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Driving shareholder value in turbulent times through EPM PwC Thought Leadership Series 2012

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PricewaterhouseCoopers Private Ltd

Power of robust performance management in turbulent times

Slide 2

The current global macroeconomic scenario has proved to be quite a challenge to even the best of economists. However there are a few organisations that are able to address volatility and display consistency better than peers. These organisations are better at ‘managing for performance’ with a tighter, more effective framework that dampens internally and externally inflicted volatilities.

Such firms possess a strong culture of Enterprise Performance Management and are rewarded by the market with a lower cost of equity that translates to higher valuation, on an industry adjusted basis.

With the level of uncertainty in economic activity trending towards a new normal, the need for all firms to gain better control on their performance is at its highest. But sometimes the seed for change is merely comprehending the impact.

Through our research, we have been able to quantify the key benefits of strong EPM culture, on an industry adjusted basis across multiple sectors. We expect our findings to open a strong dialogue among CXOs on the need for a robust performance management framework.


Table of Contents

Slide 3

• Executive Summary

• Hypothesis

• Approach and Methodology

• Analysis

• Results

• Conclusion

• Appendices


Executive Summary

4


• We have conducted an extensive cross-sectional empirical study that covered companies across 15 industries, to estimate the market impact of the quality of performance management at firms

• Our research indicates a strong correlation between a firm’s EPM culture (framework design and implementation rigour) and its control on operating and cashflow performance

• Using volatilities in operating margin and asset turnover as proxies for operational control and inventory-to-sales ratio and cashflow-to-sales ratio as proxies for cashflow control , we find that firms with strong EPM culture experience 17% lower cost of equity and a 32% lower beta than peers (on average)

• As a result, strong EPM firms experience a valuation premium of 22% higher Price to Earnings multiple and 65% higher Price to Book multiple (on average) compared to other firms, on an industry adjusted basis

• This confirms our hypothesis that the market rewards firms with a strong EPM culture due to their tighter control on translating organisational strategy into desired operating and financial performance to meet shareholder expectations.

• Firms that lack this culture fare poorly on a relative basis in terms of their ability to plan for and achieve the desired goals leading to higher volatility in operating and financial performance, in turn resulting in lower valuation.

Firms with a strong EPM culture are rewarded with significantly higher shareholder value

Slide 5


Difference in market metrics of firms with strong EPM

Slide 6

1.30

1.06

Industry adjusted Price to Earnings (PE) multiple

Strong EPM Others

14.7%

18.0% Industry adjusted Cost of Equity Industry adjusted Beta

0.75

1.11

1.65

1.01

Industry adjusted Price to Book (PB) multiple


Lower volatility in performance a prime driver in market metrics differential

Slide 7

II IV

III I

1.33

1.10

PE Multiple*

1.15

0.90

PE Multiple*

15%

17%

Cost of Equity*

15%

19%

Cost of Equity*

0.81

0.98

Beta*

0.73

1.29

Beta*

Op

er

ati

ng

Vo

lati

lity

Operating Level High Low

Lo

w

Hig

h

*Industry adjusted


Hypothesis

8


Key Hypothesis

Slide 9

“Firms that exhibit a strong culture of performance management or EPM, are rewarded by the market and achieve higher valuations than firms that do not exhibit such a culture.”

Rationale

Firms that report highly volatile numbers across periods, relative to industry, have been found to have higher beta compared to peers who exhibit better control. The higher beta, on account of volatile numbers, result in higher cost of equity and hence lower valuation of the firm, lead to erosion of shareholder value. Firms with a strong EPM culture have a structure to translate organisational strategy into coordinated enterprise wide activities and hence are able to achieve desired goals and report more consistent numbers. Consequently, as an implication of high predictability or low volatility of operating performance, these firms should have a lower beta compared to its peers resulting in higher shareholder value.


Approach and Methodology

10


Approach and Methodology Enterprise Performance Management Indicators - I

Slide 11

We selected various lead indicators for a strong EPM culture in a firm along the dimensions of EPM Design and Implementation Rigour.

• Planning and Budgeting tools • Comprehensiveness of Planning & Budgeting • KPI tree linking strategic to operational to

financial goals • Efficient operating models • Providing and meeting Earnings Guidance • Optimized Cash to Cash cycle

• Rigor in Variance Analysis • Rigor in Forecasting • Rigor in Performance and Success

Measurement • Rigor in Risk Management • Number of Budget iterations • Days to prepare Budget

On the basis of information collected through primary research, we rated a cross-section of firms across industries, on each of these indicators. Then, we computed an aggregated score for each of the firms on the strength of its EPM Design and Implementation Rigour.

We hypothesized and tested that firms with higher scores on EPM Design and Implementation Rigour have a greater control of and hence exhibit a lower volatility in their business operations.


Approach and Methodology Enterprise Performance Management Indicators - II

Slide 12

We identified four indicators of a firm’s control over its business operations, two each for control over operating performance and control over cash flow performance, as defined below:

• Asset Turnover Volatility • Operating Margin Volatility

• Cash Flow-to-Sales Ratio Volatility • Inventory-to-Sales Ratio Volatility

• Asset Turnover Volatility captures the inconsistency with which a firm generates revenues for a given size of assets, calculated on an industry adjusted basis. A high volatility suggests that the firm is not able to utilize its assets as much as it could have because it is not able to translate its organisational strategy into operating performance or it lacks integrated planning.

• Operating Margin Volatility captures the inconsistency with which a firm generates operating profits for a given size of revenues, calculated on an industry adjusted basis. A high volatility suggests that the firm does not have proper control over its costs on account of a lack of an effective KPI tree that captures and links revenues and costs to profits.

• Cash Flow-to-Sales Ratio Volatility captures the inconsistency with which a firm generates cash flows for a given size of revenues, calculated on an industry adjusted basis. Cash flows are key to a firm’s smooth functioning and survival – poor cash flows may lead to liquidation of assets at a loss or even bankruptcy. A high volatility suggests that the firm does not have an effective KPI tree that captures and links investments and revenues to cash flows.

Control over Operating Performance Control over Cash Flow Performance


Approach and Methodology Enterprise Performance Management Indicators - III

Slide 13

• Inventory-to-Sales Volatility captures the inconsistency with which a firm is left with inventory for a given size of revenues, calculated on an industry adjusted basis. Ideally, firms would have a stable inventory to sales ratio as there are costs involved in storing and managing inventory. A higher ratio indicates that the firm has not been able to sell as much it had planned. Hence, a high volatility suggests a deficiency in planning and forecasting or a lack of agility within the firm on account of a lack of an effective KPI tree that links sales plans ,short term production plans , inventory plans and procurement plans.

According to risk management theory, for any parameter, a higher volatility results in a higher Value At Risk of that parameter and consequently a higher possibility of a loss making situation on that parameter. Hence, as an enterprise risk mitigation measure, firms worldwide, for example, reduce the earnings and cash flow volatilities to reduce their earnings and cash flow Value At Risk.

Similarly, a reduction in volatilities of Asset Turnover , Operating Margin, Cash Flow-to-Sales , Inventory-to-Sales would reduce the firm’s probability of an unfavourable position on any of these parameters.

Next, we established through a regression analysis that firms with higher scores on EPM Design and Implementation Rigor have scored better on each of these volatilities, indicating that firms with a strong EPM culture have a greater control over their business operations.

Note: volatility score has been calculated in a way such that lower the volatility, higher the volatility score.


Approach and Methodology Shareholder Value Indicators

Slide 14

We classified firms into Strong EPM and Others, based on their volatility scores on the Qualitative and Quantitative aspect of control over business operations.

Firms with high scores on the Qualitative and Quantitative control over their business operations are classified as Strong EPM, while the rest as Others.

We hypothesized and tested that firms with higher scores on control over Operating Performance and Cashflow Performance are rewarded by the market with higher valuations i.e. they have higher industry adjusted PE multiple and lower industry adjusted Cost of Equity. Additionally, these firms have a higher PB multiple on an industry adjusted basis.

• Price-to-Earnings ratio or PE multiple • Price-to- Book ratio or PB multiple

Equity Valuation

• Cost of Equity


Approach and Methodology Control over business operations and Market multiple

Slide 15

To assess the significance of lower volatility or higher control over business operations, we combined all the four volatility scores into one volatility factor and all the four level scores into one level factor. We plotted firms with the volatility score and level score on the Y and X axes respectively and categorize firms into four buckets:

I. Firms with lower level performance and lower volatility

II.Firms with lower level performance and higher volatility

III.Firms with higher level performance and lower volatility performance

IV. Firms with higher level performance and higher volatility performance

We hypothesized and tested that amongst firms with similar level performance, firms achieving higher volatility performance are rewarded by the market with higher valuations.

i.e. Category I has higher valuation than Category II and Category III has higher valuation than Category IV


Analyses

16


Firms with strong EPM Design and Implementation Rigor enjoy lower Inventory-to-Sales Ratio Volatility1

Slide 17

Firms with strong EPM culture are not

only able to plan better but also

monitor and control execution against the plan resulting in good control over inventory

Correlation Inventory-to-Sales

Ratio Volatility

EPM Design 0.53

Implemen-tation Rigour

0.63

1See Appendix 1

EP

M D

es

ign

Implementation Rigor

Inventory-to-Sales Ratio Volatility*

Strong EPM Culture

*Larger the size of the bubble, lower the volatility

High Low

Lo

w

Hig

h


Firms with strong EPM Design and Implementation Rigor enjoy lower Cash Flow-to-Sales Ratio Volatility2

Slide 18

Firms with strong EPM culture have a

KPI framework linking investments

and revenues with net cash and hence have better control on the

desired net cash flows

2See Appendix 1

Correlation Cash Flow-to-

Sales Ratio Volatility

EPM Design 0.69


0.69

EP

M D

es

ign


Cash Flow-to-Sales Ratio Volatility*

Strong EPM Culture


Lo

w

Hig

h

High Low


Firms with strong EPM Design and Implementation Rigor enjoy lower Operating Margin Volatility3

Slide 19

Organisations with a strong EPM culture

have operational level KPIs that help

monitor and control costs and thus achieve the desired operating margin consistently

3See Appendix 1

Correlation Operating Margin

Volatility

EPM Design 0.69


0.55

EP

M D

es

ign


Operating Margin Volatility*

Strong EPM Culture


Lo

w

Hig

h

High Low


Firms with strong EPM Design and Implementation Rigor enjoy lower Asset Turnover Volatility4

Slide 20

Firms with a strong EPM culture have a

multilevel KPI framework that links

sales performance with assets to achieve

the desired asset turnover consistently

4See Appendix 1

Correlation Asset Turnover

Volatility

EPM Design 0.53


0.72

EP

M D

es

ign


Asset Turnover Volatility*

Strong EPM Culture


Lo

w

Hig

h

High Low


Strong EPM firms achieve a high degree of control over all key aspects of business operations

Slide 21

Strong EPM Organisations

Control over Operating Performance

(computed using Asset Turnover and Operating Margin volatility scores)

Co

ntr

ol

ov

er

Ca

sh

Flo

w P

er

for

ma

nc

e

(Co

mp

ute

d u

sin

g C

ash

flo

w a

nd

In

ven

tory

vo

lati

lity

sco

res)

High Low

Lo

w

Hig

h


Results

22


Strong EPM firms enjoy 22% higher PE Multiple than other firms

Slide 23

Higher valuation of World Class EPM firms is driven by lower Cost of Equity, which in turn is an outcome of lower beta, compared to that of other firms

1.2984

1.0616

0.60

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1.40

Price to Earnings Multiple World Class EPM

Other

Industry adjusted Average

PE Multiple

World Class EPM

1.30

Other 1.06


Strong EPM firms enjoy 65% higher PB Multiple than Other firms

Slide 24

Higher valuation of World Class EPM firms is driven by lower Cost of Equity, which in turn is an outcome of lower beta, compared to that of other firms

Industry adjusted Average

PB Multiple

World Class EPM

1.65

Other 1.01

1.6520

1.0049

0.60

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

1.60

1.70

1.80

Price to Book Multiple World Class EPM

Other


Strong EPM firms have 18% lower Cost of Equity and 32% lower Beta than other firms

Slide 25

0.0

0.5

1.0

1.5

2.0

2.5

Be

ta

Other World Class EPM

Average World Class EPM Other

Beta 0.75 1.12

14.8325%

17.9469%

12.0% 12.5% 13.0% 13.5% 14.0% 14.5% 15.0% 15.5% 16.0% 16.5% 17.0% 17.5% 18.0%

Co

st

of

Eq

uit

y

World Class EPM Other

Average World Class EPM Other

Cost of Equity

14.83% 17.95%

1.1173

0.7509


Strong EPM firms achieve higher Operating Margins as well as a greater control over it

Slide 26

1.33

1.10

0.80

0.90

1.00

1.10

1.20

1.30

1.40

Operating Margin Level Index

World Class EPM

Other 1.93

1.32

0.80

1.00

1.20

1.40

1.60

1.80

2.00

Operating Margin Volatility Index*

World Class EPM

Other

*Higher the Index value, lower the volatility


Strong EPM firms achieve higher Cash Flows Ratios as well as a greater control over it

Slide 27

3.61

1.15

0.80

1.30

1.80

2.30

2.80

3.30

3.80

Cash Flow Ratio Volatility Index*

World Class EPM

Other 1.26

1.10

0.80

0.85

0.90

0.95

1.00

1.05

1.10

1.15

1.20

1.25

1.30

Cash Flow Ratio Level Index

World Class EPM

Other



Strong EPM firms achieve lower Inventory levels as well as a greater control over it

Slide 28

1.68

1.07

1.00

1.10

1.20

1.30

1.40

1.50

1.60

1.70

1.80

Inventory Ratio Level Index*

World Class EPM

Other 1.91

1.11

0.80

1.00

1.20

1.40

1.60

1.80

2.00

Inventory Ratio Volatility Index*

World Class EPM

Other

*Higher the Index value, lower the volatility *Higher the Index value, lower the Inventory ratio


Strong EPM firms achieve higher Asset Turnover as well as a greater control over it

Slide 29

1.09

0.93

0.80

0.85

0.90

0.95

1.00

1.05

1.10

1.15

Asset Turnover Level Index

World Class EPM

Other

2.33

1.09

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40

2.60

Asset Turnover Volatility Index*

World Class EPM

Other



II IV

III I

High Low

Lo

w

Hig

h

Additionally, categorizing firms according to their volatility and level performance indicates...

Slide 30

Op

er

ati

ng

Vo

lati

lity

Operating Level


Firms with lower volatility have higher valuations compared to firms with higher volatility, at a similar level performance...

Slide 31

1.33

1.10

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

PE Multiple Index

I II

1.15

0.90

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

PE Multiple Index

III IV


...also, these firms have lower Cost of Equity and Beta compared to firms with higher volatility, at similar level performance

Slide 32

15.35%

16.77%

12.00%

13.00%

14.00%

15.00%

16.00%

17.00%

18.00%

Cost of Equity I II

14.64%

19.43%

12.00%

13.00%

14.00%

15.00%

16.00%

17.00%

18.00%

19.00%

20.00%

Cost of Equity III IV

0.81

0.98

0.60

0.65

0.70

0.75

0.80

0.85

0.90

0.95

1.00

Beta I II

0.73

1.29

0.60

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1.40

Beta III IV


Conclusion

33


Conclusion

Slide 34

The importance of control over operating and financial performance by firms and the ability of robust Enterprise Performance Management to enable the same has been established through this research. From a long term shareholder value perspective, the key to success lies in posting consistently strong performance over a long period of time. Posting consistent performances signals the investor about the ability of the firm to control and execute its strategy as desired. A manifestation of strong control increases investor confidence and leads to higher valuation of the firm. Recent macroeconomic turbulence has eroded the protective moats of many a company, however a few firms have still been able to maintain decent control over their performance, compared to peers. A strong culture of performance management is a key pillar for these successful firms to achieve consistent performance. As shown by the paper, firms with a strong culture of performance management have reported relatively less volatile performance, despite the unfavourable market dynamics, compared to other firms in their industry. Consequently, these firms with strong performance management have significantly higher valuations than peers.


Appendices

35


Appendix 1 Formulae

Slide 36

1. Inventory-to-Sales Ratio Volatility = 5 yr average inventory-to-sales ratio volatility in industry 5 yr inventory-to-sales volatility of the firm 2. Cash Flow-to-Sales Ratio Volatility = 5 yr average cash-to-sales ratio volatility in industry 5 yr cash-to-sales volatility of the firm 3. Operating Margin Volatility = 5 yr average operating margin volatility in industry 5 yr operating margin volatility of the firm 4. Asset Turnover Volatility = 5 yr average asset turnover volatility in industry 5 yr asset turnover volatility of the firm 5. Asset Turnover Level = 5 yr average asset turnover of the firm 5 yr average asset turnover of the industry 6. Operating Margin Level = 5 yr average operating margin of the firm 5 yr average operating margin of the industry 7. Cash Flow-to-Sales Ratio Level = 5 yr average cash flow-to-sales ratio of the firm 5 yr average cash flow-to-sales of the industry 8. Inventory-to-Sales Level = 5 yr average inventory-to-sales of the industry 5 yr average inventory-to-sales of the firm 9. Firm Beta = Absolute Firm beta __ Average industry beta 10. Firm PE Multiple = Absolute Firm PE Multiple_ Average industry PE Multiple 11. Cost of Equity = 10 year RBI Bond Rate + Firm Beta*Market Risk Premium 12. Control over Cash Flow = Cash Flow-to-Sales Ratio Volatility * Inventory-to-Sales Ratio Volatility 13. Control over Operating Performance = Asset Turnover Volatility * Operating Margin Volatility 14. Volatility Index = Inventory-to-Sales Ratio Volatility*Cash Flow-to-Sales Ratio Volatility*Operating Margin Volatility*

Asset Turnover Volatility 15. Level Index = Asset Turnover Level*Operating Margin Level*Cash Flow-to-Sales Ratio Level*Inventory-to-Sales Level 16. Volatility = Standard Deviation of values Mean of values


Appendix 2 Assumptions

Slide 37

1. 10 year RBI Bond rate as on 23rd April 2012 = 8.45% 2. Market risk premium in India as on 23rd April 2012 = 8.50% 3. Beta, PE Multiple values recorded from moneycontrol.com and capitaline.com on 23rd April 2012 4. The volatility score measured for an indicator is calculated in a way such that it reflects the zigzag

nature of the variability in the set of values of the indicator. For firms that reported a continuous improvement on the indicator over the period of 5 years thus resulting in a positive volatility, the volatility score has been adjusted to reflect the positive performance. These cases have been rare, and in such cases, the firm has been awarded a volatility score higher than the firm with the lowest volatility.

5. Outliers have either not been considered in the calculations or their values appropriately scaled up or down to fit with the crowd. Outliers are defined as points whose values are 80% higher or lower than the nearest point in the crowd.

6. To estimate correlation between EPM culture factors and volatilities, a subset of the firms mentioned in Appendix 3 have been taken, as data was not available on all.


Appendix 3 Sectors and Firms covered

Slide 38

• Auto Ancillary • Automobiles • Consumer Durables • Engineering • Engineering & Construction

• Entertainment & Media • FMCG • Food Processing • Information Technology • Oil & Gas

• Idea Cellular • Larsen & Toubro • Zee Entertainment • Triveni Engineering • Britannia • Thermax • Bajaj Auto • Hero Motocorp • Bharti Airtel • Bosch • Cummins • Exide • BHEL

• Shree Renuka Sugars • KSB Pumps • GSK • Dabur • Nestle • Colgate-Palmolive • Videocon • Maruti Suzuki • Reliance Industries • Cipla • Aurobindo Pharma • DLF • HDIL

• Tata Steel • Infosys • Mcnally Bharat • TVS Motors • India Pistons • Religare Technova • Huawei Technologies • Kirloskar Brothers • Allied Photographics • Tata Teleservices • Scooters India • Tata Motors • SAIL

• Punj Lloyd • Engineers India • Bajaj Auto • Wipro • Dynamatic Pumps • Shakti Pumps • Hindustan Motors • Tata Motors • MIRC Electronics • Samsung • Sahara One • Sun TV • Suzlon

• Pharmaceuticals • Real Estate • Steel • Sugar • Telecommunications

Firms

Sectors

Contact

Soumen Mukerji

Leader - Finance Effectiveness

Mobile: +91 98361 06159

E-mail: [email protected]

Contributors

Zubin Sarkar – [email protected]

Shyam Pattabiraman – [email protected]

Thank You About Finance Effectiveness Consulting at PwC

Finance Effectiveness consulting helps CFOs assess and balance their priorities and deal with challenges related to growth, profitability and risk by focussing on key finance dimensions: Insight (Enhancing effectiveness of corporate strategy ), Efficiency (Improving Service delivery parameters), Control and Compliance (Optimizing Risk Management), Enablers (Leveraging People & Technology)

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