Home > Value Creation > Performance Metrics and long term alignment (I)

Performance Metrics and long term alignment (I)

In our previous post on performance metrics related to compensation schemes, back on January 2013, https://joaquinbarquero.wordpress.com/2013/01/19/pay-for-performance-ii-performance-metrics/, we analysed different financial and non-financial metrics that are often used to assess corporate performance.

We particularly refered to the many critics that had been issued against financial metrics as for their incapacity to force managers to focus in the long-term sustainability and prosperity.

Several years after the 2008 crisis started,  financial metrics are still by far the most used to evaluate the corporate and managers` performance.

In The Alignment Gap Between Creating Value, Performance Measurement, and Long-Term Incentive Design, (1) authored by Organizational Capital Partners and commissioned by the Investor Responsibility Research Center Institute (IRRCi), Mark Van Clieaf, Karel Leeflang, Partner and Stephen O’Byrne tried to shed light on the relationship between company economic performance, shareholder return and executive compensation.

We will in this post review the performance metrics recommended by the authors to measure “value creation and performance”.

They use several basic concepts that we set forth in what follows: (i) Current Value equals Invested Capital plus Current Economic Profit; (i) Future Value equals Market Enterprise Value minus Current Value; (iii) Net Operating Profit after Tax (Nopat) equals Ebit minus Tax cash payments; (iv) Economic Profit (EP) equals Nopat minus a Capital charge; (v) Capital Charge is Invested Capital times Wacc.

 We include below a chart describing all these concepts:

Economic Profit Value Driver

They argue EP is the best measure for value creation, as it detracts all input costs. Enterprise value creation thus stems from EP; for them, strategy is the art of determining when current EP is to be sacrificed in order to obtain higher EP in the future, so that enterprise value increases as a total value. Also as a consequence, Performance Evaluation needs to be done within a large enough period.

The authors then reinforce their concepts (i) Nopat as the assets returns before remuneration to capital (debt and equity) providers; (ii) Invested Capital as the sum of all assets minus excess cash and except for non interest bearing liabilities; (iii) Return on Invested Capital, as Nopat divided by Invested Capital, that when being higher than Wacc indicates there is value creation; (iv) Roic minus Wacc is usually called Performance Spread: its value and evolution reflect the effectiveness of strategy in creating competitive advantage and value.

 In their empirical survey though, they found that TSR is the more widely used metric; also, less than 25% of firms included Balance Sheet or Capital efficiency metrics in their long-term incentive plans.

 The main problems the authors identify in TSR are: a) TSR is affected by too many variables, a lot of them (monetary policy, etc) being market or industry related; b) Relative TSR introduces these factors but does not really indicate anything about factors leading to value creation; c) it may be the case that EP being positive (negative) TSR is negative (positive).

The authors propose instead to use a different approach, measuring the two Enterprise Value (EV) components they identify, Current and Future Value: they first determine what they call Current Value (CV), which equals EP divided by Wacc plus Invested Capital. Please see below:

Current Value Driver

In their study, this model captured 48% of shareholder returns. And part of the failure to reach a better result comes from Invested Capital having a delay in producing its benefits, so that periods used don`t allow to show the full picture.

Future Value (FV) is the second EV component, and they consider it can be simply calculated as a subtraction, (FV equals EV minus CV); it represents the Net Present Value of future EP improvement already included by the stock market in the stock price. Of course, it is far more than a calculation, and it includes: (i) improvement from current operations; (ii) EP stemming from growth and innovations, as shown below:

 Future Value Driver

EV is also a driver for TSR, and the authors wonder how much of EV and TSR is driven by Current (Future) Value; see TSR drivers below:

TSR Driver

So they tried to identify how firms are being managed, in order to see if Future Value creation is being deliberately considered in managers`s pay and other managerial decisions.

The findings are relatively disappointing: (i) larger performance periods for firms are usually no more that three years long; (ii) firms have lately become less capital-intensive, so that intangibles (within the total invested capital) ann future value drivers are more important; (iii) less that 15% of firms disclose incentive plans tied to future value drivers, (such as innovation, customer and employee loyalty, new products, etc). (iv) given that capital markets recognizes a large part of enterprise value is “future value”, there is no indication on how firms and managers are trying to foster this part of value; (v) even more, a large number of firms destroy value over long periods of time; (vi) a low number of first executives have their pay variance connected to EP, (or Return on Invested Capital), or even relative TSR.

So, the authors suggest that (a) managers measure capital efficiency and Economic Value creation; (b) measure changes in future value; (c) measure value creation based on actual reinvestment in the business.

They also propose a framework for understanding long-term performance, introducing more efficient incentive plans for managers, etc. We will deal with all their additional proposals in next comments to be posted,…, soon.

 

  1. http://irrcinstitute.org/projects.php?project=75, by Organizational Capital Partners and commissioned by the Investor Responsibility Research Center Institute (IRRCi), (Mark Van Clieaf, Karel Leeflang, Partner and Stephen O’Byrne).
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