Time to Rethink Performance Metrics and Valuation Methods
GAAP, EPS and P/E are dead. The days of financial astrology are numbered. Here’s how leading investment thinkers measure real performance.
November 1 2006 by Jeff Heilman
For an all-natural extract of a company’s current harvest and future yield, investors should perhaps make a beeline for the Buffett table. Back in 1959, before Berkshire Hathaway, Warren Buffett’s balance sheet analysis-husking the corn and counting the kernels-was on the money,transforming $100 into $25 million 13 years later.
Yet, Buffett is not alone when it comes to reality-check valuation methods, as a climate of scrutiny and activism accelerates revisionist thinking in corporate income and performance measurement. In particular, patience for short-term accounting based earnings-blamed for skewing decision-making, sandbagging budgets, corrupting healthy balance sheets and thwarting shareholder value-is wearing thin. For prospectors, forecasting a company’s future cash-generating capacity remains the elusive prize, but to date, their clairvoyance has rested in the tea leaves of earnings-per share (EPS) growth. Nonetheless, both tenets-future cash flow and present earnings-are the meat and bones in a percolating stew over performance and valuation methodologies.
There is an emerging consensus that the old valuation methods don’t work. A new sensibility about performance metrics-already profitably in place at companies such as Best Buy, Hilton, Harsco and Ingersoll Rand-is getting increased investor attention. Dr. Trevor Harris, Morgan Stanley’s vice chairman of client services and former global head of the firm’s valuation and accounting team, for example, suggests that “with the proliferation of hordes of electronic data and analytically oriented investors, many accounting measures and disclosures that we live with today will be defunct, irrelevant to capital markets participants in less than 10 years.”
The New Science
Unlike Jack Nicholson’s courtroom tirade in the military drama A Few Good Men- “You can’t handle the truth!”-the refrain of choice in the realm of performance metrics is “What are you prepared to believe?” says Joseph Fuller, CEO and co-founder of renowned Cambridge, Mass.-based consultancy The Monitor Group. Fuller, author of a series of articles on valuation, sees a tacit reframing of investment rationales under way, based on creating and fulfilling expectations, not on making numbers.
“Historically,” he says, “companies present Wall Street with a financial synthesis of their strategy. Financial forecasts, however, are an incomplete and disconnected telling of the corporate story, further strained by stretching to meet quarterly guidance and often producing overstated growth targets or understated risk factors.” The better path, in Fuller’s view, is to communicate the drivers that management believes will produce value and to prepare investors to believe in the investment. “Creating a tangible level of expectation, excitement and candor around a strategy; its underlying value propositions; and its risks and uncertainties,” he says, “is more persuasive and measurable than contrived, contorted math.”
In fact, according to a recent Monitor poll of more than 350 executives, strategy execution ranks as the single most important corporate issue today. Helping organizations become strategy- focused with breakthrough results is the Balanced Scorecard Collaborative (BSCol), a division of the glob- al professional services firm Palladium Group, which is owned by Monitor’s private equity group. “BSCol and its signature performance management system, the Balanced Scorecard (BSC), arose from a 1980 KPMG-funded project addressing the declining global performance of American companies,” says Dr. David Norton, who co-created BSC with Dr. Robert Kaplan, “and has evolved from a simple measurement system into a way for companies to translate strategy into day-to-day operational, planning, budgetary and compensation management.”
Early BSC adopters included Chemical Bank and Mobil; today, according to a 2005 Bain & Company survey, 57 percent of nearly 1,000 companies polled claimed to use BSC. Similar to the way the Linux operating system performs in the software world, BSC evolves as companies implement some or all of its core disciplines and associated tools according to their particular needs. The scorecarding can be individual-based, such as evaluating senior executives on specific areas of strategic responsibility, or can cover a company-wide initiative, such as a move toward customer- centricity.
At the heart of BSC’s methodology is the “strategy map,” which sets forth a company’s key strategic objectives on one page. Michael Nagel, Palladium’s North American vice president of Strategic Solutions, describes the map as an agreement, created by the executive team and business unit leaders, on how they will create value. “Unlike changing economic or industry conditions, the strategic growth plan is something that management can control,” says Nagel. “Clarify that plan on a map, though, and now you are changing the conversation with investors, analysts and the media. Instead of stating some aspirational growth target, you are providing true insight into how you intend to hit that target. Skillful external use of strategy maps creates strategic transparency. Companies that use this tool effectively stand a better chance of earning higher market multiples.”
The map facilitates the internal conversation, too. Norton has seen complex organizations such as DuPont and the U.S. Army use the strategy map to rally the troops around common initiatives. “Strategy is everybody’s job within an organization,” says Norton. “The map identifies three or four major themes that everybody needs to internalize and build into their own plans. The logic works for the analyst side, too. Take Ingersoll Rand, for instance,” Norton continues. “How do you get analysts comfortable with a diversified industrial company offering products ranging from Thermo King freezers to Club Car golf cars? By disclosing the company’s plans for creating visible synergies among its component parts, and then rigorously communicating the progress. The company and Wall Street follow the same map, together.”
Fuller of The Monitor Group sees significant change on the horizon. “Judging corporate performance is increasingly less about solving algorithms, placing bets and meeting quarterly numbers,” he says, “and more about making mature, informed decisions based on interpreting and acting upon a connected, integrated statement of the business case. There are penalties for being too transparent, and the legal and financial markets certainly provide incentives for being obtuse. When you go beyond compliance and have an open, sustained conversation with the markets, though, you give investors a clearer picture of what they are signing up for, you are better positioned to explain missteps, and you reduce the uncertainty around future expectations.”
As Fuller notes, the days of financial astrology are numbered. “We are in the early stages of moving beyond shareholders simply accepting risk, using GAAP to dissect companies and relying on EPS as the measure of future value,” he says.
“Burn the Mathematics”
Going by the numbers alone can be misleading, meaningless or downright hazardous -there are banana skins galore in financial statements “tidied up” for earnings season. One-time charges, for instance, while properly used to take nonrecurring expenses that do not materially affect company value off the balance sheet, can hide unfavorable expenses, bad debt or poor investments. Easy to calculate, the venerable valuation standard P/E ratio-market value per share divided by EPS-reflects the market’s collective opinion regarding the company’s growth prospects. The rub, though, is that accounting-based EPS has more malleability than Play-Doh, and factors such as inflation can bend the truth of the P/E ratio. Then there is private equity’s darling, EBITDA, fine for comparing profitability between companies and industries but blind to all-important operating cash flow and changes in working capital.
If these and other acronym-heavy metrics feel like a WACC (Weighted Average Cost of Capital) in the head, the U.S. Financial Accounting Standards Board and the International Accounting Standards Board are feeling it, too, with some prodding from the SEC. Confronting GAAP’s “ambiguous, unclear, inconsistent and overlapping” overabundance of standards, the bodies are jointly under way with an initiative to “narrow the types of accounting principles that it issues,” and create a “single authoritative codification of GAAP.” A draft report is expected next year.
And if simplicity is the order of the day, then New York-based consulting firm Stern Stewart & Co. is way ahead of the curve. Its trademarked performance metric, EVA, or Economic Value Added, has been evolving since the 1970s (anointed “the latest economic elixir” by The Wall Street Journal in 1997) and is gaining new index beating currency today. Companies benchmarked using the recently introduced EVA-derived PRVit (Performance Risk Valuation investment technology), for instance, have been outperforming the Russell 3000 Index by around 6 percent.
Counting profit the way shareholders do-the after-tax earnings above the cost of their investment, or in the case of companies, the cost of invested capital -EVA has achieved commercial success through rigorous marketing, but also by its grounding in financial theory and consistency with valuation principles. Senior partner G. Bennett Stewart, III, the firm’s co-founder and author of The Quest for Value, is EVA’s most impassioned spokesperson.
“Net operating profit is implicit in economics,” explains Stewart, “espoused by classic economists like Alfred Marshall [who once wrote to a protÃ©gÃ©, €˜burn the mathematics'] and with historical antecedents including GE’s focus on residual income in the ’50s. Rediscovered in the ’70s, it became a new way of looking at capital, saying that capital is not simply bricks and mortar in the balance sheet, but anything invested today that holds the promise of sales and earnings tomorrow.”
Stewart and his colleagues advocate capitalizing traditional off-balance sheet period expenses, such as marketing, advertising, training programs- and especially R&D. “Deducting R&D as an immediate earnings charge is a mistake, when you can amortize new product development over time. The same goes for marketing. It’s not about getting the marketing budget approved; it’s delivering a return on the marketing dollars,” Stewart says. “Enterprise-wide accountability for deploying and recovering the cost of capital makes financial decisions and measuring performance elegantly simple-are you creating wealth, or consuming wealth?”
Stewart is quick to dismiss the “pervasive myths” of EPS, cash flow and traditional accounting guidance. “On a per-project basis, most companies use discounted cash-flow to arrive at net present value,” he notes. “That’s fundamentally sound, except that as the project unfolds, earnings become the metric of choice, pushing projections and hurdle rates higher. Cash flow cannot be an ad hoc measure in setting goals, talking to investors and setting bonuses, but that is what happens, creating deception and inefficiency.
“The cash flow method can be misleading, too,” Stewart continues. “A company showing negative cash flow may, in fact, be reinvesting money in the business and building up a terrific IRR. And how often do we see earnings stories depart from reality? Take the fiasco of GM’s pension accounting. They showed pension assets on the balance sheet when, in fact, they were under water.”
Complementing the process improvement tenets of Six Sigma, says Stewart, EVA is also a behavior, linking strategic goals with employee performance. Through training programs and incentive and compensation plans, EVA gets everyone conscious of and contributing to wealth creation and shareholder value. This alignment can reach down to manager levels, or all the way to the factory floor.
“At Whole Foods and Best Buy,” says Stewart, “the checkout clerks are EVA-savvy, and at Briggs & Stratton, there is a manager known as €˜Little Eva’ who oversees a capital stewardship program focused on continuous improvements to drive capital out of the system. Instead of the ineffectual capital rationing seen at many companies, you create capital efficiency and a measurable return on equity.”
Salvatore Fazzolari is another proponent of EVA. As president, CFO and treasurer of Camp Hill, Pa.-based Harsco Corporation, an industrial services and products company with $2.8 billion in sales last year, Fazzolari played an integral role in the company’s implementation of EVA. “A large international acquisition back in 2000, combined with our increasing organic growth, left us with a challenge,” he recounts. “How do we create a standardized set of strategic financial and operational practices among a diverse and global group of businesses? We also had to fix a dysfunctional incentive and compensation plan. The answer was EVA, which gave us a company- wide framework linking strategy, capital investments, day-to-day operations and shareholder value.”
Fazzolari highlights the value of EVA in working internationally. “Operating in over 40 countries, we have to contend with a host of variables, from fluctuating currency rates to local production and labor costs. By combining EVA with automated technology, we can understand and set the cost of capital with ease.” Compensation-wise, too, he heralds EVA as a model of simplicity. “Our previous system was unwieldy and burdensome to manage. Now, compensation is driven by contributions to EVA, with a system of incentives and penalties for raising or lowering EVA shareholder value.”
However, Fazzolari emphasizes that EVA is no silver bullet or panacea, and is only effective when integrated with the traditional working aspects of the business. “While EVA is a terrific solution for ensuring that all of our decisions are valuedriven,” he says, “we always say that it will never replace business judgment or execution of strategy.” Stewart concurs. “While every company has its own culture and leadership, along with distinct aspects such as internal transfer prices, joint-venture partnerships, and exotic financing vehicles,” he says, “it needs an overarching metric that integrates all aspects of management information into . EVA is a true reality check, displacing management, market and media obsession with earnings.”
“Recombining the Disaggregated Components”
Trevor Harris, who ran Morgan Stanley’s valuation and accounting team in research and has helped create a new approach to analyzing companies, is another industry veteran with a disregard for quarterly obsession. For one thing, he advocates prudence in choosing investors. “Target investors with the money and patience to invest over the long run,” he says. “Instead of creating the unnecessary pressure of trying to perform against benchmarks like the S&P 500 or make quarterly numbers, you can focus on taking care of business and creating value, which the markets will recognize over time.”
When it comes to reducing performance to a single metric, however, he has some reservations. Speaking at a recent roundtable on stock market valuation, Harris, while commending the FASB and IASB for dealing with overwrought accounting measures, deemed “naÃ¯ve” the idea of an “accounting system that can summarize in a single number called €˜earnings’ the performance and change in value of a complex organization over a short period of time.”
“You don’t need EVA or residual income or any other metric to deal with this problem,” Harris said. “Instead, we need to give investors the disaggregated components that investors themselves can recombine into their own estimates of economic earnings.”
With this in mind, Harris is optimistic about the future of accounting, citing growing interest in solutions such as XBRL (eXtensible Business Reporting Language) electronic financial delivery software. “Strongly supported by the SEC,” states Harris, “XBRL provides for customized analysis of vast amounts of high-quality financial data reported by companies and other sources, creating the transparency that Sarbanes-Oxley intended and rendering the current complex set of rules and regulations less relevant in the capital markets.”
The future of performance measurements, then, appears to lie somewhere between a refinement and simplification of accounting standards on the one hand, and a deepening and strengthening of the corporate dialog on the other, with a special focus on the power of expectation. This does not mean transparency to the point of giving up the ship, but instead providing enough insight to investors and the market that they can develop confidence in the strategy, as well as in management’s ability to execute on that strategy.
“There are many reasons behind stock price volatility-market noise and industry dynamics, talking heads and nonsensical soundbites-and CEOs who focus on controlling the short term are chasing the wrong thing,” says Harris. “What matters is your plan for managing the business and sustaining returns on invested capital, and how you communicate the risks and uncertainties associated with that plan. Market feedback on strategies is important, and people will be more forgiving of bad news if they know you are in control and have the means to change.”
Reaching Through the Firewall
“The CEO has evolved from statesperson to strategist to operational leader,” says David Garfield, a managing director at global management advisory firm AlixPartners, whose founder, Jay Alix, pioneered corporate restructuring in the early ’80s. “CEOs must be able to take a strategic objective, like becoming a low-cost provider, and drill right down to the operational changes required. For example, they must be able to define how improvements in sourcing leverage, asset productivity and inventory turns will yield specific gains in operating profit, capital efficiency and value. And they must be able to drive their organizations to achieve these results,”
“Analysts are digging deeper than ever to understand a CEO’s operating skills. They know that a compelling strategy is just the ante-nailing the implementation wins the pot. More than ever before, CEOs are being measured on their credibility-and capability-in operational execution.”