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Reform your governance from within.

A financial management system guided by 'Economic Value Added' responds to the needs for improved governance and empowerment in the information age.

CEO resignations, proxy battles, contested board seats, and compensation carping fuel the fires of corporate governance. They put heat on top management. They arouse the indignation of the press. They delight lawyers. But they are not governance. They represent the failure of governance.

Proper governance makes it unnecessary to resort to radical remedies. Proper governance is a closed-loop system of decisionmaking, accountability, and incentives. It makes not just the CEO or top management but the entire organization responsible for the successes and the failures of the enterprise. It results in a self-regulated, serf-motivated if not indeed self-propelled, system of "internal" governance.

Contrary to popular opinion, the universal need to reform the internal governance system is not driven by the flexing of institutional investor muscles. The information revolution is the root cause, and it won't go away.

The proliferation of powerful computer and telecommunications networks is forcing decisionmaking down to the level where the additional information can do the most good. A seemingly subtle but critical point, since therein lies the source of toppled government regimes, flattened corporate hierarchies, fragmenting customer markets, and the chief impetus for governance reform.

The worldwide failure of centrally directed economies and the privatization of state-owned enterprises is a direct consequence of the "power shift" precipitated by the information revolution. Closer to home, entire industries are in turmoil. Andrew Grove, CEO of Intel Corp., has observed that the computer industry is flattening from vertical to horizontal, from a small set of highly integrated producers of proprietary systems to a large number of small entrepreneurial entities that focus on one segment of the total market. Intel, Dell, Microsoft, and Novell have carved out specialized product niches, displacing the heretofore unassailable IBM. In the same vein, "category killers" such as Toys-R-Us, The Gap, Home Depot, and Wal-Mart have transformed retail distribution from vertical to horizontal, toppling Sears.

Furthermore, the force of new information technologies is pulling product markets asunder, precipitating "mass customization." Each and every customer is becoming an isolated market to be captured by the companies best able to sense and service their individual requirements.

The most successful firms are exploiting the changes the information revolution has brought about. They realize that the best way to differentiate themselves and add value is to access, process, and respond to information faster and more effectively than the competition. They operate more like neural networks than mainframe computers. Instead of hoarding information at the top and analyzing it sequentially, they share information across internal borders and act upon it in real time. They flatten hierarchies to put the managers closer to the information. They decentralize and empower. They recognize that in a world of rapid-fire change, informed opportunism is more important than strategic planning. And the only thing they can rely on to resolve order out of this chaos is the motivation and accountability that results from believing in people and making managers into committed owners.

Wal-Mart Entrepreneurism

Wal-Mart is a good example. The company has doubled returns and tripled growth versus K mart, its closest competitor, precisely because it acts as that neural network, zapping sales data from checkout counter to warehouse to supplier and back again. What really makes all the additional information pay, however, is decentralizing decisionmaking and ownership all the way down to "stores within the stores." For instance, as Fortune magazine points out in its 1990 "Most Admired Companies" issue: "Wal-Mart chief David Glass expects managers for each of the of 34 departments within a typical Wal-Mart store to run their operations as if they were running their own businesses. The managers are supported with detailed financial statements. Says Glass: 'Instead of having one entrepreneur who founded the business, we have got 250,000 entrepreneurs running their part of the business.'"

Now more than ever, top management must follow Wal-Mart's lead in delegating the effort to create value to the creativity and entrepreneurism of the organization. Managers accustomed to overseeing large enterprises may find it hard to swallow, but the fact remains that the tops-down command-and-control management system is now hopelessly obsolete (see sidebar, The 'Desert Storm' Principle of Management). Rather, decentralization and empowerment combined are the proper response to the information revolution.

Enter Governance

This is where governance comes into consideration, or at least a proposed model of "internal" governance. The first step is that top management must abandon one of the most counterproductive aspects of tops-down management -- a preoccupation with earnings-per-share growth, and the conversion of that corporate target into budgets that unit managers are required to achieve to earn a bonus.

A tops-down earnings management process is entirely at odds with the challenges posed by the information revolution. It is a remnant of an archaic model of financial management that emphasizes controlling people instead of delegating to them, analyzing variances instead of realizing a business vision, and asking questions instead of seeking answers. It encourages managers to understate and underperform the true potential of their business, and to manage the earnings and expectations of the corporate office instead of maximizing value. A consolidated earnings goal sets in motion an internal process of mutual deception, corrupting planning and budgeting and distracting the organization from its true mission. It is one of the principal failings of corporate governance in America.

As the world has become faster-paced and more unpredictable, line managers need more general, as opposed to specific, measures of performance to which they will be responsible. They need more leeway to respond to changes in the environment. They need a broader and longer-range mandate to motivate and guide them. Managers, in short, need to think like, behave like, and be rewarded like owners, a process I will describe later.

The management of accounting results from the executive suite is also destructive because it undermines the integrity of the internal financial management process. Consider, for example, that capital spending proposals are typically evaluated by asking whether the net present value of cash flows, when discounted at the firm's cost of capital, is positive. While there is nothing wrong with that in principle, it breaks down in practice. Recognizing that cash flow is a poor retrospective measure of performance, because undertaking positive NPV projects reduces current cash flow, top management feels compelled to introduce accounting proxies, such as earnings-per-share, profit margins, growth rates, and returns, as tops-down proxies. But in so doing, management unwittingly severs the vital link between the manner in which the capital appropriations requests are reviewed and how goals are set and performance is evaluated. The absence of a clear tie obscures accountability, dulls incentive and initiative, and promotes a politically charged internal competition for capital which can override rational economic calculations.

On a recent business trip to California that left me a free afternoon, I visited The Queen Mary, empress of luxury vessels now retired to Long Beach, its glory days superseded by more economical modes of transportation. One facet of the ship's rich history, gleaned from a plaque at the center of the top-most level, stands out: Shortly after the mighty ship was docked in its final resting place, it was discovered that the only thing holding its monstrous smokestacks in place was 127 layers of paint, for the steel itself had long ago rotted to the core.

The internal governance systems of many companies resemble those smokestacks. With the passage of years, a vast array of unrelated financial measures and practices, few bearing any clear relation to building shareholder value, have been layered on top of another until no one any longer has any real sense of the company's basic financial mission and how they can contribute to it. And yet, no one seems to notice that the system is rotted at the core.

A Common Framework

So what is needed? Those dulling layers need to be scraped away and replaced by a simple, focused, and well-integrated financial management system. A common language and decisionmaking framework must be introduced. Incentives should be clearly aligned with the goal of enhancing value. Line managers must be able to trace readily how their operating and strategic decisions contribute to the creation or destruction of value. In short, every company's internal governance, or financial management, system should be considered a core process in as dire need of redesign as are product processes.

Paradoxically, though, redesign and nurturing of the financial management system cannot be delegated. It must be viewed as a prime responsibility of top management and, by extension, the board.

An Internal Governance System

At Stern Stewart & Co., we work with companies to implement an integrated framework for financial management that focuses management on creating value. Empirical research has proven that a measure we call "Economic Value Added," or EVA|TM~, is the single internal performance measure that best accounts for changes in share prices over time. Very simply, EVA is net operating profit after taxes less a charge for the capital employed to produce that profit.

EVA can alternatively be thought of as the rate of return management earns on capital less the cost of that capital, multiplied by the amount of capital employed in the business. Thus, a firm that earns a return of 22% versus an overall cost of capital of, say, 12%, and which employs $1,000 in net operating assets, would have an EVA of $100. That says the company is earning $100 more in profit than is required to cover all costs, and that includes the cost of tying up capital on the balance sheet.

The EVA financial management system is simplicity itself. The overriding objective is to increase EVA with the passage of time. That being the case, there are three clear ways to increase EVA and build value.

First, management can increase the return generated on assets already tied up in the business. That is, management can improve profitability without investing any more capital on the balance sheet.

Second, management can invest additional capital and build the business, so long as the return earned exceeds the cost of capital.

The best example of this has been Wal-Mart, the spectacularly successful discount retailer. Over the decade of the 1980s, Wal-Mart's sales grew from $1.6 billion to $32.6 billion, a compound growth rate of some 35% per annum. More importantly, the shareholders realized a total compound average annual return of 45%, a performance good enough to make Sam Walton the wealthiest individual on the face of the earth. Though Wal-Mart had a negative free cash flow (after investment) in eight of those 10 years, as investment opportunities outstripped internal cash sources, the firm's EVA exploded from $60 million in surplus profits in 1980 to $710 million in 1990, earning a fairly consistent 25% return on capital versus an overall cost of capital half that. Wal-Mart is a prime example of how cash flow, good as it is as a measure of value, is a poor period-to-period measure of management's progress in creating value.

Wal-Mart's results also illustrate how rates of return can be a poor measure of performance. Over the past five years, Wal-Mart's return on capital has slipped from 25% to 20%, as the more recently opened stores have produced returns lower than the original core business. But because those new stores have more than covered the incremental cost of capital, EVA has continued to grow prodigiously, and that is what matters.

The third way to build value is to release capital from, or curtail further investment in, activities that earn substandard returns. This may encompass everything from turning working capital faster, consolidating operations, selling assets worth more to others, and speeding up cycle times.

EVA and Market Value

Beyond providing managers all of the right incentives to maximize shareholder value, EVA ties directly to intrinsic market value. The present value of all future EVA, when discounted at the cost of capital, accounts for the net present value of a company, a business unit, an acquisition candidate, or even of an individual capital project. A discounting of EVA can and should displace a discounting of cash flow, from conducting capital spending reviews to valuations.

The link between EVA and net present value is illustrated in the exhibit on page 53. Portrayed in the upper panel is a growing spread between Wal-Mart's market value, as reflected in its year-end share price, and the amount of capital, or adjusted book value, employed to produce that value. That spread, which we refer to as MVA, or "market value added," is highly significant in two ways. First, it shows how much value has been added to the shareholders' cumulative investment since the inception of the company and, second, it is the stock market's assessment of the net present value of the company, of all present and future projects. It shows, as no other measure can, how successful management has been at allocating, managing, and redeploying scarce resources to maximize the net present value of the enterprise.

By year-end 1991, Wal-Mart was the most value-adding company in America, according to the annual Stern Stewart Performance 1,000 ranking, with an astronomic $60 billion spread of market over book value, or MVA.

An examination of the results for the entire sample of Performance 1,000 companies reveals that, when compared with other conventional financial performance measures, changes in EVA have the greatest statistical significance in explaining the change in MVA over a five-year period. For example, as seen in the table below, while the change in EVA explains 50% of any change in market value, more conventional measures such as EPS growth explain only 18% of the change in market value added over time.
Analysis of MVA vs. Other Corporate Performance Measures
MVA Percent of MVA
vs. Explained
EVA 0.50
Return on Equity 0.35
Cash Flow Growth 0.22
EPS Growth 0.18
Asset Growth 0.18

Far from being an arcane new measure, MVA arises from basic and time-tested principles of corporate finance. Indeed, Warren Buffett, the highly regarded chairman of Berkshire Hathaway, believes that his performance as a manager should be evaluated in terms of MVA (though he does not explicitly label it as such): "We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained." (Berkshire Hathaway, 1984 Annual Report, Letter to Shareholders). The "Buffett Test" is equivalent to saying that increasing MVA, not sales, market share, earnings, or cash distributions, is the ultimate measure of managerial performance.

Managers ignore the Buffett test at their peril, as illustrated by the lowest-ranked companies on the Performance 1,000 ranking. During the past year, half of these companies have witnessed management changes.
The 1992 Stern Stewart Performance 1000
Rank Company MVA ($ bil)(*)
990 Champion International -$2.3
991 Alcoa -2.3
992 ITT -2.4
993 Caterpillar -2.7
994 Sears, Roebuck -3.1
995 Time Warner -3.3
996 Chrysler -3.7
997 Digital Equipment -5.0
998 IBM -5.2
999 Ford -18.9
1000 General Motors -23.0
* MVA as of year-end 1991

In the end, increasing MVA is the goal, and increasing EVA is the means. EVA is the internal measure management can decentralize throughout the company and use as the basis for introducing a new and completely integrated financial management system. EVA allows all key management decisions to be clearly modeled, monitored, communicated, and compensated in terms of value added to shareholders' investment. Whether reviewing a capital budgeting project, valuing an acquisition, considering strategic plan alternatives, assessing performance, or determining bonuses, the goal of increasing EVA over time offers a clear financial mission for management, and a means for obtaining accountability and incentive. That is the essence of the new model of internal corporate governance.

Our experience has shown that the best way to implement the EVA internal governance system is to pinch people in their pockets -- to use incentive compensation to fuel management's desire to make the change.

The Incentive of Ownership

The ultimate objective is to make the managers think like and behave like owners. Owners manage with a sense of urgency in the short-term but keep an eye on a vision for the long-term. They welcome change rather than resisting it. Above all else, they personally identify with the successes and the failures of the enterprise.

Extending an ownership interest is also the proper way to motivate managers in the information age. Maximizing shareholder value is the one goal that persists, even as the specific means to achieve it are subject to dramatic and unpredictable shifts with access to real-time information.

Coincidentally, making managers into owners also resolves the corporate critics' concerns over the absence of a link between pay and performance. Yet, to do this, making managers into owners should not be undertaken as another layer on compensation plans. It should replace them, which can be accomplished with an EVA-based incentive compensation plan.

The EVA ownership plan has two simple, distinct components: a cash bonus plan that simulates ownership and a leveraged stock option plan that makes ownership real.

The cash bonus plan simulates ownership by tying bonuses to improving EVA over time. That links pay to value-adding performance, gives managers three clear directives to build value, and, most importantly and unique to EVA, closes the loop on a fully integrated financial management system. By paying for changes in EVA, managers starting off in businesses with negative EVA, for whatever reason (cyclicality, industry forces, poor previous management, etc.), have strong incentives to perform, and managers of high performing units will not be able to coast based on past performance.

Basics for Bonuses

With an EVA bonus plan, managers participate in a bonus pool that is a set share of current and cumulative increase in EVA, plus a minimum bonus award even if EVA just treads water. While such a plan may pay a target bonus for just treading water, managers may only earn exceptional bonuses if they continue to increase EVA. Just as total quality management calls for the continuous improvement in products and processes, so do EVA bonus plans call for the continuous improvement in financial performance. Moreover, by automatically resetting the EVA targets from one year to the next by formula, operating managers are prompted to propose and carry out aggressive business plans rather than be distracted by managing the expectations of upper management.

Moreover, to discourage mangers from accelerating short-term performance at long-term expense, and to avoid improperly penalizing or rewarding merely cyclical swings in performance, exceptional positive and negative bonuses are deferred, with a portion paid out in each subsequent year. Deferring bonuses also encourages good performers to stay and poor ones to depart, and makes the EVA plan double as both a short-term and long-term bonus plan.

The second element of the EVA plan heightens management's actual ownership stake in the company or the business unit. Asking them to purchase special in-the-money stock options with a rising exercise price sets aside a minimal acceptable return for the shareholders. Leveraged options not only put real money at risk but provide shareholders a fair rate of return first, before managers even begin to participate in enhanced share value.

Lastly, to link the leveraged option plan to the EVA cash bonus plan, a set percentage of each year's cash bonus payout is directed to purchase options. Linking options to bonus payments not only lengthens the time horizon of management's decisionmaking but simultaneously leverages the incentive to perform. The larger the cash bonus, the more dollars available for option purchases. Restricting exercise of options during the first three years further limits the potential for short-term gains.

Improving Your Chances

In summary, the EVA financial management framework offers one attempt to calm the corporate governance fires and respond to the empowered organization of the information age. Yet, even proper internal governance is no guarantee of success, and it is no substitute for leadership, entrepreneurism, and hustle.

By heightening accountability, strengthening incentives, facilitating decentralized decisionmaking, establishing a common language and framework for management, and fostering a culture that prizes building value above all else, an EVA financial management system can improve the chances of winning. That's all any shareholder can reasonably expect from governance in today's fast-paced and dynamic world of instantaneous information access.

G. Bennett Stewart III is Senior Partner of Stern Stewart & Co. He co-founded with Joel Stern the corporate financial advisory firm in 1982. Stewart advises a wide range of clients on issues involving executive compensation, value-added financial planning and management, and capital structure and valuation. He also heads the firm's software division and is the principal speaker at the firm's public forums on corporate finance and EVA|TM~ methodology issues.

The 'Desert Storm' Principle of Management

It was at hour 96 of the 100-hour air/land battle against Iraq when CNN newscaster Bernard Shaw asked this question of Perry Smith, a retired USAF general who had correctly predicted a six-week engagement fought mostly from the air with minimal allied casualties: "General Smith, what lessons can we learn from the conduct of this engagement?"

"Oh, there are several," he replied, "but the most important is 'empowerment.' Unlike Lyndon Johnson, who directed bombing runs from the White House, or President Carter, who insisted upon remaining its telephone communique with the helicopters sent to rescue American hostages, only to recall them at the last moment, this time we empowered the commanders in the field and gave them one clear goal -- to win -- for a change."

General Smith believed that the action on the field of combat was equally empowered. "Our troops passed information all around, quickly responded to the shifting battlefield dynamics, and overwhelmed the Iraqis. Hampered by their Russian-style, centralized, military command-and-control system, they simply had no hope of competing with the free-flowing, time-sensitive, high-quality attack our forces waged against them, and their portends an entirely new era in warfare."

General Smith's incisive assessment is instructive for today's business leaders. Tops-down, hands-on management cannot win in a dynamic marketplace that increasingly puts a premium on speed, flexibility, and initiative far down the ranks. The decline of centrally directed leviathons, such as Sears, IBM, and GM, is a strong indicator of this new world at work. To succeed in this new era, CEO's must find ways to empower their organizations by pushing down information and incentives.
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:includes related article; financial management system
Author:Stewart, G. Bennett, III
Publication:Directors & Boards
Date:Mar 22, 1993
Previous Article:Protecting the board.
Next Article:Change begins at 'square zero.' (corporate governance)

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