Four Options for Measuring Value Creation

Strategies for managers to avoid potential flaws in accounting measures of performance

In casual, everyday language, it is often said a corporations primary role is to generate profits. However, the primary
role of a corporation is not to generate profits; it is to create shareholder value. When corporations focus their internal
performance measurement systems on short-term profits or accounting returnsnot shareholder valuebad things
often happen. Their managers can fail to identify real problems on a timely basis. They can also become shortsighted
and prone to gamesmanship.

Fortunately, many smart managers take steps to de-emphasize the management roles of accounting measures of
performance to keep the focus on value creation. This article first clarifies the problemthe reasons accounting
performance measures are often not good indicators of value creationand then describes four main alternatives
managers can use.

FLAWED MEASURES OF VALUE CREATION

Ideally, the performance measures that managers monitor and use for management decision making should go up
when economic value is created and down when economic value is destroyed. But short-term profit measures and
accounting returns often do not do that. This has been shown consistently in research over various periods.

A review of these studies shows that the coefficient of determination between annual accounting profits and annual
shareholder returns is small, ranging from 2% to 10% across numerous studies. Statisticians interpret this figure by
saying that the annual accounting profit measures explain between 2% and 10% of the variance in annual value
changes. This means that having access to a business entitys annual or quarterly profit figures tells you very little
about the value the business entity created in that measurement period.

This low correlation should not come as a surprise. Many things affect accounting profits but not economic values, and
vice versa:

1. While value is future-oriented, accounting profit measures focus on the past. Future revenues, and most future
expenses, are not anticipated.

2. Accounting systems are transactions-oriented. Although fair value accounting attempts to capture changes in the
value of certain assets recorded on the balance sheet, many changes in value are not captured in profit figures.

3. Accounting profit measures are highly dependent on the choice of measurement method. Multiple measurement
methods are often available to account for identical economic events.

4. Accounting measurement rules are conservatively biased. They are slow to recognize gains and revenues but quick
to recognize expenses and losses.

5. Accounting rules ignore some economic values and value changes that cannot be measured accurately and
objectively with conventional accounting measures. Prime examples are investments designed to create intangible
assets.

6. Accounting profit measures ignore the cost of equity capital, which is usually much more significant than the cost of
debt capital.

7. Accounting profit measures ignore risk and changes in risk. Companies that have not changed the pattern or timing
of their expected future cash flows but have made the cash flows more certain (less risky) have increased their
economic value. This value change is not reflected in accounting profits.

APPROACHES FOR ADDRESSING THE PROBLEM

To address the problems that can be caused by using GAAP performance measures, managers can use any or all of
four basic alternatives:

1. Market measures. One obvious way to avoid the inherent problems of accounting performance measures is to
focus on market indicators of value creation. In the end, market values determine what returns shareholders earn on
their investments. Emphasizing these market measures of success in incentive plans has an obvious appeal because
executives, and often other employees, benefit only when the shareholders do.
But for several important reasons, market measures are not a cure-all. Market valuations might not reflect the
companys true intrinsic value because the market does not have access to all the private information available to
managers. Market measures experience high volatility that is unrelated to management performance. They impose a
severe feasibility constraint because market measures are informative of the performance only of top-level managers
in companies whose stock is publicly traded. They do not say much about the performance of lower-level employees
whose efforts rarely can have a material effect on the performance of the whole corporation. And in privately held
companies, market measures generally do not exist. Additionally, market prices are based on market expectations that
might not come to fruition.

To illustrate this last point, consider the experience of Eastman Kodak Co. in the early 1990s. In January 1993,
Eastman Kodak hired Christopher Steffen as CFO. In anticipation of what Steffen could do for the company, Kodaks
market capitalization quickly rose by $2.2 billion. The Wall Street Journal called Steffen the $2 billion man.

However, Steffen did not fit with the Kodak culture, and he left in April 1993 having accomplished almost nothing. As a
consequence, Kodaks stock value almost immediately declined by $2 billion. But consider what would have happened
had Steffen come to Kodak in December 1992 and left in March 1993? If executive bonuses were based on market-
performance measures, executives would have been paid bonuses based on the creation of $2 billion, which was
actually never realized. To minimize this problem for incentive purposes, companies often impose lengthy vesting
provisions on grants of stock or options or add a clawback provision requiring give-backs of bonuses paid that turn
out to be unearned.

2. Improved, non-GAAP profit measures. Another alternative for avoiding the inherent problems with accounting
profit and profit-dependent measures is to try to improve the accounting measures of performance. That is, choose
better profit measures, many of which use measurement rules that are inconsistent with GAAP. These measures can
eliminate some of the noise in the GAAP measures and/or incorporate a charge for the cost of capital. Indeed, many
companies, and especially those in service and high-tech industries, are now placing attention, even primary attention,
on non- GAAP measures such as free cash flow, EBITDA, economic profit, or various forms of pro forma profit
measures that exclude line items that management deems to be unusual, non-recurring or uncontrollable. The items
that are most often excluded from the pro forma profit measures are transitory and noncash items, such as
amortization of goodwill, expenses for grants of stock options, various special charges such as for litigation, and
changes in the fair value of derivatives.

Certainly, some managers resort to non- GAAP measures to exclude bad news, to make their companys performance
look better, possibly simultaneously increasing bonuses. But there is also considerable evidence that many managers
use non-GAAP measures for internal purposes because they believe that profits calculated in some non-GAAP way
are more informative, and hence more useful, than GAAP profits.

Some research has focused on whether these non-GAAP measures, provide better indications of value creation than
GAAP measures. Studies in broad samples of companies and in specific industries suggest they do. For example, one
study that focused on the real estate investment trust (REIT) industry found that the industry-advanced measure called
funds from operations (FFO) was more highly associated with stock value changes than was GAAP net income. This
evidence suggests that for management purposes at least some non-GAAP measures provide improvements over the
standard GAAP profit and return measures.

3. Extensions of the measurement window. A third alternative for overcoming the inherent weaknesses in
accounting measures of performance is to extend the measurement window out several years. At the extreme, over
the total life of a venture, the sum of the profits generated by the entity will equal the total value created, assuming zero
inflation. Thus, the associations between profit measures and market measures of value creation would be expected to
vary with the length of the window of measurement. Indeed they do.

Studies have shown that in very long measurement windows, the correlations are actually quite high; over 10 years the
correlation is nearly 0.8. Of course managers cannot wait 10 years to get an indication as to whether performance
problems exist, and nobody wants to wait 10 years to learn the size of the bonus he or she will be paid.

In most companies, performance reviews and incentive contracts are based on one-year and shorter measurement
periods. But some companies extend the measurement window for some purposes, particularly the awarding of
incentives. The most common measurement window for this form of long-term incentive plan is three years, but some
companies use periods of up to six years.

Long-term incentives have their drawbacks. It is difficult to set properly challenging performance targets for periods
covering three to six years into a future that could be significantly affected by many macroeconomic and competitive
factors. Profit measured in a three- or five-year period is still far from being perfectly correlated with value changes;
one large sample study found the correlation in even a five-year measurement window to be only 0.57. And the
motivational impact of long-term incentive plansthe extended measurement window-type plans we are talking about
here as well as stock-based plans with extended vesting periodsis diluted because people have to wait so long for
their payments.

4. Combinations of measures. In most settings, the main problems with the profit measures are that they are short-
term oriented and backward-looking. A reasonable option, then, is to supplement the profit measures with some other
measures that are more long-term oriented and forward-looking. Many of these so-called leading indicators or
performance drivers are non-financial measures, such as customer satisfaction, product quality or R&D productivity.
Others are denominated in monetary or ratio terms, such as backlogs, inventory turns or employee turnover. Research
has shown that many of these measures are immediately informative as to how much value has been created and
leading indicators of the profits that will be reported in future measurement periods.

Which measures to focus on, and how many, varies significantly with the business setting. They should directly reflect
the companys business strategy. In essence, they should reflect what are commonly referred to as the businesss
critical success factors. They might be measures of market penetration, patents granted or Web site page views.
These measures can supplement the financial measures that are often useful to monitor, such as revenues, R&D
expenditures, G&A expenditures and operating income.

At the extreme, a company can decide that nonfinancial indicators are virtually all that is important and ignore the
accounting measures almost entirely. As an example, consider the case of a small, pre-profit firm that supplies
products to the automotive industry. The companys bonus plan for all employees, including the top executive team,
was based exclusively on nonfinancial measuresnew order commitments, shipments, quality, and the building of
production infrastructure. The companys vice president of finance explained that the bonus plan is a tool to focus
peoples attention on the right things. But he went on to explain that the nonfinancial [measures] are what we need to
pay attention to. As the company grows and nears its IPO, it will probably add a profit consideration to its bonus plan
as a useful summary of current-period product-shipment and expense-control activities.

EXECUTIVE SUMMARY

Performance measures that managers monitor and use in decision making should go up when economic
value is created and down when economic value is destroyed. But short-term profit measures and accounting returns
often do not do that.

Many things affect accounting profits but not economic values, and vice versa: Accounting profit
measures focus on the past, are transactions- oriented, highly dependent on the choice of measurement
method, conservatively biased, ignore some economic values and value changes that accountants feel cannot be
measured accurately and objectively, ignore the cost of equity capital and ignore risk and changes in risk.

Approaches to avoiding potential problems with accounting measures of performance include focusing on
market indicators of value creation, improving the accounting measures of performance, extending the measurement
window out several years for performance reviews and incentive contracts, and supplementing profit measures with
more long-term oriented and forward-looking measures of performance.