Stampede to replace the principle of profit

NOT content with the welter of ugly acronyms much beloved of businesses as measures of performance, American companies are inventing yet more. According to a recent survey by the US Institute of Cost Management Accountants, nearly two-thirds of companies are losing faith in accounting-based performance measures and seeking new ‘value criteria’ to get a better handle on their businesses.

Driving the stampede to the new measures (or ‘metrics’ as they are fashionably known) is the obsession with shareholder value, itself booted merrily along by the tidal swell of management share options. What performance measurements best correlate with movements in a company’s share price? How can a company boost the share price and shareholder value?

This is much more than a debate about measuring performance. How companies measure value determines how they are run. In its golden years, for example, Hanson measured the performance of all its businesses in terms of return on capital employed. It worked – but only for a time. When the world and the stock-market changed, Hanson didn’t, and self-destructed on its own performance metric.

Michael Black, the vice-president of management consultancy CSC Index, tells of a bank that bought a growing life insurance firm and imposed a strict return-on-capital regime. It was the wrong test to use: any growing insurance company will eat capital because costs come early, whereas returns take longer. But management remuneration was tied to return on capital, so it fired the sales force and the firm stopped growing. After four years return on capital (and managers’ pay) had soared – but the insurance business was worth half its original price. Says Black: ‘The bank had in effect paid the managers to destroy the company.’

For many managers and investors the easiest and most familiar measure – profit – has long lost legitimacy because it is easy to manipulate and backward-looking.

There are several contenders for the new favoured measure, and they all involve measuring business cash flows against the cost of generating them.

Most fashionable is probably Economic Value Added,the offering of New York consultancy Stern Stewart, which boasts 250 corporate customers, including Coca-Cola and AT& T in the US and Lucas Varity and Burton in the UK.

Its greatest rival is ‘cashflow return on investment’, or CFROI, promoted by the Boston Consulting Group and HOLT Value Associates.

Price Waterhouse claims a rush of European converts, from banks to utilities, to its ValueBuilder, a software-based process that aims to provide a breakdown of the cashflow variables. It identifies seven ‘drivers’, which can be changed to show, for example, how sales growth or working capital will affect shares. Price Waterhouse says it can be used to incorporate shareholder-value principles into decision-making at both divisional and plant as well as board level.

Since all the methods are based on the same figures, the argument is not over arithmetical ‘correctness’ but managerial appropriateness.

EVA, being a yearly measure, is widely used in the US as the basis for management remuneration schemes CFROI, which gives historical trends, is useful for the investment community, while ValueBuilder, claims Phillips, is compatible with both while giving an added strategic dimension.

Although some companies boast impressive success using the new metrics, observers counsel against putting too much faith in one version. Each has advantages and disadvantages and produces different winners and losers. Monsanto, the US chemicals company, uses both EVA and CFROI as well as a ‘balanced scorecard’ of non-financial measurements to assess its performance.

BUT how useful are the new metrics? At Warwick Business School, accounting lecturer Dr Brendan MacSweeney notes the ‘narrow economic motivation’ while Dr Peter Johnson of Balliol College, Oxford, points out that the causal link between strategic choices and share price is still unproven. CSC Index’s Black warns that off-the-peg value systems end up consuming their champions if they are not adapted over time. The bravest companies, he says, invent their own metric and sell it to their stakeholders.

Guide to the new management argot

Added Value: The difference between the market value of a company’s output and the cost of its inputs.

Economic Value Added: ‘Economic’ profit, or the difference between a company’s post-tax operating profit and the cost of the capital invested in the business.

Market Value Added: The difference between a company’s market capitalisation and the total capital invested – thus the stock market wealth created (assuming positive MVA).

CFROI: Compares inflation-adjusted cash flows to inflation-adjusted gross investments to find cash-flow return on investment.

Total Shareholder Return: What the shareholder actually gets, ie, changes in capital value plus dividends.