Chapter33 valuebasedmanagement

Chapter 33
VALUE BASED MANAGEMENT

© Centre for Financial Management , Bangalore

OUTLINE
• What is value based management (VBM)
• Methods and key premises of VBM
• Marakon approach
• Alcar approach
• Mckinsey approach
• Stern Stewart approach
• BCG approach
• Lessons from the experiences of VBM adopters
• Potential and hurdles for VBM in India

WHAT IS VBM
VBM represents a synthesis of various business disciplines
Finance

: Goal of shareholder value maximisation and
the DCF model

Business
strategy

: Value creation stems from exploiting
opportunities based on the firm’s comparative
advantage

Accounting

: Structure of financial statements with some
modification

Organisational : Notion that ‘you get what you measure and
behaviour
reward’

RISING INTEREST… VBM
• LARGE CORPORATION’S … VALUE CREATION..
CENTRAL OBJECTIVE
• GROWING CONCERN.. MGTS.. STOCK
UNDERVALUED
• TRADITIONAL INDICATORS.. EPS NOT RELIABLE..
INDICATORS.. FUTURE RETURNS
• INCREASING ATTENTION…TO LINKING TOP MGT..
COMPENS’TN TO SHAREHOLDER RETURNS
• GREATER ATTENTION.. SHRR.. PERFORMANCE
RATINGS.. (BW.. FORTUNE)
• DEV.. APPROACHES.. IMPLEMENTING VBP

VALUE BASED MANAGEMENT
• VBM INSTILLS A MIND - SET WHERE EVERYONE IN
THE ORGN … FOCUSES ON VALUE CREATION.
• A COMPREHENSIVE VBM PROGRAM …
STRATEGIC PLANNING
CAPITAL ALLOCATION
OPERATING BUDGETS
PERFORMANCE MEASUREMENT
MANAGEMENT COMPENSATION
INTERNAL COMMUNICATION
EXTERNALFinancial Management , Bangalore
COMMUNICATION
© Centre for

METHODS OF VBM
Several methods have been used in VBM. The three
principal methods of VBM are:
• The free cash flow method proposed by McKinsey and
LEK/Alcar group.
• The economic value added / market value added
(EVA/MVA) method pioneered by Stern Stewart and
Company.
• The cash flow return on investment / cash value added
(CFROI/CVA) method developed by BCG and Holt Value
Associates.

KEY PREMISES… VBM

• FOR MANAGING SH VALUE, FIRMS SHOULD USE
METRICS… LINKED TO VALUE CREATION & EMPLOY
THEM CONSISTENTLY… ALL FACETS OF FINANCIAL
MANAGEMENT.
• A WELL DESIGNED PERFORMANCE MEASUREMENT &
INCENTIVE
COMPENS’N
ESSENTIAL…
MOTIVATE
EMPLOYEES FOCUS ATTENTION… CREATING SHV.


KEY DIFFERENCE
The key difference between these methods relates to VBM
metrics. For example, the LEK/ Alcar method uses shareholder
value added, the Stern Stewart method emphasises EVA and
MVA, and the BCG method focuses on CFROI and CVA.
Each camp argues that its measures are the best and
cites supporting evidence for the same. It is difficult to
objectively assess the validity of these claims.
While the different methods to VBM have their own fan
clubs, the EVA / MVA method seems to have received more
attention and gained more popularity.

MARAKON APPROACH
The key steps in the Marakon approach are as follows:
• Specify the financial determinants of value
• Understand the strategic drivers of value
• Formulate higher value strategies
• Develop superior organisational capabilities
James M.McTaggart, Peter W.Kontes, and Michael C.Mankins
The Value Imperative, Free Press, 1994

FINANCIAL DETERMINANTS OF VALUE
According to the Marakon model, the market-to-book values ratio is
a function of the return on equity, the growth rate of dividends (as
well as earnings), and the cost of equity:
M
B

=

r–g
k–g

where M = market value of equity
B = book value of equity
r = return on equity
g = growth rate in dividends
k = cost of equity

(33.1)

STRATEGIC DETERMINANTS OF
VALUE CREATION
Market economics

Structural
factors and
trends

Average equity
spread and
growth of
market(s) over
time

Financial
determinants

Average equity
spread over
time

Value
creation

Competitive position
Differentiation
and economic
cost position
and trends

Relative equity
spread and
growth over
time

Average
growth over
time

Source:James M. McTaggart, Peter W. Kontes, and Michael C. Mankins, The Value Imperative


DETERMINANTS OF MARKET ECONOMICS
(OR PROFITABILITY)

Direct
forces

Threat of entry

Supplier pressures

Limiting
forces

Intensity of indirect
competition

Regulatory pressures

Intensity
of direct
competition

Market
profitability

Customer
pressures

Source: James M.McTaggart, Peter W.Kontes, and Michael C.Mankins,
The Value Imperative.

HIGHER VALUE STRATEGIES

Participation
strategy options
In which
markets
should we
participate?

Alternative
strategy
development
Competitive
strategy options
How should
we compete
in each
market?

Entry strategy
options

Exit strategy
options
Product offering
strategy options
Cost and asset
strategy options
Pricing strategy
options

Source : James M.Mc Taggart, Peter W.Kontes, and Michael C.Mankins, The Value Imperative.


SUPERIOR ORGANISATIONAL
CAPABILITIES
Superior organisational capabilities overcome the internal
barriers to value creation. They are:
• A competent and energetic chief executive who is fully
committed to the goal of value maximisation.
• A corporate governance mechanism that promotes the highest
degree of accountability for creation or destruction of value.
• A top management compensation plan which is guided by the
principle of “relative pay for relative performance”.

SUPERIOR ORGANISATIONAL
CAPABILITIES
• A resource allocation system which is based on four principles:
(i) the principle of zero-based resource allocation, (ii) the
principle of funding strategies, not projects, (iii) the principle of
no capital rationing, and (iv) the principle of zero tolerance for
bad growth.
• A performance management process (the high-level strategic
and financial control process) which is founded on two basic
principles: (i) The performance targets are driven by the plans,
rather than the other way around. (ii) The process should have
integrity implying that the performance contract must be fully
honored by both sides, the chief executive and each business
unit head.

ALCAR APPROACH
Alfred Rappaport Creating Shareholder Value : A Guide for
Managers and Investors, Free Press 1998
According to Rappaport the following seven factors – he calls them
“value drivers” – affect shareholder value:
• Rate of sales growth
• Operating profit margin
• Income tax rate
• Investment in working capital
• Fixed capital investment
• Cost of capital
• Value growth duration

SHAREHOLDER VALUE CREATION NETWORK
Creating shareholder
value

Corporate objective

Valuation
components

Value
drivers

Cash flow from operations

• Value growth
duration

Management decisions

• Sales growth
• Operating profit
margin
• Income tax rate

Operating

Shareholder return
• Dividends
• Capital gains

Discount rate

• Working capital
investment
• Fixed capital
investment

Investment

Debt

• Cost of
capital

Financing

Source : Alfred Rappaport, Creating Shareholder Value : A Guide for Managers and Investors.


ASSESSMENT OF THE SHAREHOLDER
VALUE IMPACT OF THE BUSINESS
UNIT (STRATEGY)
1. Forecast the operating cash flow stream for the business
unit (strategy) over the planning period.
2. Discount the forecasted operating cash flow stream using
the WACC.
3. Estimate the residual value of the business unit (strategy) at
the end of the planning period and find its present value.
4. Determine the total shareholder value.
5. Establish the pre-strategy value
6. Infer the value created by the strategy

ILLUSTRATION
The income statement for year 0 (the year which has just ended) and the balance sheet
at the end of year 0 for Ventura Limited are shown in the first column of the exhibit
shown next.
Ventura Limited is debating whether it should maintain the status quo or adopt a
new strategy. If it maintains the status quo:
• The sales will remain constant at 1,000
• The gross margin and selling, general, and administrative expenses will remain
unchanged at 25 percent and 10 percent respectively
• Depreciation charges will be equal to new investments
• The asset turnover ratios will remain constant
• The discount rate will be 16 percent.
• The income tax rate will be 40 percent.
If Ventura Limited adopts a new strategy its sales will grow at a rate of 10 percent per
year for five years. The margins, the turnover ratios, the capital structure, the income
tax rate, and the discount rate, however, will remain unchanged. Depreciation charges
will be equal to 10 percent of the net fixed assets at the beginning of the year.
What value will the new strategy create? As computed in Exhibit 33.5, the value
created by the new strategy is 58.

Exhibit 33.5

DETERMINATION OF THE VALUE CREATED BY A
NEW STRATEGY
Current
Values
(year 0)
Sales
Gross margin (25%)
S & G.A. (10%)
Profit before tax
Tax
Net profit

Income Statement Projections
1

2

3

4

5

Residual
Value
5+

1000
250
100
150
60

1100
275
110
165
66

1210
303
121
182
73

1331
333
133
200
80

1464
366
146
220
88

1611
403
161
242
97

1611
403
161
242
97

90

99

109

120

132

145

145

Balance Sheet Projections
Fixed assets
Current assets

300
200

330
220

363
242

399
266

439
293

483
322

483
322

Total assets
Equity

500
500

550
550

605
605

667
667

732
732

805
805

805
805


Cash Flow Projections
Profit after tax
Depreciation
Capital expenditure
Increase in urrent assets
c

99
30
60
20

109
33
66
22

120
36
72
24

132
40
80
27

145
44
88
29

Operating cash flow

49

54

60

65

72

Present value factor
(at 16% discount)
Present value of the
operating cash flow

0.862

0.743

0.641

0.552

0.476

42

40

38

36

34

Present value of the operating cash flow stream = 190
Residual value = 145/0.16 = 906
Present value of the residual value = (0.476)906 = 431
Total shareholder value = 190 + 431 0 = 621
–
Pre- trategy value = 90/0.16 = 563
s
Value of the strategy = 621 563 = 58
–


145
48
48
0
145

SHAREHOLDER VALUE
MANAGEMENT CYCLE
Strategic
planning

Investor
communications

Incentive
compensation

Portfolio review
and resource allocation

Performance
evaluation

Source: Alfred Rappaport, Creating Value for Shareholders : A Guide for
Managers and Invetsors

MCKINSEY APPROACH
McKinsey & Company, a leading international consultancy firm, has developed
an approach to VBM which has been very well articulated by Tom Copeland, Tim
Koller, and Jack Murrin of McKinsey & Company 5. According to them:
“Properly executed, value based management is an approach to management
whereby the company’s overall aspirations, analytical techniques, and
management processes are all aligned to help the company maximize its
value by focusing decision-making on the key drivers of value.”
The key steps in the McKinsey approach to VBM are as follows:
• Ensure the supremacy of value maximisation
• Find the value drivers
• Establish appropriate managerial processes
• Implement value-based management properly
5

Tom Copeland, Tim Koller, and Jack Murrin, Valuation : Measuring and Managing the Value of Companies, Second
Edition, New York : John Wiley & Sons Inc., 1994.

AREAS OF ACTIVITY FOR MAKING VALUE HAPPEN
Shareholder
Value
Aspirations
and targets
Portfolio management
Organisational design
Value driver definition
Business
performance
management
Metrics

Individual
performance
management
Value thinking

Mindset

Source: Tom Copeland et.al Valuation Measuring and Managing the Value of Companies,
3rd Edition.

STERN STEWART APPROACH
(EVA® APPROACH)
EVA is essentially the surplus left after making an appropriate charge for the capital employed in the business. It
may be calculated in any of the following, apparently different but essentially equivalent, ways:
EVA

= NOPAT - c* x CAPITAL

(33.8)

EVA

= CAPITAL ( r- c*)

(33.9)

EVA

= [PAT + INT (1-t)] – c* CAPITAL

EVA

= PAT- k EQUITY
e

(33.10)
(33.11)

where EVA = economic value added
NOPAT

= net operating profit after tax

c*

= cost of capital

CAPITAL = economic book value of the capital employed in the firm
r

= return on capital = NOPAT/CAPITAL

PAT

= profit after tax

BALANCE SHEET AND PROFIT AND LOSS ACCOUNT
BALANCE SHEET AS ON 31.03.2000
LIABILITIES

ASSETS

PROFIT & LOSS STATEMENT FOR
THE YEAR ENDING 31.03.2000
NET SALES

EQUITY

100

FIXED ASSETS

140

DEBT

100

NET CURRENT

60

300

COST OF GOODS SOLD

258

COE = 18%

COD = 12 (1 - 3) = 8.4%

PBT

30
9

PAT

200

12

TAX

200

42

INTEREST

ASSETS

PBIT

21

WACC = 13.2%

NOPAT = PBIT (1 - TAX RATE) = 42 (1 - 0.3) = RS.29.4 MILLION
CAPITAL = RS.200 MILLION

ROCE = 29.4 / 200 = 14.7%

FOUR WAYS OF COMPUTING EVA
EVA

=

NOPAT - c* x CAPITAL

= 29.4 - (0.132) x 200 = RS.3 MILLION

EVA

=

CAPITAL x (r - c*)

= 200 (0.147 - 0.132) = RS. 3 MILLION

EVA

=

[PAT + INT (1-t)] - c* CAPITAL

= [21 + 12 (0.7)] - 0.132 x 200 = RS.3 MILLION

EVA

=

PAT - ke EQUITY

= 21 - 0.18 x 100 = RS.3 MILLION

NUMERICAL ILLUSTRATION OF VALUE
CREATING STRATEGIES
BASE CASE
CAPITAL :
NOPAT
:
c*
:
r
:

10,000
2,000
15%
20%

EVA = CAPITAL x (r - c*) = 10,000 (0.20 - 0.15) = 500
STRATEGY 1 : IMPROVEMENT IN OPERATING PERFORMANCE
NOPAT INCREASES FROM 2000 TO 2250, DUE TO GREATER OPERATING EFFICIENCIES. THIS RAISES r TO 22.5%. AS A RESULT EVA
RISES TO 750
EVA = CAPITAL x (r - c*) = 10,000 (0.225 - 0.150) = 750

STRATEGY 2 : PROFITABLE INVESTMENT
A NEW PROJECT REQUIRING 10,000 IS EXPECTED TO EARN A RETURN OF 18% THEREBY ADDING 1800 TO NOPAT. THIS PROJECT
WILL INCREASE EVA, EVEN THOUGH THE CONSOLIDATED RETURN WILL DECLINE TO 19% (THE AVERAGE OF 20% AND 18%)
EVA = CAPITAL x (r - c*) = 20,000 (0.19 - 0.15) = 800
NOTE THAT MAXIMISING EVA IS MORE IMPORTANT, NOT MAXIMISING RETURN ON CAPITAL. HENCE THE PROJECT SHOULD BE
ACCEPTED

STRATEGY 3 : WITHDRAWAL OF UNPRODUCTIVE CAPITAL
1000 OF WORKING CAPITAL CAN BE LIQUIDATED WITH ONLY A MARGINAL DECLINE OF NOPAT. NOPAT WILL FALL BY JUST 50.
WITHDRAWING THIS WORKING CAPITAL WOULD INCREASE THE RATE OF RETURN TO 21.67% (2000 - 50) / (10000 - 1000) AND EVA
TO 600
EVA = CAPITAL x (r - c*) = 9,000 (0.2167 - 0.150) = 600

STRATEGY 4 : REDUCTION IN THE COST OF CAPITAL
THE CAPITAL STRUCTURE OF THE FIRM IS ALTERED AND THIS CHANGE LOWERS THE COST OF CAPITAL TO 13%, WITHOUT
AFFECTING ANYTHING ELSE. AS A RESULT EVA RISES FROM 500 TO 700
EVA = CAPITAL x (r - c*) = 10,000 (0.20 - 0.13) = 700

MEASURING NOPAT AND CAPITAL : ADJUSTING
FOR THE DISTORTIONS OF GAAP
The gap between GAAP-based accounting information and economic reality
stems from the extreme conservatism characterising accounting practice
To calculate EVA that is a reliable guide to value creation, several
adjustments are required to accounting earnings and accounting book value.
The purpose of these adjustments is to derive a NOPAT figure that reflects
economic performance and a capital figure that measures the capital
contributed by shareholders and lenders.
Stern Stewart have identified more than 160 potential adjustments.
These relate to things like intangible assets, strategic investments, market
promotion outlays, goodwill, timing of expense and revenue recognition, offbalance sheet financing, passive investments in marketable securities,
restructuring charges, bad-debt recognition, inventory valuation, foreign
currency translation, depreciation, taxes, and non- interest bearing liabilities
In most real life situations, however, 10 to 15 adjustments suffice. The
more important ones tend to relate to the following.

MEASURING NOPAT AND CAPITAL EMPLOYED :
ADJUSTING FOR THE DISTORTIONS OF GAAP
1. CAPITALIZE R & D INVESTMENTS & WRITE THEM OFF OVER AN APPR.
PERIOD
2. CAPITALIZE MARKET DEVELOPMENT COSTS & AMORTIZE THEM OVER
A PERIOD . . TIME
3. HOLD BACK THE OUTLAYS ON STRATEGIC INVESTMENT IN A SPECIAL
SUSPENSE ACCOUNT
4. DON’T FLOW RESTRUCTURING CHARGES THRU THE INCOME STAT’T;
INSTEAD ADD RESTR’G INVESTMENT TO THE B/S.
5. REPLACE STRAIGHT-LINE DEPR’N WITH SINKING FUND DEPR’N, IF
NECESSARY
6. EXCLUDE PASSIVE INVEST’TS & . . INCOME THEREFROM
7. MAKE ADJUSTT’S FOR GOODWILL WRITEOFFS, DEFERRED TAXES, BAD
DEBT RESERVES, & SO ON (QUASI EQUITY)
8. MOVE ALL OFF-BALANCE SHEET ITEMS, SUCH AS UNCAPITALIZED
LEASES, BACK TO THE B/S

RESTRUCTURING CHARGES
APEX LTD . . RS.100 MN FACTORY

NIL OP. PROFIT

COC : 12%
GAAP : BREAK-EVEN … EVA … -12 MN
APEX CAN SELL THE FACTORY FOR RS.60 MN RS.60 MN DIV
UNDER GAAP . . EARNINGS

40 MN . .

B/S

100 MN

UNDER EVA . . INSTEAD OF MAKING A RS.40 MN CHARGE TO ITS INCOME STATT . . APEX
ADDS A RS.40 MN RESTR’G INVT . . B/S CAP. DECLINES NOT BY RS.100 MN, BUT BY RS.60
MN, AMOUNT PAID TO SHs. EVA RISES FROM - 12 TO - 4.8

DEPRECIATION
SLM
CAPITAL
DEPR’N
CAP. CHARGE
SUM

SFM

1

2

3

4

5

100000
20000
15000
35000

80000
20000
12000
32000

60000
20000
9000
29000

40000
20000
6000
26000

20000
20000
3000
23000

SINKING FUND DEPR’N (AMORT’N DEPR’N)

CAP. CHARGE
15000
DEPR’N
14833
SUM
29833
A x PVIFA (5, 15%) = 100000

12775
10216
17058
19617
29833
29833
A x 3.352 = 100000

7273
3890
22559
25943 (PRINCIPAL AMORT’N)
29833
29833
A = 29833


EVA APPLICATIONS
• FIRM GOALS

TRADITIONAL FIN. MGT EVA BASED FIN. MGT
REVENUES PROFITS, EPS EVA

• BUSINESS PLANS

- DO -

• DIVISIONAL PERF.

DIVISIONAL PROFITS

MEASUR’T

EVA
EVA

ROI

• CAPITAL BUDGETING

DCF

EVA

• PERFORMANCE TARGET

NEGOTIATED PROFIT

FORMULA-LINKED
EVA TARGET

• INCENTIVE COMPEN’N

SMALL & RANGE
BOUND

UNLIMITED & EVALINKED

• FINANCIAL STR’RE

STATIC

DYNAMIC

WHY EVA
TIES DIRECTLY WITH SHW CREATION
CONVERTS ACCTG INF’N . . ECONOMIC REALITY . . READILY GRASPED
PROVIDES A SINGLE UNIFIED MEASURE FOR ALL PURPOSES
MAKES MANAGERS INTO OWNERS
SERVES AS AN ANCHOR FOR CORPORATE GOVERNANCE

EVA APPROACH TO VALUATION
1

2

3

4

5

6

7

NOPAT

6.0

7.2

8.6

10.4

11.6

13.0

14.1

BEG. CAP

50

60

72

86.4

96.8

108.4

117.1

X C*

11%

11%

11%

11%

11%

11%

11%

CAP. CHARGE

5.5

6.6

7.9

9.5

10.6

11.9

12.9

EVA

0.5

0.6

0.7

0.9

1.0

1.1

1.2

PV FACTOR

.901

.812

.731

.659

.593

.535

PV OF EVA

.45

.49

.51

.59

.59

.59

GROWTH (%)

20

20

20

12

12

8

8

VALUE OF THE COMPANY = BEG. CAPITAL + PV OF EVA STREAM
6

PV OF EVA STREAM

EVAt

= Σ
t=1

EVA7
+

(1+k)t

= 1.2 / [0.03 x (1.11)6] = 21.4
(K-G)(1+K)6

VALUE OF THE COMPANY = 50 + 24.6 = 74.6

EVA & MVA
EVA TIES DIRECTLY TO THE INTRINSIC MARKET VALUE OF ANY
COMPANY. WHEN IT IS PROJECTED AND DISCOUNTED TO A PRESENT
VALUE, EVA ACCOUNTS FOR THE MARKET VALUE THAT
MANAGEMENT ADDS TO, OR SUBTRACTS FROM, THE CAPITAL IT HAS
EMPLOYED.
MVA = MARKET VALUE - CAPITAL
MVA = PRESENT VALUE OF ALL FUTURE EVA
PREMIUM VALUE
M
A
R
K
E
T
V
A
L
U
E

M
V
A
C
A
P
I
T
A
L

EVA1 +
(1+c*)1
C
A
P
I
T
A
L

MV
Lost

EVA2 +……
(1+c*)2
2
EVA
+ EVA 2
1
1
(1+c*)
(1+c*)

+…

Market
Value


CAPITAL BUDGETING WITH EVA
INVESTMENT

: 100

EQUITY FINANCING : 100

DEPR’N

: ST. LINE

COST OF EQUITY

: 15%

PROJECT LIFE

: 4 YRS

TAX RATE

: 50%

SALVAGE VALUE

: NIL

1

2

3

4

• REVENUES

200

200

200

200

• COSTS

135

135

135

135

• PBIDT

65

65

65

65

• DEPR’N

25

25

25

25

• PBIT

40

40

40

40

• NOPAT

20

20

20

20

100

75

50

25

• CAP. AT CHARGE
• CAP. CHARGE

15

• CASH FLOW (PAT + DEP)

7.5

3.75

5

• EVA

11.25
8.75

12.5

16.25

45

45

45

45

CFt
NPV = Σ

- I = 128.475 - 100 = 28.475
(1+k)

t

EVA t
NPV = Σ

= 28.475
(1+k)t


EVA AND INCENTIVE COMPENSATION
The centre piece of the EVA financial management system is a
unique bonus plan that overcomes these limitations and aligns
the interest of managers with shareholders. The key elements
of the EVA bonus plan are:
• Bonus is linked to increases in EVA
• There is no floor or ceiling on the bonus
• The target bonus is generous
• Performance targets are set by formula, not negotiation
• A bonus bank is established.

BONUS BEHAVIOUR

A : Traditional bonus plan

B : EVA bonus plan
Bonus

Bonus

80%

100%

120%

Target EVA


BONUS BANK SYSTEM
NORMAL YEAR

GOOD YEAR

BAD YEAR

50

200

-100

BEGINNING BANK

100

100

200

CUMULATIVE BALANCE

150

300

100

PAYOUT RATIO

1/3

1/3

1/3

50

100

33 1/3

100

200

66 2/3

BONUS EARNED

BONUS PAID
BONUS FORWARD

BONUS = a1 . CHANGE IN EVA + a2 . EVA
IF EVA . . - a2 = 0
•

LINKED . .

a1 > > a2 . . INCENTIVE
EVA

•

NO CAP / FLOOR

•

FORMULA


•

BANK

THE TWO FINANCIAL PARADIGMS
EPS BASED FINANCIAL MANAGEMENT
SYSTEM

EVA BASED FINANCIAL MANAGEMENT
SYSTEM

MANAGEMENT TRIES TO

MANAGEMENT TRIES TO

• REPORT

STEADY INCREASES IN EPS

•

ACHIEVE IMPROVEMENT IN EVA

•

DIVERSIFY TO ACHIEVE STABILITY

•

STRIVE FOR FOCUS

•

TIGHTLY CONTROL THE ALLOCATION OF

•

DECENTRALIZE INVESTMENT DECISION

CAPITAL
•

MAKING

BALANCE THE CLAIMS OF VARIOUS

•

ACCORD PRIMACY TO SHAREHOLDER

•

ACQUIRE COMPANIES THAT AUGMENT VALUE

STAKEHOLDERS
•

BUY COMPANIES WITH LOWER P/E MULTIPLES

TO BOOTSTRAP EPS
• NEGOTIATE DIVISION PROFIT TARGETS
• AWARD MODEST TARGET LINKED BONUSES

DEFINE EVA TARGETS BY FORMULA
• MAKE BONUS VARIABLE BOTH WAYS
•

MADE SENSE IN
•

IN THE STABLE BUSINESS ENVIRONMENT THAT

MAKES SENSE IN
•

IN THE VOLATILE BUSINESS ENVIRONMENT,

PREVAILED TILL THE MID 1970s WHEN THE TOP

CHARACTERISED BY INFORMATION REVOL’N

MANAGEMENT WAS TO ACHIEVE ECONOMIES

AND RAPID TECHNOLOGICAL DEVELOPMENTS

OF SCALE IN MFRG AND MARKETING AND FIND

CALLING FOR A CHANGE IN THE STRUCTURE

GROWTH OPPORTUNITIES IN THE SAME /

OF INTERNAL CONTROL SYSTEMS OF LARGE

RELATED BUSINESSES

ORGANISATION

IMPLEMENTING THE EVA SYSTEM
• DEVELOP TOP MANAGEMENT COMMITMENT
• CUSTOMISE THE DEFINITIONS OF EVA
• IDENTIFY EVA CENTRES
• ANALYSE THE DRIVERS OF EVA
• TAILOR AN INCENTIVE COMPENSATION SYSTEM
• TRAIN ALL THE EMPLOYEES

PROBLEMS IN USING EVA
• Disincentive for collaborative relationship
• Imperfect measure
• Underinvestment
• Difficulties in divisional performance measurement


BCG APPROACH
• Boston Consulting Group (BCG), an international
consulting organisation, has developed an approach to
shareholder value management.
• Two concepts are at the foundation of the BCG
approach : total shareholder return and total business
return.
• For applying these concepts, two performance metrics
are used : cash flow return on investment and cash value
added

TOTAL SHAREHOLDER RETURN
Total shareholder return (TSR) is the rate of return shareholders earn from
owning a company’s stock over a period of time:
The TSR for a single holding period is computed as follows:
Dividend

Ending market value – Beginning market value

TSR =

+
Beginning market value

Beginning market value

The TSR for a multiple holding period is computed using the conventional
internal rate of return computation
Beginning
market value

Dividend1

Dividend2
+

=
(1 + TSR)1
+

Dividend n
+

(1 + TSR)2

+ ….
(1 + TSR)n

Ending market value in year n
(1 + TSR)n


WHY TSR IS DEEMED THE MOST USEFUL
MEASURE OF VALUE CREATION
• TSR is comprehensive
• TSR is widely used by the investment community.
• TSR can be easily benchmarked
• TSR is not biased by size
• TSR is difficult to manipulate

TOTAL BUSINESS RETURN
The total business return (TBR) is the internal counterpart of TSR. The
link between TSR, TBR, and value drivers is shown below.
Total
Shareholder
Return

Total Business
Return

Capital gains

Return on invested
capital

Free cash flows

Growth in new
investments

Measured as Cash
flow return on investment


TBR
The TBR for a single holding period is computed as follows:
Free cash flow

TBR =

Beginning value

Ending value – Beginning value

+

Beginning value

The TBR for a multiple holding period is measured using the conventional internal
rate of rate computation:
Beginning
value

=

Free cash flow1

+

(1 + TBR)
+

Free cash flow2
(1 + TBR)

2

Free cash flown
(1 + TBR)

n

+ ……

+

Ending value in yearn
(1 + TBR)n

The beginning and ending values are estimates of market values of the firm or
business unit at the beginning and end of the period. They are estimated using one or
more of the following:
Value
Value
Value
Value

=
=
=
=

Earnings x P/E multiple
Book value x M/B multiple
Free cash flow ÷ cost of capital
NPV of expected cash flow

USES OF TBR
BCG uses TBR for
• Strategic planning
• Resource allocation
• Incentive compensation


RESOURCE ALLOCATION PERSPECTIVE
Positive

Question

Current CFROI vs
cost of capital

High priority for
reinvestment

0
Do not fund

Negative

Negative

Question

0

Positive

TBR of business plan versus target TBR


CASH FLOW RETURN ON INVESTMENT (CFROI)
TBR incorporates the returns (CFROIs) both for the assets in place and the assets
to be created. Thus CFROI has an important bearing on TBR.
What is CFROI and how is it measured? BCG defines CFROI as “the
sustainable cash flow a business generates in a given year as a percentage of the
cash invested in the firm’s assets”. Sustainable cash flow is gross cash flow less
economic depreciation. Thus,
CFROI

=

Cash flow - Economic depreciation
Cash invested

Note that economic depreciation is the amount of annual sinking fund
payment earning capital cost required to replace assets.

9

To illustrate the calculation of economic depreciation, consider a plant that has an economic life of 14
years and costs Rs 250,000 to replace.

Economic depreciation x FVIFA (14, 10%) = Rs. 250,000
Rs 250,000
Economic depreciation =

Rs 250,000
=

FVIFA (14, 10%)

= Rs 8,937
27.975

ILLUSTRATION OF CFROI
To illustrate the calculation of CFROI , let us consider an example . A new plant
entails an initial investment of Rs. 300,000, Rs. 250,000 toward fixed assets and the
balance toward net working capital. The plant has an economic life of 14 years.
At the end of 14 years, fixed assets will fetch nothing but net working capital
will be recovered in full. The annual depreciation charge on fixed assets will be
Rs.250,000/14 = Rs. 17,857. The plant is expected to produce a NOPAT of
Rs.21,080 each year. The cost of capital is 10 percent. It will cost Rs.250,000
to replace the fixed assets.
Exhibit 33.20 shows the CFROI of the project for three sample years,
assuming that the actual performance is in line with forecast performance. It also
shows two other return measures popularly used, viz:
NOPAT
Return on capital employed (ROCE) =
Book capital
Return on gross investment (ROGI) =

Cash flow
Cash invested


ACCURACY OF VARIOUS
MEASURES OF RETURN
How accurate are the various measures of return? To judge the accuracy of these
measures, they may be compared with the internal rate of return (IRR), the measure most
commonly employed to assess investment projects. The IRR for the project is the value of r
in the following equation.
38,937
300,000 =

38,937
+

(1 + r)
r works out to 10 percent.

38,937 + 50,000
+ ….. +

(1 + r)2

(1 + r)14

Comparing the three measures with IRR we find that:
• ROCE understates IRR in the initial years and overstates IRR in the later years.
ROCE shows a rising trend over time, though the project is a constant cost-of-capital
performer.
• Unlike ROCE, ROGI does not show a rising trend. However, it has a constant
upward bias of about 3 percent as it does not take into account what must be
withheld to replace the asset at the end of its economic life.
• CFROI equals IRR throughout. It takes into account the replacement need and
provides the correct signal each year.

CASH VALUE ADDED (CVA)
The CFROI is the key metric used by BCG for measuring
performance and valuing a company. However, BCG has also
developed a measure of economic profit: cash value added
(CVA). BCG claims that CVA is superior to EVA because it
removes the accounting distortion that may bias EVA.
CVA is measured as operating cash flow less economic
depreciation less a capital charge on gross investment. Thus,
CVA = Cash – Economic – Capital charge on gross
flow depreciation
investment

EVA AND CVA CALCULATIONS
INVESTMENT = FIXED ASSET (250000) + NET WORKING CAPITAL(50000)
LIFE : 14 YRS

SALVAGE VALUE (FIXED ASSETS) = 0

ECONOMIC DEPR’N = 250000 / FVIFA(14,10%) = 250000 / 27.975 = RS. 8937
PANEL A : EVA

RS. IN MILLION

YEAR 1
21,080
300,000
10%
30,000

21,080
210,715
10%
21,072

21,080
103,573
10%
10,357

8

10,732

21,080

21,080

21,080

17,857
38,937
8,937
300,000
10%
30,000

17,857
38,937
8,937
300,000
10%
30,000

17,857
38,937
8,937
300,000
10%
30,000

0

EVA (1 - 4)

YEAR 12

(8,920)

1. NOPAT
2. BOOK CAPITAL (BEG.)
3. COST OF CAPITAL
4. CAPITAL CHARGE

YEAR 6

0

0

PANEL B : CVA
1. NOPAT
2. DEPRECIATION
3. CASH FLOW
4. ECONOMIC DEPR’N
5. CASH INVESTED
6. COST OF CAPITAL
7. CAPITAL CHARGE
CVA = (3 - 4 - 7)

CVA = OPERATING CASH FLOW - ECONOMIC DEPR’N - CAPITAL CHARGE ON THE FULL CASH INVESTED


LESSONS… EXPERIENCES OF
VBM ADOPTERS
• TOP MGMT. SUPPORT
• INCENTIVE PLAN
• EDUCATION
• CHOICE OF METRIC
• CONDUCIVE CIRCUMSTANCES
• UNPRODUCTIVE ASSETS
• PELL-MELL DIVERSIFICATION
• PHYSICAL ASSETS VS. INTELLECTUAL ASSETS
• NEED FOR CUSTOMISATION

POTENTIAL
•

MOST COMPANIES…. SUBSTANTIAL
PHYSICAL ASSETS… LOW PDY… CAP

•

PELL MELL DIVERSIFICATION

•

DISMAL DECADE (1992-2002) FOR EQUITIES


HURDLES
• LACK OF A GENUINE COMMITMENT…
PROMOTE WELFARE… SHS.
•

FINANCIAL LITERACY… EMPLOYEES NOT HIGH

•

ACCOUNTING MODEL DOMINATES
CORPORATE THINKING

•

DEGREE… OF DECENTRAL’N... NOT HIGH.

•

RELUCTANCE… MANY MGMTS. … GIVE UP
DISCRETION.

•

MGR. USED… HIGH PROP’N OF FIXED COMPENS’N

FUTURE
• MANY MGMTS… HAVE BEGUN TO REALISE .. NEED…
CREATE…SHV. THE FORCES OF GLOBALISATION,
LIBERALISATION,DEREGULATION, AND
COMPETITION… NOW SWEEPING THE INDIAN
CORPORATE LANDSCAPE WILL PROD COMPANIES
TO EXPLORE WAYS AND MEANS TO ENHANCE SHV.
• I EXPECT VBM TO BE A DOMINANT BUSINESS
THEME IN INDIA IN THE YEARS TO COME. IT IS A
TOOL OF REAL VALUEAND NOT A FAD OF
EPHEMPERAL ATTRACTION.

SUMMING
• To facilitate value creation, value-based management (VBM)
systems have been developed.
• Several approaches to value based management (VBM) have been
developed. The importance ones are the Marakon approach, the
Alcar approach, the Mckinsey approach, and the BCG approach.
• The key steps in the Marakon approach are as follows : (i) Specify
the financial determinants of value. (ii) Understand the strategic
drivers of value. (iii) Formulate higher value strategies. (iv)
Develop superior organisational capabilities
• The Alcar approach is based on discounted cash flow analysis.
According to this appraoch, the following seven factors-called
“value drivers” – affect shareholder value: rate of sales growth,
operating profit margin, income tax rate, investment in working
capital, fixed capital investment, cost of capital, and value growth
duration.

• As per the Alcar approach, the key phases of shareholder value
management cycle are: strategic planning, performance review
and resource allocation, performance evaluation, incentive
compensation, and investor communication.
• The key steps in the Mckinsey approach are : (i) Ensure the
supremacy of value maximisation (ii) Find the value drivers. (iii)
Establish appropriate managerial processes. (iv) Implement VBM
properly.
• EVA is the surplus left after making an appropriate charge for the
capital employed in the business.
• The EVA approach to VBM is based on the premise that EVA
provides a single, unified, and accurate measure of value as well as
performance. It links well forward looking valuation and capital
budgeting analysis with actual performance measurement. For
these reasons and more, EVA is regarded as the right measure for
goal setting and business planning, performance evaluation,
incentive compensation, investor communication, capital
budgeting, and valuation.

• Two concepts are at the foundation of the Boston Consulting
Group’s approach to shareholder value management : total
shareholder return (TSR) and total business return (TBR). For
applying the TSR and the TBR, two performance metrics are used
: cash flow return on investment (CFROI) and cash value added
(CVA).
• While the scope and need for applying VBM in India is enormous,
there are some hurdles in doing that which arise mainly from
certain attitude, beliefs, values, and practices that are inimical to
VBM. Notwithstanding these hurdles, I believe that companies in
India will introduce VBM programmes with vigour and
commitment.


Chapter33 valuebasedmanagement

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