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«Chapter 2 Competing Financial Performance Measures Abstract The choice of financial performance measures is one of the most critical challenges ...»

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Chapter 2

Competing Financial Performance



The choice of financial performance measures is one of the most critical

challenges facing organizations. Performance measurement systems play a key

role in developing strategic plans, evaluating the achievement of organizational

objectives, and rewarding managers. The measurement of financial performance in

terms of accounting-based ratios has been viewed as inadequate, as firms began

focusing on shareholder value as the primary long-term objective of the organization. Hence, value-based metrics were devised that explicitly incorporate the cost of capital into performance calculations. In this chapter, the following valuebased measures are discussed, by focusing on their measurement logic: the economic value added (EVA), the cash flow return on investment (CFROI), the shareholder value added (SVA), the economic margin (EM) and the cash flow value added (CVA). The recently emerging emphasis on market value-based measures as the best metrics for value creation is also briefly analyzed.

Á Á Keywords Financial performance measures Discount cash flow (DCF) model Á Á Economic value added (EVA) Cash flow return on investment (CFROI) Á Á Shareholder value added (SVA) Economic margin (EM) Cash value added Á Á (CVA) Residual income (RI) Market value metrics

2.1 Trends in Performance Measurement The choice of performance measures is one of the most critical challenges facing organizations. In fact, performance measurement systems play a key role in developing strategic plans, evaluating the achievement of firm’s objectives and rewarding managers.

D. Venanzi, Financial Performance Measures and Value Creation: The State of the Art, SpringerBriefs in Business, DOI: 10.1007/978-88-470-2451-9_2, Ó The Author(s) 2012 10 2 Competing Financial Performance Measures During the 1990s, many managers recognized that traditional accounting-based measurement systems no longer adequately fulfilled these functions.

A 1996 survey by the Institute of Management Accounting (IMA) found that only 15% of the respondents’ measurement systems supported top management’s business objectives well, while 43% were less than adequate or poor. Sixty per cent of the IMA respondents reported they were undertaking a major overhaul or planning to replace their performance measurement systems, in response to their flaws.

The perceived inadequacies in traditional accounting-based performance measures have motivated a variety of performance measurement innovations, ranging from ‘‘improved’’ financial metrics such as ‘‘economic value’’ measures to ‘‘balanced scorecards’’ of integrated financial and nonfinancial measures (Ittner and Larcker 1998). Despite most economic theories analyzing the choice of performance measures indicate that performance measurement and reward systems should incorporate any financial or nonfinancial measure that provides incremental information on managerial effort, firms traditionally have relied almost exclusively on financial measures such as profits, accounting and stock returns for measuring performance (Ittner and Larcker 1998). Schiemann and Associates conducted a U.S. survey of a cross section of 203 executives on the quality, uses and perceived importance of various financial and nonfinancial performance measures (Lingle and Schiemann 1996). Their results are summarized in Table 2.1. While 82% of the respondents valued financial information highly, more than 90% defined financial measures in each performance area, included these measures in regular management reviews, and linked compensation to financial performance. Conversely, 85% valued customer satisfaction information highly, but only 76% included satisfaction measures in management reviews, just 48% clearly defined customer satisfaction for each performance area or used these measures for driving organizational change, and only 37% linked compensation to customer satisfaction. Similar disparities exist for the other nonfinancial measures.

Most executives were weakly confident of any of these measures, with only 61% willing to bet their jobs on the quality of their financial performance information and only 41% on the quality of operating efficiency indicators, the highest rated nonfinancial measure (Ittner and Larcker 1998). In other words, there a wide gap exists between what is valued and what is considered accurate (Lingle and Schiemann 1996).

Nevertheless, it is interesting to note that this study supports the conclusion that good measurement is essential to good management (Lingle and Schiemann 1996).

In fact, partitioning the sample into two sub-samples1––measurement-managed and non-measurement-managed organizations––evidence emerges that the

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measurement-managed organizations performed better than the non-measurementmanaged counterparts on each of the following three performance measures:

• perceived industry-leadership over the past 3 years (74% vs. 44%);

• financial ranking in the industry top third (83% vs. 52%);

• success of the last major cultural and/or operational changes (97% vs. 55%).

Perceived inadequacies in traditional performance measurement systems as well as the managers’ confidence in financial performance have led many organizations to place greater emphasis on ‘‘improved’’ financial measures that are claimed to overcome some of the limitations of traditional financial measures. We will review these ‘‘new metrics’’ in the following section.

However, more than 10 years later, this scenario seems to have changed only a little, paradoxically. Focusing on financial performance measures, international evidence indicates that managers remain anchored to traditional financial metrics.

A recent survey of 400 U.S. financial executives2 (Graham et al. 2005, 2006) shows that the vast majority view earnings––neither cash flows nor any of the ‘‘new metrics’’––as the most important performance measure they report to outsiders. Nearly two-thirds of the respondents ranked earnings as the most important metric; fewer than 22% choose cash flows and less than 3% other metrics like the EVA. This obsession about earnings (i.e., EPS) was explained as follows (Graham

et al. 2005):

• the world is complex and the number of available financial metrics is enormous.

Investors need a simple metric that summarizes corporate performance, that is easy to understand and is relatively comparable across companies. EPS satisfies these criteria

• the EPS metric gets the broadest distribution and coverage by the media

• analysts assimilate all the available information and summarize it in one number, that is EPS

• analysts evaluate a firm’s progress based on whether a company hits consensus EPS and investment banks assess analysts’ performance by evaluating how closely they predict the firms’ reported EPS.

The surveyed CFOs showed also a short term focus. Earnings benchmarks are quarterly earnings for the same quarter last year (85% of the surveyed CFOs agree or strongly agree that this metric is important) and the analyst consensus estimate for the current quarter (73.5%). The results strongly suggest that the dominant reasons for meeting or beating short-term earnings benchmarks relate to stock The empirical findings emerging from this survey are even more impressive because of the high representativeness of the sample: the companies range from small (15.1% of the sample firms have sales less than $ 100 million and 19% less than 500 employees) to very large (25% have sales of at least $ 5 billion and 35% more than 10,000 employees), they operate in many industries (manufacturing weighs 31%, but other sectors like retail, tech, transportation, banking, public utilities are represented) and cover a wide spectrum of ownership structures and CEO characteristics (age, tenure, education, insider ownership).

2.1 Trends in Performance Measurement 13 prices: more than 80% of the interviewed CFOs agreed that meeting benchmarks builds credibility with the capital market, helps maintaining or increasing the company’s stock price, and conveys future growth prospects to investors. In other words, they believe that the price setters of their stocks (institutions and analysts, who are sophisticated investors) would not look beyond a short term earnings miss or irregularity in the earnings path.

Finally, they describe a trade-off between the short-term need to deliver earnings and the long-term objective of making value-maximizing investment decisions. Most of the surveyed CFOs would give up economic value in exchange for smooth earnings: they would decrease discretionary spending like R&D, advertising, or maintenance or delay starting a new projects in order to meet an earning target, even sacrificing value. In other words, they appear to be willing to burn ‘‘real’’ cash flows and not simply to rely on accounting manoeuvres for meeting accounting targets.

This traditional and apparently unchanged behavior in financial performance measurement seems to be confirmed by the empirical evidence that emerges from the most recent analysis about the most common financial metrics used in compensation plans, conducted in 2010 by the U.S. National Association of Corporate Directors (NACD) regarding about 1,300 individual from public company boardrooms across 24 industry sectors: profits and EPS (and similar ratios) weigh 97%, cash flow 36%, economic value measures like EVA and CFROI 16%, and stock price based measures 31% (multiple responses being allowed) (Daly 2011).

2.2 Economic Value Measures 2.2.1 The General Framework While traditional accounting measures such as earnings per share and return on investment are the most common performance measures, they have been criticized for not taking into consideration the cost of capital and for being too much influenced by external reporting rules.

While the traditional discounted cash flow (DCF) model provides for a complete analysis of all the different ways in which a firm can create value, it could become complex, as the number of inputs increases. Moreover, it could be very difficult to tie management compensation systems to a DCF model, since many of the inputs need to be estimated and could be manipulated to produce the desired results.

However, instead of an explicit DCF model, a simplified formula-based DCF approach could be used by making simplifying assumptions about a business and its cash flow stream, such as for example constant revenue growth and margins, so that the entire DCF can be captured in a concise formula (Copeland et al.

1990). The Miller-Modigliani (MM) formula (Exhibit 2.1), although simple, is a 14 2 Competing Financial Performance Measures

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Exhibit 2.1 The Miller-Modigliani DCF formula particularly useful example for demonstrating the sources of a company’s value (Miller and Modigliani 1961).

The MM formula values a company as the sum of the value of the cash flow of its assets currently in place plus the value of its growth opportunities. This formula, although too simple for real problem solving, can be used to illustrate the key factors that will affect the value of the company, and therefore show how the two components of value performance can be measured separately.

In addition, it has been stated that the NPV concept is useful only if we can discount the investment’s complete cash flow over its completed economic life: in other words, the cash flow approach becomes significant only when it is considered over the life of the business, and not in any given year. In practice, it could serve as a measure of performance only if it could be periodized into years, quarters, months or the time period of the user’s choice. In fact, this is what some ‘‘new metrics’’ try to do.

If we assume that markets are efficient, we could replace the unobservable value from the DCF model with the observed market price, and reward or punish managers based upon the performance of the stock. Thus, a firm whose stock price has gone up is viewed as having created value, while one whose stock price goes down has destroyed value. Compensation systems based upon the stock prices, including stock grants and warrants, have become a standard component of most management compensation packages. While market prices have the advantage of being updated and observable, they are also noisy. Even if markets are efficient, stock prices tend to fluctuate around the true value, and markets sometimes do

2.2 Economic Value Measures 15 make big mistakes. Furthermore, a firm’s stock performance seems to be much more reliable when evaluated over several years. Thus, a firm may see its stock price go up, and its top management rewarded, even as it destroys value. Conversely, the managers of a firm may be penalized as its stock price drops, even though they may have taken actions that increase firm value.

Summarizing, market value-based measures of performance can be affected by

the following limitations:

• they reflect factors beyond managers’ control, such as inflation and interest rates, for example. Actually, exogenous effects can be separated from the endogenous ones, but these corrections can be highly subjective

• they tend to aggregate relevant information in an inefficient manner for compensation purposes: their forward-looking character may result in compensating for promises and not for actual achievements

• they cannot be disaggregated beyond the firm level; thus, they cannot be used to evaluate the managers of individual divisions of a firm, and their relative performance; similarly they are not applicable to non-listed companies

• they can be influenced by investors’ expectations which can be inconsistent with managers’ rationale, because of the asymmetric information between investors and managers

• set as targets, they can increase the risk exposition of managers, distorting their risk perception when compared to the owners’ risk perception; furthermore, managers should face the total risk and not only the systematic (or market) risk.

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