Shareholder Value - A Business Experience

By RoyE. Johnson

Shareholder Value presents a powerful and useful toolkit of market-based perspectives, analytic approaches, valuation techniques, and specific financial metrics for use in everyday business life.

The author helps a broad spectrum of professionals understand the salient points and real world implications of a 'value management' movement which has taken hold in many corporations in the United States and around the world. This movement is being supported by some of the major institutional investors who influence financial markets.

The main goal of 'Shareholder Value' is to help working professionals grasp the concept of value 'creators' and 'destroyers', along with the implications. He also provides tools to measure the success (or failure) of major strategic and operational initiatives and enables corporate managers to understand how shareholder value is created, and then directs behaviour toward 'value-based' planning and action.

Although mainly aimed at the professional market, 'Shareholder Value' will also be of use to students of business and finance as it is intended to provide a comprehensive foundation for important elements of business strategy and acquisition valuation, corporate financial analysis, capital investments, corporate financing and economic value based metrics.AUTHOR'S REVIEW:When developing this book, I strived to achieve the following:

• Provide the finance professional and student of finance with a comprehensive template of shareholder value concepts and techniques - geared toward use in a corporate setting
• Give the non-financial professional an understanding of the underpinnings and behavioural aspects of economic value management
• Outline and provide details of an effective process for implementing a value-based financial performance system within a corporation
• ...And, combine learning with enjoyable reading by presenting technical material through a story.

The "story" and "characters" are unique features of Shareholder Value - A Business Experience. The reader can get an appreciation of the environment surrounding value-based management, along with challenges that arise when transitioning from traditional "accounting" performance (where earnings and earnings per share reign supreme) to "economic" performance (where cash flow and return on investment are emphasized). Characters occupying operating and staff roles have been created to represent people that those working inside companies (large, medium and small) may encounter and, also, to invoke some humour. Insights into how to function in different corporate roles can be gained by following the characters through the story.

• Presents a combination of analysis and case study in which a strong technical treatment is blended with a fictional case study to offer clarity and explanation
• A practical and effective implementation process for a comprehensive financial performance system
• Offers a perspective of the role of different corporate and business unit functions in the implementation of value-based financial performance within a company

• Language: English
• Publisher: Elsevier Science
• Release date: Oct 23, 2001
• ISBN: 9780080498133

Book preview

Shareholder Value

A Business Experience

First Edition

Roy E. Johnson

BUTTERWORTH HEINEMANN

OXFORD  AUCKLAND  BOSTON  JOHANNESBURG  MELBOURNE  NEW DELHI

Table of Contents

Cover image

Title page

Copyright page

Preface

List of Exhibits

1: Getting started

2: Shareholder value and sustainable value: definitions and perspectives

3: Value-based metrics: from accounting to economics

4: Cost of capital

5: Economic profit assessment: value ‘creators’ and ‘destroyers’

6: Financial ‘drivers’: support measures

Growth Rates …

Invested Capital Intensity (ICI) …

Value Profit Margin (VPM) …

7: Market value added (MVA): ‘magnifier’ concept

8: Value-based analysis: valuation hierarchy

9: Valuation methodologies

10: Corporate financial analysis

11: Value driver programs: major internal investments

12: Mergers and acquisitions: major external investments

13: Capital investments: planning, evaluation and control

14: Financial reporting and communication: traditional/modification/new

Epilogue

Index

Copyright

Butterworth-Heinemann

Linacre House, Jordan Hill, Oxford OX2 8DP

225 Wildwood Avenue, Woburn, MA 01801-2041

A division of Reed Educational and Professional Publishing Ltd

A member of the Reed Elsevier plc group

First published 2001

© Roy E. Johnson 2001

All rights reserved. No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holder except in accordance with the provisions of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England W1P 0LP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be addressed to the publishers

British Library Cataloguing in Publication Data

Johnson, Roy E.

    Shareholder value : a business experience. – (Quantitative finance series)

    1. Business enterprises – Finance 2. Corporations – Investor relations – Economic aspects 3. Corporate profits – Management I. Title

    658.1′55

Library of Congress Cataloguing in Publication Data

A catalogue record for this book is available from the Library of Congress

ISBN 0 7506 5382 5

For information on all Butterworth-Heinemann publications visit our website at www.bh.com

Typeset by Laser Words, Madras, India

Printed and bound in Great Britain

Preface

Shareholder Value – A Business Experience is a book about modern corporate finance, value-based financial performance, and economic value management. It is directed toward the most important financial goal of any ‘for profit’ enterprise – namely, optimizing the long-term return to shareholders. This ‘return’ can be the increase in the common stock price, along with dividends, for a public company; or the ‘warranted’ equity value and/or ability to remit cash distributions for a privately owned company. While directed towards shareholder value, this book is not intended to be a predictor for the public stock markets in the USA or other countries. It will also not attempt to indicate the attractiveness of any single industry, segment, or company – in terms of ‘who’s hot and who’s not’ at any particular time.

Rather, its purpose is to present a powerful and useful toolkit of market-based perspectives, analytic approaches, valuation techniques, and specific financial metrics – for use in everyday business life. The book is designed to help a broad spectrum of professionals and students, many of whom may not have strong financial backgrounds, better understand the salient points and real-world implications of a ‘value management’ movement which has taken hold in many corporations in the USA and around the world. This movement is being supported by some of the major institutional investors who influence financial markets.

One goal of the book is to help working professionals grasp the concept of value ‘creators’ and ‘destroyers’ – along with the implications. Another is to provide tools to measure the success (or failure) of major strategic and operational initiatives. Some people, in the professional workforce, may feel that they have been handed a management discipline encompassing a confusing set of new metrics, which can impact their job performance rating and compensation. The contents of the book should help corporate managers to first, understand how shareholder value is created and then, direct behavior –their own and that of others – toward ‘value-based’ planning and action.

For students of business and finance, the book is intended to provide a comprehensive foundation for important elements of business strategy and acquisition valuation, corporate financial analysis, capital investments, corporate financing, and economic value-based metrics. There is also an attempt to give a glimpse of the ‘environment’ surrounding value-based management that students may face as they embark on or pursue corporate careers.

Shareholder Value – A Business Experience is a fictional story, offering a combination of storybook reading and textbook analysis. The lead character is an experienced financial professional, whose career has been split between corporate and management consulting roles. It is a narrative of one of his last major assignments, in which he is given an opportunity to incorporate virtually all the knowledge and expertise gained during his career and assist an industrial company implement a comprehensive, value-based financial performance system. Other key characters comprise the corporate and operating management of the fictitious firm. Behavioral aspects of the effort to institute an ‘economic value’-oriented financial management system, along with potential barriers to such an endeavor, are exposed through the interaction of the various characters in the story.

It is my sincere hope that no one will be offended by the character portrayals. The characters have been developed to make the story entertaining, as well as thorough. Growing older, I realize more and more that self-reflection, self-criticism, and humor are good recipes for staying productive and maintaining one’s sanity. So, please don’t stereotype the characters or feel offended if you occupy a position portrayed by one of the characters whom you may either not like or wish to be associated with.

In the financial markets, specific rates of return can change over time. Thus, the ‘cost of capital’ rates, as presented in Chapter 4 – Cost of Capital, may not be the most accurate for the reader’s specific situation. For example, the ‘risk-free’ (long-term government bond) rate was pegged at 6.5%, a representative level at the time that the book was written. The ‘market risk premium’ – the excess return that the stock market has produced over time in comparison to the long-term (30-year) government bond rate – has been set at 5.0%. This rate (set to make the mathematical calculations as simple as possible) is at the low end of the relevant range for this statistic, which had been tracked for about seventy years at the time the book was written. Similarly, debt and preferred stock costs (rates) may or may not be accurate for the reader’s situation and/or time frame. The reader should, therefore, make any adjustment(s) necessary to apply the material to his or her particular circumstance, if the desire is to go beyond calculations for the hypothetical firms in the book. The potential inaccuracies, regarding the cost(s) of capital, do not alter any of the underlying concepts or perceptions, but they could change the magnitude of results in the numeric examples.

In a similar vein, the Financial Accounting Standards Board (FASB) – the governing body for accounting regulations in the USA – established new rules for mergers and acquisitions that effectively eliminated ‘pooling of interests’ and ‘goodwill amortization’ at the time the book was being published. Thus, some statements about ‘pooling’ and ‘earnings dilution’ would be modified slightly with the new rules, potentially impacting a few numeric calculations in Chapter 12 – Mergers and Acquisitions. Similar to the comment in the previous paragraph about Cost of Capital, the underlying concepts or perceptions of distinguishing ‘non-cash’ from ‘cash-based’ acquisition analysis – along with justifying a merger or acquisition based on the ‘economics’ of the transaction – are not altered.

As the reader might imagine, my experience and views are embedded in the story. At the same time, I have attempted to be as factual and non-opinionated as my mind allows. I hope you enjoy reading this book as much as I enjoyed writing it.

I would like to express my sincere gratitude to all the people I have worked with and consulted for since 1970, when my career began. All of you have helped me, in some way, to write this book. Therefore, Shareholder Value – A Business Experience is dedicated to you – my colleagues and clients.

List of Exhibits

1 Shareholder Value definition 18

2 ‘Accounting Profit’ – stock market test 20

3 Dynamics of a sustainable value system 23

4 Shareholder Value ‘vector diagram’ 24

5 ‘Accounting Profit’ – example 34

6 ‘Economic Profit’ – example (partial) 36

7 ‘Economic Profit’ – example (complete) 37

8 Economic Profit – key elements 41

9 Economic Profit – ‘fine tuning’ 45

10 Stock market theory 52

11 XYZ Industries, Inc. – capital structure and costs 60

12 XYZ Industries, Inc. – weighted average cost of capital (CCAP) 61

13 XYZ Industries – ‘Economic Profit’ (Level ‘1’ – profit & loss) 74

14 XYZ Industries – ‘Economic Profit’ (interest, taxes and NOP) 75

15 XYZ Industries – ‘Economic Profit’ (Level ‘1’ – balance sheet) 76

16 XYZ Industries – ‘Economic Profit’ (Level ‘1’ – summary) 77

17 XYZ Industries – ‘Economic Profit’ (Level ‘2’ – profit & loss) 78

18 XYZ Industries – ‘Economic Profit’ (Level ‘2’ – taxes & NOP) 81

19 XYZ Industries – ‘Economic Profit’ (Level ‘2’ – balance sheet) 81

20 XYZ Industries – ‘Economic Profit’ (Level ‘2’ – EP & ROIC) 83

21 XYZ Industries – cost of capital (CCAP) 84

22 XYZ Industries – ‘Economic Profit’ (Level ‘3’ – profit & loss) 85

23 XYZ Industries – ‘Economic Profit’ (Level ‘3’ – balance sheet) 86

24 XYZ Industries – Economic Profit – ‘CVA’ (cash value added) 87

25 Growthstar Inc. – ‘TOTAL CO.’ (historical income statement) 94

26 Growthstar Inc. – ‘TOTAL CO.’ (historical balance sheet) 95

27 Growthstar Inc. – ‘PRODUCTS’ (historical income statement) 96

28 Growthstar Inc. – ‘PRODUCTS’ (historical balance sheet) 97

29 Growthstar Inc. – ‘SERVICES’ (historical income statement) 98

30 Growthstar Inc. – ‘SERVICES’ (historical balance sheet) 100

31 Growthstar Inc. – ‘OPERATING LEASES’ 101

32 Growthstar Inc. – Economic Profit – summary (historical) 103

33 Growthstar Inc. – Comparisons [Levels ‘1’, ‘2’ and ‘3’] 104

34 Growthstar Inc. – Economic Profit/‘TOTAL CO.’ [Level ‘1’] 109

35 Growthstar Inc. – Economic Profit/‘TOTAL CO.’ [Level ‘2’] 110

36 Growthstar Inc. – EP and ROIC comparisons/‘TOTAL CO.’ 114

37 Growthstar Inc. – Economic Profit/‘TOTAL CO.’ [Level ‘3’] 116

38 Growthstar Inc. – Economic Profit/‘PRODUCTS’ [Level ‘2’] 119

39 Growthstar Inc. – Economic Profit/‘SERVICES’ [Level ‘2’] 120

40 Financial ‘drivers’ … support measures 124

41 Value Profit Margin (VPM™) 128

42 Value Profit Margin (VPM™) … continued 128

43 Services – growth indicators/‘ICI’/‘VPM’ 130

44 Services – historical growth rates 131

45 Products – growth indicators/‘ICI’/‘VPM’ 133

46 Products – historical growth rates 134

47 TOTAL CO. – growth indicators/‘ICI’/‘VPM’ 136

48 TOTAL CO. – historical growth rates 137

49 Shareholder value definition 141

50 ‘Economic Profit’ – example 142

51 ‘Market Value Added’ – example (Assumptions) 143

52 ‘Market Value Added’ – example 143

53 ‘Accounting Profit’ – example 147

54 ‘Economic Profit’ – example 148

55 ‘Economic Profit’ – example 149

56 TOTAL CO. – ‘EP’ 152

57 Services – ‘EP’ 153

58 Products – ‘EP’ 156

59 Financial ‘Drivers’ … support measures 157

60 Financial ‘Drivers’ … continued 157

61 Products – historical growth rates 158

62 Invested capital intensity (ICI) – Products 160

63 Products – VPM 161

64 Services – historical growth rates 162

65 Invested capital intensity (ICI) – Services 163

66 Incremental ICI – Services … ‘cash flow’ basis 164

67 Services – VPM 165

68 TOTAL CO. – historical growth rates 166

69 Invested capital intensity (ICI) – TOTAL CO. 167

70 TOTAL CO. – VPM 167

71 How to increase shareholder value – Company ‘A’ 171

72 The ‘magnifier’ effect – for Co. ‘A’ 172

73 How to increase shareholder value – Company ‘B’ 174

74 How to increase shareholder value – Company ‘C’ 175

75 The ‘magnifier’ effect – for Co. ‘C’ 176

76 Summary – EP, financial ‘drivers’, MVA 176

77 ‘Project’ analysis – Machine Center to Save Costs 186

78 ‘Program’ analysis – ‘Cost Savings/Quality’ Program 188

79 ‘Strategy’ analysis – Enhance Product Quality and Control Costs to Grow Sales and Maintain Margins 190

80 Quote from Peter F. Drucker 191

81 Value-based analysis … valuation hierarchy 192

82 Present value 196

83 Valuation via Free Cash Flow (FCF) – Company ‘A’ … 20% growth 201

84 Valuation via Free Cash Flow (FCF) – Company ‘A’ … 15% growth 202

85 Valuation via Economic Profit (EP) – Company ‘A’ … 20% growth 203

86 Valuation via Economic Profit (EP) – Company ‘A’ … 15% growth 204

87 Valuation via Value Profit Margin (VPM) – Co. ‘A’ … 20% Growth 208

88 ‘PRODUCTS’ – 3-year plan/income statement 215

89 ‘PRODUCTS’ – 3-year plan/‘compound growth rates’ 217

90 ‘PRODUCTS’ – 3-year plan/new investment 218

91 ‘SERVICES’ – 3-year plan/income statement 219

92 ‘SERVICES’ – 3-year plan/‘compound growth rates’ 221

93 ‘SERVICES’ – 3-year plan/new investment 222

94 ‘TOTAL CO.’ – 3-year plan/income statement 224

95 ‘TOTAL CO.’ – 3-year plan/‘compound growth rates’ 226

96 ‘TOTAL CO.’ – 3-year plan/new investment 227

97 Growthstar – valuation … ‘base’ period 230

98 Growthstar – valuation … ‘no growth’ (FCF approach) 231

99 Growthstar – valuation … ‘no growth’ (EP approach) 231

100 Growthstar – valuation … ‘no growth’ (VPM approach) 232

101 Growthstar – valuation … ‘no growth’ (MVI & M/B ratios) 233

102 ‘PRODUCTS’ – valuation … ‘strategy/3 yrs.’ (FCF approach) 235

103 ‘PRODUCTS’ – valuation … ‘strategy/3 yrs.’ (EP Approach) 236

104 ‘PRODUCTS’ – valuation … ‘strategy/3 yrs.’ (VPM approach) 236

105 ‘SERVICES’ – valuation … ‘strategy/3 yrs.’ (FCF approach) 238

106 ‘SERVICES’ – valuation … ‘strategy/3 yrs.’ (EP Approach) 239

107 ‘SERVICES’ – valuation … ‘strategy/3 yrs.’ (VPM approach) 239

108 ‘TOTAL CO.’ – valuation … ‘strategy/3 yrs.’ (FCF approach) 240

109 ‘TOTAL CO.’ – valuation … ‘strategy/3 yrs.’ (EP approach) 240

110 ‘TOTAL CO.’ – valuation … ‘strategy/3 yrs.’ (VPM approach) 241

111 Growthstar – valuation … ‘no growth’ + 3-year growth plan 242

112 ‘TOTAL CO.’ – valuation input … ‘investor scenario’ (5 Years) 243

113 ‘TOTAL CO.’ – valuation … ‘investor scenario’ (FCF approach) 243

114 ‘TOTAL CO.’ – valuation … ‘investor scenario’ (EP approach) 244

115 ‘TOTAL CO.’ – valuation … ‘investor scenario’ (avg. of FCF& EP) 245

116 Growthstar – valuation … ‘MVI’ (3-yr. growth & no growth) 247

117 Growthstar – valuation … ‘M/B’ (3-yr. growth & no growth) 247

118 Growthstar – valuation … ‘MVI’ and ‘M/B’ (investor scenario) 248

119 ‘PRODUCTS’ – valuation … future years – assumptions 248

120 ‘SERVICES’ – valuation … future years – assumptions 251

121 ‘PRODUCTS’ – valuation … ‘strategy/5 yrs.’ (FCF approach) 251

122 ‘SERVICES’ – valuation … ‘strategy/7 yrs.’ (EP approach) 252

123 Products + Services = TOTAL CO. – valuation (future/beyond ‘plan’) 252

124 Products + Services = TOTAL CO. – ‘MVI’ & ‘M/B’ (future/beyond ‘plan’) 255

125 Growthstar – cash flow and valuation highlights 260

126 Sustainable (‘cash B-E’) growth 262

127 Growth and cash (operating and financial management) 263

128 Growth and cash (cash generated and consumed) 264

129 Growthstar – ‘sustainable growth’ inputs 266

130 Growthstar – ‘sustainable growth’ analysis 267

131 Growthstar – cash flow highlights … ‘net cash flow’ 269

132 ‘PRODUCTS’ – next 3 years/growth plan (sales/NOP/IC) 272

133 ‘SERVICES’ – next 3 years/growth plan (revenue/NOP/IC) 273

134 ‘TOTAL CO.’ – next 3 years/growth plan (revenue/NOP/IC) 274

135 Products – future growth rates (next 3 years) 274

136 Services – future growth rates (next 3 years) 276

137 TOTAL CO. – future growth rates (next 3 years) 277

138 Incremental ICI – ‘3-year plan’ 278

139 Value Profit Margin – ‘VPM’ (3-year plan average) 278

140 Growthstar – valuation … ‘no growth’ 281

141 Growthstar – valuation … ‘no growth’ plus 3-year ‘plan’ 282

142 Growthstar – valuation … ‘investor scenario’ 283

143 Growthstar – valuation … ‘plan’ plus future years 285

144 ‘SERVICES’ – ‘magnifier’ effect 287

145 TOTAL CO. – ‘plan’ … ‘magnifier’ effect 288

146 TOTAL CO. – ‘plan’ plus 2/4 years … ‘magnifier’ effect 289

147 Products + Services = TOTAL CO. – ‘MVI’ & ‘M/B’ (future/beyond ‘plan’) 291

148 Market value and cash flow 293

149 ‘Sustainable growth’ 295

150 ‘NG EURO’ – market potential (units) 305

151 ‘NG EURO’ – market potential ($ millions) 305

152 ‘NG EURO’ – market potential (by type of sale) 306

153 ‘NG EURO’ – market shares … ‘new equipment’ sales 306

154 ‘NG EURO’ – market shares … ‘retrofit’ sales 307

155 ‘NG Euro’ Program – Europe sales 307

156 ‘NG EURO’ – gross profit %’s 308

157 ‘NG EURO’ – profit & loss summary 310

158 ‘NG EURO’ – ratios 311

159 ‘NG EURO’ – invested capital (working capital) 311

160 ‘NG EURO’ – invested capital (fixed capital) 312

161 ‘NG EURO’ – EP … ‘drivers’ 313

162 ‘NG EURO’ – valuation 316

163 ‘OCS’ Financials – service revenue 318

164 ‘OCS’ Financials – operating costs/expenses 319

165 ‘OCS’ Financials – net operating profit (NOP) 319

166 ‘OCS’ Financials – invested capital and net new investment 320

167 ‘OCS’ Financials – valuation 322

168 ‘Leasing’ acquisition – historical income statement (‘reported’) 327

169 ‘Leasing’ acquisition – historical balance sheet (‘reported’) 328

170 ‘Leasing’ acquisition – historical supporting data & ratios 329

171 ‘EuroServ’ acquisition – historical income statement (‘reported’) 336

172 ‘EuroServ’ acquisition – historical balance sheet (‘reported’) 338

173 ‘EuroServ’ acquisition – historical supporting data & ratios 340

174 ‘Leasing’ acquisition – cost of capital (CCAP) 345

175 ‘Leasing’ acquisition – future outlook income statement 346

176 ‘Leasing’ acquisition – future outlook balance sheet 347

177 ‘EuroServ’ acquisition – historical income statement adjustments 350

178 ‘EuroServ’ acquisition – historical economic profit 352

179 ‘EuroServ’ acquisition – historical value profit margin 352

180 ‘EuroServ’ acquisition – valuation (‘no growth’) 353

181 ‘EuroServ’ acquisition – historical financial ‘drivers’ 354

182 ‘Leasing’ acquisition – historical profit & loss (‘economic’) 357

183 ‘Leasing’ acquisition – historical IC and EP (‘economic’) 358

184 ‘Leasing’ acquisition – future outlook profit & loss (‘economic’) 359

185 ‘Leasing’ acquisition – future outlook IC and EP (‘economic’) 360

186 ‘Leasing’ acquisition – valuation 362

187 ‘EuroServ’ – income statement … current year and next year AOP 368

188 ‘Leasing’ acquisition – highlights/issues 374

189 ‘Leasing’ – revenue and net income 375

190 ‘Leasing’ – future growth rates 376

191 ‘Leasing’ – ‘economic’ ROIC 377

192 ‘Leasing’ – ‘economic’ ROE 380

193 ‘Leasing’ – invested capital intensity and equity capital intensity 381

194 ‘Leasing’ – Economic Profit (EP) – equity 383

195 ‘Leasing’ – valuation 384

196 ‘EuroServ’ – future outlook … capital expenditures 388

197 ‘EuroServ’ – ‘most likely’ scenario … revenue 391

198 ‘EuroServ’ – ‘most likely’ scenario … profit & loss 392

199 ‘EuroServ’ – ‘most likely’ scenario … invested capital 393

200 ‘EuroServ’ – ‘most likely’ scenario … EP and VPM 395

201 ‘EuroServ’ – ‘most likely’ scenario … valuation 396

202 ‘EuroServ’ – ‘most likely’ scenario … ‘pro forma’ post-acquisition 399

203 ‘EuroServ’ – ‘downside’ case … revenue 400

204 ‘EuroServ’ – ‘downside’ case … profit & loss 401

205 ‘EuroServ’ – ‘downside’ case … invested capital 402

206 ‘EuroServ’ – ‘downside’ case … EP and VPM 403

207 ‘EuroServ’ – ‘downside’ case … valuation 405

208 ‘EuroServ’ – ‘downside’ case … ‘pro forma’ post-acquisition 406

209 ‘EuroServ’ – ‘downside’ case … valuation (+ 2 years = 7 years total) 408

210 ‘EuroServ’ – new financing … debt/equity capital 415

211 ‘EuroServ’ – ‘pro forma’ … current year net earnings and EPS 416

212 Value-Based Performance Report – quarterly 441

213 Value-Based Performance Report – annual (summary) 442

214 Value-Based Performance Report – annual (invested capital) 443

215 Annual Report write-up: value-based performance 450

1

Getting started

The cup of early morning black coffee tasted good. "At least we’ve crossed one hurdle, sighed Jason Aradvizer, who had a lot on his mind that first day of July. His totally relaxing and satisfying, if not spectacular, golfing vacation had ended just two days ago, but the matters at hand put it in the distant past. Jason was experiencing a typical set of ‘first day on the job’ thoughts by wondering if he had done the right thing, even though he felt so positive about this new challenge. What better way, he reminded himself, to conclude a corporate and consulting career than to take on this assignment as a consultant to the Chief Financial Officer of Growthstar Inc., a publicly traded industrial products and services company on the verge of a new market expansion strategy. The opportunity to utilize my thirty-something years of experience to ‘reinvent’ a significant segment of the corporate finance function seems almost too good to be true … but, as he mused to himself, some poor soul has to do it!"

"The business landscape has changed, he thought to himself. Boards of Directors are paying more attention to their large institutional shareholders, and making the enhancement of shareholder wealth a ‘priority’ for the Chief Executive Officer (CEO). Many CEOs, in turn, are now realizing that increasing the company’s stock price is not their challenge alone, and are pushing ‘shareholder value creation’ down to their business unit and division general managers. Even key staff members in virtually all functional disciplines and support areas are getting ‘clued in’ to the importance of achieving shareholder value objectives, not just growing revenue and net earnings".

He continued talking silently to himself, as he typically did at the beginning of major work assignments … "Every key manager in this company, and every other ‘for profit’ enterprise, needs to gain an understanding of ‘value-based’ performance and measurement – some obviously more than others. My role is to facilitate both the accumulation and application of a ‘new body of knowledge’ in Finance, for execution in various parts of this company. I need to help these people think differently about the financial aspects of their business. They need to understand that there is a ‘story’ about shareholder value in their financials, which the traditional ‘accounting-based’ approach and measures will not reveal or be able to explain. With the help of the new ‘economic-based’ approach and measures, I can help these people uncover that message. To do this, I need to make financial theory understandable and useful to them".

There are also potential ‘gold mines’ and ‘minefields’ in the company’s strategies, future plans, and capital investment programs which need to be evaluated. The major analytic routines and the notion of ‘how’ and ‘where’ to apply a time-tested valuation technique, as well as a couple of new ones, need to be driven into the organization.

He concluded his self-reflection with the same thought he had felt so many times. "It’s always exciting and always a challenge. Many people in business really do need a dose of ‘new thinking’ to an ‘age-old problem’ – how to get that stock price up and sustain it. The financial framework, approaches and measures – in and of themselves – do not contain all the answers, but they can help in ‘driving’ managers toward acting in the best interests of the shareholders".

Jason then began to focus on the present situation. His former graduate school colleague, Jonathan Steadfast, had been with Growthstar for the past ten years, rising from the post of Corporate Controller and appointed as the company’s CFO five years ago. Jonathan’s acceptance of the new ‘economic metrics’ during the past year had convinced Jason that the environment at Growthstar was right for a revamping of the planning and analysis systems, plus key measurement and reporting functions, within finance.

Concerns still loomed in Jason’s mind, however, as he looked over the corporate organization chart, which had his handwritten notes from conversations with Jonathan, highlighting the various personalities of the corporate vice presidents.

John (Jack) Earningsly, Corporate Controller, was going to be a ‘tough sell’ – a classic accountant who knew (and used) every accounting treatment to boost quarterly earnings per share (EPS) and often seemed to be more concerned about where an item went rather than what it meant. He scratched his head as he thought about Jonathan’s comment that Jack had not ever made an incorrect accounting entry or misinterpreted a FASB ruling. The fact that Jack hung his CPA certificate above his college degree in his office was not lost on Jason. Neither was Jack’s comment, in their only meeting, questioning what a bunch of new measures would really add to the company, except more work for an already burdened accounting staff. Last year, Jack celebrated his twentieth anniversary with Growthstar, having spent his entire career with the company in some capacity. He joined Growthstar as Accounting Manager after five years with the company’s auditing firm, having been the junior and senior auditor, then manager, for the Growthstar account. Being one of the longest-serving employees, and the longest-tenured corporate executive, he had no plans of leaving and had developed his own agenda. He also had visions of occupying the CFO’s office if Jonathan decided to move on or retire.

Moving on to Earl D’Mark, Growthstar’s Treasurer, Jason smiled. Earl was a fortyish ‘young tiger’ whom Jason had met a few years ago at a shareholder value conference. Earl had a master’s degree from a rock-solid, if not overly prestigious, mid-west graduate business school, and seemed to almost worship cash flow, deriding EPS as far as was politically palatable in a company which had historically been ‘earnings driven’. "Jack and Earl’s luncheon conversations must be interesting", thought Jason, wishing he might be a ‘fly on the wall’ as he mentally compared the almost opposite views of these two key finance executives. From the time of his arrival at Growthstar three years ago, Earl had been one of the proponents of adopting more ‘economic-based’ ways to analyze the company’s businesses and investments and, according to Jonathan, had been almost relentless in his admonitions, much to the dismay of Jack. While an experienced treasurer, Earl was a bit ‘light’ on some of the more technical aspects of valuation theory and its application, and welcomed an experienced outsider, to add credibility to the undertaking which Jonathan had now sponsored. To indicate his support for the endeavor, Earl had promised to make his best financial analyst available for up to 50% of his time over the next several months, to assist Jason with the ‘number crunching’. Earl was, obviously, the ‘coach’ – a consultant’s name for a key ally to get support for important findings and recommendations, especially since he had gained Jonathan’s ear during the past year or so, and Jonathan was the CEO’s closest confidant.

Human Resources, which Jason had called ‘Personnel’ until it got him in trouble several years ago with an important client, was going to be interesting. Jason gazed attentively at his notes on Florence (known to everyone as ‘Flo’) Withetide, realizing that he had spent virtually no time thinking about the comments that Jonathan had provided about her. Flo was a classic case of the Horatio Alger success story – a woman approaching middle age who started as an executive secretary in another company. She attended night school and earned a college degree after eight years of part-time study. She then worked her way up through compensation, recruitment and human resource administration to the position of Director for one of Growthstar’s competitors. Almost everyone in Growthstar felt she was a ‘steal’ when she was enticed to join the company as Vice President, Human Resources to replace the retiring incumbent. For Flo, this job was the crowning achievement for a long road of hard work, so much so that she seemed unwilling to take strong positions on anything that the CEO might not agree with. To call her a ‘yes’ person would be unfair, but she literally calculated the impact of every comment she made to the CEO, especially on subjects he (the CEO) felt strongly about. "She’s going to be a very intriguing person to figure out, Jason thought out loud, as he mentally progressed to the stage where his work would require changes to the compensation plan. Oh well, he rationalized, we’re a few months away from that issue".

Valerie (Val) Performa, Vice President of Corporate Strategy and Development, was the exact opposite of Flo. Born and raised in an affluent family, she earned her bachelor’s degree from a prestigious east coast college and a master’s in business, concentrating in marketing, from an equally prestigious west coast university by the age of twenty-four. ‘Sophisticated’ was the term Jonathan had used as a ‘one-word descriptor’ for Val. She was also a very gracious person and, while confident of her ability, was one who listened to others and appeared to be open-minded and respectful of the opinions of others. She had moved rapidly in her twelve-year career, and was the youngest vice president ever appointed at Growthstar, having joined the company two years ago.

With a working knowledge of financial concepts, she had developed a reputation as a ‘big picture’ person constantly striving to be on top of – some thought ahead of – the next major strategic breakthrough in the overall global economy and Growthstar’s markets. During the past year, she had formalized the strategic planning process, and the two businesses now had their ‘first ever’ strategies. She had collaborated with Earl D’Mark to generate ‘high-level’ financial expressions for these strategies, which represented a good first step in developing meaningful financial outlooks.

In terms of Corporate Communications and Investor Relations, Jonathan had managed this area himself, working closely with Val, Jack and Earl to structure the ‘message’ that he and the CEO took to the investors. This would soon change, as an Investor Relations Officer was about to join the company. Jonathan, while still somewhat tied to the ‘old school’, did believe in open and candid reporting – good or bad – to the ‘street’.

Finally, the ‘big man’ – Ian Lord – Chairman, President and Chief Executive Officer. Ian was a striking figure. Standing ‘six-foot five’, he was a basketball star at a Division 1 university in his ‘playing days’. Everything about him was impressive, especially his thick, silver-colored hair, and he had built a reputation over the past thirty years as a tough, yet fair, task master – one who demanded nothing short of excellence, both for himself and his subordinates. His only major shortcoming, according to Jonathan, was a predisposition to certain conclusions, even if convincing analysis demonstrated a totally different result. Ian was not irrational, as he could be swayed, but he did go into situations with at least a strong idea, if not a conviction, of what he thought the outcome should be. Ian was not fond of ‘heavy’ analysis. He wanted answers and decisions, not a lot of detail. Ian had the ability to get to key issues quickly, and was very decisive. He expected no less from those who worked for him. He was the quintessential executive who wanted all memos and letters to be no more than one page, with a recommended course of action supported by brief, yet compelling, rationale. "This isn’t so surprising", thought Jason, as Ian fitted a profile of several CEOs he had worked for and advised.

So, there they were – the executive team he would work with at the corporate level. Jonathan had given him a very condensed overview of the business unit general managers (the ‘producers’) which would have to be expanded in the very near future.

Jason looked at his watch. He had spent nearly an hour reviewing his notes and thinking about the corporate officers and his initial interactions with them. With his ‘kick-off’ meeting with Jonathan scheduled to start in less than thirty minutes, Jason turned his attention to the outline of the process he had put together three weeks ago to structure and prioritize the major work activities for the next several months.

The process Jason had developed was the culmination of his many years in consulting. Having used it with several clients during the past five years, he felt confident that it would work well at Growthstar. "A cohesive process, he reminded himself, was so important for an undertaking of this magnitude. However, he also knew that Jonathan was not a process-oriented person. Jonathan would constantly have to be held in check, since he was a lot like Ian in prematurely wanting the ‘answer’. The ‘answer’ – what good is it, Jason said to himself, without the rationale and supporting analysis!"

Now, it was showtime. Jason took a left turn out of the office provided for him and strolled the short distance down the hall to Jonathan’s office. Jonathan preferred a worktable with straight-back chairs to the comfortable couches that many executives, including Ian Lord, Flo Withetide and Val Performa, had in their offices. For some strange reason, Jack Earningsly and Earl D’Mark also had worktables with straight-back chairs in their offices. The two men, who had now known each other for nearly thirty-five years, extended warm greetings as Jason entered Jonathan’s office. Jonathan had instructed his assistant not to stop or announce Jason, unless an important meeting or conference was going on.

So, you’re going to straighten us out financially, thundered Jonathan.

Some people felt intimidated by the volume and intensity of Jonathan’s voice, but Jason was not. Besides, he had listened to that voice for so long, that its volume had lost its impact. I’m going to give it everything I have, Jason shot back, assuming the CFO doesn’t ‘stonewall’ me!

He handed Jonathan the one-page chart he had put together outlining the major tasks and approximate time frames for their completion. First, Jason stated, "we have to get everyone on the corporate staff ‘on board’ with some basic definitions and perspectives as to what shareholder value is all about. Then, I explain the transition from ‘accounting’ to ‘economics’ and introduce ‘value-based metrics’ and ‘Economic Profit’ (EP)".

At that point, Jonathan gave Jason his first reaction. "A year ago, Jack would have tried to ‘blow this apart’ right from the outset. He knows that this tactic won’t succeed now, because the stock market evidence is so compelling against EPS as a proxy for equity value, that he’ll look foolish. In spite of his strong support of accounting measures as adequate for managing the company, Jack is no fool, so maybe this will not be that major an issue".

I hope not, said Jason, because it can sidetrack the entire process. However, even in the worst possible scenario, it will only cause a delay. Jason continued … the next major step is to do a ‘value assessment’ of the company’s business units (BUs). This analysis should highlight performance which creates shareholder value versus that which destroys it, and performance that is value neutral. We begin the assessment work by analyzing the Cost of Capital. As I think you know, this goes well beyond the cost of debt financing to capture the most important and expensive financing instrument used by most companies – namely, common equity. We’ll want to determine if we have one cost of capital for all the businesses within Growthstar, or if there are any differences, based on business risk or financing structure.

As he was prone to do, Jonathan again interjected his thoughts. While the assessment is obviously essential, we run the risk of making some enemies at this point. Thus, we need to inform the BU General Managers (GMs) as to where their units are in terms of their stage in the business ‘life cycle’ and what we expect of them now and in the next year or so. Jason, you need to meet these people, and I think a group session would be best.

Jason sighed, as he thought to himself … "Jonathan is getting it, and he is focused on the ‘behavioral’ side of this effort, as well as the ‘technical"’. In a ‘matter-of-fact’ tone to hide his excitement, Jason replied with a simple I agree, and the sooner, the better. Another important aspect of the assessment phase, Jason continued, is an understanding of the underlying support measures for the aggregate metrics, which I call Financial ‘Drivers’. These ‘Drivers’ are what the operating managers really must focus on. They establish a relatively simplistic template which, by the way, has all the substance of modern corporate finance and market valuation theory.

Jonathan responded with a smile … if you can give these operating people something that’s simple and has integrity, you’ll win them over … and, if you win them over, Jack will come ‘on board’ .

Just wait until you see how powerful and simple these ‘Drivers’ are, Jason retorted.

OK, Jonathan said quickly, let’s move on.

"The next step involves progressing from ‘discrete time period’ metrics (EP and the ‘Drivers’) to a measure of the actual value created over time, which is called ‘Market Value Added’ (MVA). It’s important to recognize that EP and its support measures give us important inputs into the ‘value equation’, but do not constitute ‘market value per se’. EP provides a good indicator, but is usually limited to a given year or discrete time period … and, to repeat, EP is not ‘market value per se’. MVA is equivalent to the ‘Net Present Value’ you are familiar with and is synonymous with ‘Shareholder Value impact’; that is, the value created (or destroyed) by management".

Jason paused for a moment – to gather his thoughts – because it was important that he communicate the next message clearly. Jonathan, do you remember back in ‘grad’ school when we had that case study in a Business Policy course dealing with growth through acquisition or internal expansion?

Of course, how could I forget it, Jonathan howled, almost bursting into a fit of laughter. You made an absolute fool of yourself by analyzing three plant expansions separately, with elaborate internal rate of return calculations, and then trying to compare each individual plant’s results to an acquisition which provided the company with the overall capacity to manufacture the combined output of the three plant expansions. You got so confused and wound up in your details that you missed the ‘big picture’, the result being that the professor and class members (myself included) ridiculed you for weeks.

Knowing that he had communicated his point ‘crystal clear’, Jason began to speak again. That ridiculing had a profound effect on me for a while, but it took years until I understood the full impact of the experience. Believe it or not, that incident, which happened so many years ago, helped me to focus on what I believe is one of the most important and misunderstood aspects of economic analysis.

How so? asked Jonathan.

Jason responded, I began to realize that there is a natural ‘hierarchy’ for value-based analysis, and that it is vastly different from what is done here and in most other firms.

Jason could see that Jonathan was perplexed, as the CFO began to roll his eyes, and asked, What in the world are you talking about?

Jason, now comfortable that he had Jonathan’s complete attention, spoke again … Let me explain the concept this way. I assume you do fairly extensive evaluations of capital investments.

You bet, Jonathan responded (indicating a sense of pride). "We analyze all capital projects over $250,000 and nobody spends any significant amount of capital around here without justifying it with an Internal Rate of Return (IRR) of 15% or more and a positive Net Present Value (NPV). We take all projects over $500,000 to our Board of Directors".

Jason, now feeling his hook entering the fish’s mouth, retorted … Well, isn’t that just grand! Now, let me ask you a question. How do know if you should be making the investment in the first place?

Jonathan was now getting impatient … Is this some type of ‘intellectual game’ you’re playing with me?

Jason, with the most empathetic look he could place on his face, responded by saying, "in one sense it is, but it’s also a very serious problem. This is not only wasting a lot of time in corporate staff departments such as yours, but is also giving senior management and the board bad information about the return on investment of new capital. Here’s the point … I’ll bet you have never done an IRR (or NPV) evaluation of a business strategy. So, how do you know that capital should be invested in a particular business in the first place? You’re making the same mistake I made over thirty years ago! You’re applying value-based analysis techniques at the wrong level. To say it another way, the ‘project’ IRRs and NPVs are meaningless, because they are done at too low a level and you can never link these ‘project returns’ to what is going on at the business unit level, much less at the corporate level".

Jonathan was dumbfounded, a rare feeling for him. Oh, my God, how could I have missed this over the course of so many years? What you did as a graduate school student, I have been promoting throughout my career.

You and many other CFOs, Jason retorted, so don’t feel too bad. The good news is that there is a solution, and it will be integrated into our Value-Based Financial Performance System.

Jonathan was not about to let this topic get away, and asked … OK, ‘Mr Smart Guy’, give me at least a ‘taste’ of what we’re talking about here.

Jason, wanting to conclude this topic and move on, responded by saying We apply the ‘value metrics’ at the corporate, business unit, strategy and major investment program levels, where we can establish a link to strategic or operational goals, but we do not evaluate individual capital projects. As you can see in the outline I gave you, there is a distinct phase in the process devoted to this subject, and we’ll cover all the aspects of it at that time.

Jonathan, seeming to be satisfied, albeit still bewildered by his new realization which was now two minutes old, nodded his head and said, You have made a startling revelation, and I withdraw my part of the ridicule which was cast upon you so long ago!

Jason, smiling gently, responded with a simple thanks. He then forged ahead … "The next major task is to understand the potential market value of your business strategies and growth plans. We’ll utilize the Market Value Added (MVA) approach that we discussed to determine how growth affects value creation. I call this the ‘Magnifier Effect’, and the results of the analysis are often startling".

How so? asked Jonathan.

By demonstrating that not all business unit growth produces an equal impact on your stock price, Jason answered. We’ll also perform an extensive financial analysis, in terms of each major business unit’s ‘No Growth’ and ‘Growth’ (or ‘Strategy’) values. In other words, what’s the value of maintaining the status quo versus expanding? Further, we’ll calculate ‘Sustainable Growth’, which is how fast the company can grow without the need for new equity financing. This is an important element in mapping out the company’s future.

Ian’s been ‘bugging’ me for this type of growth and financing perspective for a long time, so we should get his attention on this point.

Jason, hoping for more, asked Won’t Ian also be concerned about the contribution of the major BUs to the company’s market value?

To some extent, but, you have to remember that Ian believes that growth delivers stock price gains, and really doesn’t understand or have a lot of patience for all this ‘return on capital’ and ‘economic profit’ stuff. Why do you think he changed the name of the company when he took over the top spot ten years ago? You do remember what we used to call this company, don’t you Jason?

Oh yes, Jason snickered, Q-Form Products.

At that point, Jonathan noticed his empty coffee mug and looked sheepishly at Jason, realizing that he had not offered him his favorite hot beverage. Jason quickly picked up the gesture, and said what he must have said thousands of times … black, no sugar.

As they both sipped a fresh cup of coffee, Jason continued … Merger and acquisition analysis is tackled next. We’ll lay out an approach for valuing deals, to be consistent with the ‘value metrics’ that the group has agreed should be used in measuring the performance of the various businesses. I’m telling you right now, though, that we may dispute the notion of buying companies for the purpose of increasing earnings per share.

Jonathan leaned back and folded his arms. He was silent for a moment and then, with a very serious expression on his face almost whispered, Well, my friend, let’s just hope that my retirement portfolio is in good shape by then, and that you’ve collected a substantial portion of your fee.

Jason was taken back both by Jonathan’s words and his expression. Then, Jonathan burst out laughing and roared … I got you, didn’t I? I’ve been preparing Ian for a change in perspective on acquisitions for about six months, and he is receptive. At Earl’s insistence, I have also been ‘ramming’ it into Jack’s head for about the same time, so he knows where I’m coming from. But, it was worth at least the price of the coffee to see you tense up a bit. I’ll keep it serious from now on.

Jason smiled, somewhat relieved. You still have your sense of humor, which is good. I owe you one, now. Moving along, the internally generated investments analogous to acquisitions are called ‘Value Driver Programs’. These are major strategic or operational programs, intended to support and provide ‘building blocks’ for your strategies and operational goals.

Jonathan leaned forward before Jason could continue and said, That was a mouthful, so please, let’s talk about it briefly.

Value Driver Programs are an important part of strategy and value-based performance systems, Jason went on. As I stated, they can be ‘strategic’ or ‘operational’ in nature. The key criterion is that they are significant to the business unit or the company. New product lines, alternate channels of distribution, and major manufacturing initiatives are examples. A Value Driver Program is not, however, the classical capital project, such as a machine tool, which has historically been evaluated at the expense of major programs.

Jason was ‘on a roll’ now. This transitions nicely into the capital budgeting system. Based on what I’ve seen of your current approach, I believe a major overhaul is needed. Growthstar needs to take a more strategic perspective to its capital investments, and get a better understanding of the level of capital spending necessary to move the business in the directions you have selected. Part of this change is understanding invested capital intensity, the capital required to generate each dollar of sales. Another aspect will be fitting capital investment into a ‘major program’ framework, applying value-based analysis to the Hierarchy we discussed a few moments ago, and ‘scrapping’ the analysis of small capital projects.

Sounds logical, Jonathan responded, and I know that Earl is anticipating the outcome of this work, along with ‘Sustainable Growth’, since it affects our financing strategy and dividend policy. In fact, I now remember Earl making a comment to me several months ago about being too myopic with our capital project analysis. Unfortunately, we were in the middle of an ‘earnings release’ to Wall Street, and I wasn’t totally focused on what Earl was saying. Now, I get it, but I have a new problem. I don’t know how long I can wait, since when I get ‘juiced up’, I want everything yesterday. Well, you know me, ‘Mr Impatient’!

You’ll just have to be a bit patient, Jason snipped, and we will get there. Finally, we’ll review and probably revise the company’s financial reporting system, based on everything we’ve done. Then, you’ll be in a position to structure your internal communications and take the message to your investors. In conjunction, we should begin training the people. The training provides the management and staff with both a generic and company-specific perspective.

Jonathan leaned forward and took a long sip of coffee. "Before I tell you to leave my office and start working, I need to set up a meeting with our two general managers (GMs) and the corporate officers. In terms of the GMs, Larry Buildermann runs our Industrial Products business, and Peter Uppcomer is the GM of Industrial Services. I think you know that Services was acquired over two years ago. Larry, GM of Products, is a solid manager with a manufacturing background, and a bit more conservative than Ian would like. Larry has consistently delivered the ‘bottom line’, however, and will only pursue growth that is profitable. Peter is very aggressive with a sales and marketing background. He’s probably the closest thing to a ‘clone’ we have for Ian, and feels strongly that Services growth is the key to increasing our revenue, profit and stock price over the next several years. Let me have Kay Hoppins, my Executive Assistant, set up a meeting ASAP!"

How much of the process should I share with them? Jason asked.

I think, said Jonathan, "that you should concentrate on our overall objective of shifting to a cash flow-oriented economic profit and return-on-capital approach, to replace our traditional EPS focus, with the supporting rationale and impact for them. If they accept the concept, directional changes and rationale, they’ll do whatever is required and enlist the support of their people".

I assume, interjected Jason, "that ‘simplicity with integrity’ is the message".

You’re learning fast, chuckled Jonathan. You will also have to meet Mary Frightly, Ian’s Administrative Assistant. Make sure you get on her good side. Mary only knows two types of people – friends and foes – and you don’t want to be one of her foes, at least not in this company. She’s followed Ian throughout most of his career, is very protective of him, and expresses her opinion of the people who are trying to influence him. And Ian listens to her. Now, as we seem to have all the necessary introductions in place, I will ask you to get out of my office and get started.

It will be my pleasure, Jason responded with a smile, as he exited and turned back down the hall toward the office that had been provided for him.

All the corporate staff and the two GMs were prepared to meet with Jason, so scheduling a meeting with the entire group for the next day was not a problem. They all knew about the endeavor, having been prepped by Jonathan – with Ian’s blessing.

Jason began delving into the pile of historical financials on the major business units. He wanted to have some background perspective for the meeting tomorrow. Jack’s group had compiled the reports for Jason to begin his initial value assessments. Jack had also, at Jonathan’s insistence, agreed to provide a senior accountant to answer questions and assist Jason with his historical analysis. Earl D’Mark’s top analyst and most senior aide would also get involved.

Tomorrow did arrive, and Jason spent the morning preparing for the kick-off meeting scheduled for 1:30 pm. As part of his preparation, he paced around his office and kept reminding himself … "simplicity with integrity – that’s the message!"

2

Shareholder value and sustainable value: definitions and perspectives

At 1:25, the group began arriving at the boardroom, where Jonathan had decided