Sie sind auf Seite 1von 81

Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under

the relevant copyright,


designs and patents acts, this publication may only be reproduced, stored or transmitted, in any form or by any means, with the prior
permission in writing of the publishers.

SHAREHOLDER
VALUE
DEMYSTIFIED

MARIA BARBERA MCom (UNSW) is the research officer of the Australian


Centre for Management Accounting Development (ACMAD) at the
University of New South Wales. Her position involves the preparation and
commissioning of research documents that promote organisational
innovation, effective resource management, and inter-organisational learning.
RODNEY COYTE BCom (Melb) MCom (UNSW) AACS joined the
School of Accounting at the University of New South Wales in 1992, and
lectures there in business strategy, management and management accounting.
He previously held a number of senior management positions including
business planning manager and information technology manager for a unit of
the Mars Corporation.

THE AUSTRALIAN CENTRE FOR MANAGEMENT ACCOUNTING DEVELOPMENT


(ACMAD) is a member-driven and member-financed network of almost 100
organisations and universities. Its mission is to stimulate and facilitate
learning about the innovative management of organisational resources. This
series is one expression of its mission. ACMAD welcomes inquires. Further
information about the Centre is provided on its website at:
www.ace.unsw.edu.au/acmad
THE INSTITUTE OF CHARTERED ACCOUNTANTS IN AUSTRALIA believes that the
Strategic Resource Management series will contribute to the clarification of a
range of significant issues facing managers and business professionals in the
future. The practical insights and distinctive perspectives offered will greatly
benefit our members and will add value to anyone who is a strategic business
thinker.
Other books in the series:
Controls in Strategic Supplier Relationships
Suresh Cuganesan, Michael Briers and Wai Fong Chua
Innovative Management Accounting: Insights from practice
Maria Barbera, Jane Baxter and William Birkett
Organisational Learning and Management Accounting Systems:
A study of local government
Louise Kloot, Maria Italia, Judy Oliver and Albie Brooks

STRATEGIC RESOURCE MANAGEMENT

Maria Barbera

Rodney Coyte

SHAREHOLDER
VALUE
DEMYSTIFIED
AN EXPLANATION OF
METHODOLOGIES AND USE

A UNSW Press book


Published by
University of New South Wales Press Ltd
University of New South Wales
Sydney 2052 Australia
www.unswpress.com.au
ACMAD 1999
First published 1999
This book is copyright. Apart from any fair dealing for the purpose of private study, research,
criticism or review, as permitted under the Copyright Act, no part may be reproduced by any
process without written permission. Inquiries should be addressed to the publisher.
National Library of Australia
Cataloguing-in-Publication entry:
Barbera, Maria.
Shareholder value demystified: an explanation of methodologies and use.
Bibliography.
ISBN 0 86840 697 X.
1. Corporations Valuation. 2. Corporations Valuation Accounting.
I. Coyte, W. (Rodney William). II. Title. (Series: Strategic resource management).
332.63221
Printer BPA, Melbourne

CONTENTS
PREFACE ix
INTRODUCTION xi
1

SHAREHOLDER VALUE IN CONTEXT 1


Organisational stakeholders 1
Organisational strategies 3
Organisational performance 4

THE INADEQUACIES OF TRADITIONAL ACCOUNTING MEASURES 6


Accruals, generally accepted accounting principles (GAAP) and cash flow 6
Short-term and long-term considerations 7
Ex-ante and ex-post considerations 7
The inadequacies of accounting earnings 7
The inadequacies of accounting return on investment 8
The inadequacies of accounting return on equity 9
The superiority of market-based measures 9

RAPPAPORTS SHAREHOLDER VALUE ANALYSIS 11


The components of shareholder value 11
The measurement of shareholder value 12
The drivers of value 15

STERN STEWARTS ECONOMIC VALUE ADDED MODEL 16


Calculating EVA 16
The drivers of value 19
Market Value Added 19
Economic profit 21

TOTAL SHAREHOLDER RETURN AND TOTAL BUSINESS RETURN 22


Profitability 22
The cost of capital 24
Growth and free cash flow 25
The drivers of value 26

COMPARING THE MODELS 27


Comparison to traditional accounting 27
Accuracy 27
Summary 28

USING SHAREHOLDER VALUE CONCEPTS 31


The drivers of value 32
Strategy evaluation and implementation at corporate level 34
Setting targets 37
Strategy evaluation and implementation at business unit level 39
Linking shareholder value creation and performance measures 41
Focusing organisational effort 42
Communication 44

CONCLUSION 45
CASE STUDY 1
CASE STUDY 2
CASE STUDY 3

COCA-COLA AMATIL LIMITED48


QANTAS AIRWAYS LIMITED 53
RGC LIMITED 59

APPENDIX A
APPENDIX B
APPENDIX C

THE CAPITAL ASSET PRICING MODEL64


THE PERPETUITY METHOD 67
ADJUSTMENTS TO CAPITAL AND NOPAT IN EVA 67

REFERENCES 68

STRATEGIC RESOURCE MANAGEMENT

Organisations are devices for creating value through the effective use of resources.
While they need to create value for all contributors of resources, a premium is placed
on value creation for customers and shareholders. After all, an organisation is unlikely
to be able to offer inducements to other resource contributors if it does not provide
value to its customers. Also, shareholders are aware that failure in value creation for
customers will be reflected in the value that they can receive. Value creation for
customers and shareholders, then, is broadly regarded as the litmus test for judging
organisational effectiveness.
Value creation by organisations takes place against a backdrop of fast moving
competition in resource and service markets, and increasingly rapid shifts in the value
expectations of customers. Under these conditions it is insufficient to meet or beat
the competition with present service offerings; new service offerings have to be
invented and made competitive, as previous offerings cease to be serviceable and are
thus devalued.
As service offerings change, so will the materials, technologies, skills and
processes that are needed to produce them. New service offerings require different
constellations of resources and new relationships with new resource contributors.
An organisation's strategies define how it proposes to create value for customers
in terms of its service offerings over the immediate period and the opportunities it
seeks over a longer term. Whether or not an organisation will be successful in these
endeavours will depend on its capabilities for doing so.
Strategies, then, have to deal with both the known (the creation of value through
present service offerings) and the unknown (the invention of service offerings that
will create value in an as yet unknown future). And capabilities need to sustain both
the organisation's present effectiveness in offering services and its future renewal by
capitalising on opportunities as they emerge.
An organisation's success in strategy realisation or renewal will be dependent on its
effectiveness and creativity in managing resources. This places a premium on strategic
resource management and on new ways of understanding organisational resources,
resourcing and resourcefulness. What are an organisation's resources, what forms do
they take and how can they be used effectively and not wasted? What constellations of
resources constitute strategic capabilities, useable now in meeting the competition and
converting possibilities into future opportunities? And what strategic capabilities are
sufficiently distinctive to constitute the core competences underlying an organisation's
continuing identity?
These questions are answered in the Strategic Resource Management Series. Each
volume will address them in relation to particular subject matter, drawing on relevant
theories and providing illustrations from contemporary organisational practice.

PREFACE

The interest of organisations in shareholder value has been amply


demonstrated by the number of people attending ACMAD activities and
other conferences on the subject, and by the frequent references to the
methodologies in the financial press. ACMAD feels that, although interested,
many firms are confused about the different methodologies and the claims
made for them. This report is an attempt to redress this uncertainty.
The aim of the report is to provide relevant information about
shareholder value techniques and their use in value-based approaches to
performance measurement, thereby assisting readers in their consideration of
relevant issues. Specifically, this book:

identifies the inadequacies of traditional accounting measures as


performance measures
explains the rationale for the shareholder value approach
describes and compares three of the major methodologies, highlighting
their commonalities and differences
identifies the ways in which consideration of shareholder value can be
applied to strategy selection and implementation
places shareholder value methodologies within organisations'
frameworks for value creation, through a discussion of value-based
management
examines the role of shareholder value measurements in incentive
compensation decisions
relates the experiences of some Australian corporations which have
adopted shareholder value techniques.

In addressing these areas, the report not only explores and compares the
major methods, but also clarifies the purpose and use of the concept of
shareholder value in both strategic and operational decision making. The
conclusion considers the advantages and limitations of shareholder value
analysis. This report should be of value to a range of managers.

Acknowledgments
The authors wish to thank the organisations who agreed to participate in this
project and the senior staff members of those organisations who gave their
time and assistance. Thanks are also due to Mark Joiner (Boston Consulting
Group), Denis Kilroy (KBA Consulting Group), the reviewers, and Professors
Bill Birkett and Wai Fong Chua for their helpful comments.
The opinions expressed in this document are those of the authors only and
do not necessarily represent the views of the National or State committees
of ACMAD.

INTRODUCTION

The quest to create value at an increasing rate over the long term is the focus of
most contemporary business enterprises. While the term `value' means different
things to different stakeholders, the emphasis in this report is on the creation
and measurement of value for one specific stakeholder group: shareholders.
For shareholders, value is created when a business, through the efficient
management of its resources, earns a return greater than the cost of the capital
employed to generate that return. This is not a new concept, but is one that
has attracted the intense focus of managers and investors over the last decade.
Shareholders are interested in the cash increments, over and above outlay, to
be received over the life of their investment: that is the dividends and capital gain
delivered. Whether or not these increments represent value is related to the risk
associated with the investment investors will require a higher return from
investments that are seen to be risky. Arguably, share market prices incorporate
expectations about the value creation potential and the risk of corporations.
In view of the imperative for organisations to create value for their shareholders, how do organisations measure the value created by their operations?
Traditionally, such measurement used accountancy-based indicators such as
earnings, return on investment and return on equity. However, these measures
are not based on cash-flow and do not take into account the full cost of
capital (that is, the costs of equity and of debt). The suggested inadequacies
of accountancy-based measures are summarised in Chapter 2.
New methodologies include three which support the theory that a value
maximising organisation will be interested only in investments which, in
discounted cash flow terms, offer a return greater than the cost of capital.
These three are:

Shareholder Value Analysis (as proposed by Alfred Rappaport)


Economic Value Added (developed by Stern Stewart & Co.)
Total Shareholder Returns and Total Business Returns (developed by the
Boston Consulting Group).

These are not the only methodologies available. Indeed, every consulting
firm appears to have devised its own variation. Nevertheless, these three
incorporate the principles of shareholder value measurement and are
sufficiently different to be of interest. They are described in Chapters 3 to 5
respectively and compared in Chapter 6.
Having measured the shareholder value achieved through their operations,
organisations are faced with the need for initiatives and actions which will impact
favourably on that value into the future. To this end, they develop strategies (that
is, patterns of resource allocation) and select those that, if implemented successfully, will optimally increase shareholder value. Again, shareholder value

xii

SHAREHOLDER VALUE DEMYSTIFIED

metrics are used: for example, to calculate the shareholder value that can be
added by acquisitions or divestments, select between synergistic opportunities,
make decisions about resource allocation, choose between potential product
or service market portfolios and projects, and so forth.
The concept of shareholder value is being adopted by many Australian
companies. It is seen as facilitating, indeed enabling, growth, restructuring,
product and customer selection, and profitability. Much depends, however,
on how well it is understood, how well it is integrated into organisational
thinking, strategic planning, decision-making, and operational activities, and
how efficiently it is used as a motivational device. Understanding is
facilitated by training, and integration is assisted by the introduction of valuebased management concepts. Motivation is sponsored by the introduction of
value-based compensation which effectively links performance and
shareholder value. Such aspects of value-based management are covered
briefly in Chapter 7.
Value, however, is not created by merely measuring financial
performance. Organisations create value in their product or service markets in
the face of competition, ever shorter life cycles, and high levels of
uncertainty and ambiguity. In today's world, value creation depends on
innovation, creativity and collective organisational capability (including the
quality of management). While shareholder value approaches may provide
description and give structure to organisational effort, they cannot substitute
for the wellspring of creativity. Shareholder value creation is, after all, an
outcome of organisational efforts and accomplishments.

A note on terminology, nomenclature and tradenames


The terminology used in this area is extensive and rapidly changing. There
are two reasons for this. Firstly, while shareholder value techniques
developed by individuals or organisations were given specific names (which
are in some cases trademarked), the concepts which underlie these
proprietary names have now become generic. Thus people and journal
articles use words such as `economic value', `value metrics', `shareholder
value' without meaning to specifically refer to one or any of the proprietary
methodologies available.
Secondly, earlier books and articles principally addressed the
shortcomings of accounting numbers, the rationale for shareholder value, and
the application of shareholder value metrics to strategic choices. The focus of
shareholder value has now shifted from the mathematics of shareholder value
to its implementation, management and distillation throughout the
organisation.
In this report, proprietary systems are indicated by the use of proper
names. For instance the Stern Stewart trademarked version is referred to as
Economic Value Added or EVA. Where terms are used generically, lower
case is adopted.

CHAPTER

1
SHAREHOLDER
VALUE IN CONTEXT

Organisational stakeholders
`An organisation is an association of productive assets (including individuals)
which voluntarily come together to obtain economic advantages' (Barney
1997, p. 31). Thus, owners supply capital which is used to acquire assets,
customers provide revenue, employees contribute expertise, government
provides services, the community allows organisations to exist and confers
advantages such as limited liability on corporations, suppliers provide inputs
to production, and so on. Each of these groups can, however, withdraw its
contribution from the organisation and, indeed, will do so unless the value
received (in terms of income or satisfaction) is, after adjusting for risk, at
least as large as that which could be expected from similar alternatives.
In order to ensure that shareholders and the owners of other productive
assets are willing to continue to remain associated with it, the organisation
seeks an equilibrium between the `inducements' it must pay in return for the
`contributions' it receives. The word `equilibrium' suggests that the
organisation will seek to achieve some sort of a balance between its various
stakeholder groups.

Value trade-offs
One problem is that `value' is what a stakeholder group cares about; and
different groups care about different things. The community values high

SHAREHOLDER VALUE DEMYSTIFIED

standards of corporate citizenship, and the provision of employment and


opportunity; employees value personal involvement and job satisfaction, as
well as remuneration; shareholders value investment return and capital gain;
customers value quality, service, price, and so on. An organisation can rarely
implement strategies that fully satisfy the performance demands of all groups,
at least in the short term. Furthermore, the task of isolating and measuring
performance for each stakeholder group would be overwhelming. For these
reasons, the interests of certain stakeholders are usually emphasised over the
interests of other stakeholders over time. Current organisational thinking
concentrates on the creation of shareholder value.
Copeland, Koller and Murrin (1996) justify this emphasis on shareholder
value (as opposed to the weighted approach, which considers all stakeholder
groups, adopted in continental Europe and some Asian countries) by
demonstrating that shareholder value and national economic performance (as
measured by GDP, productivity and job creation) are positively correlated:
Empirical evidence indicates that increasing shareholder value does not conflict
with the long-run interests of other stakeholders. Winning companies seem to
create relatively greater value for all stakeholders: customers, labor, the
government (via taxes paid), and suppliers of capital (p. 22)
All claimants benefit when shareholders . . . use complete information and their
decision-making authority to maximise the value of their own claim. The alignment
of information and incentives within the equity claim is what makes this form of
organisation (the modern corporation) the best competitive mechanism.
Shareholders maximise the value of other claims in the attempt to maximise their
own value (p. 27).

Cash generation
In addition to creating value for the providers of capital (in order to compete
with alternative investment opportunities), an organisation needs the cashgenerating ability to satisfy the financial claims of its stakeholders. It
generates cash from operating its businesses: receiving revenue, and paying
for investments in assets and expenses. Any additional cash required is
obtained from two external sources: debt and equity. Both borrowing power
and the market price of shares depend on the organisation's cash-generating
ability. Lenders will not be prepared to deal, or will require a premium rent, if
the risk of non-compliance with the terms of the loan is high. Equity holders
will be unwilling to provide additional funds if their prospective reward, in
the form of dividends and capital gain, is inadequate or uncertain when
compared with other investment opportunities.

SHAREHOLDER VALUE IN CONTEXT

Organisational strategies
In order to create value for their constituencies, organisations develop strategies:
patterns of resource allocation that enable them to maintain or improve their
performances in particular product and service markets. Organisational
strategies are typified in management literature in three major ways:

as a hierarchical structure, where the mission and objectives are


determined by top management, business-level strategies are decided
upon at business unit level, and appropriate tactics are devised at
operational level
as an on-going process through which a firm analyses its environment,
resources and capabilities to determine how it might gain competitive
advantage and leverage resources to increase that advantage
as some combination of both.

Whichever approach is adopted, the identification of possible strategies


does not obviate the need to select some strategies rather than others.
Shareholder value metrics calculate the impact of potential product/service
market portfolio choices, strategy alternatives, synergistic opportunities,
resource allocation decisions, project choices and so forth on organisational
value. This is done by calculating the potential net cash flows arising over
time and adjusting them (by discounting, or subtracting a capital charge) for
the cost of capital. It thus enables the selection of strategies which will, if
they succeed as planned, optimally increase shareholder value.
Similarly, decisions are made at business unit and operating levels about
markets, technologies and processes, and the allocation of resources (people,
technology, and capital) to activities, products or customer segments. Here,
shareholder value analysis guides the creation of value through the
identification and management of value drivers (those factors which have the
greatest potential to enhance or diminish shareholder value).
Once strategies are defined, the real work starts. How are these strategies
to be implemented? What are the amounts and timing of revenue streams
arising from a project (for a firm is basically a collection of short- and longterm projects)? What resources are required? What technologies will be
used? What are the trade-offs between shareholder and customer value? How
are costs to be measured and controlled? What are the critical performance
factors? How are they to be measured? How can organisational effort be
focused on shareholder value?

Driving value creation


The ability to measure value is a technical exercise in the use of value-based
financial performance metrics (such as those in Chapters 3 to 5) applied to

SHAREHOLDER VALUE DEMYSTIFIED

either the whole organisation, to units within it, or to projects within units.
Measuring value more accurately is an important exercise and can promote
understanding of what outcomes will have an impact on value. However,
measurement in itself will not create shareholder value.
In today's dynamic world, shareholder value creation depends on
innovation, creativity, and collective organisational capability (including the
quality of management). Techniques such as `value-based management' and
`economic value management' are suggested as means of nurturing the
capabilities of an organisation, promoting the ability to put those capabilities
to good effect (for instance, by acquiring strategic assets, developing internal
and external relational contracts, co-ordinating diverse skills and/or
integrating streams of technology), and achieving the integration of
shareholder value concepts and strategic and operational decision-making.
Incentive compensation is believed to have an important role in encouraging
the creation of shareholder value.

Organisational performance
External and internal evaluations
From a shareholder's perspective, the return on investment outlay in an
organisation's ordinary shares is the present value of the dividends received
throughout the life of the investment and the capital gain achieved on sale.
Whether these returns constitute `value' depends on the opportunity cost of
risk-free investment plus a margin for the risk related to the specific
investment.
Stock prices on share markets are not determined solely by the profit per
share, or the net tangible assets per share. They reflect not only the current
state of the company but also the expectations of investors regarding a
company's future growth, risk and return profile and the quality of its
management, in view of the expected future state of the economy and the
relevant industry.
The various shareholder value techniques described in the following
chapters have been designed to reflect shareholder thinking. One test of their
validity is the correlation between the result of the shareholder value
calculation (whether undertaken inside the firm or by an external investor)
and the stock market price. This issue is considered in Chapter 6.
From the viewpoint of the organisation's management, shareholder value
techniques are utilised, not only in the selection of strategies which will
enhance value, but in the implementation and management of those
strategies. Thus, employees at all levels of the organisation are trained in the

SHAREHOLDER VALUE IN CONTEXT

importance of shareholder value concepts and the role each can play in
strategy selection and strategy implementation.

Relativities and benchmarks


Shareholder value added, as measured by movements in the prices of stocks
on the share market, provides organisations with an external benchmark.
Such movements will not always be positive: prices may move up and down
either broadly across stocks or across stocks operating in particular industries
or sectors. However, whether prices are falling or rising, corporations can
assess their relative performance against that of their competitors or peers,
attempt to identify the factors or capabilities that separate top performing
companies from others, and apply this understanding to the creation of
reform programs targeted at key drivers of shareholder value or to the
identification of higher value strategies (Kilroy 1997/1998).
Internally, shareholder value analysis can be used to assess and compare
the value created by individual business units or segments, and to reconsider
current strategies where appropriate.
The issues that arise from the above discussion are:

How should the change in a company's shareholder value be measured?


How can the measure be used in evaluating and selecting strategies?
How can the measure be used in guiding strategy implementation?
How can the measure be used to drive performance improvements and
wealth creation?

CHAPTER

2
THE INADEQUACIES
OF TRADITIONAL
ACCOUNTING MEASURES

Accruals, generally accepted accounting principles (GAAP)


and cash flow
The most common way of measuring corporate performance is through the
use of accounting measures. This is understandable: the information is
extensive and readily available; and produced in compliance with rules
(accrual accounting and generally accepted accounting principles or GAAP)
which are claimed to permit comparisons across firms.
Accounting approaches typically use ratios derived from balance sheets
and profit and loss statements to assess performance. Common ratios are
those directed towards assessing:

profitability (with some measure of profit in the numerator and some


measure of firm size or assets in the denominator)
liquidity (that focus on the ability of a firm to meet its short-term
obligations)
leverage (that focus on the level of a firm's indebtedness)
activity (that focus on the level of activity, usually in relation to time).

Other ratios, such as earnings per share (EPS) and price over earnings,
combine accounting numbers with share market information.

THE INADEQUACIES OF TRADITIONAL ACCOUNTING MEASURES

Criticisms of the use of accounting-generated ratios, as bases for decisionmaking by internal and external users, include the following three:

Accrual accounting based measures do not equate with the cashgenerating ability of the firm.
GAAP allows management some discretion in the choice of accounting
methods. Managerial self-interest or a perceived need to protect the price
of stock can lead to the use of methods (such as of depreciation,
amortisation, asset valuation) which will smooth, increase or decrease
income.
Accounting practice typically undervalues intangible resources.
Alternatively, it ignores such assets because of the difficulty of
ascertaining an objective value.

Short-term and long-term considerations


One problem for external users of accounting reports is the short-term bias
built into accounting measures. In some instances (such as research and
development expenditure, or marketing expenditure), GAAP does not allow
capitalisation unless there is some degree of expectation or certainty that the
expenditures will result in revenues adequate to cover incurred outlays. This
conservatism in asset recognition may discourage managers from accepting
projects with negative short-term effects on profits, even though long-term
prospects may be good.

Ex-ante and ex-post considerations


Accounting information is `ex-post': that is, it adopts a historical aspect in
reporting on past events. Of itself, it provides neither external nor internal
users with prospective information. External users, however, use accounting
information (from annual reports and supplementary releases of information)
to confirm their expectations about a company's success. Internal users
typically use this historical information in strategic planning for subsequent
periods.

The inadequacies of accounting earnings


Rappaport (1986, p. 20) outlines five fundamental reasons why accounting
earnings fail to measure changes in the economic value of the firm:

alternative accounting methods may be employed: different methods for


depreciation, inventory valuation, goodwill amortisation, and so on
both business risk (determined by the nature of the firm's operations),

SHAREHOLDER VALUE DEMYSTIFIED


and financial risk (determined by the relative proportions of debt and
equity used to finance assets) are excluded
accrual based accounting numbers differ from cash flows from
operations
dividend policy is not considered
the time value of money is ignored.

Other shortcomings of using earnings are that they do not consider the
quality of earnings (merely the quantity) or distinguish earnings derived from
operating and non-operating assets. Further, earnings growth does not
necessarily lead to the creation of economic value for shareholders. If the rate
of earnings is less than the cost of capital, then an increase in earnings will, in
fact, correspond with a decrease in shareholder value.

Inadequacies of accounting return on investment


Return on investment (ROI) is derived by dividing earnings by the total
investment in the corporation (that is shareholders' equity plus total debt).
Whereas the earnings figure provides an absolute measure of corporate
performance, ROI provides a relative measure, as it takes account of the
amount of resources used to generate the level of return.
The ROI measure inherits the limitations of the earnings measure as it is,
again, a measure based on accrual accounting. An ROI greater than the cost
of capital does not necessarily lead to an increase in shareholder value, as it
does not necessarily follow that the cash flow generated will exceed the cost
of capital.
As long ago as 1966, Solomon concluded that ROI is neither accurate nor
reliable when compared with a cash flow method discounted for changes in
the time value of money (known as discounted cash flow or DCF) for two
main reasons. Firstly, ROI varies from the DCF return to an extent
determined by:

the length of the project life


the capitalisation policy
the rate at which depreciation is recorded
the lag between investment outlays and the recoupment of these outlays
from cash inflows.

Typically ROI will understate rates of return during the early stages of an
investment and overstate rates of return in later stages, as the undepreciated
asset base continues to decrease.
Secondly, ROI is affected by the rate of new investment. Faster growing
companies or divisions will be more heavily weighted with more recent

THE INADEQUACIES OF TRADITIONAL ACCOUNTING MEASURES

investment projects leading to higher book-value denominators. Thus, their


ROIs will be smaller than for a non-growth company investing at an identical
rate of return (Rappaport 1986, p. 34).

The inadequacies of accounting return on equity


Return on equity (ROE) is calculated in the same way as ROI, except that the
investment figure used excludes the debt of the corporation. It shares all the
shortcomings of ROI and, in addition, is more sensitive to leverage.
An increase in earnings derived from new projects financed by additional
debt will increase the measure, as long as the earnings are greater than the
interest cost of the debt. However, ROE does not take into account the fact
that the increase in the debt increases financial risk, and decreases the value
of the business. Since the increase in financial risk increases the cost of
capital, the company's economic value will be increased only if the additional
debt generates a positive cash flow after discounting that cash flow by a
higher (risk-adjusted) rate. A focus on ROE will encourage corporations to
continue to borrow to finance growth as long as the return is greater than the
cost of the debt. To the extent that this return is lower than the cost of capital
(that is, the weighted average of the cost of debt and the cost of equity),
which has also risen along with the increased financial risk, the economic
value of the firm will decline.
G Bennett Stewart III, co-founder of the management consultancy Stern
Stewart & Co., paints a very clear picture of the limitations of the accounting
model, from which ROI and earnings per share are generated, as a measure of
value creation and, ultimately, as a guide to investment decisions. Using the
results of research into share price movements following changes in
accounting practices and the treatment of goodwill and expenditure on
research and development, he offers evidence to demonstrate that share prices
are determined by expected cash generation, and not by reported earnings: `A
company's earnings explain its share price only to the extent that earnings
reflect cash. Otherwise earnings are misleading and should be abandoned as
the basis for making decisions ... and for determining (management) bonuses'
(Stewart 1991, p. 28).

The superiority of market-based measures


Recently, the concept of shareholder value (the net present value of expected
cash flows discounted by the cost of capital) has gained prominence as a
better measure of enterprise performance. In addition, shareholder value
metrics are claimed to provide:

10

SHAREHOLDER VALUE DEMYSTIFIED

a superior method of analysing and understanding `how much value the


corporation and each of its business units [are] creating for shareholders
and what the options [are] for improving performance' (Rappaport 1986,
p. 52)
a basis for restructuring and managing a corporation so that it creates
value
a means of sponsoring behavioural change in organisations towards
decisions and actions consistent with shareholder wealth creation.

Shareholder value is supported by modern finance theory, which proposes


that economic value is the right yardstick for measuring business
performance, since it reflects both risk and the time value of money.
Broadly, shareholder value analysis is stated to provide a basis or
methodology for managing a corporation which will:

guide strategy formulation and selection at corporate, business unit and


operational levels of the organisation
assist management in reviewing and questioning current strategies and
existing activities and structures
provide the right criterion for pursuing business improvements and
focusing such efforts in the right direction
provide a powerful tool for setting priorities and, through a focus on
value drivers, determine how to act upon them
create value by redirecting managers' focus from accrual accountingbased profits and income statements alone to a focus on all the key
factors that affect shareholder value
help set a focus on the key value drivers in the business.

CHAPTER

3
RAPPAPORTS
SHAREHOLDER
VALUE ANALYSIS

Rappaport presents a method for estimating the shareholder value of the total
firm or business unit. This includes current value (that is, value created in the
past), and the value expected to be created in the future. The `future' is
divided into a specific forecast period (in Rappaport's example, three years),
and the period beyond the forecast period.

The components of shareholder value


The total economic value, or `corporate value', of a business entity is the sum
of its shareholder value and its debt. Therefore:
Shareholder value = corporate value - the market value of debt
`Corporate value' is comprised of:

the present value of cash flow from operations during the forecast
period; plus
the residual value of the business (including marketable securities) at the
end of the forecast period.

`Debt' is future claims to cash flow and would typically include both short
and long term debt, capital lease obligations, unfunded pensions, and other

12

SHAREHOLDER VALUE DEMYSTIFIED

claims such as contingent liabilities. Debt is, in most cases, the accumulation
of several debt instruments. The yield to maturity is used to calculate the
market value of each debt instrument which are then added. Note that the
`market value of debt' is not the `face value of debt'. It is the amount that
would have to be paid today if the debt were to be retired (Fera 1997).

The measurement of shareholder value


In order to determine shareholder value, its elements (cash flow from
operations, residual value, and debt) need to be measured in present value
terms. This is achieved by using DCF analysis with the cost of capital as the
discount rate. These elements are determined as follows:

Cash flow from operations


Cash flow from operations equals cash inflows less cash outflows for the
forecast period discounted by the expected cost of capital over the same
period.

Note: Rappaport (1986, pp. 53-54) defines the `operating profit margin' as the ratio of pre-interest,
pre-tax operating profit to sales. Although a non-cash item, depreciation expense is not added back
in this section of the calculation. Instead, depreciation expense is deducted from fixed capital
expenditures in the calculation of fixed capital investment. Incremental working capital investment is
the net investment in accounts receivable, inventory, accounts payable, and accruals that is
required to support sales growth.

The cash flow from operations for each year (calculated as described
above) is then discounted by the cost of capital to compute present value. The
present values for each year of the forecast period are summed to give the
value of cash flow from operations over the forecast period.
The appropriate forecast period is an issue to be considered by each
organisation or business unit. Although business plans are usually based on
three to five years, this period may result in inaccurate valuation if the
business plan period does not match what Rappaport (1986, p. 77) calls
`value growth duration', that is, `management's best estimate of the number of
years that investments can be expected to yield rates of return greater than the
cost of capital'.

RAPPAPORT'S SHAREHOLDER VALUE ANALYSIS

13

The cost of capital


The cost of capital comprises the cost of debt and the cost of equity capital
(the latter is typically called `the cost of equity'). It is determined by
calculating the weighted average of the costs of debt and equity capital. For
example, if a business is financed 40 per cent by debt at an after tax servicing
cost of 8 per cent, and 60 per cent by equity at an estimated cost of 12 per
cent, and this ratio is not expected to change significantly over the forecast
period, its weighted average cost would be as follows:
Weight (%)

Cost (%)

Debt

40

3.2

Equity

60

12

7.2

Cost of capital

Weighted cost (%)

10.4

The 10.4 per cent figure (the weighted average cost of capital or WACC)
is the appropriate discount rate for this company to use, as it takes account of
the claims of each group shareholders and debtholders in proportion to
each group's targeted relative capital contribution over the forecast period.

Cost of debt
The cost of debt is determined by taking the prevailing rate of interest
charged and the tax rate incurred, and allowing for any expected changes
over the forecast period.

Cost of equity
Estimating the cost of equity over the same period is more complex and is
based on the implicit rate of return required to persuade investors to purchase
or retain the firm's stock. The starting point for estimating the cost of equity
is the risk-free investment rate: the rate that can be earned on government
securities, in particular, long-term treasury bonds.
As investors expect to get a rate of return that will compensate them for
the increased risk of investing in a specific company listed on the share
market (rather than in treasury bonds), a premium for equity risk is
calculated. This is the product of the market risk premium for equity (the
excess of the expected rate of return on a representative market index such as
the All Ordinaries Index over the risk-free rate), and the individual security's
systematic risk: its `beta co-efficient':
Risk premium = beta (expected return on market - risk-free rate)
The value of the beta co-efficient is based on the degree to which the

SHAREHOLDER VALUE DEMYSTIFIED

14

individual security is more or less risky than the overall market. It is


measured by the volatility of its return in relation to that of a market
portfolio. Beta co-efficients for stocks are calculated by running a linear
regression between past returns for that stock and past returns on a market
index. (The beta co-efficients of all listed stocks are available from the
Australian Graduate School of Management at the University of New South
Wales.)
In summary:
Cost of equity

risk-free rate + the risk premium

risk-free rate + beta (expected return on market risk-free rate)

Security analysts use the Capital Asset Pricing Model (CAPM) to


determine the cost of equity for an individual company. The CAPM is
described in Appendix A.

Residual value
Residual value is the anticipated value of the entity beyond the forecast
period. It often forms the largest component of a corporation's value. Its value
depends on the assumptions made for the forecast period and an assessment
of the competitive position of the business at the end of the forecast period.
There is no unique formula for determining residual value: different
methods suit particular circumstances. For instance, an entity adopting a
harvesting strategy during the forecast period would use liquidation values;
whilst an entity seeking to build its market share during the forecast period
would calculate a going-concern value.
The Perpetuity Method is a going-concern method of calculating residual
value. This method recognises that market dynamics will not allow
businesses enjoying excess returns to continue doing so indefinitely.
Eventually, such a firm will face new competition. The Perpetuity Method is
suggested by Rappaport as one method of calculating residual (or terminal)
value and is described in Appendix B. Other methods are:

the use of public information to assess the market's expectation for a


company's value growth duration (discussed in Rappaport 1986)
the application to an organisation of Michael Porter's competitive
structure in the light of the five forces of industries (discussed briefly in
Fera 1997).

Valuing a strategy
To estimate the expected shareholder value to be created by particular

RAPPAPORT'S SHAREHOLDER VALUE ANALYSIS

15

prospective strategic investments in the forecast period, the method is to


calculate the value of the firm at the end of the forecast period; then subtract
its current value (that is, the pre-strategy value):
Value created by strategy = shareholder value - pre-strategy shareholder value
The pre-strategy value is the current residual value of the business. It is
based on current data and does not include any anticipated value creation
from the entity's prospective investments.

The drivers of value


Value drivers are the factors which drive value creation. Rappaport (1986)
lists the financial drivers of shareholder value and presents a model of the
way they relate to management decisions, valuation components (the factors
used in measuring shareholder value), and the corporate objective of creating
shareholder value.
Figure 1
Financial drivers of shareholder value (following Rappaport 1986)

CHAPTER

4
STERN STEWARTS
ECONOMIC VALUE
ADDED MODEL

Since the beginning of the 1990s, EVA has become a widely advocated
method of measuring single period enterprise performance. The methodology
is claimed to be `the one measure that properly accounts for all the complex
trade-offs involved in creating value' and therefore, `the right measure to use
for setting goals, evaluating performance, determining bonuses,
communicating with investors, and for capital budgeting and valuations of all
sorts' (Stewart 1991, pp. 136, 4). EVA is the spread between the rate of return
on capital and the cost of capital, multiplied by the `economic book value' of
the capital employed to produce that rate of return.

Calculating EVA
The formula for calculating EVA is:
EVA

(rate of return cost of capital) x capital employed

(rate of return x capital employed) (cost of capital x capital employed)

net operating profit after tax (NOPAT) (WACC x capital employed)

Note that this formula for evaluating the value created by an organisation
or a business unit in the current year is identical to the formula to calculate
Residual Income (RI) using WACC as the capital charge rate.

STERN STEWART'S ECONOMIC VALUE ADDED MODEL

17

As an example, for an organisation with NOPAT of $250 000, capital of


$2 million, and a WACC of 10 per cent:
EVA

NOPAT (0.1 x $2 000 000)

=
=

$250 000 $200 000


$50 000

However, the figures for NOPAT and capital cannot be taken directly
from conventional accrual accounting based financial statements. Stern
Stewart has identified a total of 164 possible adjustments. The consultancy,
however, recommends making an adjustment only when all the following
apply:

it is likely to have a material impact on EVA


managers can influence the outcome
operating people can readily grasp the purpose of the adjustment
the required information is relatively easy to track and derive.

Adjustments to NOPAT and capital


Extrapolating from the formulae above:

This is, in essence, the ROE formula. The problems associated with this formula
using accrual accounting-based numbers are specified in Chapter 2. The adjustments
to NOPAT and capital in EVA are designed to counter those problems. In EVA, such
adjustments are not confined to those required to convert accrual accounting based
numbers to cash. Rather, adjustments are also made to:

eliminate the effects of gearing (that is changes in the mix of debt and
equity, as such changes confuse the effect of operating and financial
decisions)
include other financing factors such as preferred shareholders and
minority interests (since capital employed and NOPAT should include all
providers of funds)
eliminate accounting distortions.

Some commonly made adjustments are:


1. To eliminate the effects of gearing:
interest-bearing debt and the present value of non-capitalised leases
are added to common equity

SHAREHOLDER VALUE DEMYSTIFIED

18

interest expenses after tax on the debt and the leases are added to
NOPAT.
2. To eliminate other financing distortions:
preferred dividends and minority interest provision are added to
NOPAT
the value of preferred stock and minority interest are added to
capital employed.
3. To convert to cash-based numbers:
taxes are charged to profit only when they are paid (thus also
requiring adjustments to deferred tax reserve accounts)
goodwill amortisation is added back to NOPAT, and accumulated
goodwill amortisation is added back to capital employed (The
reasoning is that intangibles, if they are paid for, are not written off
as they too must earn a return.)
restructuring charges that involve cash payments, and gains or losses
on dispositions of assets, are adjusted in NOPAT (by adding where
losses are sustained and subtracted where gains are made, after tax)
and in the calculation of capital employed
provisions for bad debts and warranties, and other equity equivalent
accounts are excluded (by adjustments) as these practices amount to
taking up losses in advance of their occurrence.
Other adjustments to accounting-based numbers are necessitated, not in
order to achieve cash-based figures, but to reflect economic reality. For
example, depreciation is not added back to profits in EVA. It is viewed as a
true economic expense reflecting the operational use of plant. However, if an
organisation's practice is to base depreciation charges on tax-based
considerations, rather than the operational use of plant, it should be reworked and adjusted in NOPAT and capital employed. Similar considerations
apply to research and development, and advertising and promotion
expenditures. These are not written off in one go for EVA purposes; rather
the write-offs are spread across the estimated useful life of the expenditures.
Marketable securities and construction in progress are subtracted from
capital employed (and presumably any income statement effects are also
eliminated) if these are not part of `operations'.
A list of adjustments taken from The Quest for Value (Stewart 1991) is
shown in Appendix C. Note that this list is based on United States GAAP and
thus includes items (such as LIFO reserves) not applicable in Australia.

STERN STEWART'S ECONOMIC VALUE ADDED MODEL

19

The cost of capital


Stewart views the concept of cost of capital in the same way as Rappaport:
WACC is used in EVA as in SVA. However, Stewart suggests that the
immediate past three-year period be used for the weighting process:
As the minimum rate of return on capital required to compensate debt and equity
investors for bearing risk, the cost of capital is the cut-off rate to create value. The
cost of capital is computed by weighting the after-tax cost of debt and equity by
the relative proportions employed in the firm's capital structure on average over
the trailing three years. (Stewart 1991, p. 743)
The EVA calculation of the cost of debt and equity differs from that in
SVA, in that the cost of debt is determined by the yield to maturity on a
firm's own outstanding and publicly traded debt or, alternatively, on longterm bonds issued by companies of equivalent credit risk; and the cost of
equity assumes that the risk premium typical of common equities is 6 per
cent.

The drivers of value


The drivers of value in EVA are profitability in current operations, and the
amount and cost of capital employed. Stewart (1991, p. 138) states that three
strategies will increase EVA:

improve operating profits without tying up any more capital


draw down more capital on the line of credit so long as the additional
profits management earns by investing the funds in its business more
than covers the cost of the additional capital
free up capital and pay down the line of credit so long as any earnings
lost are more than offset by a savings on the capital change.

Market Value Added


Whilst EVA is a single-period internal measure of a company's performance,
Market Value Added (MVA) is a multiple period measure. Stewart (1991, p.
180) describes MVA as:
. . . the stock market's assessment at any given point of time, of the net present
value of all a company's past and projected capital investment projects. It reflects
how successful a company has invested capital in the past and how successful
investors expect it to be in investing capital in the future.
It is therefore an absolute measure at any point of time. The change in
MVA from one financial year to the next is equivalent to the EVA for that
period. If EVA is positive for the period, MVA will increase; if EVA is
negative for the period, MVA will decrease.

20

SHAREHOLDER VALUE DEMYSTIFIED

MVA can also be a cumulative measure of corporate performance. When


assessing past performance, the organisation can calculate the market value
added (or lost) between two specific dates. Used as a forward-looking
measure, the MVA is the present value of anticipated EVAs with the cost of
capital used as the discounting factor.
MVA is calculated by the difference between a company's fair market
price, as reflected primarily in its stock price, and the economic book value of
capital employed:
MVA = market capitalisation + borrowings - capital employed
It is important to understand that, as capital employed includes all
interest-bearing debt, that same interest-bearing debt must be added to market
capitalisation to calculate the market value added. The methods of calculating
market capitalisation plus borrowings, and capital employed are provided
below. However, in less precise terms, MVA can be thought of as the
difference between market capitalisation and shareholder's equity.
Market capitalisation plus borrowings is calculated as:

the actual market value of ordinary shares at a date times the number of
shares outstanding; plus
the book value of:
preferred shares
minority interests
long-term non-interest-bearing liabilities (except deferred income tax)
all interest-bearing liabilities and capitalised leases and the present
value of non-capitalised leases (estimated by discounting the minimum
rents projected for the next five years by the implicit rate of interest);
minus

the book value of marketable securities and construction in progress


(because these items also are subtracted from capital).

Note that in the last two points above, book value is used. Stewart states:
`Book value is used to approximate the market value of all items except
common equity due to the absence of broad availability of quoted prices' (p.
744).
As shown above, capital employed is subtracted from market value to
obtain MVA. Capital employed is the same as that used for EVA: details of
adjustments are listed under `Adjustments to NOPAT and capital' above
(page 17). Broadly, capital employed is a company's net assets (total assets
less non-interest bearing current liabilities) with three adjustments:
1.
2.

Marketable securities and construction in progress are subtracted.


The present value of non-capitalised leases is added.

STERN STEWART'S ECONOMIC VALUE ADDED MODEL


3.

21

Certain equity equivalent reserves are added:


bad debt reserve is added to receivables
the accumulated amortisation of goodwill is added back to goodwill
R&D expense is capitalised as a long-term asset and smoothly
depreciated over a period approximate to the economic life of the
investment in R&D (Stewart suggests 5 years).

While Stewart shows that MVA moves with EVA, other authors (for
example the Society of Management Accountants of Canada 1995, p. 22)
point out that the former is sensitive to general market movements: `Weak
companies can ride a rising market to big MVA gains that may prove
ephemeral, while robust performers can unjustifiably lose MVA if their shares
fall into a temporary rut'. This is undoubtedly true in the short term (witness
the share market fluctuations in late 1997/early 1998). However, Stewart
defends the long-term efficiency and sophistication of the share market and
quotes evidence to support his stand (see Stewart 1991, pp. 56-67).

Economic profit
Economic profit (EP) is similar to EVA, but does not involve adjustments to
accounting numbers. It can be derived from an equity approach:
EP = (ROE - cost of equity) X book value of equity
or from a total capital approach
EP = (ROI - book weighted WACC) X book value of capital (Kilroy 1996).
As single period measures which are based on book values or adjusted
book values (rather than market values), EP has its limitations. Nevertheless,
such measures do, according to Kilroy (1997/98), give reasonably sound
economic signals concerning strategy choices.
EP is applied, not only to businesses and projects, but also to customers,
customer segments, products and product packs.

CHAPTER

TOTAL SHAREHOLDER
RETURN AND TOTAL
BUSINESS RETURN
Both these methods have been developed by the Boston Consulting Group
(BCG). Total Shareholder Return (TSR) is what it says: the total return to
shareholders that is, the actual capital gain from the beginning to the end
of the financial year plus any dividends paid. It is an ex-post measure used by
top management and external users (investors) to compare an organisation's
performance with the total market, or an appropriate index of peers.
Total Business Return (TBR) is the internal proxy for TSR used by
organisations for assessing future plans, internal business-unit performance,
resource allocation strategies, and for implementing long-term incentives
intended to drive changes in behaviour that generate increased shareholder
value. TBR focuses on the factors which drive capital gains and dividends:
profitability, growth through investment, and free cash flow.

Profitability
For measuring profitability, the BCG suggests Cash Flow Return on
Investment (CFROI):
CFROI represents the sustainable cash flow a business generates in a given year
as a percentage of the cash invested to fund assets used in the business. The
result of the calculation can be expressed as a ratio if economic depreciation is

TOTAL SHAREHOLDER RETURN AND TOTAL BUSINESS RETURN

23

subtracted or as an internal rate of return (IRR) over the average economic life of
the assets involved. CFROI is an economic measure of a company's performance
that reflects the average underlying IRR on all investment projects (BCG2, p. 33)

Calculating CFROI: the IRR method


The first step is to convert accounting data (income statement and balance
sheet) into cash in current dollars. Adjustments, which will vary from
organisation to organisation, are necessary. The process is as follows:
1.

Calculate the cash flow. This is:


net income after tax (but before abnormals); plus
depreciation and amortisation; plus
interest expense; plus
operating rental expense; plus
inventory and monetary items inflation adjustment.
The resulting sum is the current dollar gross cash profit for the year.

2.

Calculate capital employed (cash invested to fund assets). Re-state all


assets in current dollar equivalents (that is, historical investment before
deduction of accumulated depreciation expressed in current dollar
terms). It is necessary to ensure that all cash invested to fund assets, for
example non-capitalised operating leases, are included. Capital
employed equals:
book assets; plus
accumulated depreciation; plus
gross plant current-dollar adjustment; plus
non-capitalised operating leases; minus
non-debt liabilities.
The result of this calculation is the current dollar gross cash investment.

3.

4.

Allow for asset lives, that is the fact that firms have differing asset lives
and asset mixes that are relevant to the performance, and so to the value,
of each business. This step involves the calculation of the amount of
non-depreciating assets (land and inventory, net working capital and
investments) which would remain at the end of the depreciating assets'
working life.
Calculate the IRR. Use present value principles to find the discount rate
at which:
cash profit income
stream

non-depreciating assets
+

released at the end of the


depreciating assets'
economic life

current dollar gross


=

cash investment.

SHAREHOLDER VALUE DEMYSTIFIED

24

If the IRR exceeds the cost of capital in percentage terms, shareholder


value is created. The converse is also true.

The cost of capital


As with other value measuring approaches, TBR uses WACC. The formula is:

where:
Ke = real cost of equity
Kd = real pre-tax cost of debt
D = market value of debt
E = market cost of equity (BCG3, p. 2)

With regard to debt, inflationary expectations which are built into


prevailing interest rates should be deducted if the real cost of debt is to be
used. An analysis of long-term bonds will reveal long-run inflationary
expectations.
For the cost of equity, BCG does not recommend the use of the CAPM
model, which it claims contains two assumptions which are increasingly
under challenge:

that relative volatility (beta) is the only factor affecting the way the
market discounts expected cash flows for an individual stock
that the market risk premium remains stable.

Consequently, BCG estimates the cost of capital by relating market prices


to current and expected future cash flows using its market-derived discount
rate methodology, which prices equities like bonds:
Under this method, current net cash flows are projected forward (for the market
as a whole), allowing for the average rate of company growth and changes in
profitability to move towards long-run averages. Armed with current market
capitalisation and projected net cash flows (i.e. before interest, after capital
expenditure), it is relatively simple to solve for WACC being applied by the
market. The equation can be approximately expressed as:

The schematic is shown on the next page.

TOTAL SHAREHOLDER RETURN AND TOTAL BUSINESS RETURN

25

Figure 2 The Boston Consulting Group's recommended method for estimating the cost of capital

* Spot value is BCG calculated value of a company based on CFROI.

BCG has observed three common failings when organisations apply cost
of capital concepts:
1.

2.

3.

Internal inconsistency, through:


the use of debt rates that reflect maturities significantly different
from the expected life of the project or the depreciable assets
the use of inflation assumptions that do not reflect the inflationary
expectations inherent in prevailing interest rates which are used to
establish part of the discount rate
mixing the treatment of tax (for instance varying between before tax
and after tax numbers) in the cash flows and the interest rate used
using book or proposed gearing of the particular project under
review, rather than target or normal gearing for the company in
market terms.
Using minimum hurdle rates: that is hurdle rates set at the cost of capital.
These will only meet investors' minimum expectations. The objective of
managers should be to exceed this.
Giving too much attention to cost of capital differences between
divisions or business units. It is better to use a single discount rate,
unless some business units have clearly different risk profiles.

Growth and free cash flow


Growth in invested capital producing CFROIs which exceed market
expectations is the second strategy for the achievement of capital gains.
Growth is promoted by free cash flow (also referred to as operating cash flow).
At the corporate level, free cash flow pays for dividends, share repurchase, debt

26

SHAREHOLDER VALUE DEMYSTIFIED

retirement, or investment growth all of which have the potential to increase


TSR. It consists of net cash flow derived by the business units and made
available to the parent in a given year (BCG2). (Note that free cash flow is not
relevant to understanding a company's performance over a single year, as it is
determined by discretionary investments in fixed assets and working capital.)

Projecting future cash flows


Stock market prices are the result of investors' expectations of a company's
future cash flows. Investors are aware that a company which has grown very
rapidly is not likely to sustain that rate of growth indefinitely. Similarly,
companies which have been exceptionally profitable are unlikely to be able to
sustain that level of profitability. Increased competition, new entrants into the
market or the advent of substitutable products will inevitably force profits to
normal levels. (Note the similarity between this view and Rappaport's
Perpetuity Method.) On the other hand, investors are also aware that,
although a company's profitability may be affected by a cyclical downturn,
the upturn will restore profitability eventually.
BCG believes that companies with the primary objective of maximising
shareholder wealth must think like the market. Consequently, in projecting
future cash flows, exceptionally high or low CFROI and investment growth
are `faded' back to sustainable averages. This is termed the `cash flow fade
concept'. It is particularly important when valuations incorporate high
terminal values arising from growth or profitability assumptions beyond the
planning horizon.
The application of this concept means that computing the value of a
business, given only its latest reported performance, involves:

establishing current CFROI performance, using latest results


projecting net cash flows by fading future CFROI and capital growth
rates so they approach long-term market norms
discounting the resulting cash flow using an appropriate cost of capital.

The drivers of value


As indicated above, the BCG methodology offers three value drivers: ROI,
growth, and free cash flow. The return on invested capital can be increased
by either:

gaining increased return on existing capital


investing more capital at ROIs above the cost of capital
reducing capital at ROIs below the cost of capital.

The growth implicit in the second method can, to some degree at least, be
funded by free cash flow.

CHAPTER

6
COMPARING
THE MODELS
Comparison to traditional accounting
The value-based models vary from the traditional accrual accounting-based
model in that the former:

use cash flows, rather than accrual accounting based numbers (EVA is
the exception with regard to depreciation)
give equal weight to both income statement and balance sheet cash
flows, rather than concentrating on income statement flows
use discounted cash flows for decisions applying to entire businesses,
rather than to capital spending proposals only
use the weighted average cost of capital, rather than the time value of
money, as the discounting factor.

Clearly, traditional accounting methods and the shareholder value


methodologies vary in complexity, in that the value-based models start with
accounting numbers and then make adjustments. Complexity is dependent
on the number of adjustments: SVA is probably the simplest, followed by
EVA, with TBR the most complex.

Accuracy
Increasing the number of adjustments to accounting numbers achieves greater

28

SHAREHOLDER VALUE DEMYSTIFIED

levels of `accuracy' in measuring performance. Accuracy, however, can be a


misleading word in this context. Organisations operate in product/service
markets which are characterised by strong competition, rapidly changing
technology, and short product life cycles. Ambiguity and uncertainty abound
in a global world where both local and external events are often unpredictable
and have widespread effects. In the midst of this level of change, organisations
estimate the effect on shareholder value of potential strategies, investments,
projects, technologies, and so on by estimating future cash flows, and the cost
of capital. Behind these estimates are more estimates: of market size, market
share, market growth rate, and selling price; of investment required and the
residual value of investment; of operating costs, fixed costs, and the useful
life of facilities.
If the inputs to all value methodologies contain estimates, perhaps the
level of accuracy, and therefore value to organisations, of each can be judged
by the degree to which the outputs of the measurement process correlate with
stock prices. Academic research long ago established that the movement of
share market prices, after allowing for general market movements, does not
correlate with the financial information contained in annual reports unless
that information has cash flow effects.
Anecdotal evidence (for instance in articles in recent Australian business
magazines, and BCG publications, or the convictions expressed by executives
of various companies using, or about to use, one of these methodologies)
concerning the correlation of share market prices and calculated shareholder
value measures suggests that, while all are good, the more complex the
methodology, the better the correlation.
Academic research of the correlation of EVA and stock market prices is
inconclusive. Dierks and Patel (1997) report on three research findings: Lehn
and Makhija found a significant positive correlation between EVA and MVA
and stock market prices; a University of Washington study found that at best
EVA added `incremental information in some settings'; while Dodd and
Chen found that although stock returns correlated with EVA, the alignment
was similar to that explained by residual income.

Summary
As stressed previously, the use of value-based methodologies does not, of
itself, create value. What they, and indeed traditional accounting
measurement techniques such as ROI and ROE, provide is a more or less
adequate indication of which organisational outcomes have an impact on
shareholder value.
Stewart (1991, pp. 75-76) summarises the shareholder view nicely:

COMPARING THE MODELS

29

... cost of capital can be used to divide projects and, in the aggregate, companies,
industries, and even countries, into three categories:
Group 1: Projects return more than the cost of capital. Because management can
earn a greater return by investing capital inside the company than investors could
by investing in the market, value is created.
Group 2: Projects break even in economic terms. The return earned just covers
the cost of capital, so that no value is created over and above the capital
invested.
Group 3: Projects, a favourite of many large, mature companies with cash to burn,
return less than their cost of capital. Because the return earned on the capital
invested within the company is less than investors could earn elsewhere, an
economic, or opportunity loss is suffered and value is destroyed.
In short, shareholder value will increase if the project generated a positive
cash flow after either:

discounting the cost of capital (SVA and MVA)


subtracting a capital charge (EVA)
comparing the IRR (adjusted for cash flow fade in the long term if
necessary) with the cost of capital (TBR).

Table 1 provides a comparison of the shareholder value methodologies


described in Chapters 3, 4 and 5.
Table 1
A comparison of the shareholder value models
For use by investors and top management
Uses

Measurement

SVA
Not suitable as
changes in stock
prices not
incorporated

MVA
Change in value over
time

TSR
Change in value over
time

Change in (market
capitalisation +
borrowings capital
employed)

(Closing stock price


X no. of shares) +
dividends paid
(opening stock price
X no. of shares)

30

SHAREHOLDER VALUE DEMYSTIFIED

For use within the organisation or business unit


SVA
Uses
Strategy evaluation
(forecasts)
Investment/
divestment decisions
Past performance and
benchmarking
Operational decisions
Incentive
compensation
Measurement
Net cash flows
discounted by the
cost of capital

Drivers of value

Complexity

Useful surrogate

duration of value
growth, sales growth,
operating profit
margin, income tax
rate, working capital
investment, fixed
capital investment,
cost of capital.
Relatively simple
adjustments to
accounting profit

Threshold margin: the


minimum level of
operating profit at
which shareholder
value is created

EVA
Strategy evaluation
Investment/
divestment decisions
Past performance and
benchmarking
Operating decisions
Incentive
compensation

TBR
Strategic planning
Resource allocation
Incentive
compensation

NOPAT (cost of
capital X capital
invested) i.e. residual
income over period
Discount by the cost
of capital if evaluating
forecasts
Profit improvement,
amount and cost of
capital

Estimated closing
value of business +
net cash flow for
period estimated
opening value of
business, i.e. IRR
over period
Profitability, growth,
free cash flow

Complex adjustments
to NOPAT and capital
employed

Complex adjustments
to cash flow and
capital employed.
Includes restatement
of assets in current
dollar terms and
inflation adjustments
applied to monetary
and inventory items.
For projections, uses
Cash Flow Fade
Model.
At business unit level:
Value = Earnings X
P/E multiple
Value = Free cash
flow ÷ cost of capital

CHAPTER

7
USING SHAREHOLDER
VALUE CONCEPTS

The measurement of shareholder value, of itself, achieves little except to alert


management to the fact that value is or is not being created, and to provide an
opportunity to benchmark financial performance in shareholder value terms
against competing firms. The next step, then, is to ask what organisational
changes, initiatives or actions contribute to the achievement of the desired
outcome of being, in Stewart's terms, a `Group 1' organisation.
Proponents of shareholder value believe that the answer lies in the
adoption of value-based management (VBM), which is described by
Copeland et al. (1996, p. 97) as `an integrative process designed to improve
strategic and operational decision-making throughout an organisation by
focusing on the key drivers of corporate value'. VBM operates at corporate,
business unit and operational levels. Corporate managers formulate strategies
based on the creation of shareholder value by the organisation as a whole.
Business-unit and operational managers select strategies, set targets, develop
tactics, design activities, and devise performance measures aligned to
corporate objectives. This alignment of the goal of creating shareholder value,
strategy evaluation and selection, targets, tactics, activities and performance
measures is claimed by Copeland et al. to be why VBM is superior to other
approaches (such as TQM, flatter organisations, empowerment, Kaizen,
team-building) to improving organisational performance.

32

SHAREHOLDER VALUE DEMYSTIFIED

The drivers of value


In Chapter 6 the drivers of value for shareholders were identified as return,
cash flow and asset growth. Underpinning these drivers are Rappaport's seven
drivers of financial value:

revenue growth rate


operating margin growth
the cash tax rate
working capital
capital expenditure
WACC
competitive advantage period (or `value growth duration').

The next layer of drivers are those operational decisions, initiatives and
actions which will have a beneficial effect on the seven financial drivers.
Black et al. (1998, pp. 92-93) classify, under the financial driver headings,
initiatives or tactics that Price Waterhouse has observed being used by global
corporations to generate shareholder value, as follows:
Revenue growth rate
Ensure profitable growth that will add value
Consider new market entry
Develop new products
Globalise the business
Develop customer loyalty programmes
Offer pricing advantage with new distribution orders
Develop focused advertising based on differentiation
Operating margin growth
Modernise working practices
Restructure, including introducing multi-skilling
Cut costs by sharing services and outsourcing
Centralise and consolidate back office and finance functions
(treasury, tax, corporate finance, financial systems)
Introduce business process re-engineering with IT system initiatives
including consolidation and integration of billing, customer care,
activity-based costing, data warehousing, network management and
configuration
Cash tax rate
Consider international holding structure

USING SHAREHOLDER VALUE CONCEPTS

33

Locate and exploit intellectual property and brands


Use co-ordination centres
Customs duty and transfer pricing planning
Minimise foreign and withholding taxes

Working capital
Implement working capital reviews
Improve debtor management
Introduce supply chain management systems and just-in-time
inventory methods
Capital expenditure
Develop capital appraisal and utilisation reviews and project finance
techniques
Weigh up lease versus buy decisions
Develop treasury, hedging and risk management systems
WACC
Build management understanding of cost of capital
Calculate gearing/leverage optimisation
Calculate business-unit-specific WACC
Consider share buy-backs and de-merger of non-core business
Competitive advantage period
Improve investor relations by providing predictable and sustainable
financial performance
Improve business unit cash flow information
Return to core competencies
Develop executive performance reward schemes linked to share
price improvement
Give all employees the opportunity to have an economic stake in the
company
Incorporate strong risk management procedures
A number of other operational value drivers, which can improve the seven
financial drivers above, have been found in the literature or were identified
by firms interviewed by ACMAD. They include:

sales volume
pricing
market share
capacity
product mix

34

SHAREHOLDER VALUE DEMYSTIFIED


selling terms
cost improvements
productivity
wastage
downtime
product/service quality
location decisions
market and promotion
capital budgeting
innovative initiatives
funding choices.

The challenge for the organisation, with a consciousness of the value


drivers that apply, is to:

evaluate and implement strategies at a corporate level which will


maximise value
flow these through to business unit and operational levels.

In this way, decisions and actions throughout the organisation are all directed
towards the objective of shareholder value.
The number of potential value drivers means complexity in selecting the
best strategies/initiatives (that is, the ones which will have the greatest effect
on shareholder value).
The need, according to BCG, is not to identify which aspects of
operations have an impact on value (since most do), but which have the
greatest potential for affecting the overall worth of the company. In BCG's
view, the most effective value drivers must satisfy two requirements:
1.
2.

their impact on value must be substantial, whether it be positive or


negative
they must be manageable by the business.

Sensitivity analysis and value mapping are techniques to measure the


impact of both negative and positive swings.

Strategy evaluation and implementation at corporate level


At the corporate level, strategy evaluation is generally concerned with the
long-term direction of the organisation and the scope of the organisation's
activities, both illuminated by knowledge of the environment in which the
organisation operates. Such issues often involve decisions concerning the
existing or desired portfolio of investments, growth prospects, and related
financing requirements.

USING SHAREHOLDER VALUE CONCEPTS

35

Portfolio analysis
`Portfolio analysis' takes the view that a corporation is a portfolio of
investments, to be managed to produce the best total return. Over the last ten
years, many different approaches to the assessment of business units or
segments have been developed around the world. (For example, BCG's `stars,
question marks, cash cows and dogs' classifications, McKinsey's 3x3 matrix:
see Lewis et al. 1993, Johnson and Scholes 1997).
Proponents of shareholder value methodologies claim that shareholder
value-based analysis can indicate whether a business unit has been earning at
greater than the cost of capital. Wenner and Le Ber (1989) describe such a
process. First, the original cost of each business and the incremental cash
flows into and out of each business in the years between original investment
and the current year is ascertained. When discounted by the cost of capital,
this provides a figure representing the total net investment in each business.
Second, the economic value (net present value of future cash flows and
terminal value) of each business is calculated. The difference between these
figures is the shareholder value expected to be contributed by each business.
A negative figure does not necessarily mean that a particular business should
be closed down or sold. However, it does mean that further analysis of
current and prospective business strategies, operations and (perhaps)
financing is required. It also raises the consideration of alternatives (such as
the feasibility of outsourcing areas of operation).
In Australia, firms appear to be increasingly applying shareholder value
approaches to the evaluation of business unit performance. Pacific Dunlop, a
diversified manufacturing organisation, for example, has recently stated its
intention to measure each business within the group in EVA terms. Any
business which is not providing a positive return will be restructured in terms
of size, focus and allocation of capital. If, after this, it still does not make the
grade then its sale may be an option (Knight 1996).
Divestment decisions are not necessarily simple. Although each business
unit within an organisation may have its own unique competitive problems
and opportunities, there are often interactions between various business units.
For example, an insurance company may have separate business units for life
insurance, general insurance, and superannuation but also a considerable
`cross-sell' factor which may be lost in the event of the sale or closure of any
one of these three.

Growth
Shareholder value analysis is also claimed to be useful in assessing the
desirability of growth in assets through expansion of existing activities,
diversification, or acquisitions and takeovers. In broad terms, shareholder value

SHAREHOLDER VALUE DEMYSTIFIED

36

methodologies assert that growth will increase shareholder value only if the
new investments earn more than the additional cost of capital. Qantas
Airways Limited adopted this principle in 1997 when it considered the
appropriateness of making substantial investments in new international
aircraft. The decision was not to do so at that time but, rather, to lease for the
short-term or use surplus capacity of British Airways (its major shareholder)
if necessary. The company's managing director explained that current low
margins (resulting from strong competition in the Asian market) meant that
increased investment in asset growth would actually damage the business as
the resulting profit would be less than the cost of the additional money
invested.
A common way of achieving growth is through takeovers. In these cases,
the reasons are often complex and based on expectations of operating benefits
and synergies (such as economies of scale, technical and managerial skill
transfer, control over supply or distribution) which may or may not eventuate.
(Hubbard, in Lewis et al. 1993, lists 22 reported reasons for takeovers, only
two of which relate directly to earnings. Shareholder value was not
mentioned.) Further, return and cash flow do not necessarily move in tandem
in growth situations: growth may either diminish cash flows but maintain or
increase return, or increase cash flow but reduce return.
Growth and risk are also interrelated. Black et al. (1998, p. 84) claim that
shareholder value methodologies do not recognise the relationship between
growth and risk (that is, the probability of actually being able to achieve the
expected growth rate):
Many companies are now struggling to fulfil aggressive growth and value
agendas, but fewer recognise that taking risks is essential to both growth and
return. Enterprises must integrate explicit measurements of risk into their strategic
planning in order to identify the possible organisational, cultural, and financial
changes that will be needed to achieve to achieve their SHV [shareholder value]
and growth goals.

Financing
In shareholder value terms, financing strategies are dependent on the
availability and potential return of investment opportunities, and the cost of
the finance. Should opportunities not be available (so the status quo is
maintained) financing strategies would centre around the desired result of
reducing the cost of capital by either:

reducing capital requirements; or


changing the source and mix of debt and equity capital.

Share buy-backs (where corporations repurchase some proportion of their


ordinary shares from shareholders) are one means of reducing capital which is

USING SHAREHOLDER VALUE CONCEPTS

37

consistent with shareholder value principles, if growth opportunities of a


quality which will increase shareholder wealth are not available to the
corporation.
Reducing capital through the retirement of debt is a question of
judgement. One argument is that debt reduction, by reducing risk, may
reduce investors' required rates of return and therefore increase share price.
However, as debt is the cheapest form of capital, a level of debt which is less
than the optimal debt-carrying capacity of the organisation may in fact
decrease share price.
Changing the source and mix of capital may involve swapping debt for
equity, debt swaps, revising terms of debt, and so on. In all cases, the aim is
to optimise the gearing of the organisation.
On the other hand, organisations may have numerous investment
opportunities, and ready access to funding through equity, debt, or an optimal
mix of the two. The task then is one of making investment decisions which
will direct resources to where they make the highest contribution to
shareholder value.

Resource allocation
Organisations use economic value metrics to determine capital allocations to
business units by prioritising proposals or projects according to their ability
to increase shareholder value. Telstra Corporation, for example, intends to
use EVA `to ration and better prioritise its huge capital expenditure program
... with the aim of lifting shareholder value ... over the longer term' (Lewis
1997, p. 7).
Kilroy (1997) suggests that the management of value requires the
establishment of a value-based business planning and resource allocation
mechanism, which he calls an `Internal Capital Market' (Figure 3 on p. 38):
The [internal] market operates in a similar way to the external capital markets by
allocating capital and other resources on the basis of value creation potential. It is
built around a strong business planning process which requires managers to
consider alternative strategies, value their businesses under each alternative
strategy, and build a business plan around the value-maximising strategy.
The difference between this and other resource allocation models is the
explicit recognition that product markets (the source of customer value) and
capital markets (the source of shareholder value) are intimately involved in
allocation decisions.

Setting targets
Part of the language of shareholder value is the incorporation into decisionmaking of financial performance measures that are consistent with
investment at or above the cost of capital. `Hurdle rates' of return are a way
of establishing a target for key projects.

38

SHAREHOLDER VALUE DEMYSTIFIED

Figure 3

Traditionally, companies have established hurdle rates for projects in


ROI, DCF or payback period terms. However, as mentioned in Chapter 2,
ROI is typically not based on cash flow and does not consider the cost of
capital, and DCF, which is cash-flow-based, does not ordinarily use the cost
of capital as the discounting factor. Payback is a relatively simple method
which uses cash inflows and outflows, but lacks precision in estimating the
profitability of projects and ignores the time value of money.
The hurdle rate suggested by Rappaport (1986, p. 69) is the threshold
margin, that is, the minimum operating profit margin (in cash flow terms) a
business needs to attain to maintain shareholder value. Rappaport views it as
a means of bridging the `valuation concepts of modern finance theory and the
needs of corporate decision makers [with] an easily understood, operationally
meaningful concept that enables managers to assess the value creation
potential of alternative strategies'. It needs to be remembered, however, that
at a rate of return equal to the threshold margin, growth will only maintain
value, not increase it.

USING SHAREHOLDER VALUE CONCEPTS

39

While the threshold margin and other methods may be good overall
guides, they are unlikely to be adequate for successful strategy
implementation. Targets need to be tailored to the level of the organisation
(strategic business units, functions, operations), based on key value drivers,
and expressed in financial and non-financial terms. Short-term targets (one
year) are linked to longer targets (say, three years and ten years). The tenyear targets express the unit's aspirations, the three-year targets set the gameplan to achieve the planned progress over the longer period, and the one-year
targets set the immediate goals. Such targets may be accompanied by action
plans which specify a series of steps the business unit will take to achieve its
targets.

Strategy evaluation and implementation at business unit level


Business unit managers also evaluate and select strategies from a range of
possibilities. Within the bounds specified by corporate management, they
take strategic decisions about the markets in which the unit participates, the
technologies and processes utilised, the allocation of resources (people,
technology and capital) to areas of activity, and how the performance of the
business unit is to be measured and assessed.
The strategy selection process at business unit level involves the
identification and clear articulation of the alternative strategies which the
business unit could pursue, as shown in Figure 4.
Figure 4
The strategy selection process at business unit level

40

SHAREHOLDER VALUE DEMYSTIFIED

Probably, additional data gathering or market research will be necessary


before the valuation and the subsequent strategic decision can be made. Such
information is usually derived from:

market related analysis and data


return requirements
product profitability analysis
customer or customer segment profitability analysis.

By linking this information with value driver information, decisions and


actions which will enhance shareholder value are made.
Market related analysis requires information related to customer
requirements or needs, industry structure and forces, competitor strengths
and weaknesses and, importantly, in-house organisational, resources, and
skills competencies that can be leveraged to obtain competitive advantage in
the marketplace.
Return requirements will typically be defined by corporate management
in terms of shareholder value added. Ultimately, returns depend on revenues
(competitive prices) and costs. Costs are the results of operational decisions
in terms of the efficiency of activities and processes, and the effective use of
resource inputs (technology, fixed assets, working capital, people and so on).
Product profitability analysis is conventionally determined using shortterm ROI measures, but may be more useful if based on cash flow projections
over the life cycle of the product. There are various ways in which product
profitability can be improved. For example, resource consumption can be
managed by reducing the costs of resource inputs, reducing the investment in
assets, eliminating non-value activities, and/or improving productivity. On
the revenue side, product differentiation can bring financial rewards by
changing customer perceptions. Synergies between products can provide
incremental sales or differentiation advantages.
Customer or customer segment profitability analysis is an examination of
which customers or customer segments provide most shareholder value, and
analysing whether to enter or exit particular customer or customer segments
and/or shift resources between different products or different customer
groups. Large organisations in Australia are typically undertaking customer
profitability analysis in terms of the differential economic value added. CocaCola Amatil Limited, for example, considers the economic value and growth
potential of its four major customer groups (foodstores, route, vending, and
key accounts), each of which displays differential revenue, cost, asset use and
growth potential. A major bank segments its customers, identifies the needs
of each segment, and designs and develops appropriate products which will

USING SHAREHOLDER VALUE CONCEPTS

41

create segment value. An insurance company takes an individual customer


approach, calculating a `potential lifetime value' on the basis of current
profitability, potential profitability, and a cross-sell factor.

Linking shareholder value creation and performance


measures
The strategic priorities and specific plans developed through value driver
analysis feed into performance measures. To determine appropriate
performance measures, organisations in one way or another establish
financial and non-financial critical success factors (CSFs) or key performance
indicators (KPIs) linked to value creation. For example Qantas Airways:

develops key performance targets for all levels of the organisation, from
the highest to the lowest
links personal and departmental performance to the delivery of
shareholder value.

Another Australian company has, at group level, linked a balanced


scorecard approach to EVA in assessing business unit performance. The
process undertaken was described as follows:
The group office wanted a set of about 16 measures from each of the business
units and we wanted those measures to be consistent across the businesses so
we could see how each one is performing.
So first we looked at our overall vision of the organisation. The next step was
looking at the strategies that the organisation as a whole had in place. And then
looking at the four segments of the balanced scorecard as they support each of
those strategies. A whole suite of measures was determined for each one of
those strategies in the balanced scorecard approach. Then those measures
(there were about 50 of them) were examined with regard to SVA. So all of the
measures that are in there in the SVA approach are consistent with the strategies
because that is how we got the initial fifty. And then the way you cull that down is
to go back and have a look at which ones are going to have most effect on our
SVA. We selected 16. And so we have kept it consistent - balanced scorecard,
SVA and strategic planning.
The 16 levers or drivers are the important ones. There will be, of course, a whole
suite of backup drivers and levers. So if the business unit managements want to
do a drill-down on what the group office say are the important ones, there might
be four or five others that are important and then there might be four or five for
each of those. But the business units themselves will be identifying and working
on the backup drivers. The management of the businesses will be driving that.
The best known balanced scorecard approach is that proposed by Kaplan
and Norton (1996). This performance measurement methodology is claimed
to have significant advantages in that:

42

SHAREHOLDER VALUE DEMYSTIFIED

performance targets are derived directly from strategies and so


consciously focus on the critical areas of the business
financial measures, which report the results of actions already taken, are
complemented by operational measures which are the drivers of future
financial performance
targets and measures cover a variety of perspectives: external (financial
and customer) and internal (business processes and innovation and
learning).

Focusing organisational effort


Creating mindsets
The shareholder value literature emphasises that long-term value creation
requires the cultural transformation of the organisation. All employees need
to have a broad understanding of shareholder value, and accept that
shareholder value creation is the primary objective of the business.
An equivalent term to value-based management, economic value
management (EVM) is, according to Mayfield (1997, p. 32), a way to focus
the organisation and to improve communication and understanding by
providing a common `language':
The great attraction of EVM is that, implemented effectively, it focuses the entire
organisation and helps avoid confusion since it is one measure which is easily
understood. Managers and employees are able to identify the key operating
drivers for which they have responsibility because successful implementation of
EVM assigns accountability to lower and lower levels of the organisation. They
should be able to see how it links through into financial performance and
therefore economic (and shareholder) value. EVM is a very effective `language'
which promises to ease communication and improve understanding both inside
the organisation ... and outside to shareholders and analysts alike.

Training
There is some debate about the degree to which employees at various
organisational levels need to understand the mathematical aspects of
shareholder value methodologies (see the Case Studies). However, there is
agreement that, at the very least, managers and employees need to understand
what economic value is, how it can benefit the company, and how each
employee can assist in its achievement. Corporations such as Coca-Cola
Amatil and Qantas put considerable emphasis on educating employees in the
principles of shareholder value creation, with the aim of encouraging
involvement and changing behaviour.

USING SHAREHOLDER VALUE CONCEPTS

43

Incentive compensation
The last link in the performance loop of an organisation is the reward system.
Organisations and commentators alike mention the opportunity provided by
value metrics to align the interests of managers and shareholders through
incentive compensation. Indeed, Stewart believes this is perhaps the most
important aspect of the methodology.
While doubtless important, the use of value metrics for incentive
compensation is not straight-forward. It is necessary to find the right balance
between the rewarding (for the achievement of planned performance in the
present) and motivating (seeking ever greater value creation in the future)
aspects of incentive compensation.
The Society of Managing Accountants of Canada (1995) quotes O'Byrne's
proposal for a scheme with three elements:

a target incentive award


a fixed percentage interest in EVA improvement above the expected
EVA improvement
a bonus bank.

The target incentive award ensures that managers are competitively


compensated for their efforts, thereby avoiding staff retention problems.
While based on a labour market analysis, it is biased upwards because it is
linked to the achievement of a target EVA. The fixed percentage interest
component applies only to EVA improvement above the target. The bonus
bank aligns management and shareholder interests in that it exposes
managers to risk the risk that they might suffer a negative `bonus'. Annual
bonuses are banked forward rather than paid in full in the first year. In order
for managers to cash in their bonus bank balance, they must continue to
increase shareholder value. The bonus bank smooths the ups and downs of
the business cycle and extends forward managers' time horizon for decisionmaking.
Joel Stern also seeks to align the long and short terms. He suggests that
management and employees be paid bonuses (one-third in advance, with the
remainder delayed) according to their business unit's contribution to EVA
(Jeanes 1996). The concept of a percentage of compensation being `at risk',
which is inherent in this suggestion, is becoming common in Australian
organisations.
Kilroy (CFO, May 1998) suggests an incentive compensation system
based around incremental cash flow and value creation:
In submitting a business plan built around the value-maximising strategy, ... the
business unit general manager is essentially saying to the CEO and the CFO `this
is the value (or cash flow over time) that I can deliver to you' ... If he or she delivers

SHAREHOLDER VALUE DEMYSTIFIED

44

the promised value, and it is greater than the expected cash flow under the
current strategy, then value will have been created for the business. In some
organisations, this understanding is formalised into a performance contract
between the GM and the CEO.
Rewards, then, should be linked to increases in shareholder value over time. For
a listed company, the best way to do this is usually to focus on equity cash flow
(which ultimately equates to dividends plus share price appreciation over time).
For a non-listed company, the focus should be on incremental operating cash
flow.
One issue which remains open at present is the level or levels of the
organisation to which incentive compensation based on shareholder value
should be applied.

Communication
As stated above, economic value concepts are believed to provide an
effective `language' which promotes understanding and communication
within the organisation.
It is also claimed that the language is useful in communicating with
investors, particularly the institutional investors who are the major
shareholders. (Institutional investors today own or manage on behalf of
clients a large percentage of the shares listed on the Australian Stock
Exchanges). The benefits to corporations are that they can:

ensure that the market has sufficient and appropriate information to


evaluate the company at all times
use the `right' (value-based) language in framing press releases
ascertain how investors view a particular organisation's stock and the
likely reactions of fund managers to alternative strategies.

Two companies recently told ACMAD of the importance they attach to


communicating with existing and potential shareholders and understanding
their expectations:
Talking to the market about shareholder value is really trying to generate some
option value. If you can convince them that something different from the typical
fade model is actually going to occur, then you have option value. This is not
rocket science. It is very simple stuff. TSR is the only model I have found that can
give me any guide as to how potential shareholders out there value our stock and
therefore a guide as to what we can do internally to try and improve that value.
(Company 1)
[Since adopting TSR] we have a better understanding of what the share market
expects from us; and we are much better able to communicate with our large
shareholders about what we are doing and what our objectives are. (Company 2)

CONCLUSION

Shareholder value methodologies differ from traditional accounting methods


principally in their preoccupation with cash flows and their use of the cost of
capital as the cut-off rate in determining value-adding investments. These two
factors, it is believed, are what the market is concerned about, and therefore
what corporations should be concerned about. By aligning the thinking of
organisations and their shareholders, shareholder value methodologies are
claimed to:

provide a focus for all decision-makers within an organisation. This


single focus on shareholder value directs and simplifies decision-making
(particularly in times of change and uncertainty) and encourages all
organisational members to `pull in the same direction'.
provide a mechanism to facilitate the allocation of resources to areas of
an organisation which have the capacity to use those resources in a
manner which maximises shareholder value
constitute a performance measurement system which enables
benchmarking externally, and the internal alignment of shareholder
value, strategic planning, operational activities and reward systems
provide a management system which is more comprehensive than other
management systems which have been proposed in recent years (such as
quality, flexibility, empowerment, the team approach) in that economic
value management can incorporate all these others and, with its own
shareholder value focus, use them in a more directed manner
provide a `language' which facilitates communication internally and
externally.

There are, however, limitations. Successful implementation requires a


strong belief in one or another methodology by top management, and a
preparedness to commit substantial effort and resources to driving
shareholder value thinking throughout the organisation.
The methodologies are complex (some more than others) and differences
of opinion exist with regard to the `right way' to measure some elements. For
example, BCG challenges the value of published betas, preferring a marketderived discount rate methodology. This consultancy also advocates the use
of a single organisation-wide discount rate unless some business units have
clearly different risk profiles. The KBA Consulting Group, by contrast,
believes that estimates of both the beta and the debt carrying capacity are
necessary for each business unit.
The need for precision in calculations is open to debate. It is evident that
some organisations take a less formal approach to calculating, for example,
the cost of capital. When asked to describe how it calculated its cost of
equity, one organisation told ACMAD:

46

SHAREHOLDER VALUE DEMYSTIFIED


What we do, we try to assume what our beta would be in regard to the market
average return. So the market average our estimation is that it is about 8% or
7% now (August 1997) for the risk free rate the 10 year Commonwealth
Government bond rate is the reference that you might use. The market premium
for a listed company is approximately 5%. You might argue that it is not, but then
others will argue that it is over the long run. So that's 12% and then we look at our
beta in relation to that 5% excess. Is it a 0.8 beta or is it 1.2 or [what]? Now that's
where there is a lot of subjectivity. I can't say what ours is - but there are
arguments both ways, whatever it is. But we take into account how we feel about
our organisation - is it blue chip? is it not blue chip? would people pay a premium
to be guaranteed a steady rate of return? what are the earnings we have
projected into the future? are they steady? are they going to be lumpy? how is our
dividend flow? We would look at all those sorts of things to come up with what we
think our beta is, take into account dividend imputation, franking credits, etc. and
then bingo, you have got your cost of equity.

Another admitted `You can argue with the maths, you can kick it
whichever way ...' but nevertheless argues:
... if I can get any form of model that gives me a better guide as to what the
shareholder might do and the share price might be, then I'll use it. Because most
organisations only ever look internally, and then they say `we've got all those you
beaut plans, why the hell aren't they in the share price?' But, of course, the guy
out there can't see them. And to me there is real value in having some form of
anticipation of what the guy out there is thinking.
Despite the adjustments made, shareholder value analysis is still based on
accounting numbers. Hence, soft assets (for instance organisational
capabilities, organisational cultures and structures which foster knowledge
transfer and learning, the skills and know-how of employees, corporation
reputation and customer base) are ignored. These are believed to have a large
impact on profitability now, and an even larger impact on future growth and
sustainability. Yet they are not captured in the balance sheet and shareholder
value metrics do not include them in the asset base. (However, the value of
soft assets can be captured by re-valuing the business in the management
accounts at the present value of the expected cash flow under its current
strategy, that is at market value.)
Shareholder value methodologies underestimate creativity. Kilroy
(1997/98, p. 165) believes that the emphasis on value drivers is overstated as
there is a limit to the extent to which costs can be reduced or revenues
increased under the current strategy. New strategies are needed because the
goal posts are always moving:
Management must continually seek to identify higher value strategies. As soon as
a new and higher value strategy is communicated to the capital markets, the

CONCLUSION

47

markets place a value on the new strategy. If the new strategy is well received,
the company's share price rises ... The challenge then becomes to create value
for those shareholders who invested at the new and higher share price. This
challenge can only be met by continually bringing new ideas into play.
We need to accept that shareholder value creation is a creative act, requiring a
combination of creative and analytical thinking skills.
Creativity should be grounded in analysis but should not be suppressed by it.

CASESTUDY

Coca-Cola Amatil Limited


Coca-Cola Amatil Ltd (CCA) is an Australian-based international beverage
company and the most geographically diverse bottler of Coca-Cola
trademarked products in the world. It is a very different company to that
which existed in 1989. At the beginning of that year, Amatil Ltd, as it was
then known, operated tobacco, beverage, snack foods, communications and
packaging, and poultry businesses. A British tobacco company was its major
shareholder. By 1996 it operated solely in the beverage business, held and
operated Coca-Cola franchises in 18 countries, and had the United States
Coca-Cola Company as its major shareholder. Its revenues in the 1997 year
were $4.824 billion (compared with $842 million from its beverage operations
in 1989) and it employed approximately 40 000 people worldwide.

The origins of economic value at CCA


The enhancement of shareholder value has been an objective of Amatil Ltd
for many years. At the time of the re-organisation and the change of name to
Coca-Cola Amatil Ltd in 1988/89, it was a very conscious commitment. Dean
Wills, the chairman and then managing director, commented as follows in the
1989 Annual Report:
The company's prime objective has always been to enhance the value of its
shareholders' investment. As the new Coca-Cola Amatil, we will continue to add
value through the profitable growth of our businesses.
This philosophy of long-term value creation through growth had
underpinned the company's decision to divest itself of the broad range of
businesses it had operated in earlier years and concentrate on beverages. It
continued to guide decision-making about the best way to rapidly expand the
beverage operations.
CCA does not distinguish between EVA and SVA, believing that
`trademark' methodologies in this context are irrelevant. However, the
existence of trademark methodologies which employ different mathematical
formulae make a description of the measurement system used by a particular
organisation important. CCA uses accounting profit less a capital charge as
the measure of economic profit and the change from one year to the next as
the measure of economic value added. The cost of capital comprises the cost
of debt based on a target debt/equity structure, and the cost of equity. For the
cost of equity, it uses the Capital Asset Pricing Model, obtaining its beta
factor from a database at the Australian Graduate School of Management at
the University of New South Wales in Sydney.

CASE STUDY 1

49

Economic profit and economic value added, however, are only two of a
wide range of measures used at CCA. Others include:

market share
accounting profit
return on net assets
net present values.

The process in place


The term `economic profit' is frequently used in CCA. It is measured down to
business unit level in some areas of the company's activities (for instance in
Australasia) and to divisional level in overseas operations where the
businesses are new and rapidly growing but as yet lack the required
sophistication in their information systems to make measurement at business
unit level feasible.
A great deal of thought and planning went into the process of introducing
the concept at business unit levels. Consultants were extensively used in the
initial stages for all the usual reasons - the desirability of having an
independent party involved, their usefulness as agents of change, the fact that
they are extra resources, have different experiences, and so on. It was
considered important to appoint consultants who were in agreement or in
sympathy with the views of the company.
A structured process was followed. It started with training sessions for
business unit managers: explaining the company objective of creating
shareholder value, what it meant theoretically, what it meant practically and
how to manage for its achievement. This was followed by a pilot project
using the consultants, and eventually, the methodology was `rolled out' in a
number of different areas. The aim was to have managers who were thinking
in the same sort of format as the organisational centre that value is not just
volume, not just profit, but also a strategic awareness of the business
environment and a consciousness of the need to obtain an economic return on
assets and, through a more concrete understanding of the economics,
making better decisions.
Over time the concept of economic profit has been introduced to
operational staff, using an explanatory manual expressed in simple terms.
Another form of on-going education for staff has been the use of
presentations in which pilot programs and their outcomes have been
demonstrated.
Resistance has not been a major problem although there was initially a
certain amount of scepticism from operations people. This was alleviated by

SHAREHOLDER VALUE DEMYSTIFIED

50

the fact that the company has been successful in terms in share price
appreciation and many employees were current or potential shareholders as a
result of their participation in the employee share plan or in the option
scheme.
Because of the company's corporate structure, internal disagreements
about estimates did not occur. While management throughout the group is
decentralised, the Board retains authority over capital matters and head office
financial people set the measurement rules. The cost of capital is calculated at
corporate level as it reflects the corporate debt-equity structure; hurdle rates,
risk adjusted where appropriate, are also determined by head office;
managers require head office approval for capital expenditure. Cost
allocations to operational areas are made only where those areas have the
ability to control the costs.

Compensation
The company believes that there is a relationship between compensation and
value creation but regards getting that relationship right as difficult. The
approach adopted by CCA is to provide incentives and to take a long term
view. Share ownership by all employees through the employee share plan is
encouraged. Share options, which have for some years been offered to senior
executives, are now offered to executives at lower organisational levels.
In the near future, the company sees itself moving to a base level of
compensation and an `at risk' portion, which may be a combination of both
cash and equity, plus longer term incentives through both the share plan and
through options.

Diagnostics
The cash concept which underlies CCA's approach to shareholder value is
used to assess acquisitions, proposed initiatives, business development plans,
and specific plans such as distribution channel development. There have been
instances when evaluation has led to plans being reworked. On other
occasions, evaluation has led to the acceleration of plans. However, a
negative net present value does not necessarily result in the rejection of a
proposal; nor does a positive net present value mean the expansion or
multiplication of an initiative. There are two reasons for this:

discounted cash flows necessarily contain assumptions about future


events. If assumptions are wrong, the answer may also be wrong.
Therefore, it is imperative to understand the proposal and the
assumptions behind it

CASE STUDY 1

51

every firm operates in a strategic environment and there are sometimes


actions that have to be taken for strategic reasons, even if they do not
stack up from a cash point of view.

With regard to the impact of new concepts or philosophies on systems, it


is considered that concepts always lead systems. Economic profit is no
exception. Whilst the philosophy is entrenched in the organisation, the
information systems are still catching up. The company is now at the stage
where economic profit on individual product packs, calculated by a number
of different measures, is available on line. It believes it is further ahead than a
lot of companies in this regard. Currently, most of the focus is on getting the
assets understood, accountability for, and control of them defined, and
incorporating asset management into the existing systems.

Customers and suppliers


The company recognises that it is necessary to create value for its customers
as well as for itself. In line with this view, initiatives have been undertaken in
working with trade customers to re-engineer processes. More importantly, the
company feels that the use of economic profit has helped CCA management
to understand retailers' capital and asset structures and appreciate how
retailers think.

Implementation
The cost of capital is defined in head office and is given to operations.
Corporate policy is that, for example, tax and treasury are best centralised. So
business units are not making tax or funding decisions and are evaluated on
their trading profit line excluding items such as interest and tax.
No adjustments are made to account for the differences between
accounting and economic value. Indeed, this is not seen as useful as it is not
compatible with CCA's view that any measurement of value is an indicative,
not particularly precise technique which is useful in relationship with other
pieces of information. It is felt that to go to extremes of accuracy is probably
not adding much to the picture, and that issues such as tax and tax incentives
have little to do with general management operating decisions.
Neither is using economic value or economic profit to measure
performance against other companies seen as useful. Internal benchmarking
against other operations within the group is, however, at a high level of
sophistication.
Internally, economic value is regularly monitored at Board level and is an
integral part of financial planning and budgeting at corporate and operational
levels.

SHAREHOLDER VALUE DEMYSTIFIED

52

Lessons
At the corporate level, the application of shareholder value principles has
been highly successful in CCA. Growth has been rapid, profitability good,
and the share price has consistently outperformed the market. Internally, its
use has facilitated organisational change and sponsored organisational
learning. For example, operational managers now appreciate the impact of
assets on value and sales people have a better understanding of the business
and are thinking differently. There is a common language, desirable
behavioural changes and a better level of internal debate.
The following factors appear to have been instrumental in this success:

the concept of economic value supports the principal objective of the


company
it is the basis of organisational strategy formation
it is a philosophy or belief which has provided a basis for consistent
decision-making throughout the organisation
it has been consistently communicated internally and externally
it was introduced correctly, with commitment by top management, a
consistent approach, a willingness to start slowly and the persistence to
keep going
it is reinforced by the remuneration system.

In CCA's view, the calculation of economic profit and economic value


added is an outcome, the result of the company's approach to the market,
strategic planning and investment decisions. But the philosophy of
shareholder value the long term expectation of future value creation
must, in a decentralised operation, be the basis of all decision-making and an
integral part of the thinking of all employees. As one of the finance people
intimately involved with the introduction of economic value explained:
It is important that [employees] understand it, but not only understand it, but adopt
it and believe it rather than just adhere to it. There is a difference. You are not just
filling out a travel expense form. It is a belief system and should influence
behaviour. From that point of view, ownership of the concept by all is critical. If
you don't have ownership, nothing will happen in terms of change.

CASESTUDY

Qantas Airways Limited


Qantas Airways Limited is a major player in the international and domestic
airline business, ranking tenth in the world in terms of revenue passenger
kilometres. In addition to passenger traffic, the company carries freight both
internationally and domestically. Turnover is around $8 billion and market
capitalisation at current prices (June 1997) about $2.7 billion. In the year
ended 30 June 1997, operating profit before tax was $A403.7 million.
Qantas commenced as a small privately-owned airline in Queensland on
16 November 1920. The name was originally an acronym of `Queensland and
Northern Territory Aerial Services'. In 1947, the original company was
acquired by the Australian Government and Qantas became Australia's
international airline.
Historically, domestic routes were covered by various privately-owned
airlines (notably Ansett Airlines Limited) and by another Australian
Government-owned airline, Australian Airlines (AAL). The government's
privatisation programme resulted in the sale of AAL to Qantas in June 1992.
In March 1993, British Airways acquired from the Australian Government a
25 per cent stake in the now integrated airline. Then, in July 1995, the portion
of Qantas still owned by the government was floated on the Australian Stock
Exchange. The available shares were purchased by institutional and
individual investors.
The view of Qantas top management is that, of its nature, an airline must
operate as a network and that it is the network which creates value. Internally,
the organisation is split into functional divisions: Airport Operations, Aircraft
Operations, Commercial, Associated Businesses, Information Technology
and Finance. There are several subsidiaries including regional airlines,
island resorts, and catering organisations which, while managed
independently on a day-to-day basis, are viewed as part of the group and are
subject to central control with regard to investments, divestments, industrial
relations issues, policies related to image, and standards of safety.
The airline industry is one where intense competition has led to gradually
declining prices, yet large capital expenditure on new technology is a regular
requirement and the cost of inputs is constantly increasing. To increase, and
even maintain, profitability requires a continuous reduction in costs. Qantas
seeks to achieve this through investing in projects which offer cost savings
and constantly revisiting the way it does business with regard to the type of
customer service provided, supplier arrangements, the use of information
technology which enhances efficiency, and work practices in every aspect of
the business. Continuous improvement and business re-engineering is very

54

SHAREHOLDER VALUE DEMYSTIFIED

much a way of life in the battle to be ahead of competitors, who are never far
behind in engaging in change.

The origins of wealth creation


In government-owned airlines in Australia, the prospect of privatisation has
been a powerful driver of change. In the late 1980s and early 1990s when
AAL appeared to be headed towards privatisation, there was an attempt to
prepare the organisation for that event. With the help of the Boston
Consulting Group (BCG) and under the leadership of the chief financial
officer and his staff, AAL began to adopt a value-based management
philosophy. With the purchase of AAL by Qantas, some of the employees
most involved in this initiative left the company and went their own ways. In
1993, after the government's decision to privatise Qantas, they were brought
back with a clear brief to get the company ready for public listing. Again,
BCG was part of the team.
The focus of performance evaluation is TSR, a long-term measure that
looks at capital appreciation plus dividends. This, the finance people in the
company believe, is the ultimate performance measure which will be
maintained for the foreseeable future because it is the most accurate measure
of wealth creation for the shareholders.
TSR is a BCG-derived methodology which is claimed to be widely
accepted, comprehensive, unbiased by size and suitable for benchmarking.
Qantas's present group general manager for financial planning and control
has watched its development since the late 1980s. At that time, he says, it was
a new idea and there were not many believers. However, as time has gone by,
evidence of its worth has accumulated, and converts are now numerous. In
addition to firms, a large number of institutional investors have adopted the
methodology as part of their assessment procedures. The fact that analysts,
investors, and management are now sharing the same philosophy is seen as
positive in that, if management delivers in terms of TSR, recognition by
investors is certain.
The drivers of TSR are profitability (ROI), asset growth, and cash flow.
Profitability is cash-flow-based and termed CFROI (cash flow return on
investment). It represents `the sustainable cash flow a business generates in a
given year as a percentage of the cash invested to fund assets used in the
business' (BCG2). The measure by itself is short-term in nature, and so
ignores growth. However, it has the advantages of including the entire asset
base required to generate cash flows (and so avoids accounting-based
distortions, such as old assets, uncapitalised operating leases and intangibles)
and measuring assets in current-dollar equivalents.

CASE STUDY 2

55

A high CFROI alone, however, will not generate shareholder value. It is


necessary to use these returns to acquire more assets which, in turn, will
generate further high cash flow returns. The methodology recognises that it is
a combination of profitability and growth in business that generates
shareholder value.
Free cash flow is the third driver of TSR. It can be used at the corporate
level to pay dividends, repurchase shares, or retire debt, all of which can
improve TSR performance. At the business-unit level, it is the cash flow
which is available to be returned to the parent for the purposes above or used
for further asset growth.
The following comment indicates the way in which Qantas has
`operationalised' the TSR philosophy:
For investment appraisal, we use discounted cash flows and discounted
paybacks but, if the investments are large, they form part of our longer term
planning we have a three-year corporate plan and, in view of the life of our
aircraft assets, longer term plans and we assess the impact of the investments
on the forecast TSR. We use a modelling technique to forecast what our share
price is going to be in the future. That forecast and the dividends we pay tells us
what the TSR in the future is going to be. Our aim, when assessing investments,
is to ensure that the TSR generated out of those investments is one that will
satisfy the minimum requirements of our shareholders.
It is obvious that, if shareholder value is to be enhanced, the TSR
generated by investments must exceed the cost of equity. At Qantas, the cost
of equity is assessed using the BCG methodology, which derives the cost
from the marketplace:
By looking at the cash flows generated by a business and the value that the
market puts on the investment and the cash flows, we can calculate what
investors believe the return on equity should be. If the cash flow is lower than
anticipated, shareholders through the market mechanism adjust the price to
reflect what they perceive to be the risk associated with the company's
investments and their required cost of equity.
We've used an analysis of our current market price to determine what our cost of
equity is but, of course, it is not only cash flows and the cost of equity that
influences share price in the short term; there are things like market sentiment.
We have also looked at the cost of equity of other airlines in other markets and at
more traditional approaches such as the Capital Asset Pricing Model (CAPM).
There are all sorts of experts out there who can tell you what your beta will be but
we tend to avoid CAPM as we are convinced that the market-derived cost of
equity is more appropriate.

56

SHAREHOLDER VALUE DEMYSTIFIED


But the ultimate check was talking to some of our large investors and talking with
their analysts at a more educated level to try to find out the type of returns that
they are expecting, given the type of industry and the gearing. The one large
factor coming out of it is the relationship between the leverage of the company
and the required returns. The debate about the impact of gearing on share price
is not settled. Some believe that, if leverage is reduced by, for example, raising
equity, there will be a negative impact on earnings per share and a reduction in
share price. The other side, with which we agree, is that lower gearing means
lower risk and, if the cash flow generated out of the business is the same, the
value of the shares will increase. Although raising equity capital may cause
earnings per share to drop, shareholders are, we believe, concerned about longer
term value creation and a lower earnings per share does not automatically
translate into a lower TSR.

The combination of cash flow return on the current value of investments


and growth in assets is seen as vital.

The process that is in place


Impending privatisation was the factor that led the finance director and his
team to ask questions such as: Who are our new owners? What are their
requirements? How do they measure performance? This led to theories of
value creation and the need to manage the company in a way that would
create value. Then followed a lengthy study of the way in which the company
was managed, the types of performance evaluation that it was managed by
and the tools that were employed. One result of this was the establishment of
TSR at the corporate level. Another was a total transformation of the
management and reporting processes to ensure that everything was consistent
with the TSR objective.
At corporate level and at operational level, Du Pont-style analyses are
used to define the value drivers. These are, of course, structured in different
ways but all are directed towards TSR elements. Sensitivity analysis was
employed to identify which value drivers add most value at the end of the
chain. From these value drivers, the company has developed key performance
indicators (KPIs) and tracks, through the Du Pont analyses, the link between
an improvement in a KPI and the impact on value.
Currently, Qantas has three levels of reporting, all of which are directed
towards TSR-related performance measures:

to the Board of directors


divisional reports to the managing director
at operational level.
The use of teams, both cross-functional and in individual functions, has
been extensive in developing KPIs and designing Board and management

CASE STUDY 2

57

reports, as well as in initiatives to improve efficiency and re-engineer


processes.
There is a formal three-year planning process both at corporate and at
divisional level. Once the plan is approved, it is dis-aggregated into the
budget for the first of the three years. Because of the company's investments
in aircraft with a life of 20 years or more and a discounted payback of around
10-12 years, longer-term forecasts are also prepared. In addition, the formal
corporate planning process for the three year period looks at wealth creation.
The calculations are based on traditional accounting statements but the
numbers and statements are converted into cash flows, as described earlier, so
that they provide the value-added and the TSR. As indicated earlier, these
new planning processes have impacted on investment decisions.

Implementation issues
Acceptance roadblocks to the introduction of the shareholder value
methodology have not been encountered although there was initially a certain
amount of scepticism and a lack of understanding. Whether or not it is
necessary for managers at divisional level to have a full recognition of the
benefits of the TSR philosophy is questioned. Although it is essential that
managers understand and accept that the ultimate objective of the company is
to deliver value to shareholders and that the KPIs are directed towards this
aim, it is doubtful that they need to understand the details of the link between
the KPIs and TSR.
Although continuously investing heavily in this area, Qantas agrees with
comments made by other companies that information systems are `never up
to scratch' as far as adequacy goes. Whilst the historical information provided
is regarded as good, the perceived need now is for information systems which
predict the future, thus allowing management to take actions to ensure that
the future is what the company wants it to be. One example is the yield
(quality of earnings from passenger traffic) management system: where on
the basis of past patterns of demand, the company forecasts what the demand
is going to be in the future and takes action in the marketplace to obtain a
favourable result.
The impact on suppliers and customers is generally good. Customer value
is the focus of some of the KPIs selected as it is through customers that the
shareholders get their returns. Nevertheless, there are occasions where
customers expect to receive a level of servicing the full cost of which they are
not willing to pay, and in these cases shareholders do not benefit. The issue is
seen as one of balancing customer needs and wants and shareholder returns.
Value-based management in itself is not seen as affecting relationships

58

SHAREHOLDER VALUE DEMYSTIFIED

with suppliers. It is more the focus on costs that has resulted in relationships
with suppliers becoming more straight-forward and honest.
Compensation issues: At the time of the float, each employee received
$500 of shares in Qantas Limited. This value was dictated by the tax laws at
the time. Since that time, a further $500 share issue has been made to each
member of staff.
All executives participate in a performance-based reward scheme that
provides for cash performance bonuses. The bonuses are paid on the
achievement of pre-determined objectives, including planned profit levels
and/or revenue improvement targets.
Executive directors and certain senior executives also participate in an
Executive Incentive Plan, which provides for a bonus which is related to
Qantas's TSR ranking amongst the top 100 listed Australian companies, and
the TSRs of a pre-determined basket of international airlines listed on
overseas stock exchanges.

The value of the TSR concept


The introduction of TSR has been quite costly in terms of commitment and
effort. However, this cost is seen as worthwhile:
We have an excellent understanding of the concepts; we have a better planning
framework; we have better reporting; we have a better understanding of what the
share market expects from us; and we are much better able to communicate with
our large shareholders about what we are doing and what our objectives are.
To us, the main thing that came out of TSR was the importance of growth in any
strategy. It wasn't a matter of whether we grew or stayed as we were. It was a
matter of finding out what creates value. And this is a combination of growth in
profits and growth in the size of the business.
We believe that all firms should try to understand what makes their share prices
move the way they do and work from there to develop strategies that will deliver
value to their shareholders. They need to understand their cost of capital and cost
of equity, the gearing aspect and how all that impacts on the required return to
shareholders. And then bring it in-house and start working on developing strategies
that will deliver the cash flows and the growth that the shareholders want.

CASESTUDY

RGC Limited
RGC Limited (RGC) is an Australian listed company engaged in the mining
of mineral sands, tin, gold, coal and base metals. Its origins go back many
years to a time when a number of different organisations were engaged in the
mining of various metals around Australia. In the early 1980s, these
combined to form one group. Over recent years, the company has pursued a
growth strategy, exemplified by the 1996 takeover of Pancontinental Ltd.
The group has 13 active mining sites in Australia, Papua-New Guinea and
the United States. In addition, it undertakes exploration in South America, Sri
Lanka, Africa, Australia and Papua-New Guinea.
The management structure is devolved, with each mining site having a
great deal of autonomy. A small head office in Sydney, however, keeps a
close eye on capital expenditure. For short-term planning, RGC uses a rolling
24-month forecast which is adjusted quarterly to adjust for latest
expectations. The forecasts lead directly to the setting of targets for each of
the company's mining sites. These targets are set and monitored by the
general manager of each site and an executive committee member. They
incorporate a degree of `stretch' and thus motivate, focus on controllable
variables (production levels, cost, and safety), and are the basis for a variable
component of the remuneration scheme. Longer term planning is undertaken
through an annual strategy review which involves the Board of directors and
is based on long-term site planning.
Although long conscious of the need to provide value to shareholders and
aware of economic value techniques, RGC has only recently begun to
investigate the adoption of the BCG's TSR/TBR methodology.

RGC's current methods


RGC uses a composite of profit-based measures (accounting profit, return on
investment, return on equity, and earnings per share) to assess corporate
performance. Net present value, internal rate of return and the payback
method are used for asset acquisitions, make or buy decisions, and business
acquisitions and mergers. The most pervasive method for ongoing
management is a sophisticated Du Pont analysis initially introduced to the
organisation some years ago by the BCG and now an integral part of the
operations.
The Finance Director described what he found when he joined RGC:
The Du Pont Charts covered corporate, divisional and operational levels. At each
level, the components were taken out to the right, and actually broken down

60

SHAREHOLDER VALUE DEMYSTIFIED


through the whole organisation so that there were key performance indicators at
all levels. Every function was covered maintenance, production, accounting,
etc. Because of all the little lines drawn on the charts, they became known as
`Plumbing Charts'. Amazing. I hadn't seen any other company do it to that level of
detail.

The high-level components of the Du Pont charts have for some years
been the basis for monthly Board reporting which focuses on profit, cash
flow, return on operating assets and key performance indicators. The
company has found this a useful way of capturing the major performance
measures, financial and non-financial, for each operation. In addition, it has
been seen as:

appropriate for the businesses in that it provides managers with the


necessary information to manage their businesses
understandable to operational people
encouraging an `ownership' mentality
sponsoring a consciousness of operating assets, costs and cash flow.

Cost, in particular, is important to mining companies which are mainly


price takers on their products. The price element in revenue is largely
uncontrollable as it depends predominantly on the world market price for the
various metals and on the United States-Australian dollar exchange rate. The
focus then is on what can be controlled: cost, and being on the low end of the
cost curve for the industry. The logic is simple. There will be commodity price
fluctuations, and companies with the lowest costs are likely to survive longer.
At the strategic level, the company calculates the cost of debt on a group
basis, not at divisional or operational levels. To charge a rate of interest to a
division has traditionally been seen as just another set of allocations. Thus,
instead of allocating a capital charge to divisions, the company takes the
desired return on shareholders' funds and converts that into an appropriate
long-term return for each division. Although a rule of thumb, experience has
shown this to be a reasonable approximation and something that people can
understand.
The optimal level of debt is also considered to exist only in a conceptual
sense. Practically, the level of debt is seen to be a function of the available
projects/investments that the organisation wishes to undertake. If the demand
for capital is low, it does not make sense to borrow more than you need. If
the demand is great and cash flow expectations from new projects are
adequate, the organisation may go above its theoretical optimal level for a
period of time.
Of course, not all investment decisions are straight forward. The
estimated cash inflows and outflows and the discounting rate applied are
necessarily based on assumptions about an investment that can be variable to

CASE STUDY 3

61

a substantial degree. If a project or investment is extremely good and offers


substantial returns, the fact that the calculation is not exactly accurate does
not matter. If it is marginal, the validity of the assumptions is very important.
It is reasonable to say that `simplicity' and `understandability' have long
been the watchwords at RGC. Unnecessary complexity and intricacy are to
be avoided.

The reasons for considering the adoption of the BCG


methodology
Recently, RGC has become disenchanted with the use of accrual accountingbased numbers as the basis for future planning. The company's finance
director believes that the existing strategic process does not adequately
recognise value lost or value created, or provide an adequate basis for
decisions about investments. Two points at issue are investment decisions in
existing mines and the treatment of exploration costs.
With regard to investment decisions in existing mines, he commented:
We have in some cases been spending money chasing volume and not necessarily
value. You can get caught up in the reinvestment trap. You've got an ore body
which is declining and the costs are going up and the revenue coming down. You
have invested so much in it and if you don't spend some more money, the
mine will stop. But if you do spend the money, you know that you will not recoup
the additional investment. We need a new way of looking at these decisions.
Exploration costs are expenses, according to RGC. To capitalise such
costs and carry them on the balance sheet may lead to fluctuations in profit
results, as exploration costs need to be written off if no ore body is found.
The result is that profit fluctuates, not as a result of operational factors but
because of success or failure in exploration.
However, the major asset of a mining company is the ore in ground and,
as it is mined over time, the asset has progressively less and less value. In
mining, the critical issue for the long term is that reserves are replaced so that
the firm stays in business. Companies must either discover or buy resources
so that they can maintain their productive capability. Clearly, exploration has
value and is an investment for the long term future of the organisation.
Indeed, in assessing the success of an organisation in the resources industry,
successful exploration is a major component.
The RGC accounting treatment (expensing exploration expenditure),
whilst very conservative, does not reflect such value on the balance sheet.
This leads to potential misunderstanding of the nature of the expenditure by
decision-makers both within and outside the organisation. The answer is not
necessarily to capitalise exploration expenditures on the balance sheet but,
rather, to ensure that the value of such expenditures is recognised in strategic
decisions.

SHAREHOLDER VALUE DEMYSTIFIED

62

These issues led the company's top management to rethink the strategic
process and to consider the adoption of a different perspective on investment
strategy. Accordingly, BCG were consulted and the company is currently
considering the adoption of TSR and CFROI at the corporate level. The
advantages are seen as:

the BCG methodology's capacity to develop a model that has the ability
to, with some reliability, predict share price and thus provide insights on
the gap between where a firm is and where it needs to be if it is to be
competitive on a shareholder return basis
the enhanced ability of the organisation to make portfolio decisions
based on value
the enhanced ability to plan for the creation of option value which
shareholders will incorporate into share price
the ability to monitor the group's performance against that of its peers on
a TSR basis. This is especially important in the mining industry because,
as in any cyclical industry, there are times when TSR will be negative.
The critical performance issue is whether you are doing as least as well
as your peers.

Issues
RGC questions the need to change in any substantial way its performance
measurement structure at business unit level:
I don't know that it is important to take shareholder value-based measures right
down through the organisation although there do need to be linkages to
operational performance. There has to be people at the edge between strategy
and operations and those people will have to cross the hurdle between one and
the other. We are going to have to think carefully about how we build these
linkages. What you need is effective decision making and performance monitoring
throughout the organisation, which meets the operational needs yet can be
demonstrated to add shareholder value.
To me this is all about the measures and getting them to link in a hierarchy. I don't
believe the dis-aggregation (from corporate to divisional to operational
management) has to be:
(i) perfect; or
(ii) complete.
The points that really matter are that your people understand the linkages and
make better decisions. This means keeping decision criteria and performance
measures simple.

CASE STUDY 3

63

Compensation is another issue. For some time in RGC, a percentage of


every employee's remuneration has been `at risk', that is dependent upon the
performance of the division against key performance indicators. These
indicators at the operational level include output, safety, and cost per unit of
output and will not necessarily change. However, the company believes
that, if TSR is to be introduced successfully, it should be the primary measure
for executive incentives:
I don't think anybody has ever got executive compensation right in terms of
incentive payments. There are, and always were, times when executives win and
times when they lose. There is no such thing as a perfect system. The best you
can do is to focus executives on the critical drivers. Get executives focused on the
right things and the inequities over time should balance out.
RGC was at an early stage in its investigation of shareholder value
concepts when it merged in late 1998. The company's thinking at that time
pointed to the need for shareholder value methodologies to be flexible
enough to suit different businesses' need or desire for simplicity versus
complexity, precision versus approximation, and perfect versus partial
integration throughout the organisation. As the finance director said: `It's
absolutely useless putting in complex measures if people can't use them to
make better decisions. It defeats the purpose.'

APPENDIX

The Capital Asset Pricing Model


Calculating the cost of equity capital brings us more deeply into the world of
finance theory. The staple tool of security analysts in determining the cost of
equity capital is the Capital Asset Pricing Model (CAPM). CAPM is an
`idealised portrayal of how financial markets price securities and thereby
determine expected returns on capital investments. The model provides a
methodology for quantifying risk and translating that risk into estimates of
expected return on equity' (Mullins 1982, p. 105).
The model is based on a series of simplifying assumptions and the
categorisation of risk into two types: systematic and unsystematic.
Unsystematic risk is the risk that is peculiar to the company and can be
diversified away by holding a portfolio of shares. Systematic risk is the
portion of risk related to the movement of the share market that cannot be
diversified away. Consequently, for investors with well diversified portfolios
only systematic (that is, market) risk matters (Mullins 1982, p. 107).
To measure systematic risk, financial analysts normally use the stock's
beta factor, which can be regarded as a measure of the stock's volatility
relative to the market's volatility. For example, a stock with a beta of 1.00
an average level of systematic risk rises and falls at the same percentage
as a broad market indicator such as the All Ordinaries Index. These
conceptual building blocks culminate as the CAPM risk/expected return
relationship (based on the proposition that only systematic risk measured by
beta matters).
The CAPM states that stocks are priced such that:
Rs = Rf + risk premium
Rs = Rf + Bs(Rm - Rf)
where:
Rs = the stock's expected return (the company's cost of equity)
Rf = the risk free rate
Rm = the expected return on the share market as a whole
Bs = the stock's beta.
The risk-free rate is the return on a risk-free investment such as a treasury
bill. The risk premium is measured as:
beta X the expected return on the market the risk-free rate
As the financial literature generally defines the cost of equity (Ke) as the
expected return on a company's stock then the CAPM model can be used to
obtain an estimate of the cost of equity:

APPENDIX A

65

Ke = Rs = Rf + Bs(Rm - Rf)
where:
Ke = the company's cost of equity
Determining the cost of equity involves developing estimates for future
values of the risk free rate (Rf), the expected return on the market (Rm), and
beta (Bs).

APPENDIX

The Perpetuity Method


The Perpetuity Method provides a means of calculating the residual value of
an organisation which is going concern. It is based on the assumption that
market dynamics will mean that new businesses enjoying excess returns
(above the cost of capital) will eventually face new competition. This in turn
will create excess capacity, drive down margins and reduce the returns of all
competitors in that industry to the minimum acceptable or cost of capital rate.
The method assumes that after the forecast period the business will earn,
on average, the cost of capital on new investments. In this situation, periodby-period differences in future cash flows do not alter the value of the
business. As a consequence these future cash flows can be treated as if they
were a `perpetuity' or an infinite stream of identical cash flows (Rappaport
1986, p. 61).
The present value of a perpetuity then is the value of the annual cash flow
divided by the rate of return as follows:

Using the perpetuity method, the residual value is determined as:

For example, say the Company X generated $25 million in cash flow in the
previous year. If it were to continue to generate $25 million annually into
perpetuity, and its cost of capital is 12.5 per cent, the value of the company
would be equal to $200 million, that is:

APPENDIX

Adjustments to capital and NOPAT in EVA


The following is adapted from Stewart 1991, p. 112. For further details
regarding the nature of these adjustments, refer to pp. 113-17 of this source.
For EVA calculation, add the following to `capital':

deferred tax reserve


LIFO reserve
cumulative goodwill amortisation
unrecorded goodwill
(net) capitalised intangibles
full-cost reserve
cumulative unusual loss/gain after taxes
other reserves, such as:
bad debt reserve
inventory obsolescence reserve
warranty reserve
deferred income reserve.

For EVA calculation, add the following to NOPAT:

increase in deferred tax reserve


increase in LIFO reserve
goodwill amortisation
increase in (net) capitalised intangibles
increase in full-cost reserve
unusual loss/gain after taxes
increase in other reserves.

REFERENCES

Barney, Jay B, Gaining and Sustaining Competitive Advantage, Addison-Wesley, 1997.


Black A, Wright P and Bachman JE, In Search of Shareholder Value: Managing the Drivers of
Performance, Financial Times Management, 1998.
Boston Consulting Group, Drivers of Value, Managing for value series, Boston Consulting
Group [BCG4].
Boston Consulting Group, Estimating the Cost of Capital, Managing for Value Series, Boston
Consulting Group [BCG3].
Boston Consulting Group, Financial Benchmarking, Managing for Value Series, Boston
Consulting Group, 1995 [BCG1].
Boston Consulting Group, Shareholder Value Metrics, Shareholder Value Management booklet
2, Boston Consulting Group [BCG2].
CFO, `How to measure value creation', CFO, May 1998, pp. 48-50.
Copeland T, Koller T and Murrin J, Valuation: Measuring and Managing the Value of
Companies, 2nd ed., John Wiley, 1996.
Dierks PA and Patel A, `What is EVA and how can it help your company?', Management
Accounting, November 1997, pp. 52-58.
Fera N, `Using shareholder value to evaluate strategic choices', Management Accounting,
November 1997, pp. 47-51.
Jeanes M, `EVA looking for likely companies', Australian Financial Review, 13 December 1996,
p. 36.
Johnson G and Scholes K, Exploring Corporate Strategy: Text and Cases, 4th ed., Prentice Hall,
1997.
Kaplan RS and Norton DP, The Balanced Scorecard: Translating Strategy into Action, Harvard
Business Press, 1996.
Kilroy D and Zmood S, `Calculating business unit costs of capital', Australian Corporate
Treasurer, 12, 1997, pp. 13-16.
Kilroy D, `Managing for value: the role of the corporate treasurer in a value-managed company',
Australian Corporate Treasurer, 6, 1997, pp. 21-24.
Kilroy D, `Measuring, creating and managing shareholder value', Reward Management Bulletin,
December 1997/January 1998, pp. 159-65.
Kilroy DB and McKinley MT, `Stop analysing and start thinking: the importance of good
thinking skills in a value-managed company', Management Decision, 35, 3, 1997, pp. 18593.
Knight E, `EVA: PacDun's new mistress', Sydney Morning Herald, July 19 1996, p. 37.
Lewis G, Morkel A and Hubbard G, Australian Strategic Management: Concepts, Context and
Cases, Prentice Hall, 1993.
Lewis S, `Telstra on the EVA of performance campaign', Australian Financial Review, 18
December 1997, p. 7.
Mayfield John, `Economic value management: the route to shareholder value', Management
Accounting, 75, 8 September 1997.
Mullins DW, `Does the capital asset pricing model work?', Harvard Business Review,
January/February 1982, pp. 105-114.
Rappaport Alfred, Creating Shareholder Value: The New Standard for Business Performance,
The Free Press, 1986.
Society of Management Accountants of Canada, Improving Shareholder Wealth, Management
Accounting Issues paper 11, 1995.
Solomon E, `Return on investment: the relation of book yield to true yield', Research in
Accounting Measurement, American Accounting Association, 1966.
Stewart G Bennett III, The Quest for Value: A Guide for Senior Managers, Harper Business,
1991.
Wenner DL and Le Ber RW, `Managing for shareholder value from top to bottom', Harvard
Business Review, November/December 1989, pp. 52-65.