Chapter 23
Value-based management
Learning objectives
A large portion of this textbook addresses the problems that firms encounter when making investment decisions
designed to maximise shareholder wealth. In Chapters 11 to 13 we discussed the use of net present value and
other tools to analyse project cash flows and compare them to the investment outlays required. Also, in Chapter
14 we considered how to estimate the proper required rate of return for a firm’s investments. But how can we be
sure that the assets which emanate from these outlays will be managed and operated to maximise the overall
returns of shareholders? This fundamental problem of managing a firm’s operations to create shareholder value is
the focus of this chapter. We can call this value-based management (VBM).
When you have completed this chapter you will be able to:

appreciate the importance of shareholder value to a firm’s management;

understand the agency problem inherent in the financial goal of a firm which manages shareholder value;

appreciate the concept of market value added (MVA) of a firm;

appreciate two models used to value firms in the capital market;

define value drivers to affect managerial decisions regarding the value of a firm;

understand the concept of economic value added (EVA) of a firm;

appreciate the applications of EVA in a mnemonic device, the four Ms; and

understand the basics of management compensation policies and the role of EVA.
Introduction
Throughout the textbook the notion has been suggested that a firm’s management should make decisions that
lead to increased shareholder value. After all, the ordinary shareholders ‘own’ the firm and it is not uncommon
for company mission statements to endorse shareholder value maximisation as the firm’s primary goal. However,
the incentives of top management are not always aligned with those of the company shareholders. In Chapter 1
the agency problem was discussed: a firm’s managers will not work to maximise benefits for the firm’s owners
unless it is in the managers’ interests to do so. In practice, many large companies are not run on a day-to-day
basis so as to maximise shareholder wealth.i In fact, it appears that many destroy shareholder value.
In this chapter we use the free cash flow valuation model that serves as the basis for estimating project value in
an analysis of new capital expenditure proposals to estimate the value of the business enterprise. We then link
this valuation to value drivers that can be used by managers for setting performance goals that can be tied
directly to firm value. Next we look at EVA as a measure of firm or business unit performance. This performance
1
measure has become popular among some firms that have focused their efforts on the creation of shareholder
value. In Australia these include ANZ Bank, Fletcher Challenge Ltd, James Hardie Industries, National Australia
Bank and Telstra.
Finally, we discuss the fundamental issues arising in examining an incentive compensation program that
encourages employees to engage in activities that create shareholder value. The old adage that what gets
measured and rewarded gets done is the guiding principle behind managing a firm to create value for its
shareholders.
The issue we address in this chapter is to address the problems associated with making sure that the firm
maintains a return on its investments that meets or exceeds its cost of capital. Economic value added, or EVA, is a
performance measure that is designed to accomplish this goal.
Who are the top creators of shareholder value?
Stern Stewart and Company have devised market value added (MVA) to measure how much wealth a firm has
created at a particular moment in time.ii MVA is computed as follows:
MVA ═ firm value ─ invested capital
(1)
By firm value we mean the market values of the firm’s outstanding debt and equity securities. Invested capital is
more problematic. Conceptually, a firm’s invested capital is the sum of all the funds that have been invested in it.
Although this sum is related to the reported value of the firm’s total assets it is not the same thing. Accounting
conventions used in constructing the firm’s balance sheet distort the reporting of the firm’s invested capital, so
that we have to make adjustments to the firm’s total assets from its balance sheet. Stern Stewart has identified
over 160 such adjustments. For example, generally accepted accounting principles (GAAP) call for the
expensing of 100% of the firm’s research and development (R&D) expenditure in the year in which the
expenditure is incurred. Thus, such expenditure which has value to the firm is not reflected in the total assets of
the firm, unlike new expenditure for plant and equipment. Stern Stewart adds back R&D to the firm’s total assets
and amortises it over several future years, so that the book value of assets more clearly reflects the total
investment made by the firm.
For 1998 Stern Stewart ranked 150 listed Australian companies by MVA using reported accounting data. iii An
approximation to invested capital was obtained by adding the borrowings in the business to the capital (including
retained earnings and other equity gains), since the accounting equation for a balance sheet states that assets
equal liabilities plus capital. The top and bottom five companies comprised:
Rank
Company
MVA
Invested capital
($ billion)
(4 billion)
1
Telstra
58.2
20.8
2
News Corporation
22.9
42.3
3
Brambles Industries
4.9
3.6
4
Coles Myer
4.7
8.4
5
Woolworths
4.7
4.6
146
Australian National Industries
–0.4
1.7
147
Pacific Dunlop
–0.5
5.6
2
148
Crown
–0.6
2.2
149
Qantas Airways
–0.9
7.5
150
Burns Philp & Co
–1.1
3.1
Investors placed $20 billion in the assets of top-ranked Telstra, but the MVA at the end of 1998 was over $58
billion reflecting the bargain price at which the Commonwealth government sold one-third of Telstra to investors
and the share market’s subsequent enthusiasm for Telstra. News Corporation had an outstanding year: $42 billion
invested capital yielded an MVA of over $22 billion. Thirty-six of the 150 companies destroyed shareholder
value with negative MVAs. Shareholders and lenders provided more than $18 billion of invested capital in the
bottom five companies, yielding negative MVAs.
How is it that some firms can create so much value for their shareholders while others destroy it? Value creation,
very simply, results from the marriage of opportunity and execution. Opportunities must be recognised and, in
some cases, created, and this is the stuff of which business strategy is made. However, opportunity is not enough.
Firms have to have employees who are ready, willing and able to take advantage of business opportunities. It is
on this side of the value creation equation that we focus our attention. Specifically, managing for shareholder
value requires that we resolve two separate issues. First, we must identify a set of performance measures that are
both linked to value creation and are under the control of the firm’s management. Second, we must design a
system of incentives that encourages employees to base their decisions on these performance metrics in their
day-to-day decisions. In essence, we must develop a performance measurement and reward system that
encourages managers to think and act like business owners. How this might be accomplished is now considered.
Business valuation – The key to creating shareholder value
To understand how shareholder value is created we must first understand how firms are valued in the capital
markets. There are two competing valuation paradigms that have been used to explain the value of a firm’s
ordinary shares in the capital market: the accounting model and the discounted cash flow model.
The accounting model
Although both the accounting and discounted cash flow models can be consistent in theory, they are not
generally used in a consistent manner and they can lead management to act in very different ways as it tries to
manage for shareholder value. If management uses the accounting model to think about the value of its equity,
then it will focus on reported earnings in conjunction with the market’s valuation of those earnings as reflected in
the price-earnings ratio. The accounting (earnings) model is represented by the following equation:
Equity value ═ price-earnings ratio × earnings per share
(2)
For example, if the price-earnings ratio is 20, then a $1 increase in earnings per share will create $20 in
additional equity value per share. Similarly, a $1 loss in earnings per share will lead to a drop of $20 in share
value. To see what’s wrong with this approach, consider the following scenario. In 2005, imagine that Teutonic
Energy spent $3 million on research and development (R&D) on a potentially new energy source that could well
become a source of revenue in the future for the company. This total represents five cents per share after taxes.
On 1 July 2006, the firm’s price-earnings ratio was 20, reflecting earnings per share of $0.50 and a share price of
$10. Ask yourself the following question: ‘Do you believe that Teutonic’s share price would have been 50 cents
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higher (i.e. five cents in R&D per share times 10), or $10.50, if Teutonic had not spent anything on R&D?’ Of
course not! Teutonic’s expenditures for R&D are its life’s blood in creating its future profitability. Without its
R&D, the firm’s services and new products would evaporate, as would its future cash flows. This simple
example serves to caution against managing for shareholder value by managing the firm’s reported accounting
earnings.
We discussed earnings per share, price earnings ratios (PER) and share valuation in a Focus on Finance in
Chapter 10 (Valuation of bonds and shares). This is what we said:
The appeal of the PER approach to share valuation lies in its operational simplicity and its ‘practical’
focus … Nevertheless. this does not change the fact that the present worth of an asset such as a share is
its intrinsic value, equal to the present value of expected future cash flows discounted at the required
rate of return … Investors look to the cash flows generated by the firm, not the earnings, for value. A
firm’s value truly is the present value of the cash flows it produces.
We have learned in our discussion of capital budgeting in this text that the discounted cash flow valuation model
incorporates investor expectations of future cash flows into the indefinite future as well as the opportunity cost of
funds when estimating value. In this model, the R&D investment used in our scenario would lead to a reduction
in cash flow during the period in which the expenditure is being made, but would correspondingly increase future
cash flows when the anticipated rewards of the investment are being reaped. Hence, the appropriate model for
use in managing the firm for shareholder value is one that focuses on the cash flow consequences of the firm’s
decisions for the future, not just the current period, because this is how investors view their investments.
Free cash flow valuation model
The free cash flow model for valuing a firm provides a method for analysing value as the present value of the
firm’s projected free cash flows for all future years.
We cannot forecast free cash flows for an infinite future, so we generally project them for a finite number of
years called the planning period, perhaps three to five years, and then capture the value of all subsequent free
cash flows using the concept of a terminal value. There are many ways to estimate the terminal value at the end
of a planning period depending on the projected pattern of free cash flows after the planning period. For
example, we may estimate a firm’s free cash flows for each of years one to five in our planning period, and
believe that there will not be further growth in free cash flows for years six to infinity, i.e. the free cash flow for
these latter years will be the same as for year five. This means that the terminal value at the end of year four will
be the present value of a level perpetuity – refer to Perpetuities in Chapter 4.
When we calculate the value of a firm using the free cash flow model, we are using the same basic model we
used in earlier chapters to estimate the value of a capital investment proposal. The three basic determinants of
value are the same. We rely on two fundamental principles:
1.
Risk-return trade-off – we discount the expected firm free cash flows using the firm’s risk adjusted
weighted average cost of capital.
2.
Cash, not profits, is king – we estimate the firm’s free cash flow and not the firm’s accounting profits as
the basis for valuation.
Free cash flow provides the basis for valuing the firm as an entity and is calculated as follows:
4
Net operating income (NOI)
Estimated as revenue less cost of sales and operating expenses
Less: Taxes
Taxes estimated at the level of NOI
Equals: Net operating profit after tax
NOPAT
Plus: Depreciation expense
Add back noncash depreciation
Less: New investments in the period
Increase in current assets less accounts payable and other noninterest-bearing
Additional net working capital
liabilities
Capital expenditure (CAPEX)
New investments made in capital assets during the period
Equals: Free cash flow
Cash available to pay dividends, interest, and principal
Value drivers
Let’s now consider how we can use the free cash flow model to manage the firm for shareholder value. We are
interested in value drivers which can be defined as variables which can be controlled or influenced by the firm’s
management to affect the value of the firm. These are in contrast to historical values which are not manageable
variables. In managing future operations for Australia Co. Ltd (ACL) these could include, for example:
beginning sales, government taxation rate and policies, total liabilities at close of last year, and number of
ordinary shares at close of last year. Such items provide the base values for analysis and are not decision
variables over which management has control for the planning period.
On the other hand, value drivers for ACL represent the variables that are in some degree under the control or
influence of the company management and that are connected in a meaningful way to the determinants of the
company’s value. For a planning period these could include: gross profit margin, operating expenses (before
depreciation), net working capital-to-sales ratio, and cost of capital. Consider the following potential strategies
that the management could consider in their value-based management of ACL.
Sales growth for years 1–3

Implement a new marketing campaign to promote exciting or new products.

Form a distributional alliance to enter a new market.

Invest in R&D to create new products.

Acquire a competitor firm.
Operating profit margin

Initiate cost-profit programs to reduce operating and administrative expenses.

Invest in a promotional campaign aimed at improving the brand image of existing products to support
premium prices.
Net working capital-to-sales ratio

Initiate inventory control policies to reduce the time inventory is held before sales.

Implement credit analysis and control to reduce time taken by customers to pay.

Negotiate more lenient credit terms for supplies.
Property, plant and equipment-to-sales ratio

Consider outsourcing of production to more efficient strategic partners.

Apply stringent controls over acquisition of new plant and equipment to ensure that all purchases are
5
economically viable.

Reduce the need for new plant and equipment by improving the maintenance of existing plant and
equipment.
Cost of capital

Review the firm’s financial policies to ensure that finances are being obtained at lowest-cost rates.

Bypass public market costs by approaching institutional investors for direct sources of funds for new capital
needs.
While these strategies have the potential for increasing firm value it is not certain that they will. For example,
ACL might spend $4 million on a new advertising campaign that only leads to improvements in cash flow of $3
million. This would destroy value by $1 million. Each of the strategies would need to be analysed by
management and decisions made based upon the likely merits of the specific proposal.
Economic value added (EVA)®
Earlier we used market value added (MVA) to measure the total wealth created by a firm at a particular point in
time. As such, MVA is a market-based reflection of investor expectations regarding the total value they expect
the firm to create in the future less the total capital invested in the firm. Stated like this, there is a direct analogy
between MVA and net present value (NPV) for the firm as a whole.
MVA is really a ‘capital concept’ or value of the type that accountants show on balance sheets at specific points
of time, although accountants use historical rather than current or forward-looking values. The link between
successive balance sheets and a means of estimating firm performance for a past period is the firm’s net
accounting income (profit or loss). The equivalent ‘income concept’ to support MVA is an alternative measure to
that of accounting income called economic value added (EVA)®.iv
EVA is the difference between a firm’s net operating profits after taxes (NOPAT) and a capital charge for the
period, being the product of the firm’s cost of capital and its invested capital at the beginning of the period:
EVA ═ net operating profit after tax – (weighted average cost of capital × invested capital)
(3)
Note that EVA is related to accounting profits (i.e. NOPAT ═ net operating income [1 – tax rate]) but differs
because it is reduced by a charge for the capital invested in the firm. The result is a measure of the contribution
of the firm’s operations for the period to the value of the firm and therefore provides a guide to the value-based
management of the firm.
Stern Stewart and Co. originated both MVA and EVA, although it is common for their overall model to be called
the ‘EVA model’.v They recommend a number of adjustments to the firm’s reported traditional accounting
numbers for the express purpose of converting both NOPAT and invested capital from accounting book values to
economic book values.
Accounting standards require R&D spending to be expensed over a number of years, but we believe that the
share market recognises R&D as an investment in the future of the business and not just an annual expense such
as printing and stationery or travelling expenses. Stern Stewart therefore capitalises R&D spending and amortises
it over five years. Other adjustments to accounting profit include adding back abnormal and extraordinary items,
and interest costs which are captured in the firm’s cost of capital. Differences between accounting standards and
economic reality are also recognised when estimating EVA and MVA. Starting with all interest-bearing debt and
6
equity, adjustments are made to reverse the effect of asset revaluations and write-offs, restating equity to that
provided by shareholders. Non-cancellable operating leases are brought on to the balance sheet to ensure that all
capital is recognised.
While they mention more than 160 possible adjustments for US data, only ten to 15 adjustments are more
typically made. These adjustments are made for three reasons:
1.
to convert from accrual to cash accounting (eliminating many of the reserves that accountants have created
in financial statements, e.g. reserves for bad debts);
2.
to capitalise market-building expenditures that have been expensed in the past (converting from a liquidating
perspective to a going-concern perspective, e.g. capitalising expensed R&D); and
3.
to remove cumulative unusual losses or gains after taxes (converting from successful-efforts to full-cost
accounting).
There are at least three major ways in which firms can increase EVA. The companies in the following examples
were part of the 1998 company study discussed earlier. vi
1.
Growth without investing Improving profit without tying up more capital improves EVA. The Victorian
leisure/gaming group, Tabcorp, consistently improved its profit for the three years to 1998 with negligible
new funding. EVA rose to $50 million for 1998 and shareholders were $1.8 billion richer.
2.
Investing capital where the increased profit more than covers the charges for additional capital Woolworths
has held its top-five position for three years to 1998 by consistently investing above its cost of capital.
Amcor, also in the top 20 three years earlier with Woolworths, has fallen to 18, because it spent capital for
poor returns – Amcor destroyed $3.2 billion of MVA.
3.
Shrinking to grow Divesting assets that earn less than their cost of capital. In 1995 Goodman Fielder had
$2.5 billion in capital, but reduced this by $500 million by divesting underperforming Asian and European
operations. EVA was lifted by $63 million and MVA increased by $1.4 billion.
What is the relationship between EVA and MVA, bearing in mind that the objective of value-based management
is to maximise MVA? MVA is the present value of all future EVAs over the life of the firm. Thus, managing the
firm in ways that increase EVA will generally lead to a higher MVA. This is a simplistic interpretation of the use
of EVA that sometimes does not hold. For example, there are situations in which very large capital investments
lead to a decrease in EVA in the near term that is more than offset by future increases in EVA. Thus, simply
maximising EVA is not always the same thing as maximising MVA.
The following examples of MVA and EVA data are from the 1998 company study. vii
The News Corporation had an outstanding year in 1998 with MVA of over $22 billion but EVA was a negative
$844 million. Presumably the market was confident that News Corp. would deliver outstanding earnings growth
in the future and that EVA would follow MVA. Brambles was ranked third in terms of MVA ($4.9 billion) for
1998 but it too had a negative EVA (–$37 million).
The big MVA casualty for 1998 was Coca-Cola Amatil. It led the MVA list for 1997 despite negative EVA
which was expected to improve dramatically because of the company’s exposure to emerging markets in Asia
and Central Europe. It fell to 6th on the 1998 MVA list ($3.8 billion) and registered another negative EVA (–
$468 million).
Wesfarmers and Southcorp both had negative EVA’s (–$8m and –$75m respectively) but still retained their 9th
7
and 10th MVA rankings respectively. The gas utility AGL on the other hand had a positive EVA ($72 million)
and climbed four places from 1997 to 1998 in MVA rankings with $1.5 billion for 1998. The EVA of Harvey
Norman rose sharply to $26 million and it improved its MVA ($1.2 billion) ranking by 19 places (from 33 to 14).
Foster’s Brewing has risen from a MVA rank of 116 to 16 in three years to 1998 despite a negative EVA of $292
million for 1998. The increase in MVA of $2.9 billion for the three years came from the sale of assets and a
heavy reduction in debt plus continued domination of the Australian beer business and entry to the wine
business. Qantas is near the bottom of the MVA rankings with a negative MVA of $923 million but its 1998
EVA was $61 million.
Quite clearly the relationship between EVA and the firm’s MVA for the same period is far from clear.
Discussion of the limitations of EVA as an indicator of value creation is beyond the scope of this chapter. The
interested reader is referred to Martin and Petty (2001) for a detailed treatment of these and related issues. viii
There is an alternative definition of EVA which highlights the fact that a firm creates value only when its return
on invested capital (ROIC ═ NOPAT ÷ invested capital) exceeds its cost of capital:
EVA ═ (return on invested capital – weighted average cost of capital) × invested capital
(4)
If the difference between ROIC and cost of capital is positive then EVA tends to be positive. Using the top and
bottom five MVA rankings below from the 1998 company study this can be seen to be correct.
Rank
Company (MVA)
EVA ($m)
ROIC (%)
Cost of Capital (%)
1
Telstra
2149
20.5
10.0
2
News Corporation
–844
6.8
9.0
3
Brambles Industries
–37
10.5
11.6
4
Coles Myer
202
8.8
6.3
5
Woolworths
150
11.4
8.1
146
Australian National Industries
–65
4.4
8.4
147
Pacific Dunlop
–348
4.6
10.8
148
Crown
–316
–5.4
9.4
149
Qantas Airways
61
7.1
6.3
150
Burns Philp & Co
–172
5.9
12.0
Only four of the ten companies have a positive EVA and in each case their ROIC exceeds their cost of capital.
For the remaining six companies with negative EVAs the reverse is true. Clearly, as we said earlier, a major way
to increase EVA is to invest funds where the increased profit more than covers the charges for additional capital.
Following examination of value drivers, the variables which managers can control or influence to change the
value of a firm, we discussed the conceptual bases for MVA and EVA in Equations (1) and (3) respectively. The
whole emphasis is on maximising shareholder value. The measurement of MVA and EVA has been discussed
and a 1998 company study has highlighted such measurements based on public accounting information for listed
companies.
Stern Stewart argue that their EVA system is more than a measurement system to be used alongside other
financial systems in the firm. It should supersede all financial and operating measures and become the ‘language’
8
used throughout the firm. Using a mnemonic device they describe the four applications of EVA, including the
linking of the system to incentive compensation plans for managers.
The four Ms of EVAix
The four Ms of EVA are measurement, management system, motivation and mindset.
Measurement
The aim of EVA is to translate accounting data and profit into economic reality and true economic value. EVA is
a derivative of free cash flow, and using EVA to evaluate capital expenditure projects will give the same
decisions as NPV.x
Financial managers know that what gets measured gets managed, but in many firms what gets managed is
accounting-based and value drivers can therefore often be ignored. For example, although the NPV of future cash
flows may be used to evaluate capital expenditure projects the results of accepted projects tend to be lost in
accounting profit estimates.
EVA is an economic measure of performance, specifically tailored to the unique circumstances of the firm.
Conventional earnings is adjusted to eliminate accounting anomalies and bring them closer to economic results.
We have discussed the expensing of R&D as one such adjustment. To customise EVA to a firm’s situation, only
five to 15 adjustments may be needed by balancing simplicity with precision. The aim is to improve accuracy
and performance:
The basic tests are that the change is material, that the data are readily available, that the change is
simple to communicate to non-financial managers, and, most important, that making the change can
affect decisions in a positive, cost-effective way. The intuition part of the decision making process refers
to the market.xi
As a firm develops its EVA measure there are three important qualities that it should possess:
1.
EVA should utilise the determinants of corporate value.
2.
Is the focus on R&D?
3.
How should assets shared between divisions be treated?
The design of EVA for a specific firm will have behavioural implications which need to be foreseen. What will
managers be encouraged to do? Will EVA encourage behaviour to increase or destroy value? If capital projects
have negative EVAs for the first few years but positive NPVs thereafter should they be accepted? If divisional
costs of capital differ between sections of the firm how will managers react? How will sales managers react to
being held accountable for the working capital needed for new product lines?
Thirdly, EVA should be an operational initiative to change the operating activities of the firm. Therefore, EVA
should be a measure of performance that is usable and acceptable to managers. It should be kept simple, practical
and able to be reconciled to existing measures traditionally used in the firm.
Management system
EVA could be used by a company simply to provide a measured focus of how it is performing with regard to
shareholder value. However, Stern Stewart claims that the true value of EVA comes in using it as a
comprehensive financial management system under which the goal of increasing EVA is paramount. This would
include:
9

all policies, procedures, methods and measures that guide operations and strategy;

top management decisions including strategic planning, allocation of capital, pricing acquisitions and
divestitures;

setting annual goals; and

day-to-day operating decisions.
This could well entail the deletion of all other financial metrics used in a company which can lead to misleading
decisions by managers. For example, what if the stated corporate goal is to maximise the rate of return on net
assets, then highly profitable divisions may become reluctant to invest even in attractive projects for fear of
actually reducing their overall aggregate returns for the planning period. Poorer divisions on the other hand may
be inclined to invest in projects even if the expected return is below the firm’s cost of capital, in order to increase
their average rate of return. If instead, the focus is on constantly improving EVA, it is more likely that all
managers will make the best decisions for shareholders.
The way that managers establish targets is critical to the success of the EVA financial management system. Stern
Stewart once consulted with a furniture company. In the company’s annual planning process, performance
targets were established (and incentive payments were based on these). Managers submitted plans for
performance to senior management who, aware of the incentive to understate (‘sandbag’) likely future
performance, would negotiate with managers a more acceptable target. This negotiation procedure created an
adversarial climate and led to the hoarding of information at the divisional level. This target-setting process
spread throughout the organisation and the resulting behaviour destroyed value and was therefore contrary to the
interests of shareholders.
Implementing EVA with Stern Stewart meant a change to this process. Multi-year targets were objectively set
with reference to the value drivers in the company needed to improve the share price. This process provided
objectivity and certainty and freed managers at all levels of the organisation to plan for extraordinary
performance, without the threat of being penalised for their ambition.
Motivation
In our introduction to this chapter we mentioned the agency problem in many large companies arising from the
fact that the interests of ordinary shareholders differ from those of top management. This means that such
companies are not run on a daily basis so as to maximise wealth for the shareholders. Rather, shareholder value
tends to be destroyed.
Developing an EVA (value focused) measure of performance within an EVA financial management system is of
little use without a similarly value focused incentive plan for the firm’s decision-makers leading to the best
interests of ordinary shareholders. Managers need to be motivated in the right direction if the agency problem is
to be overcome.
Before we discuss this further we need to take an important sidetrack into firms’ compensation policies.
Basic components of a firm’s compensation policy
Managerial compensation plans generally provide for three types of compensation:

Base pay is the fixed salary component of compensation.

The bonus payment is generally a quarterly, semi-annual, or annual cash payment that is dependent upon
10
firm performance compared to targets set at the beginning of the period. EVA provides one such
performance measure that can be used in this regard.

Long-term compensation consists of share options and grants (such as discounts on share purchases) that are
also made periodically to employees. Share options provide the holder with the right to buy (a call option)
shares of the firm at a specified price (the exercise or strike price). This type of compensation is the most
direct method available to the firm to align the interests of the firm’s employees with those of its
shareholders.
Note that both bonus and long-term compensation are ‘at-risk’ in that both depend upon performance of the
individual and the firm. We often use the term incentive, or performance-based compensation, to describe this atrisk component of managerial compensation.
Designing a compensation program
A firm’s compensation program can be complex. There are four fundamental issues that every firm’s program
must address:
1
How much should be paid for a particular job?
2
What portion of the total compensation package should be in base salary and what part should be incentivebased?
3
How should incentive pay be linked to performance?
4
Finally, what portion of the incentive pay should be paid as a cash bonus and what portion should be in
long-term (equity) compensation?
The design of a compensation program that supports the creation of shareholder value must arrive at a
satisfactory answer to all four of these questions. We will touch on each issue briefly; however, from the
perspective of creating shareholder value, issue number three is particularly important.
Issue 1: How much to pay?
How much to pay for a particular job is dictated by market forces outside the firm’s control. That is, the total
value of the entire compensation package for a given employee must meet a market test. The firm will only be
able to hire sound employees if it offers a competitive level of compensation. The size of the total compensation
package may determine where you go to work, but the mix of base pay and performance-based pay may
determine how hard you will work. Therefore, the key to creating shareholder value lies in linking the incentive
portion of the compensation package to the value drivers determining EVA.
Issue 2: Base pay versus at-risk or incentive compensation
What fraction of the total compensation package should be tied to performance or placed at-risk? There are no
hard-and-fast rules for determining the mix of variable (at-risk) versus fixed compensation. However, in practice,
the firm’s highest ranking employees generally have a larger fraction of their total compensation ‘at-risk’ and the
fraction declines with the employee’s rank in the firm.
Issue 3: Linking pay to performance
The procedure used to link the level of incentive compensation to performance is the same regardless of the
particular performance measure that is chosen. Our discussion about this will be very basic. In practice there are
many possibilities and in most firms incentive pay is based on multiple performance metrics. For example,
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executives may receive 75% of their incentive pay based on financial results and 25% based on personal
objectives. In other cases incentive pay might be based on individual performance, financial performance and
strategic performance.
The following formula is for an unbounded incentive compensation payout:
Incentive pay ═ (base pay)(fraction of pay at risk)(actual performance / target performance)
(5)
Incentive pay is unbounded. That is, there are no limits specified as to the maximum or minimum levels of
incentive pay that can be earned. Incentive pay is a function of the portion of the employee’s compensation that
is at-risk or subject to firm performance (the product of base pay and fraction of pay at-risk) and the firm’s actual
performance for the period relative to a target level of performance. Note that we have not yet specified the
measure of firm performance, although historically this has been in terms of absolute profits or revenue growth,
and sometimes a return on investment measure is used such as return on shareholders funds.
Unbounded plans vary directly with actual performance in relation to target or planned performance with no
floor (minimum) or cap (maximum). Employees are ‘incentivised’ to improve firm performance regardless of the
level of firm performance in such a system.
Most firms do not use an unbounded incentive pay program. Instead they use a system that provides for a
minimum, or threshold, level of performance (in relation to a target level) before the incentive plan kicks in, and
a maximum level of performance (again in relation to the target) above which no incentive pay is rewarded. We
refer to these plans as bounded incentive pay programs.
Consider the example of an 80/120 plan and its possible consequences depending on the measure of performance
that is used for the plan. The minimum or threshold level of performance at which incentive compensation will
be paid is 80% of the budgeted level of performance. The maximum performance for which incentive pay will be
awarded is 120% of the target performance. Incentive compensation is only paid for actual performance that falls
within the 80/120 range. Consequently, there is a wide range of performance for which no incentive pay is
awarded (i.e. performance above 120% or below 80% of the budget). As a result of the boundaries, this type of
program encourages employees to meet their performance targets only within the range of performance for which
the payout varies with performance.
This type of bounded incentive plan also has some unfortunate effects on employee incentives to improve firm
performance. Specifically, consider the effects on employee incentives under such an 80/120 bonus plan that uses
firm earnings to measure performance. Under this plan, managers have an incentive to select accounting
procedures and accruals to increase the present value of their bonus. For example, as it becomes obvious that the
firm’s performance for the budget period (say a quarter or a year) will fall below the 80% threshold, employees
have no direct pay-for-performance incentive to work harder in order to raise firm performance during the
remainder of the budget period. In fact, there is an incentive to reduce the current period performance even
further in the hope that it will lower the budget targets for the coming period. In addition, reducing current period
performance may allow management to shift some or all of the unrewarded performance from the current to the
subsequent budget evaluation period when it hopes to be rewarded for it.
Similarly, perversity can arise at the upper end of the performance spectrum when management realises that the
firm (or division) may exceed the upper bound on the incentive compensation program. If it looks as if the firm’s
performance is going to surpass the maximum payout level, then the employees once again could lose motivation
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to improve performance. First of all, they are not paid for actual performance above the maximum, and second,
they may be able to postpone some of the current period’s business until the next period when they can count it
toward incentive pay for the period.
Issue 4: Paying with a cash bonus versus equity
The amount of incentive pay is determined by firm performance and the particulars of the payout function (i.e.
whether it is bounded or not). However, the form of the compensation is also a vital component of the firm’s
compensation program. Specifically, the firm can pay in cash, shares, or some mix of the two. If the firm chooses
shares, then the employees are rewarded for current performance and are also provided with a long-term
incentive to improve performance.
Baker, Jensen, and Murphy (1988) summarise the case for equity-based compensation as follows:
Compensation practitioners argue that fundamental changes in the ‘corporate culture’ occur when
employees are made partial owners of the firm. The effects of these plans include ‘rooting for the home
team’ and a growing awareness of and interest in the corporate bottom line. We do not understand how
these effects translate into increased productivity, nor do we have a well-developed economic theory of
the creation and effects of corporate culture.
Many executives accept the limitations of traditional accounting performance measurement. What remains less
widely appreciated is the need to align incentive programs with shareholder value objectives.
Many listed companies have made progress in this area by linking executive compensation to share market
performance. ‘But issues remain, particularly with respect to “line of sight”, or ensuring a tangible link between
effort and reward.’xii What is the sentiment created in the minds of divisional managers from a share grant or
share option scheme? The same question needs to be asked for middle management or factory and shop-floor
employees. ‘Do schemes aligned to shares act as an effective incentive or more as a “bonus” – an addition to
employee remuneration that has little to do with their own performance?’xiii
EVA removes this ambiguity. It provides the direct link to the firm’s ordinary share price, but it is also
measurable, able to be compared to established targets and can be affected at any level of the firm.
To instil both the sense of urgency and the long-term perspective of a firm’s owner, Stern Stewart in its
recommendations of EVA programs designs cash bonus plans that cause managers to think like and act like
owners. Under an EVA bonus plan managers make more money for themselves only by creating even greater
value for shareholders. Therefore such bonus plans can have no upside limits.
EVA bonus targets can be reset by formula each planning period. If EVA rises considerably, next period’s bonus
can be based on improvement above the new, higher level of EVA. A portion of extraordinary bonuses can be
‘banked’ and paid out over several years. Bonus banks make it possible to have ‘negative’ bonuses when EVA
drops sharply, to ensure that bonuses are paid only for sustainable increases in EVA.
Mindset
Stern Stewart argues that when implemented in its totality, the EVA financial management and incentive
compensation system can change the corporate culture of a firm.
The EVA framework is, in effect, a system of internal corporate governance that automatically guides
all managers and employees and propels them to work for the best interests of the owners. xiv
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The aim should be to put all financial and operating functions on the same basis, and thus provide a common
language for all employees, across all corporate functions. Two essentials are required for this to eventuate.
It should provide a hierarchical as opposed to a ‘balanced’ scorecard. Because EVA is a measure of total factor
productivity based upon value drivers appropriate to the specific firm it should supersede other accounting,
financial and operating measures.
The second requirement is that EVA be incorporated into decision-making processes. It needs to be customised
and applied to the vast range of decisions in the firm and inserted into formal procedures, including budgeting
and strategic planning.
Summary
Using performance measures that are directly linked to firm value as the basis for compensating managers has
been found to be a strong tool for focusing behaviour on the goal of shareholder wealth maximisation. However,
as simple as the idea might sound, its implementation can be fraught with difficulties. In this chapter, we
provided a framework for analysing both the choice of a performance measure and a discussion of the issues that
must be addressed when linking performance to pay.
Which firms create shareholder value and which ones destroy it? This sounds like a difficult question but, in fact
it can be addressed. We can assess the market’s assessment of whether a firm is creating value for its
shareholders directly using market value added (MVA), which is calculated as the difference in the market value
of the firm (i.e. the sum of market values of all the firm’s securities – debt and equity) less the total capital
invested in the firm.
Throughout this text we have argued that the underlying basis for understanding the determinants of firm value
lies in the discounted cash flow model. With this model of firm value in mind, we then considered the underlying
drivers of free cash flow. We referred to these as value drivers.
We identified a key set of value drivers in the free cash flow valuation model such as operating profit margins.
These drivers, in turn, have their determinants in the actions taken by the firm’s management. For example,
instituting a just-in-time inventory control system can lead to reductions in inventories and, consequently, an
increase in the efficiency with which assets are utilised. Other things remaining the same, this could lead to a
reduction in expenses and an increase in firm value.
Economic value added (EVA) represents a measure of performance that can be used to capture the success or
failure of a firm (or a business unit) to create shareholder value over a specific interval of time or operating
budget period such as one year. Although EVA is related to accounting profits, it differs in that it importantly
incorporates a charge for the capital invested in the firm – equal to the product of the firm’s invested capital at
the beginning of the period and the firm’s weighted average cost of capital. The result is a measure of the
contribution of the firm’s operations for the period to the value of the firm.
By using the four Ms of EVA we discussed the role of EVA as an overall firm financial management system and
managerial compensation program.
Study questions
1
Although the financial goal of large companies should be to maximise the wealth of the ordinary
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shareholders the personal goals of the top managers may be something different. Comment on this statement
and refer to the agency problem that is involved.
2
Refer to Question 1. Discuss solutions known to you that may help to solve the agency problem.
3
What is market value added (MVA) and how is it calculated?
4
Explain the accounting model of equity valuation. What are its limitations?
5
Explain the free cash flow valuation model. In particular, what does the terminal value in this model
represent?
6
What are value drivers? List and describe four value drivers.
7
Define economic value added (EVA). How is it calculated, and how is it related to market value added
(MVA)?
8
List the four Ms of EVA and briefly explain each one.
9
List and discuss the fundamental components of a firm’s compensation program.
10 Explain the behavioural implications of the bounded compensation program.
11 What could be the role of EVA in a firm’s compensation program?
12 Explain how the usage of the full EVA program in a firm could help solve the agency problem referred to in
Question 1.
Endnotes
i
In their book on value-based management, McTaggart, Kontes, and Mankins assert that ‘the great majority of large
corporations throughout the world are not managed with the objective of maximising wealth or shareholder value’,
Managing for Shareholder Returns: The Value Imperative (Free Press, 1994), p. 41.
ii
P. Rennie, ‘The Wealth Creators’, Business Review Weekly (December 7 1998), pp. 64–68.
iii
ibid.
iv
J. Bown, ‘VALUE+ Looking at EVA’, Australian CPA (April 1999), p. 3.
v
ibid, <www.sternstewart.com>.
vi
Rennie op cit.
vii
ibid.
viii
J.D. Martin and J.W. Petty, Value-based management: The corporate response in the shareholder revolution
(Boston: Harvard Business School Press, 2001).
ix
Bown op cit., <www.sternstewart.com>.
x
ibid.
xi
ibid.
xii
ibid.
xiii
ibid.
xiv
ibid.
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