How did he impact them?
Roberto Goizueta’s dentist, bought 100 shares in 1984 for $6,237.50, which by mid-1997 climbed to a value of $180,000 after four stock splits.
Has a value of $7.6 billion, almost all from their holdings of 119 million Coke shares, which has allowed them to increase charitable giving from $5 million in 1980 to about $220 million in 1997.
Emory University endowment increased from $250 million in 1981 to one of the nation’s largest at $3.8 billion. The university holds about 40 million Coke shares, making up 63% of the endowment’s value. As a result, Emory has built facilities, offered scholarships, endowed professorships, and expanded programs.
Copyright © 2003-2009 Economic Value Advisors
Source: The Wall Street Journal’s tribute to Roberto Goizueta, October 24 th , 1997
6

VBM gauges success based on the value created for others
“Price is what you pay. Value is what you get.” – Warren Buffett
Defining management performance based on short-term stock price success is both impractical and does not necessarily ensure a company manages to value.
"Try not to become a
[person] of success, but rather try to become a [person] of value."
- Albert Einstein
Copyright © 2003-2009 Economic Value Advisors
7

Value Based Management goes beyond managing to earnings
Reported earnings doesn’t represent the true economics of a business
Earnings can often lead to the wrong behavior when tied to compensation as demonstrated by the following excerpt from Enron’s in-house risk management manual:
“Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with the underlying economics. However, corporate management’s performance is generally measured by accounting income, not underlying economics. Therefore, risk management strategies are directed at accounting, rather than economic, performance.”
Enron Economic Profit vs Net Income
$1,500
$1,000
$500
$0
($500)
($1,000)
($1,500)
($2,000)
1993 1994 1995 1996 1997 1998 1999 2000
Year
Economic Profit Net Income
The Smartest Guys In The Room by
Bethany McLean and Peter Elkind page 132.
Copyright © 2003-2009 Economic Value Advisors
8

Creating value begins by managing towards the right measure
Determining how to increase Shareholder Value is often confusing
Operations
Capacity Utilization
Capital Turnover
Capital budgeting
Volume
Inventory
Which measure should you focus on?
Sales & Marketing
Sales Growth CRM
ROI Margins
Market Share
Human Resources
Sales per Employee
Balanced Scorecard
Subjective Evaluations
Finance
EPS IRR
NPV EBIT
Cash Flow
EBITDA
Copyright © 2003-2009 Economic Value Advisors
9

Economic Value is the true measure of value creation
Economic Value provides focus, simplicity, and line of sight


Economic Value is a truism of finance and economics
Economic Value - different names, same concept:
Economic Value Added (EVA)
Residual Value or Income
Economic Profit
Shareholder Value Added (SVA)
Cash Value Added (CVA) …

Your return on investment must be higher than the cost of capital
Long-term
Shareholder Value
Economic Value
Return on investment
Borrow
Profit
10%
5%
5%
Yes
5%
10%
-5%
No
Copyright © 2003-2009 Economic Value Advisors
10

The concept of Economic Value is well established
Economic Value is endorsed by all facets of the business community
Business Academics
"... there is no profit unless you earn the cost of capital. Alfred
Marshall said that in 1896,
Peter Drucker said that in 1954 and in 1973, and now EVA
(economic value added) has systematized this idea, thank
God."
- Peter Drucker
Wall Street Analysts
"Economic Value Added (EVA) is a superior metric ... EVA has a higher correlation with wealth creation than do EPS,
ROE, or cash flow."
- Steven Milunovich
Copyright © 2003-2009 Economic Value Advisors
Institutional Investors
"Unlike earnings or ROE or any of those other measures, EVA gets at what we're really after: the creation of value by earning returns above our required cost of capital across time."
- Bob Boldt, Senior Investment
Officer
Corporations
“Economic Profit is the way to keep score. Why everybody doesn’t use it is a mystery to me.”
- Roberto Goizueta, Past CEO
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However, the “measure” of value is not what creates wealth
“Wealth is the product of a [person’s] capacity to think.” – Ayn Rand
There is no substitute for the “right” people:

Integrity

Judgment

Leadership

Competence

Diligence

Intelligence

Strategy

Vision

Passionate work ethic

Regardless of the measure used to access performance (accounting or economic based), it is only as accurate as the managers and employees that measure it.

It’s the genuine adoption of a VBM business philosophy that will maximize longterm shareholder wealth versus simply the adoption of a measure.

Genuine adoption of a VBM business philosophy requires managers to measure, manage, and reward performance with the honest intent, spirit, and principle of maximizing long-term shareholder value.
Copyright © 2003-2009 Economic Value Advisors
12

Sections:
1.
2.
Defining Value Based Management
Economic Value - creating value
3.
Executive Pay for Performance
4.
Shareholder/Management alignment
"... there is no profit unless you earn the cost of capital. Alfred
Marshall said that in 1896, Peter
Drucker said that in 1954 and in
1973, and now EVA (economic value added) has systematized this idea, thank God."
2.
- Peter Drucker
Economic Value – creating value
Learning Objectives:
 Understand how to calculate Economic Value
 Demonstrate Economic Value embodies all other measures
 Economic Value leads to value enhancing operating decisions
 Shortfalls of other traditional measures
 Economic Value’s ability to be understood and used at the shop floor level
Copyright © 2003-2009 Economic Value Advisors

A simple Economic Value case study
Case study highlights:

Carl Carlton, CEO

Aspiring Entrepreneur


Total Investment $1,000
Sources of Funds:
−
−
Personal savings: $500 in stocks
$500 Debt / Lender - Dad
C.C. calling his Stock Broker to sell
Cost of Capital:

Opportunity cost – was earning a 15% return in the Stock Market


Dad charging him 5% after tax
Weighted Average Cost of Capital = 10%
Fund Source
Equity
Debt
Capital
Amount
% of Total
Investment
$500
+$500
50%
50%
$1,000 100%
X
X
Rate
15%
5%
=
=
Weighted
Average
7.5%
+2.5%
10.0%
Copyright © 2003-2009 Economic Value Advisors
14

Economic Value is simple common sense
There are 2 simple methods for calculating Economic Value
$200
1) Economic Value =
$300
NOPAT
_
Sales
- Expenses
EBIT
2
- Taxes
NOPAT
$2,500
-$2,000
$500
-$200
$300
$100
Capital Charge
Capital
X Cost of Capital
Capital Charge
$1,000
X 10%
$100
$200
2) Economic Value =
30%
20% spread
_
10%
Cost of Capital X
DuPont Formula
1) NOPAT – Net Operating Profit After Tax
2) EBIT – Earnings Before Interest and Tax
3) ROC – Return on Capital
Return on Capital
NOPAT
Capital
$300
$1,000
30%
=
=
=
NOPAT Margins
NOPAT
Sales
$300
$2,500
X
X
X
Capital Turns
Sales
Capital
$2,500
$1,000
= 12%
X
2.5x
Copyright © 2003-2009 Economic Value Advisors
$1,000
Capital
15

Economic Value - a simple yet robust measure of performance
Economic Value offers clarity into 4 value creating mandates
Economic
Value
=
ROC
Return on
Capital
_
Cost of
Capital
X
Capital
DuPont Formula
Profit Margins
NOPAT
Sales
X
Capital Turns
Sales
Capital
4. Optimize Capital Structure
• Financial flexibility
• Dividend policy
• Investor disclosure
1. Improve operations and efficiency by increasing margins
• Reduce manufacturing Costs
• Process improvements
• JIT, Lean Manufacturing
• Six Sigma, Kanban, TQM
Copyright © 2003-2009 Economic Value Advisors
2. Divest capital – doing more with less
• Sell a business when the alternative of keeping it is less profitable
• Reduce overhead expenses
• Maintain Sales while reducing
Net Working Capital and
Fixed Capital Turns
3. Invest profitably by allocating capital towards value creating investments
• Value creating acquisitions
• Invest in positive NPV equipment and facility initiatives
• Establish foreign and domestic joint ventures
• Invest in marketing and research development
16

Economic Value’s greatest strength – making daily decisions
You have an opportunity to increase sales with a new customer
Sales opportunity of $500,000, but you will require an increase of $200,000 of inventory
Projected operating expenses are 95% of sales. Should you take on the new customer?
Potential New Customer
Economic Profit Analysis ($)
Sales Increase
- Incremental Costs
= Operating Income Increase x 1 - Tax Rate
(1) = NOPAT Increase
Working Capital Increase x Cost of Capital
(2) = Capital Charge Increase
(1-2) Economic Profit
Year
500,000
475,000
25,000
60.0%
15,000
200,000
10.0%
20,000
(5,000)
Copyright © 2003-2009 Economic Value Advisors
17

Economic Value applies to every business decision
Your daily operating decisions determine the value created












Taking on a potential new customer
Negotiating a supplier contract
Adding human resources
Making an equipment purchase
Prioritizing customer orders
Divesting idle assets
Acquiring a business
Make versus buy decisions
Developing a new product line
Adding a new shift
Upgrading equipment
Negotiating past contracts
Copyright © 2003-2009 Economic Value Advisors
18

VBM compensation incentive must be tied to the right measure
Traditional measures, independently, do not necessarily increase value.

Earnings measures (Net Income, EPS, EBITDA, Operating Income, etc.) can lead to investment at inadequate rates of return.

Return measures (ROE, ROC, ROA) can lead to rejecting good investments that diminish current returns or accepting poor investments that enhance current returns.

Long-term shareholder value can only be maximized by increasing a company’s Economic Value over the long-term.
Copyright © 2003-2009 Economic Value Advisors
19

Carlton decides to make his first acquisition





C.C. closing Patterson’s Lawn Care acquisition



Copyright © 2003-2009 Economic Value Advisors
Mr. Patterson pleased with negotiations
20

Traditional measures can encourage value destroying growth
Drivers are important but should not be maximized independently
Sales
EBIT
NOPAT
NOPAT Margin
Capital
Return on Capital
Cost of Capital
Capital Charge
Economic Value
Base
Business
$1,000
$83
+
$50
5%
$1,000
5%
10%
- $100
- $50
New
Business
$200
$67
$40
20%
$500
8%
10%
- $50
-$10
=
Total
Business
$1,200
$150
$90
7.5%
$1,500
6.0%
10%
- $150
- $60
Copyright © 2003-2009 Economic Value Advisors
21

Benchmarking – CVS/Caremark
Despite CVS’s increased NOPAT Margin, Economic Value has declined
Revenue and Revenue Growth
100,000.0
90,000.0
80,000.0
70,000.0
60,000.0
50,000.0
40,000.0
30,000.0
20,000.0
10,000.0
0.0
80%
70%
60%
50%
40%
30%
20%
10%
0%
Despite CVS’s increasing revenue and NOPAT
Margins, Economic Value has declined due to a lack of focus on capital efficiency resulting in a decline in
Capital Turns.
Most probably the reduction in Capital Turns is due to the company’s inability to fully capitalize on their minute clinics.
2006
Revenue
2007
Revenue Growth
2008
$ in millions
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
(1.0%)
0.00x
0.50x
Return on Capital - Drivers
1.00x
Size of bubble is based on Revenue
2008
2006
1.50x
2.00x
Capital Turns
2007
2.50x
7.3% Avg. Cost of
Capital
3.00x
3.50x
NOPAT, Capital Charge, Economic Value
$6,000.0
$4,000.0
$2,000.0
$0.0
-$2,000.0
-$4,000.0
-$6,000.0
2006
Capital Charge
2007
NOPAT
2008
Economic Value
$1,600.0
$1,400.0
$1,200.0
$1,000.0
$800.0
$600.0
$400.0
$200.0
$0.0
-$200.0
$ in millions
Copyright © 2003-2009 Economic Value Advisors
22

Carlton doesn’t make the same mistake twice




C.C. acquires Billy’s Mowing Service



Billy McGuire mowing his last lawn
Copyright © 2003-2009 Economic Value Advisors
23

Economic Value strikes the right balance between value drivers
Compensation tied to Economic Value ensures the right behavior
Sales
EBIT
NOPAT
NOPAT Margin
Capital
Return on Capital
Base
Business
$2,500
$625
$375
15%
$1,500
25%
Cost of Capital
Capital Charge
Economic Value
10%
- $150
$225
+
New
Business
$2,000
$167
$100
5%
$500
20%
10%
- $50
$50
=
Total
Business
$4,500
$792
$475
10.6%
$2,000
23.8%
10%
- $200
$275
Copyright © 2003-2009 Economic Value Advisors
24

Benchmarking – Catalyst Health Solutions
NOPAT Margins are not the only way to create value for shareholders
Revenue and Revenue Growth
3,000.0
2,500.0
2,000.0
1,500.0
1,000.0
500.0
0.0
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Although Catalyst’s NOPAT Margin has been declining, the company’s capital efficiency has been a major contributor to its rise in Economic Value.
Catalyst’s ability to increase capital turns seem to be driven by a strong capability in valuing acquisitions and post-acquisition integration, which has resulted in strong Revenue and NOPAT growth while maintaining discipline in the amount of capital invested.
2003 2004 2005
Revenue
2006 2007
Revenue Growth
2008
$ in millions
Return on Capital - Drivers
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
(0.5%)
0.00x
2.00x
4.00x
2005
2003
2006
2004
2007 2008
9.1% Avg. Cost of
Capital
6.00x
8.00x
10.00x
12.00x
14.00x
Capital Turns
Size of bubble is based on Revenue
$60.0
$50.0
$40.0
$30.0
$20.0
$10.0
$0.0
-$10.0
-$20.0
-$30.0
-$40.0
$ in millions
NOPAT, Capital Charge, Economic Value
2003 2004
Capital Charge
2005 2006
NOPAT
2007 2008
Economic Value
$25.0
$20.0
$15.0
$10.0
$5.0
$0.0
Copyright © 2003-2009 Economic Value Advisors
25

All performance measures cascade into Economic Value
Copyright © 2003-2009 Economic Value Advisors
26

How a Forklift Driver ‘drives’ Economic Value
Cultivating ownership accountability right down to the shop floor
Forklift Driver - “As inventory gets closer to shop floor, the capital charge on inventory is reduced …
… and warehouse space can be consolidated to reduce the overall invested capital, … which directly increases a company’s Economic Value
Copyright © 2003-2009 Economic Value Advisors
27

Economic Value is fundamental to a VBM business philosophy
…captures all operating measures …
Margins
IRR
EBIT
Capital Turns
Market Share
Returns
Production
EPS
NPV
Sales
Cash Flow
Etc …
Copyright © 2003-2009 Economic Value Advisors
… is used in every aspect of business …
Acquisition Analysis
Performance Measurement
Incentive Compensation
Financial Planning
Communication
Goal Setting
Operating Decisions
Strategic Planning
… binds functions with a common language
Finance
Human Resources
Operations
Sales & Marketing
28

Sections:
1.
2.
Defining Value Based Management
Economic Value - creating value
3.
Executive Pay for Performance
4.
Shareholder/Management alignment
3.
Executive Pay for Performance
Objectives:
Review overall structure of a Value Based Management incentive compensation
Present parameters of the compensation design
Apply @Risk to calibrate an effective incentive system
Copyright © 2003-2009 Economic Value Advisors

Traditional incentive plans are poorly structured
Bonus
$36,000
Maximum
$30,000
Target
Bonus
$24,000
Threshold
2.
No
Incentive
80%
Threshold
3.
Achieving
100% of
Goal
120%
Maximum
2.
No Incentive
1.
2.
3.
4.
Wrong performance measures or too many conflicting measures
Threshold and caps that result in year-end “sand bagging” and budget negotiations, which incent mediocrity
Targets are independent of shareholder value
Each year is independent of other years, leading to short-term thinking
1.
Performance
Copyright © 2003-2009 Economic Value Advisors
30

Value Based Management (VBM) Incentive Plan
Bonus Declared
Use the right measure of performance
No limits
Bonus reserve
Multi-year targets based on improvement (3 years)
4.
Target Bonus
Bonus
Bonus
Reserve
Bonus
Reserve
3.
1/3 of the remaining bonus reserve is paid
Up to 100% of the
Target Bonus is paid
Interval
$x,xxx,xxx
2.
5% probability of Zero
Cumulative Bonus over 3 years
EVI Target
$x,xxx,xxx
Economic Value Improvement (EVI) Excess
= Actual EVI – EVI Target
= Actual EVI - $x,xxx,xxx
1.
Copyright © 2003-2009 Economic Value Advisors
31

Economic Value Improvement (EVI) Target
Bonus Declared
The Economic Value Improvement (EVI)
Target is the EVI required to get a shareholder return on the Market Value, equal to the cost of capital.
Bonus
Reserve
Bonus
Bonus
Reserve
Target Bonus
1/3 of the remaining bonus reserve is paid
Up to 100% of the
Target Bonus is paid
Interval
$8,500,000
5% probability of Zero
Cumulative Bonus over 3 years
EVI Target
$820,000
Economic Value Improvement (EVI) Excess
= Actual EVI – Expected EVI
= Actual EVI - $820,000
1.
Copyright © 2003-2009 Economic Value Advisors
32

EVI target is derived by determining the Growth Value (GV)
1.
Market Value (MV) of the company is determined by taking the market value of the equity and debt. For a private company, we add the discounted future Economic Value to ending capital or discount the Free Cash
Flows. In either case, we get the same answer.
2.
Operations Value (OV) is determined by assuming the current Economic
Value stays constant into perpetuity (Economic
Value ÷ Cost of Capital) and then we add the capital invested. This represents the value of the company if no additional growth is expected.
3.
Growth Value (GV) is determined by simply subtracting the COV from the Market Value of the business. FGV represents the expected
Economic Value
Improvement imbedded in the Market Value of the
Company
4.
Economic Value
Improvement (EVI)
Target is the constant
Economic Value
Improvement needed to get a return equal to the cost of capital on the GV and hence the Market
Value.
Market Value
(MV)
$473.3 million
GV = MV – OV
Economic Value
÷ Cost of Capital
$ 365.0 million
Capital
$18.1 million
GV
$90.2 million
OV
$383.1 million
EVI
$820,000
EVI
$820,000
EVI
$820,000
GV x Cost of Capital = $9.02 million.
For every dollar of EVI there is an additional $11 of value created to shareholders ($1 + 1/10%). By dividing $9.02 million by the $11, management is required to generate approximately $820,000 dollars of EVI annually.
Copyright © 2003-2009 Economic Value Advisors
33

Economic Value Improvement (EVI) Target – Benchmarking against peers
The Estimated EVI Target is further supported by peer analysis
3 Yr Economic Profit Improvement as % of Gross Profit
8.0%
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
20% 30% 40% 50% 60% 70% 80%
An EVI Target of $820,000 for our Client, based on a
Discounted Economic Value Valuation, represents
0.8% of Gross Profit and lies within the 29 th percentile among our Client peers.
Based on peer analysis the EVI Target as a % of
Gross Profit should fall within the 75 th and 50 th percentile or 6.7% and 4.0%, respectively.
As a result, the estimated EVI Target falls below the range of $5.3 million and $3.2 million range, assuming $97.9 million in Gross Profit at the end of
2008.
An EVI target at the 29 th percentile is justified (under the proposed total compensation design, i.e. interval, target bonus, bonus reserve) based on future growth prospects of the industry, simulation results, and the other factors.
Copyright © 2003-2009 Economic Value Advisors
34

Interval
The interval helps establish a balance between strong incentives, limited retention risk, and reasonable shareholder cost by providing exceptional pay for outstanding performance, average pay for expected performance, and below average pay for poor performance.
Bonus
Steeper slope increases risk
(small interval)
Bonus
Reserve
Bonus Declared
Target Bonus
Flatter slope decreases risk
(larger interval)
1/3 of the remaining bonus reserve is paid
Up to 100% of the
Target Bonus is paid
Bonus
Reserve
Interval 1
$8,500,000
2.
5% probability of Zero
Cumulative Bonus over 3 years
EVI Target
$820,000
Economic Value Improvement (EVI) Excess
= Actual EVI – Expected EVI
= Actual EVI - $820,000
1. Interval will change at a constant ratio to Target Bonus. If Target Bonus does not change, then the interval will stay constant.
Copyright © 2003-2009 Economic Value Advisors
35

Economic Value Interval - bottom up approach
Monte Carlo analysis confirms our analysis – using a bottom up approach
Using various distributions per driver of Economic Value we can simulate various combinations of assumptions to come up with a range of
Economic Value and valuation results.
In the case of our Client, a triangle distribution was used for the key drivers of value.
MONTE CARLO SIMULATION
LTM
12/31/08 12/31/09 12/31/10
Growth Phase
12/31/11 12/31/12 12/31/13 12/31/14 12/31/15
Transition Phase
12/31/16 12/31/17
Stable Growth
12/31/18 Continuing Value
Sales
Sales Growth
Triangle Distribution Min
M. Likely
Max
NOPAT
NOPAT Margins
Triangle Distribution Min
M. Likely
Max
Capital
Capital Charge
Capital Turns
Triangle Distribution Min
M. Likely
Max
Cost of Capital
Triangle Distribution Min
M. Likely
Max
Return on Capital
Triangle Distribution Min
M. Likely
Max
Spread
Economic Value
Economic Value Check
Discount Rate
PV of Economic Value
Terminal Value
NOPAT / Economic Value Growth
Median
Standard Dev
Minimum
Maximum
1.8%
7.5%
0.0%
0.0%
9.1%
$1,042
(1.8%)
---
---
---
$37.7
3.6%
---
---
---
$12.1
(1.2)
85.8x
---
---
---
10.0%
---
---
---
310.4%
---
---
---
300.4%
$36.5
0.0000
1.00x
---
$810.2
(22.3%)
(24.1%)
(20.1%)
(12.1%)
$970.4
19.8%
8.3%
15.0%
32.6%
$1,083.0
11.6%
7.7%
13.0%
24.6%
$1,223.2
13.0%
7.1%
11.5%
19.7%
$1,339.8
9.5%
6.7%
10.3%
16.5%
$1,527.0
14.0%
6.5%
10.3%
16.2%
$1,688.5
10.6%
6.3%
10.3%
15.9%
$1,855.9
9.9%
6.2%
10.3%
15.6%
$2,128.9
14.7%
6.0%
10.2%
15.3%
$2,279.2
7.1%
5.9%
10.2%
15.0%
$21.9
2.7%
1.8%
4.2%
7.9%
$17.2
(1.6)
47.0x
43.8x
46.1x
50.7x
9.5%
9.0%
10.0%
11.0%
127.3%
---
---
---
$51.4
5.3%
1.8%
4.2%
7.9%
$32.8
(3.2)
29.6x
22.9x
25.6x
32.5x
9.8%
9.0%
10.0%
11.0%
156.9%
---
---
---
$54.0
5.0%
0.1%
3.7%
8.4%
$41.3
(4.3)
26.2x
11.0x
25.6x
32.5x
10.4%
9.0%
10.0%
11.0%
130.8%
---
---
---
$43.8
3.6%
(0.3%)
3.6%
8.4%
$52.0
(5.1)
23.5x
11.0x
25.6x
32.5x
9.8%
9.0%
10.0%
11.0%
84.2%
---
---
---
($4.5)
(0.3%)
(1.4%)
3.4%
8.6%
$49.2
(4.8)
27.2x
11.0x
25.6x
32.5x
9.7%
9.0%
10.0%
11.0%
(9.1%)
---
---
---
$48.7
3.2%
(0.8%)
3.0%
7.4%
$70.5
(7.3)
21.7x
11.0x
25.6x
32.5x
10.4%
9.0%
10.0%
11.0%
69.1%
---
---
---
$39.4
2.3%
(0.2%)
2.6%
6.1%
$83.6
(9.1)
20.2x
11.0x
25.6x
32.5x
10.8%
9.0%
10.0%
11.0%
47.1%
---
---
---
$37.7
2.0%
0.3%
2.2%
4.8%
$101.1
(9.9)
18.4x
11.0x
25.6x
32.5x
9.8%
9.0%
10.0%
11.0%
37.3%
---
---
---
117.8%
$20.3
0.0000
Outputs
0.91x
$18.5
MVA
$284.7
147.2%
$48.2
0.0000
0.83x
$40.1
120.4%
$49.7
0.0000
0.75x
$37.4
74.4%
$38.7
0.0000
0.69x
$26.6
(18.9%)
($9.3)
0.0000
0.62x
($5.8)
Inputs
Legend
Stats
Tot End Capital Intrinsic Value
$42.9
$327.6
Inputs / Outputs
Valuation
Debt & Equiv.
Equity Value
0.0
$327.6
58.7%
$41.3
0.0000
0.57x
$23.4
36.3%
$30.4
0.0000
0.51x
$15.5
27.5%
$27.8
0.0000
0.47x
$12.9
45.6%
$35.5
0.0000
0.42x
$15.0
Shares Out.
Shares Price Current Price xpected Return
0.003890
$84,227.79
$35.37
238033.4%
23.4%
$23.1
0.0000
0.38x
$8.9
$43.4
2.0%
0.9%
1.8%
3.6%
$77.9
(7.9)
27.3x
11.0x
25.6x
32.5x
10.2%
9.0%
10.0%
11.0%
55.8%
---
---
---
$32.9
1.4%
1.4%
1.5%
2.3%
$98.6
(9.8)
23.1x
11.0x
25.6x
32.5x
9.9%
9.0%
10.0%
11.0%
33.3%
---
---
---
$2,479.5
8.8%
5.7%
10.2%
14.7%
$28.7
1.2%
1.0%
1.0%
2.1%
$87.5
(8.8)
28.3x
11.0x
25.6x
32.5x
10.1%
9.0%
10.0%
11.0%
32.8%
23.0%
25.0%
33.0%
22.7%
$19.8
0.0000
4.65x
$92.3
Copyright © 2003-2009 Economic Value Advisors
36

Economic Value Interval - bottom up approach
Based on driver assumptions – average bonuses will be at target bonus
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0.00
5.0%
Total Bonus Declared / 3 years
0.40
6.58
90.0% 5.0%
Total Bonus Declared / 3 years
Minimum
Maximum
Median
Std Dev
10%
25%
75%
90%
Values
-1.5039
8.9568
3.2505
1.8679
0.9263
1.9816
4.6581
5.9192
5000
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0.00
5.0%
Bonus Paid and Earned / 3 years
1.40
4.41
90.0% 5.0%
Bonus Paid and Earned / 3 years
Minimum
Maximum
Median
Std Dev
10%
25%
75%
90%
Values
0.0784
6.0677
2.8869
0.9075
1.7103
2.2746
3.5336
4.1037
5000
0.04
0.03
0.02
0.01
0.00
0.07
0.06
0.05
5.0%
Total Bonus Declared / 5 years
1.22
9.82
90.0% 5.0%
Total Bonus Declared / 5 years
Minimum
Maximum
Median
Std Dev
10%
25%
75%
90%
Values
-0.8087
12.9219
5.3890
2.5640
2.0492
3.6123
7.2499
8.9472
5000
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0.00
5.0%
Bonus Paid and Earned / 5 years
3.04
7.03
90.0% 5.0%
Bonus Paid and Earned / 5 years
Minimum
Maximum
Median
Std Dev
10%
25%
75%
90%
Values
1.4330
9.6208
5.0374
1.2136
3.4454
4.1723
5.8758
6.6074
5000
Copyright © 2003-2009 Economic Value Advisors
37

Bonus Declared, Bonus Reserve, and Bonus Earned/Paid
Bonus Declared
The Bonus Declared provides the starting point in determining the bonus earned/paid and the amount left in the bonus reserve to ensure short-term performance wasn’t made at the expense of long-term shareholder value.
Target Bonus
Bonus
Bonus
Reserve
3.
1/3 of the remaining bonus reserve is paid
Up to 100% of the
Target Bonus is paid
Bonus
Reserve
Interval
$8,500,000
5% probability of Zero
Cumulative Bonus over 3 years
EVI Target
$820,000
Economic Value Improvement (EVI) Excess
= Actual EVI – Expected EVI
= Actual EVI - $820,000
Copyright © 2003-2009 Economic Value Advisors
38

Simulating Ownership
Manage short-term demands while delivering long-term results.
"Companies perform better when all important parties
- management, employees, and directors - have the incentive of ownership in the business."
- George R. Roberts, Co-Founder of KKR
Bonus
Declared
Target Bonus
A Share of the
Improvement in Economic Value
Copyright © 2003-2009 Economic Value Advisors
Bonus
Reserve
Beginning Balance
Current Year's
Bonus Declared
Bonus
Paid
100% up to
Target Bonus
1/3 of Any
Remaining Balance
39

Bonus Declared
Strong incentive for yearly as well as cumulative long-term performance
It is best to look at a Value Based Management incentive system in terms of a multi-year period (i.e. cumulative 3 year bonuses), where long-term performance is the objective versus year to year performance.
Nevertheless, from a year to year bases there is a healthy balance of receiving an approximate 1x bonus in each of the years by creating expected returns to shareholders, while having strong incentive to exceed those expectations and deliver outstanding results.
0.06
0.05
0.04
0.03
0.02
0.01
0.00
2009
5.0%
Total Bonus Declared / 2009
-0.71
3.02
90.0% 5.0%
Total Bonus Declared / 2009
Minimum
Maximum
Median
Std Dev
10%
25%
75%
90%
Values
-1.4469
4.2094
0.9624
1.1268
-0.4087
0.2162
1.8551
2.6171
5000
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0.00
2010
5.0%
Total Bonus Declared / 2010
-1.06
4.08
90.0% 5.0%
Total Bonus Declared / 2010
Minimum
Maximum
Median
Std Dev
10%
25%
75%
90%
Values
-3.6531
6.5299
1.4045
1.5719
-0.5560
0.3541
2.5308
3.5766
5000
0.04
0.03
0.02
0.01
0.00
0.07
0.06
0.05
2011
5.0%
Total Bonus Declared / 2011
-2.60
4.37
90.0% 5.0%
Total Bonus Declared / 2011
Minimum
Maximum
Median
Std Dev
10%
25%
75%
90%
Values
-5.4074
7.1782
0.8107
2.1206
-1.9349
-0.6484
2.3432
3.6632
5000
Copyright © 2003-2009 Economic Value Advisors
40

Bonus Reserve – 3 year ending balance
There is a expected balance of 0.20x multiple left in reserve by the 3 rd year
0.30
0.25
0.20
0.15
0.10
0.05
0.00
5.0%
Bonus Reserve (Ending) / 3 years
-1.71
2.45
90.0% 5.0%
Bonus Reserve (Ending) / 3 years
Minimum
Maximum
Median
Std Dev
10%
25%
75%
90%
Values
-3.8026
4.1188
0.2082
1.1801
-1.1381
0.0000
1.1648
1.9646
5000
The expected bonus reserve after three years is
0.20x, which will provide a decent buffer in case of an atypical bad year.
There is a 25% chance of having zero balance in the reserve at the end of three years.
The most frequent occurrence is a zero balance in the bonus reserve, which means that the bonus paid is fully warranted by cumulative EVI improvement.
There is only a 5% probability of having a negative 1.71x bonus reserve in the 3 rd year.
Copyright © 2003-2009 Economic Value Advisors
41

Sections:
1.
2.
Defining Value Based Management
Economic Value - creating value
3.
Executive Pay for Performance
4.
Shareholder/Management alignment
4.
Shareholder/Management Alignment
Objectives:
Understand how to quantify the alignment of management and shareholder self interests
Introduce the concept of Wealth Leverage as the measure of
Shareholder/Management alignment
Review Client’s Wealth Leverage under the proposed compensation design
Copyright © 2003-2009 Economic Value Advisors

Wealth Leverage – aligning Management and Shareholder self interests
Healthy balance between short-term results and long-term performance
10.0%
7.6%
Management
Wealth
Shareholders
Wealth
-7.6%
Wealth Leverage quantifies how strongly Shareholder and Management self interests are aligned. Wealth Leverage measures how much management’s total long-term wealth will rise or fall for every 1% rise or fall in
Shareholder’s long-term wealth.
In the case of our Client, for every 10.0% increase in Shareholder wealth management’s long-term total wealth will increase 7.6%.
Too high a Wealth Leverage may encourage unnecessary risk taking, while too low a wealth leverage provides week shareholder/management alignment. A Wealth Leverage that fall between 50-100% alignment provides the right incentive 1 .
- 10.0%
Wealth Leverage
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
0%
Wealth leverage above the line may encourage management to incur too much risk
20% 40% 60%
Shareholder Wealth Change
Wealth leverage below the line
The optimal Wealth Leverage falls within a range of 50% - 100% provides week shareholder/management alignment
80% 100%
Optimal Wealth Leverage - Lower Limit Optimal Wealth Leverage - Upper Limit Total Wealth Leverage
1. Stephen F. O'Byrne and S. David Young, "Top Management Incentives and Corporate Performance," Journal of
Copyright © 2003-2009 Economic Value Advisors
Applied Corporate Finance (Winter 2005) 43

Wealth Leverage – Monte Carlo Simulation
Bonus Wealth Leverage falls within a range that provides optimal incentive
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0.00
5.0%
Wealth Leverage / 3 year
1.1652
1.2271
90.0% 5.0%
Wealth Leverage / 3 year
Minimum
Maximum
Median
Std Dev
10%
25%
75%
90%
Values
1.1378
1.2501
1.1995
0.0189
1.1719
1.1848
1.2120
1.2218
5000
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0.00
5.0%
Wealth Leverage / 5 year
1.1652
1.2271
90.0% 5.0%
Wealth Leverage / 5 year
Minimum
Maximum
Median
Std Dev
10%
25%
75%
90%
Values
1.1378
1.2501
1.1995
0.0189
1.1719
1.1848
1.2120
1.2218
5000
The 3 and 5 year Wealth Leverage for the total bonus declared is 119.9%. As to be expected, the 3 and 5 year should equal.
The total Wealth Leverage is then the weighted average of the bonus and salary. Since salary is for the most part independent of performance, the
Wealth Leverage for salary is zero.
Compensation
Bonus
Salary
Total Wealth Leverage
Wealth
Leverage
119.9%
0.0%
% of Total
Comp
63.9%
36.1%
Weighted
Average
76.7%
0.0%
76.7%
Client’s Wealth Leverage is 76.7%, which fall within the optimal range of 50-100%, providing a healthy balance of management/shareholder alignment and incentive to take intelligent risks.
Copyright © 2003-2009 Economic Value Advisors
44