BCG Rethinking Value Based Mgmt Sept 02

8/9/2019 BCG Rethinking Value Based Mgmt Sept 02

1/16

28 6 HANDBOOK OF BUSINESS STRATEGY

Rethinking

Value-BasedManagement

In the early 1990s, the business press, securities analysts,and management consultants widely touted value-basedmanagement (VBM ) as a new tool to help investors assesscompanies and help executives evaluate business perfor-mance and shareholder value. And conceptually, VBM wasa great idea. But after a decade of experience both on Wall

Street and inside companies, has VBM realized its promise aseither an investing tool or a management tool?

The answer appears to be mixed. In a recent survey of VBMadopters by professors at INSEAD, respondents views rangedfrom high impact to lit tle or even negative impact of VBM ontheir companies. The studys authors concluded that VBM as a

discipline added value for those companies that adopted it as away of lifei.e., a cultural changeand was limited in those thatmore narrowly deployed it as yet another management tool.

And recent events raise even broader questions about VBMsimpact. Where was the influence of the VBM discipline on WallStreet during the dot-com boom and bust, or in the corporatesuite during the more recent and ongoing controversies over exec-utive pay and accounting improprieties? Did investors, venturecapitalists, analysts, consultants, boards, and executives fail toheed the principles, or did the principles of VBM fall short in pro-viding guidance? And, looking forward, does VBM sti ll offer acompetitive edge or even a relevant management approach for

the next decade?VBM s mixed track record suggests that we should reexamine

the lessons of the last decade and craft a more comprehensiveand effective approach to deploying VBM. And, in the end, therereally is no alternative but to do so. For many reasons, deliveringsuperior value creation has become senior managements mostpressing task. Investors expect it and respond aggressively to itsabsence. Management and employee security, opportunity, and

ERIC OLSEN

Value-based

management theories

have fallen short in

practice, especially

when it comes to

investor strategy.

Er ic Olsen is a senior vice president

and Worl dwide Topi c Area Leader for

Value Management for t he Boston

Consul ti ng Group . He is based in the

fi rm s Ch icago office. For fur ther

in formati on, go to www.bcg.com.


2/16

remuneration are more and more closely tied tostock value performance. Through stock options,its promise has become a key factor in the attrac-tion or retention of both managerial and technicaltalent. Most major business publications now puta spotlight on annual value creation performance

rankings. Andperhaps most importantlyit hasbecome increasingly obvious in many industriesthat long-term competitive advantage is dependenton access to the capital resources that accompanysuperior value creation.

The clear challenge is to rethink how manage-ment can better apply the principles and practicesof VBM to help deliver superior value creation ona sustained basis. Here, there are a number of newinsights and evolving best practice approaches thatcan elevate and extend both the art and the sci-ence of managing value creation. These newapproaches better connect VBM with capital mar-kets outcomes and better align organizations todeliver sustained value creation.

THREE MISSING LINKS

Traditional VBM approaches did not ful ly equipexecutives with comprehensive perspectives andguidelines for managing value creation. As a result,many pursued agendas that either had missinglinks or disjointed connections with the strategiesthey were pursuing. And VBMs credibi li ty as an

overarching management framework sufferedwhen executives who bought into the philosophyfound the approach too narrow to address impor-tant management issues.

For example, VBM showed managers how toimprove net present value (NPV), but offered littleadvice about how to achieve a premium valuationmultiple, or price-earnings ratio (P/E). It definedwhat the organization should strive for and how toassess decisions or tradeoffs along the way, butoffered little practical guidance on how to alignthe organization and its culture to be more proac-

tive and effective at achieving value creation goals.And, often, VBM practices created unintendedconsequences in internal behavior and externalstock price, because the practices were notgrounded in a complete systems view and imple-mentation process that resulted in a consistentand reinforcing value creation agenda.

These shortcomings stem from three pragmat-

ic missing links in traditional approaches toVBM . Some might observe that these missinglinks are more the province of good general man-agement than of VBM. But another view is thatVBM has much to offer good general manage-ment beyond economic principles and measures,and it loses impact as a respected and enduringdiscipline if it is not fully woven into the overallfabric of managing long-term value creation.Therefore, it is important that VBM approachesbe extended to connect these frequently missinglinks. They are:

1. An incomplete connection with capital mar-kets realities.

2. An incomplete connection with organizationand culture.

3. An incomplete process for managing the sys-tem of levers that determine value creation.

Within each of these categories of missing links,there are a number of new insights and impliedchallenges. For example, a stronger focus on capi-tal market realities reveals the gaps between intrin-sic value and actual stock price. The need tobridge this gap puts the responsibility for manag-ing a companys long-term relative P/E (or othervaluation multiple) more squarely on businessleaders lists of levers to manage proactively. Andthere are a number of new insights and tools avail-

able to quantify and act on the specific drivers ofrelative valuation multiples.

Similarly, a stronger emphasis on capital mar-kets linkages opens up the opportunity to connectwith and manage a companys investor base moreeffectively. New thinking about investor strategyextends the VBM principle of stock market eff i-ciency to recognize that, like ones potential cus-

HANDBOOK OF BUSI NESS STRATEGY 28 7

Long-term competi t i ve

advantage can be

dependent on access to

the capi tal resour ces that

accompany super i or

value creati on .


3/16

tomer base, stock markets are also segmentedaround investor groups that have different priori-ties and that can put different valuations on thesame performance.

During the 1990s many companies stumbled inpackaging their offerings to investors by assuming

that markets were efficient at recognizing intrinsicvalue improvements and investors would readilymigrate to their offering. For example, those infavor of the Merck-Medco business combinationundoubtedly believed the intrinsic value improve-ment logic was obvious, but the different investorsegments that sought out pharmaceutical versuspharmaceutical benefits management companiesdidnt agree. Extending VBMs linkages to capitalmarkets provides important insights for portfoliostrategy thinking.

The second missing link, connecting VBM withorganization and culture, gets to the heart of man-agement practice, and to how VBM can helporchestrate improved value creation. This is per-haps the most difficult yet richest long-term veinto tap for driving sustained superior value creation.From empowering and enabling human capital tobuilding superior management capabilities, thereare many levers and practices to manage.

For example, few companies have effectivelyaligned their planning, budgeting, target setting,and incentive compensation processes. This failure

is largely a result of assigning ownership of eachprocess to different functional areas with anunclear accountability and/or process for bringingthem together. The consequences are commonlymanifested in sandbagged or gamed plans, negoti-ated budgets or targets, and incentives that con-flict with long-term value creation. Or, in a differ-ent vein, many companies have not aligned thesocial contract between corporate and businessunit management in ways that effectively balanceempowerment, intervention, and accountability forvalue creation. The result is often no small dose of

frustration and cynicism on both sidesratherthan team spirit around a shared goal of value cre-ation. Here VBM needs to be extended to addressthe entire range corporate center practices, that is,to headquarters activities that promote value cre-ation across operating units.

The third missing link is lack of grounding in aprocess for thinking about and managing the

entire system of influences and levers that deter-mine value creation. Here, traditional VBMapproaches provided rich guidance for managing asubsystem of economic principles and leversbutlittle on how to further align strategic, cultural,and behavioral levers. This shortcoming becomeseven more pronounced when the capital marketsmissing link is added to the equation. Portfoliostrategy and operational priorities need to belinked to their impact on P/E, their appeal to thetype of investors who own the stock, and to themanagement practices that determine their effec-tive delivery. Conversely, investor ownership mixhas implications for portfolio strategy, operationalpriorities, and the design of internal metrics andincentive plans. Value creation results from howthe entire system of influencers, priorities, andlevers interact to maximize realized value.

In short, there is both a wide-ranging challenge

and a big opportunity to harness VBM to achieveimproved value creation. Assumptions, priorities,tradeoffs, tools, mind-sets, and culture all need tobe reexamined, and at many levels across a compa-nys management team.

ASYSTEMS APPROACH TOVALUE CREATION

A recent observation by a senior executive at a For-tune100 company illustrates the core challenge indeveloping a value creation agenda: The easy partof managing value creation is conceptually con-vincing managers and employees that it is their

most important, overriding, and shared focus. Thehard part is figuring out where to start and how allof the pieces fit together. Delegation, training, andincentives only take you so far and then they breakdown into unproductive or misdirected efforts.

The system depicted in Figure 1 offers asequence for thinking about value creation in away that helps crystallize where to start and how

28 8 HANDBOOK OF BUSI NESS STRATEGY

Change, not l evel of ROI

on sunk costs, i s what

matter s to i nvestor s.


4/16


5/16


3. Promote the well being of all other stakeholders.These sound good on paper and provide a great

deal of grist for leadership speeches, but they donteffectively focus thinking and behavior. Line exec-utives in this company were frustrated whenstrategies to maximize market share failed to meet

short-term financial targets for bonuses, and, con-versely, when proposed acquisitions conflictedwith corporate definitions of markets served. Thislatter frustration is similar to what Jack Welchobserved in From the Gutabout the potential trapof being #1 or #2 if it leads to defining markets ina way that limits growth.

In our experience, RTSR can be the most usefulsingle way to define and communicate a compa-nys aspirations and the supporting plan foractionif it is done in the right way. That is, if it isgrounded in external value realization, explicitlyquantified, and then cascaded down into the orga-nization as a long-term goal that energizes linemanagement and empowers local entrepreneurialthinking about all of the levers to achieve it.

The process of doing so is not arcane, and itcreates targets that are objective, appropriatelystretch, and directly link business area manage-ment to capital markets discipline. As one seniorexecutive put it: Translating our RTSR goal intobusiness unit targets made managers accountablefor value creation as if they were CEOs of their

own publicly traded companiesand, you cantnegotiate performance targets with investors.

Whether the RTSR goal was met at the corpo-rate level can be readily measured after the fact bysimply ranking a companys TSR against its select-ed peer groups TSR. Management can also set aforward-looking target for RTSR and use it toassess the impact of corporate and business unitplans or major strategic initiatives. This requirestranslating a ranking goal such as top half, topthird, or top quartile TSR into a specific numbera number that, if achieved internally, will have a

high probability of resulting in reaching the target-ed ranking for actual external TSR in the future.Figure 2 illustrates the calculations required todevelop a forward-looking RTSR target.

In Figure 2, the first calculation arrives at aninvestors view of the risk-adjusted average expect-ed return that a company, peer group, or marketindex is priced to deliver. In this sense it represents

a fair not superior return, and can be thought of asreflecting the expected average TSR for the marketor a peer group. There are several methods avail-able for estimating the cost of equity, includingcapital asset pricing models (CAPM ) arbi tragepricing theory (APT), and dividend discount mod-els, but for most companies today, the expectedcost of equity is in the 10% range.

The second calculation requires judgment toselect the stretch above-average TSR that isaspired to. Here a word or two of caution is inorder. Achieving superior TSR year in and year outis a difficult challenge, because it is accomplishedonly through superior performance improvementsand not simply by maintaining superior absolutelevels of performance (i.e., return on equity, ROE;return on capital employed, ROCE; economicvalue added, EVA, etc.). Figure 3 displays twokey considerations in selecting a goal for relativeTSR spread above average.

The left panel in Figure 3 shows the probabilityof outperforming the S&P 500 average over con-secutive years. By definition only half of the com-panies will be above median in any given year. Forthose that outperform in one year, the probabilitythat they will outperform again in the next year isonly 25%, and only 12% for outperforming threeyears in a row. In this sense, its more difficult tocontinue to be the most improved player in theleague each year than it is to continue to be votedthe most valuable player each year. From a valuecreation perspective, it is more reasonable to set

goals for superior achievement cumulatively overthree, five, or ten years than it is to strive for con-tinuous superior performance each year.

The right-hand panel in Figure 3 providesbenchmarks for the degree of stretch required tomeet a cumulative top quartile TSR goal over dif-ferent time periods. On average over the last 20years a company needed to deliver a TSR that was

Figure 2. Forward RTSR Calcula tion

Antic ipa ted 5-year company cos t of equity 10%

Anticipated spread to achieve relative TSR goal 6%

Forward looking 5-year RTSR target 16%


6/16

210% of the S&P 500 median TSR to be top quar-tile in any given year. This stretch dropped to160% to be top quartile over any given five-yearperiod. Thus, if the S&P 500 median TSR in agiven year was 10%, it would have taken a 21%TSR that year to make it into the top quartile,Similarly, if the five-year compound average TSRfor the S&P 500 was 10%, it would have taken acompound average 16% TSR to be top quartileover five years.

With no change in a companys P/E multipleand during periods of normal (i.e., 10%) stockmarket returns, top-quartile TSR performanceover a five-year period requires an 16% growth inEPS, minus a companys dividend yield. This isactually a heroic accomplishment to deliver consis-tently, considering that the historical average EPSgrowth for the S&P 500 is in the range of 6% peryear. Aspirations need to be believable and achiev-able to have positive impact on motivation andbehavior. Many companies would be better suitedto set aspirations for long-term RTSR at 2-3%

points above the market averageafter all, mostfund managers would be pleased to achieve thislevel of performance for their portfolios cumula-tively over the long term.

Once management has set a RTSR aspiration,the next task is to cascade it down into the organi-zation (business units, geographies, product lines)as a local accountability. Doing so requires choices

in two different areas.One is whether or not tode-average the overall tar-get to take into accountbusiness unit or productline near-term potential.

For example, if the over-all target is 16%, shouldbusiness unit A, which iscompetitively disadvan-taged, have a 12% targetwhile business unit B,which has just launcheda blockbuster new prod-uct, have a 20% target, orshould all businessesalways have an 16% tar-get? The best approachwill vary given cultural

norms, management philosophy, and diversity ofbusiness characteristics. Most, but not all, of BCGclients that employ this approach have opted for acommon target across all businesses or productlines as the fairest and most objective way to allo-cate capital markets requirements to internal busi-ness units.

The second choice is what internal measure thecompany will employ to capture a business unitsor product lines contribution to the RTSR goal.

Here, the most effective approach is to use thetotal business return (TBR) measure. This mea-sure captures the capital gain and dividend yieldcontribution of a business unit or product line in asimple and transparent formula. Figure 4 showsone version of the formula, using growth in earn-ings before interest, tax, depreciation and amorti-zation (EBITDA) as the driver of capital gains. Theformula can be readily adapted to use earningsbefore interest and taxes (EBIT), net operatingprofit after tax (NOPAT), or operating income forbusinesses that are not capital-intensive.

Many companies have found TBR to be a usefulcapstone measure because it requires businessunit management to balance tradeoffs betweengrowing EBITDA and managing capital invest-ments. In order to increase TBR, a business unitthat elects to use cash for investments to improveEBITDA must provide a capital gain that is greaterthan the free cash flow dividend yield they would


1 yearin a row

Frequency of above median TSR Rat io of top quart ile t o median TSR (1)

50

25

12

2 yearsin a row

3 yearsin a row

60%

50%

40%

30%

20%

10%

0%

Over a year

Over 3 years

Over 5 years

Over 10 years

210 %

170%

160%

140%

Note S&P 500 avg.TSR over last 30 years=10%

(1)Calculated in rolling periods over the last 20 years for S&P 500

Figure 3. RTSR Probability and Timeframe


7/16

have gotten by returning the cash to corporate.And, empirical studies by BCG indicate that theTBR measure has a much higher correlation toactual RTSR than other measures such as EPSgrowth, change in EVA, and improvement in ROE.

Companies deploying the TBR measure inter-nally send a clear, objective, and empowering mes-sage to their business area teams: You are incharge of the value creation tradeoffs in your busi-ness as if you were CEOs of your own publiclytraded companies. You must manage them todeliver a value contribution that is consistent withcapital markets expectations for any publicly trad-ed companyeither through increasing value orby freeing up cash to return to corporate.

This philosophy removes corporate as a bufferbetween business units and capital marketsaccountability, eliminates unproductive negotia-

tions about targets, and empowers and disciplinesbusiness unit management to chart their owncourse for improved value creation.

In summary, aspirations are an important tool tofocus, align, and stretch an organization, but theymust be clear, quantifiable, achievable, locallyempowering, and linked directly to capital marketsexpectations. Grounding aspirations in a RTSRgoal that is cascaded down to business unitaccount abil it ies is theleading-edge approach foractivating the aspiration

lever. Companies thathave effectively incorpo-rated this approach intotheir planning and incen-tive compensationprocesses experience anumber of benefits:Negotiations around tar-

gets are eliminated, sandbagging or gaming ofplans and budgets disappear, requests forresources are more honestly linked to value cre-ation, and local empowerment and accountabilityfor value creation delivery are increased. And, theusefulness of aspirations as a vehicle for driving

reexamination and stretch thinking about opera-tional effectiveness and competitive strategy at thebusiness unit level is greatly enhanced.

DIRECTLEVERS FOR VALUE CREATION

Management has four basic levers that they candirectly activate to meet their RTSR goal: opera-tional effectiveness, competitive strategy, portfoliomanagement, and investor strategy. These leversare not independent and must be activated in away that aligns them with each other and withvalue creation.

Most traditional VBM approaches focus on howto improve the first three levers and largely ignorethe investor strategy lever. The intent of traditionalapproaches was to provide economic principlesand supporting measures that helped managersfocus these three levers on value creation. Earn areturn above the cost of capital, grow profitably,and maximize cash flow, not accounting earnings,were the guiding principles of new value metricssuch as cash flow return on investment (CFROI),EVA, net present value (NPV), and others. These

principles and measures promised a rational andcommon language for assessing business plans,evaluating operating tradeoffs, allocatingresources, measuring performance results, reward-ing managers, and managing the overall portfolio.

All in all, it was a compelling array of potentialbenefits that prompted many companies to adoptone form of VBM or another. But, whi le manycompanies achieved a number of these benefits,


Figure 4. TBR Formula Exa mple

TBR = Intrinsic ca pital gains + Intrinsic dividend yield

TBR = % EBITDA +Free cash flow

EBITDAx multiple

In practice, most companies use an EBITDA multiple that is derivedfrom the weighted average cost of capital to ensure a correct bal-ance between investing cash or returning it to the parent

OperationalEffectiveness

InvestorStrategy

CompetitiveStrategy

PortfolioManagement RTSR

+ + +

Figure 5. Direct Levers for Value Crea tion


8/16

many others did not.And many non-VBMadopters had TSRs thatoutperformed industrypeers that had adopted aformal VBM approach.

Clearly, adopting VBMwas not a panacea fordelivering superior valuecreation.

Traditional VBM prin-ciples fell short of pro-viding the best guidancefor value creation largelybecause they ignored thefourth direct leverinvestor strategy. M ostapproaches to VBMfocused on delivering improvements to underlyingintrinsic (theoretical) value and not externally real-ized value. Figure 6 illustrates how a number ofcommon VBM principles take on different impli-cations when viewed from an investors perspec-tiveand how those principles need to evolve toprovide better guidance for operations, strategy,and portfolio management activities.

Earn a return above the cost of capital hasbeen a core underpinning of all approaches toVBM. But most approaches have viewed this prin-

ciple solely from an internal perspective. Theoperational guides most VBM users focus on aregetting the ROI on existing assets up to or abovethe cost of capital and ensuring that all incremen-tal new investments earn returns above the cost ofcapital. Yet these prescriptions can fall short oreven distort the ultimate goal when viewed froman investors perspective. For investors, earning areturn above their cost of capital means achievinga risk-adjusted capital gain or dividend yield thatis above average (i.e., RTSR >1). Their goal is toinvest in companies that will deliver fundamental

performance that exceeds the performance expec-tations already imbedded in the companys cur-rent stock price. They are less concerned withwhether a companys ROI on existing assets isabove the cost of capital than with whether it willimprove from its current or expected level. LowROI companies that improve ROI are good invest-ments while high ROI companies that are not

improving can be bad investments. Change, notlevel of ROI on sunk costs, is what matters toinvestors. Figure 7 shows the relative TSR perfor-mance of companies in the S&P 500 given theirstarting level of ROI.

As shown in Figure 7, companies that had thelowest quartile ROIs on existing assets deliveredRTSRs during the next five-year period that wereon par with those that were originally in the high-est quartile of ROI. The implication of thisinvestor-centered logic is that having a high ROI

relative to the cost of capital does not equate to asuperior TSR. To drive value, ROIs must eitherimprove above expected levels or be accompaniedby greater than expected reinvestment growth. Andinternal targets for ROI improvement or reinvest-ment for growth need to reflect the expectationsthat are already in the current stock price. HighROI business units cant coast, and low ROI busi-ness units are not value eroders per se if they canimprove ROI above expectations.

In the 1990s many managers were side-trackedby VBM implementations based on the narrow

conclusion that ROI levels below the cost of capi-tal were bad and ROI levels above the cost of capi-tal were good. This prompted unproductivedebates about sunk cost, acquisition good will,allocating shared assets, or calculating the cost ofcapitaldebates that distracted from the focus onimproving fundamental performance.

Similarly, the focus on improving intrinsic value


Figure 6. Shortcomings in Traditional VBM Principles

Traditional Principle

Earn a return above the costof capital

Existing assets

Incremental investments

Improve intrinsic value NPV, EVA Cash, not accounting

Stock markets are efficient Investors readily migrate

Issues

Ignores investorexpectations

Ignores drivers of realizedvaluation multiples

Ignores investorsegmentation

Evolved Princ iple

Earn a TSR greater thanaverage

Improve your business

more than expected

Manage both intrinsic valueand realized value

NPV must come in apackage that appeals toinvestors

Relative multiples aredriven by managementactions

Treat investors like customers Understand the implications

of your investor mix


9/16

created mind-sets andpriorities that fell shortof maximizing realizedvalue creation. An over-reliance on improvinginternal measures such

as EVA or NPV resultedin lack of attention tomanaging the companysvaluation multiple. Mostmanagers believed theirmultiple was not man-ageable or it would takecare of itself (i.e., reflectintrinsic value improve-ment) and focused onmeasuring intrinsicvalue correctly and then taking actions to improveit. Absolute valuation multiples do, in fact, dependon macroeconomic and investor sentiment factorsthat are outside managements influence. Howev-er, relative valuation multiples are largely driven byfactors that are under managements control.M anagement of risk, t ransparency of report ing,portfolio mix composition, consistency of results,management and meeting of expectations, and therelative priority among revenue growth, marginimprovement, and balance-sheet management atthe operating level all determine the appeal of a

companys value proposition to investors.A number of tools are available to isolate and

quantify the manageable drivers of a companysrelative valuation multiple. These include investorinterviews, benchmarking against a high-multiplepeer, regression analysis of industry multiple dif-ferentiators, and longer-term market multipleanalyses. But the overriding focus on intrinsicvalue thinking in the 1990s prevented many com-panies from taking steps to manage their valuationmultiple. As a consequence many executives werefrustrated when their NPV packages did not

impress investors or created investor compromisesthat undermined their valuation multiple.

In a related, but somewhat different, vein, theprinciple of stock market efficiency masked therequirement and opportunity to proactivelyincrease a companys appeal to investors. Whilemarkets are efficient, they are also segmented.Growth investors will look at a companys NPV

proposit ion through a different lens than wil l valueor income investors. In essence, they are like cus-tomer segments that look for different features,benefits, and branding. It is difficult to create asingle package that will appeal to all segments atthe same time. As a result, each company needs todevelop an effective investor strategy that identi-fies how it can improve value in a way that the tar-geted investor segments will find attractive overthe long term. This means that companies need acapital markets fact base that includes a carefulanalysis of investor segments that currently own

them, and a process for incorporating the owner-ship mix implications into the other direct leversthat make up a companys value propositionoperational effectiveness priorities, competitivestrategies for growth, and overall portfolio strategy.

Good things to do from an intrinsic value per-spective may not be the best things to do from arealized value perspective, particularly in the shortto medium term. Introducing a balance sheetmanagement program driven by EVA will notimpress the growth investor base of a high P/Ecompany, and it may even result in erosion of the

multiple (realized value) if the program distractsmanagers from a top-line revenue growth priority.Adding a growth leg to a mature business portfoliowill attract few growth investors and may alienateexisting value investors who prefer that manage-ment focus on improving the core business anduse free cash flow to repurchase shares, reducedebt, or increase dividends. M any moves that


1 2 3 4

Past

5 yearavg.ROI

S&P 500 quartil e

20

15

10

5

01 2 3 4

Next

5 yearRTSR

Previous S&P 500 quart ile

1.5

1.0

0.5

0.0

Figure 7. ROI vs. RTSR


10/16

increase intrinsic value measures such as NPV orEVA may also reduce a companys valuation multi-ple. This is because they may dilute the companysappeal to its current investor base and, at the sametime, fail to appeal to new investors.

In summary, managing the tradeoff between

improving intrinsic value and improving realizedvalue is a key challenge that was masked by theassumptions in traditional VBM approaches. Thistradeoff affects how each of managements fourlevers should be activated. Adjusting traditionalVBM principles so that they are more investorfocused is the first step in better maneuveringthose levers for value creation. The follow-up stepis to equip investor-oriented VBM principles withmore effective tools for identifying and quantifyingopportunities to increase realized value.

Here there are two additional tools that canhelp enhance a companys ability to manage real-ized value. One focuses on understanding the fun-damental performance drivers behind relative P/Eor other valuation multiples. The other focuses onunderstanding the investor-oriented drivers of pre-miums or discounts to a companys valuation.Combined, they provide rich insights about how toimprove realized valuation and what accompany-ing changes to priorities or tradeoffs in operations,competitive strategy, portfolio management, orfinancial policies are necessary.

Quantifying relative P/E drivers. Until the lastdecade, P/E multiples were widely used as the pri-mary indicators of company valuation. But withthe advent of value measurement techniquesemphasizing net present value, EVA, and cash flowreturn on investmentand with increasing acade-mic and consultancy research showing low corre-lations between P/E levels and EPS growththedefensibility of P/E ratios as a management bench-mark came into question. Yet many senior execu-tives still talk about, worry about, and wonderabout how to improve their P/E ratio, and it is still

the metric that investment bankers and sell-sideanalysts emphasize when speaking with corporateexecutives about their stock market valuation.And, when properly interpreted, P/Es (or other val-uation benchmark multiples) provide importantinformation that can help management shape avalue creation agenda.

Although P/E ratios are a residual measure and

not a hands-on driver of stock price (i.e., you cantdirectly pull the P/E lever), they do summarize thehealth of underlying factors that determine thevaluation investors assign to a companys EPS. Assuch, the ratio is a reservoir of important insightsthat can be acted upon to improve valuation (ifthose insights can be clearly identified). This wonthappen by simply comparing company P/Eratioseven when artful investment bank or ana-lyst interpretations are applied.

BCG has employed two different analyticalapproaches to assessing the underlying drivers thatdetermine client P/Es (or any other valuation mul-tiple such as EBITDA/total value, price/book, orprice/revenue multiples). One approach is a pairedcomparison of fundamental drivers between two

companies with different valuation multiples. Bycomparing the two companies, it is possible toidentify the factors that would intuitively explaindifferences in valuation from an investors perspec-tive (e.g., performance volatility, leverage risk, cashflow leakage, ROI, portfolio complexity, consisten-cy of strategy). Where there is a direct peer with ahigher P/E, this approach can pinpoint clearactions that can improve the companys valuation.

A second approach uses regression analysis toderive the fundamental factors that explain differ-ences in valuation multiples across a group of

companies. The technique, termed relative multi-ple factor analysis, empirically derives the funda-mental factors that explain differences in valuationmultiples across a specific sample of companies.

Sometimes these factors are traditional finan-cial performance variables (e.g., return on netassets, return on sales volatility, sales growth, grossmargin, debt to capital). But sometimes they are


Unti l sen i or execut i ves

know what matter s most

to k ey i nvestors, thei rstr ategi c moves can

destr oy value rather than

create i t.


11/16

more operational factors such as the ratio of self-service to full-service customers (brokerage indus-try). The approach allows testing of a wide rangeof potential valuation differentiators, and results ina formula that quantifies the potential impact ofchanging the performance of any given indicator.

Investor strategy premium/discount. Develop-ing an effective customer-oriented strategy is afundamental pillar of good business practice. Butdisciplines such as customer segmentation andproduct packaging have not been widely applied toa companys ultimate customersinvestors.

Like end-use customers of a product or serviceoffering, investors differ widely in their apprecia-tion of different combinations of features or bene-fits. And, as in the case of product/service cus-tomer strategy, companies need to develop aninvestor strategy that best meets the needs ordesires of targeted investor segments.

Simply offering a future NPV outcome that ishigh is not enough. Investors care about the pack-aging of the NPV perhaps more than they careabout what the bottom line number is. NPV pack-ages that impress or satisfy management may notconnect with current investor or potential investorsegments, resulting in a valuation that is a dis-count to underlying intrinsic value.

For example, until senior executives know whatmatters most to their key investors, they can make

strategic moves that destroy value rather than cre-ate it. That is what nearly happened to one compa-ny with a strong brand franchise and a long historyof delivering modest, but profitable, organicgrowth. Senior executives were concerned abouthow the company wasgoing to meet investorsexpectations. Theyassumed that sustainingthe companys unusuallyhigh P/E required thatthe company grow more

rapidly.Management was well

down the road toward anew acquisition and amajor geographic expan-sion when it discoveredthat these big strategicbets were precisely what

its core investors did notwant. The companysinstitutional investors were dominated by growthat a reasonable price(GARP) shareholders. Theywere looking primarily for stabilityconsistent,above-average earnings growth but with very lowrisk. They were eager to see aggressive reinvest-

ment to protect and grow the main franchise, butnot an expensive acquisition and a potentially riskyexpansion into volatile economies with significantexchange rate risks. The companys plan ran therisk of alienating its major investors, therebydestroying its P/E multiple rather than saving it.

The goal of investor strategy is to create a prod-uct offering that either eliminates discounts tounderlying intrinsic value or that creates a sustain-able valuation premium. Figure 8 outlines thesources of company discounts.

Obviously, a companys value will suffer if itsstrategy is misguided or its operational execution ispoor; these represent failures to capitalize onintrinsic value improvement opportunities. Thisfirst source of company discounts is a classic focusfor tradit ional VBM activities, but is unrelated toinvestor strategy.

The remaining three sources of discount aredirectly related to investor strategy. Each repre-sents managements a failure to align the offeringto investors needs and desires. A governance dis-countoccurs when the needs or interests of dif-

ferent segments of investors are in conflict. Ittypically arises where there is a mix of dominantand marginal investors, different classes ofshares, or partial listings of subsidiaries. Thesesituations are more common than is appreciated.


PotentialValue

Strategy,OE Discount

CurrentIntrinsic

Value

GovernanceDiscount

CredibilityDiscount

CompromiseDiscount

ActualValue

12

3 4

Figure 8. Sources of Discount


12/16

Individuals, management, family trusts, or foun-dations that have significant holdings can havevery different objectives than institutionalinvestors. For example, the interests of the FordFoundation trust can differ not only from thoseof Ford management but also from those of their

institutional investors. How well managementsalign these diverse interests will determinewhether institutional investors place a discounton the companys value.

A credibil i ty discountoccurs when manage-ments agenda is either not clear to investors or isinconsistently delivered upon. Lack of clarity arisesfrom either vague or incomplete discussions ofstrategic intentions, or from ineffective line ofbusiness or strategic milestone reporting thatleaves key operational performance insights to theinvestors imagination. Inconsistency erodes credi-bility when managements statements of strategicintent change frequently, when actions dontmatch stated intent, or when results dont followcommitments. Credibility with investors can be acompanys most important off balance sheetasset, if managed effectively.

Compromise discountsoccur when managementoffers an overall NPV package that contains trade-offs that are not att ractive to investors. Mixingbusinesses having value characteristics with busi-nesses having growth characteristics in the same

portfolio is a clear cause of compromise discounts.For example, companies in mature industries

that add new growthbusinesses to their portfo-lios may not be able tocapture the underlyingvalue of these new busi-nesses. Growth investorsprefer pure play invest-ments that have criticalmass around growthopportunities, while

value investors preferthat management doesnot dilute near-termvalue realization poten-tial by making risky orlonger-term growthinvestments with excessfree cash flow. Also, as

many firms have discovered, mixing businesseswith radically different risk profiles can result in adiscount to their intrinsic risk-adjusted value.Novart is, M onsanto, and others discovered thiswhen they mixed high-risk biotechnology business-es with lower risk pharmaceutical businesses.

Financial theory describes an efficient frontier forrisk-return tradeoffit is difficult to occupy differ-ent places on that frontier at the same time andmaintain an optimal valuation.

Companies can remove discounts and achieve amodest sustainable premium to underlying intrin-sic value by creating a company brand that eitherreduces investors perceptions of risk or increasestheir confidence in the stabili ty or extendibility of acompanys sources of value creation advantage.Under Jack Welch, GE established such a brandthat led to a sustained premium over the discount-ed cash flow valuation of underlying performance.But the underlying brand features must be sus-tainable or the premium quickly disappears andcan even lead to a disappointment discount. Fig-ure 9 outlines an investor strategy approach to cre-ating a sustainable premiumor at least ensuringthe absence of a discount.

If you were to build a powerful product or ser-vice brand, you would first assemble a rigorouscustomer fact base and then use that knowledge todrive both your product/service development agen-

da and your marketing/advertising agenda to sup-port it. The same is true for building a company


Acquisitions

Diversification

Growth vs. Return Focus

Capital Structure

Dividend PolicyShare Repurchase

Incentive & Target Setting

Planning & Budgeting

Who are your investors,segmented by investment style?

Investor strategy employs the same elementsas marketing strategy to customers

Tailored communication/outreach strategyFact base development

What are investors' expectationsfor performance?

What is your credibility quotient with

current investors?How could or should your investorbase change

To improve valuation? In response to strategies?

Communicationcontent/focus

Targeting New Investors

LOB Reporting

Strategic MilestoneReportingValue Creation Commitment

Investor Migration Plan

Feedback tomanagement agenda

Figure 9. Investor Strategy Steps


13/16

brand that creates a pre-mium price withinvestors.

As outlined in Figure9, the process beginswith a clear understand-

ing of the currentinvestor segmentation,what their expectationsand needs are, what NPVfeatures are most attrac-tive to them, what thecompanys credibilityquotient is, and how thefirm could migrate tonew investor segments tomaximize the appeal ofits NPV offering. Thisinformation then feeds back to managementsaction agenda to orchestrate the content, priority,timing, and consistency of strategic, operational,and financial policy actions. It also feeds forwardto establish the focus, content, and positioning ofinvestor relations communications.

Many companies trade at a discount to intrinsicvalue; very few trade at a sustainable premium. Aneffective investor strategy can eliminate the formerand promote the latter. When deep knowledge ofinvestors is combined with analysis of fundamental

factors that explain valuation multiple differencesamong peers, actionable insights to raise valuationbecome clear and high priority. Figure 10 showsthe results for XYZ Inc.

Over the last decade, XYZ Inc. had consistentlyexperienced a lower EBITDA multiple than theleading peer in its industryeven though XYZconsistently had a higher ROCE than its peer.Using direct benchmarking and relative multiplefactor analysis, XYZ quantified the four primarydrivers of the discount that the companys value-oriented investors were concerned with. Subse-

quently, management developed and implementeda revised value creation agenda that, within sixmonths, significantly closed the gap in their rela-tive multiple.

CORPORATE CENTER PRACTICES

Once management has developed a game plan foractivating the four levers for value creation, it must

align corporate center practicesthat is, head-quarters activitiesto ensure delivery. This is amore important and difficult task than most execu-tives perceive.

Yet the practices of the corporate center are crit-ical to sustained superior value creation. Whenthey are aligned with value creation, they empow-er, enable, discipline, and orchestrate an organiza-tions ability to reach its full potential in deliveringvalue. When they are unaligned or misaligned,they can create barriers or foster counterproduc-

tive thinking and behavior. And the cumulativeimpact of these headquarters activities largelydetermines the pragmatic aspects of company cul-ture. Corporate center practices convey beliefs andvalues, establish behavior norms, and signal priori-ties. Reinforcing or changing culture to focus onvalue creation is largely a matter of how corporatecenter practices are designed and carried out.

More often than not, the combined impact ofcorporate center practices is neutral to negative infostering value creation. Often these practiceshave not been subject to a comprehensive reexami-

nation that identifies strong vs. weak practices,misalignment across practices, or missing linkswithin the overall set of practices. Figure 11depicts the range of corporate center practices thatcan either foster or inhibit an organizations abilityto deliver sustained superior value creation.

There are three steps to developing an alignedset of corporate center practices that contribute


XYZ

EBITDAM

ultiple

ROIvolatility

Use of f reecash flow

Debt t ocapital ratio

Portfoliocomplexity

Leadingpeer

6.6 +0 .8+0 .5

+0 .5+0 .5 8.9

Figure 10. Example of Multiple Drivers


14/16

optimally to value creation. The first is to reexam-ine the appropriate balance among four differentgoals: empowerment, enablement, discipline, andorchestration. Is the overarching goal of long-term value creation better served by fostering agreater sense of local empowerment, thus makingline managers more proactive? Will exploitingcorporate talent, skills, and capabilities throughdirect interventions better enable line managersto improve results? Will a more rigorous disci-

pline for accountability and for results mostenhance value creation? Is it to better orchestratesynergies across businesses, to capture between-business opportunities, or to develop commonplatforms or capabilities?

It is simply not possible to fully realize all fourgoals at the same time. There are tensionsbetween these goals that make it difficult to giveall of them equal emphasis. For example,approaches that increase local empowerment tendto reduce enablement and orchestration-and viceversa. And the priority of these goals will differ,

depending on a companys characteristics (focusedvs. diversified, high growth vs. mature, etc.) andcultural starting point.

Too often, companies continually tweak theircorporate center practices to try to achieve thebest of all worldsand end up with the worst ofall worlds. One recent BCG study revealed how farout of alignment corporate center goals and sup-

porting practices can get.Several years previously, acompany had realignedits planning, budgeting,and incentive processesto foster greater empow-

erment and accountabili-ty for its business unitmanagement teams.M anagement wanted toincrease entrepreneurial-ism and eliminate unpro-ductive budget negotia-tions. But when theprogram didnt producepositive results as fast asexpected, corporatelaunched a series of top-down enablement pro-

gramsa balanced scorecard tool, a customerrelationship management program, and then anasset productivity program. These programs dis-rupted local managements focus and priorities,caused them to miss previously established incen-tive targets (requiring reengaging the negotiationprocess), and resulted in an erosion of corporatecredibility with line managers. The disconnectreached a climax when corporate uncovered a sig-nificant opportunity to reduce costs and improve

new product development by orchestrating a bestpractices sharing program for manufacturing andtechnology development. None of the businessunit leaders would agree to champion the effort oroffer their best people to support it. Cynicism sopervaded the atmosphere between corporate andbusiness units that driving value creation becamesecondary to managing organizational politics.

Incremental tweaks to corporate center goalsand practices can result in one step forward andone or two steps backward. A more effectiveapproach is to periodically reexamine all elements

in the corporate center and then align them in anew direction as appropriate. This reexaminationprocess begins with assessing the match betweencorporate center goals and the existing corporatecenter style. Figure 12 il lustrates how dif ferentstyles interact with different goals.

The three corporate center styles shown on theleft of Figure 12 represent the range of ways in


"Direct Levers"

OperationalEffectiveness InvestorStrategyCompetitiveStrategy

Corporate Center Practices

"Determine what actually happens"

Balance across goals Role of center style Supporting practices

EmpowermentEnablementDisciplineOrchestration

Leadership & guidanceExploiting linkagesManagement processes

Hands-on ownerHands-off investorActivist partner

PortfolioStrategy RTSR+ + +

Figure 11. Corporate Center Practices


15/16

which corporate canposition its social con-tract with line man-agers. One extreme isthe hands-on ownerstyle, where corporate

executives control mostof the major decisionsabout priorities, trade-offs, and new initiativesthat aff ect day-to-dayoperating results. Manycompanies with afocused customer set,technology base, or com-mon business model across geographies gravitatetoward this style. At the other extreme is thehands-off investor style, where corporate has littleor no direct influence on day-to-day operatingmatters and focuses on disciplining financialresults and making decisions about managing theportfolio mix. M any diversif ied companies adoptthis style.

As indicated in the cells of the matrix, the twostyles tend to be polar opposites in their impact onempowerment, enablement, discipline, andorchestration goals. As a result, many corporatecenters are tempted to vacillate between the twostyles to get the best of both worlds. They do this

by off and on direct interventions, periodic tweaksto management processes (e.g., planning, budget-ing, or incentives), and leadership pronounce-ments. Done carefully, this can work wellfor awhile. But more often it eventually results in frus-trationnot a healthy tensionamong both cor-porate and business unit management.

If staying at or moving to either style extreme isnot appropriate for a company, then the activistpartner style may be the right answer. It representsa different type of social contract than vacillationbetween hands-on and hands-off styles. And it

puts a different burden on corporate behavior andsupporting practices. But it is a style that has to beconstantly worked at to maintain its integrity. Gen-eral Electric is a leading-edge example of how thisstyle is applied.

The activist partner style works to create a teamspirit around a shared long-term goal of value cre-ation based on an enduring respect for clearly

established roles and boundaries for both corpo-rate executive and line manager behavior. Empow-erment is granted to line managers, but coachingand thought partnering is expected. Enablement isdone primarily through high-level capability devel-opment programs, not specific interventions.Accountability and discipline are promotedthrough frequent and open inter-year reviews andflexible incentive program design. Orchestration isdone by corporate taking the time to sell its casefor synergies, common platforms, or shared ser-vices to line executives.

Any of the above three styles can workif it fitsthe business characteristics and is adhered to con-

sistently. Lack of alignment of practices aroundone style or vacillation across styles can diminishthe contribution from corporate center activit ies.

Once goals and style have been defined, theremaining issue is to clearly align specific corpo-rate center practices to support them. Practices forleadership and guidance, exploitation of linkages,and management processes need to reflect the pri-ority of goals and the intended corporate style. Forexample, performance metrics used if the goalwere maximum empowerment under a hands-offstyle would be very different from those used if the

goal were maximum discipline under a hands-onowner style. In the former case, one high-levelmetric (e.g., EVA or TBR) that allowed local trade-offs to be optimized would be appropriate. In thelatter case, a larger number of focused metrics thatlimited local degrees of freedom would be appro-priate (e.g., revenue growth, margin, capital turns,free cash flow targets).


Figure 12. Corporate Center Style vs. Goals

Line empowerment Results enablementAcc ountability

discipline

Orchestra tion oflinkages

Hands-on ow ner

Low

Most decisionsmade at center

High

Intervention focusedon short-term impact

Medium

Paternalorientation

High

Mandate directly

Hands-off investor

High

Autonomous

fiefdoms

Low

Few corporate

programs

High

Financial, short-term

focus

Low

No intent to

capture synergies

Activist partner

Medium-high

Shared partnership

philosophy

Medium-HighIntervene forcapabilities

development

Medium-HighCoaching, long-term

results, frequentreviews

Medium-High

Sell benefit to line

first

Goal

Style


16/16


Similarly, a larger range in annual bonus poten-tial may be more appropriate for a hands-off style,and a narrower range of bonus with a higher basesalary may better fit a hands-on owner style. Or adisciplined and robust long-range business unitplanning process may better accompany a hands-off style and a more limited business unit annualbudget process may better suit a hands-on style.

Few companies have developed a formal processfor reexamining and aligning corporate centergoals, styles, and practices. Evolution throughtweaking is the norm. Best practice is to step backperiodically (every three to five years, or after amajor acquisition) and charter a task force to com-prehensively reexamine how effectively the corpo-rate center is fostering value creation. The task-force should start by developing a capabilities andculture fact baseone that solicits a wide range of

inputs and assembles objective data on capabilitiesand the effectiveness of practices. M apping thisfact base against the current agenda for manage-ments four direct value creation levers reveals theviability of current corporate center goals, style,and practices. Then the (often surprisingly obvi-ous) alignment steps can be implemented.

Company characteristics or the business envi-ronment can change significantly over any giventhree- to five-year period. Companies need tomanage the evolution of their corporate centerpractices in a systematic way to capture untapped

opportuni ties for in value creation.

REAPING THE BENEFITS

The full benefi ts of VBM will accrue to thosecompanies that best connect VBM practicesexternally with capital markets and internally withtheir organizations. Focusing the organizationsefforts around a relative total shareholder return

aspiration that is cascaded down into businessareas is a first step. M anaging direct levers forvalue creation in a way that recognizes tradeoffsbetween intrinsic value improvement and realizedvalue improvement is a second. Doing so requiresa focus on the levers that determine relative valu-ation multiples and cause investor discounts. Thethird step is to align corporate center practices toleverage capabilities and the impact of culture onvalue creation.

These steps seem straightforward on paper, butthey have long been overlooked. In fact, it is clearthat the last decades VBM approaches either didnot fully address them or masked the importanceof tackling them with a fact-based and systemsperspective.

We hope the past lessons, new insights, andorganizing frameworks described here will providereaders with the ingredients to craft and imple-ment a VBM approach that delivers a successfulvalue creation agenda for next decade.

FURTHER READINGFrom t he Gut, by Jack Welch, Warner Books;2002.

M anaging for Value: It s Not Just About theNumbers, by Philippe Haspeslagh, Tomo Noda,and Fares Boulos, Harvard Business Review, July-August 2001

Treating Investors Like Customers, by GerryHansell and Eric Olsen, The Boston ConsultingGroup Perspective, June 2002.

When Vision Undermines Culture, by EricOlsen, The Boston Consulting Group Perspective,

July 1999.

The cumul at i ve impact

of headquar ter s acti vi ti es

l argel y determ i nes the

pr agmati c aspects of

company cul tu r e.

BCG Rethinking Value Based Mgmt Sept 02

Documents

Transcript of BCG Rethinking Value Based Mgmt Sept 02