Perspectives New Directions in Value Management
New Directions in Value Management Every CEO of a public company runs the risk of getting caught between two powerful constituencies: on one side, increasingly demanding investors, determined to maximize their returns relative to the risk they take; on the other, the organization and its managers, largely insulated from shareholders and typically focused on what s achievable given the constraints of industry, competitive position, and corporate culture. The CEO s constant challenge is to manage the tension between the two: to get the organization to act in ways that will lead to success in the capital markets. Value management was supposed to help CEOs meet this challenge. By instituting new metrics that better capture improvements in intrinsic value, the thinking went, value management would focus a company s executives on improving business fundamentals. And since capital markets were efficient, improvements in intrinsic value would translate automatically into improvements in a company s stock price thus rewarding investors. It hasn t entirely worked out that way. To be sure, value management has helped many
companies focus internal decision making on increasing intrinsic value. In many instances, it has improved the management of existing capital employed and brought a more explicit value-creation focus to incremental investment decisions. But increasing the intrinsic value of a business is one thing; realizing that value in the capital markets can often be quite another. One of the lessons of recent years is just how much investor expectations can drive shareholder value either above or below the level that the intrinsic value of a company would suggest. (For a more complete treatment of this subject, see The Continuing Relevance of Investor Expectations, BCG Perspectives, December 2001.) Traditional value management largely ignores the gap between intrinsic value and realized value. Fortunately, some companies are developing techniques to address that shortcoming. Consider the following two examples. Eliminating Valuation Gaps There are two ways for a company to improve its total shareholder return (TSR). One way is by generating improvements in the fundamental indicators of intrinsic value. In this approach, traditional measures for determining intrinsic value (such as earnings per share) are complemented with a set of
more sophisticated metrics for example, free cash flow, economic value added (EVA), or cash flow return on investment (CFROI). But it is also possible to increase TSR by improving how the market actually values those fundamental indicators, as measured by a company s valuation multiple (usually quantified as the price-to-earnings ratio). A company s multiple is a snapshot of how investors view both current performance and future growth prospects. Many factors influence it: the company s cost of capital, the relative riskiness of its businesses, its sources and uses of free cash flow, its outlook for revenue growth, its financial policies, its management vision and credibility, and its portfolio strategy, to name just a few. Traditional value management doesn t have much to say about multiples, despite their importance. As a result, most executives manage as if their company s multiple were outside their control. They re wrong. Although it is true that the absolute level of a company s multiple is influenced by macroeconomic or industrywide factors, there is a lot that managers can do to analyze what drives their relative multiple within their peer group and to improve their relative valuation over time. The experience of one industrial-goods company provides a good example of both
the limits of traditional value management and what managers can do to overcome them. In terms of intrinsic value, the company s performance looked great. The company consistently delivering a higher return on capital employed (ROCE) than its most direct competitor. And yet, its multiple was 25 percent below that of its rival. How to explain this valuation gap? By analyzing the economic characteristics of the two companies and using regression analysis to isolate the factors determining multiples for their entire peer group, managers were able to identify and quantify four key sources of the gap. (See the exhibit Quantifying the Sources of a Valuation Quantifying the Sources of a Valuation Gap EBITDA multiple 10 8 6 6.6 +0.8 +0.5 +0.5 +0.5 8.9 4 2 0 Company ROI volatility Use of free cash flow Debttocapital ratio Portfolio complexity Leading peer SOURCE: BCG analysis.
Gap. ) For one thing, the company s high ROCE was accompanied by above-average volatility. As a result, value investors, who constituted the company s dominant investor group, perceived the stock as a relatively risky investment and discounted it accordingly. What s more, the company s chief competitor was far more disciplined in its use of free cash flow. Our example company was replacing its assets at a rate 20 percent faster than that of its competitor. As a result, investors weren t fully benefiting from the high ROCE whether in dividends returned to shareholders or in more cash to reinvest in profitable growth. The company also had a much higher debtto-capital ratio than its competitor, which exacerbated volatility and added default risk. Finally, diversification gave the company an overly complex portfolio, which caused investors to discount the company s stock even more. Once corporate executives realized the true sources of their relatively low multiple, they were able to design a series of moves to address the key problems. The company reshaped its portfolio to increase focus and minimize volatility (even at the price of sacrificing some high-margin but relatively risky businesses). It used the proceeds from these divestitures to pay down debt. Finally, it
revised its capital-allocation process to lengthen investment cycles and depreciation periods. Within six months, these moves contributed to closing the valuation gap, resulting in a $2 billion increase in the market value of equity. Getting Managers to Think and Act Like Owners Another promise of value management was to get line managers to think and act like owners by linking compensation and incentives to some measure of intrinsic value, such as EVA and CFROI. However, this approach had the unintended consequence of insulating line managers from the signals of the capital markets. The reality is that incentive targets are usually the result of negotiation about what s achievable not about what would be required if the business units in question were standalone, publicly traded entities. Over time, this practice only perpetuates the climate of negotiation, gaming, and tensions between the corporate center and the line that existed before value-based measures were introduced. Business unit managers need to be directly exposed to the demands of investors in the capital markets. They need to manage to goals that can deliver superior TSR, and they need
to understand how their local priorities and tradeoffs affect the company s overall valuation multiple. This approach holds everyone accountable for delivering realized value creation. Here s how one manufacturing company did it. Management set itself the goal of delivering a top-quartile TSR within a large group of diversified manufacturing companies. To reach that goal, the company calculated it would have to deliver an annual TSR of about 16 percent (assuming there was no change in its relative multiple). The incentive plan used that target to set bonus levels for corporate, sector, and division executives. If a business unit contributed less than 6 percent to TSR, its executives received no bonus at all. A 10 percent contribution (equivalent to average performance in the peer group) amounted to an average bonus. A contribution of 16 percent triggered the maximum bonus. To measure each business unit s contribution to TSR, the company employed a simple internal measure of capital gains and dividend yield at each operating level. The proxy for capital gains was the business unit s percentage change in earnings before interest, taxes, depreciation, and amortization (EBITDA). The proxy for dividend yield was the net free-cash flow to (or from) corporate
by the end of each year. This measure provided a simple way to link business unit results to capital market targets. It also clearly positioned each line executive to act as if he were CEO of his own publicly traded company with direct accountability for meeting or exceeding the returns required by investors and full freedom to manage priorities and tradeoffs in order to do so. Because the bonus-award schedule was preset, there was no need to negotiate with the business units. (After all, companies can t negotiate targets with investors.) Before adopting the new approach, the company ran it as a shadow exercise. Unsurprisingly, the exercise revealed that under the old system, the best negotiators (those with the most modest plans) got the biggest bonuses, even though they contributed less to TSR than managers of other businesses. Meanwhile, executives who fell short of what were often ambitious plans for improvement got little or no bonus even though they made very high contributions to TSR. Aligning internal measures and incentives with TSR can go a long way towards both empowering and disciplining value creation efforts at the operating level. Both these examples demonstrate how companies can begin to transcend the limits
of traditional value management. Employing the new generation of approaches helps CEOs anticipate the likely impact of strategic moves on TSR performance and align manager accountability with investor expectations. Eric E. Olsen Eric E. Olsen is a senior vice president and director in the Chicago office of The Boston Consulting Group and a CEO of the BCG ValueScience Center. The Boston Consulting Group, Inc. 2002. All rights reserved.
This article is the fourth in a recent series of Perspectives on corporate finance and value management. The previous titles are: Treating Investors Like Customers, by Gerry Hansell and Eric E. Olsen When Growth Is Not an Option, by Ron Nicol and George Stalk Jr. The Continuing Relevance of Investor Expectations, by Daniel Stelter and Mark Joiner To request copies or to comment on these or other Perspectives, please contact BCG by e-mail at imc-perspectives@bcg.com.
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