Nofie Iman

We know that managers and investors obsessed with next quarter’s results, failure to invest in long-term growth, and even the accounting scandals that have grabbed headlines. When executives destroy the value they are supposed to be creating, they almost always claim that stock market pressure made them do it. In their defense, some executives contend that they have no choice but to adopt a short-term orientation, given that the average holding period for stocks in professionally managed funds has dropped from about seven years in the 1960s to less than one year today.

The reality is that the shareholder value principle has not failed management; rather, it is management that has betrayed the principle.

What matters is not investor holding periods but rather the market’s valuation horizon. While investors may focus unduly on near-term goals and hold shares for a relatively short time, stock prices reflect the market’s long view. Studies suggest that it takes more than ten years of value-creating cash flows to justify the stock prices of most companies. Management’s responsibility, therefore, is to deliver those flows to pursue longterm value maximization regardless of the mix of highand low-turnover shareholders.

Then, what do companies have to do if they are to be serious about creating value?

Alfred Rappaport, Professor Emeritus at Northwestern University’s Kellogg School of Management, has set out ten basic governance principles for value creation that collectively will help any company with a sound, well-executed business model to better realize its potential for creating shareholder value. Though the principles will not surprise you, applying some of them calls for practices that run deeply counter to prevailing norms.

Earning Management

The first principle said that value-oriented companies should not manage earnings or provide earnings guidance as well. What’s so bad about focusing on earnings?

• The accountant’s bottom line approximates neither a company’s value nor its change in value over the reporting period.
• Organizations compromise value when they invest at rates below the cost of capital (overinvestment) or forgo investment in value-creating opportunities (underinvestment) in an attempt to boost short-term earnings.
• The practice of reporting rosy earnings via value-destroying operating decisions or by stretching permissible accounting to the limit eventually catches up with companies.

Strategic Decisions

Companies should also make strategic decisions that maximize expected value, even at the expense of lowering near-term earnings. Expected value is the weighted average value for a range of plausible scenarios.

A sound strategic analysis by a company’s operating units should produce informed responses to three questions:

• How do alternative strategies affect value?
• Which strategy is most likely to create the greatest value?
• How sensitive is the value of the most likely scenario to potential shifts in competitive dynamics and assumptions about technology life cycles, the regulatory environment, and other relevant variables?

Acquisitions

Companies typically create most of their value through day-to-day operations, but a major acquisition can create or destroy value faster than any other corporate activity. That’s why companies should only make acquisitions that maximize expected value, even at the expense of lowering near-term earnings.

Sound decisions about M&A deals are based on their prospects for creating value, not on their immediate EPS impact, and this is the foundation for the third principle of value creation.

Carrying Assets

Value-oriented companies should carry only assets that maximize value. This principle takes value creation to a new level because it guides the choice of business model that value-conscious companies will adopt. There are two parts to this principle:

• Value-oriented companies regularly monitor whether there are buyers willing to pay a meaningful premium over the estimated cash flow value to the company for its business units, brands, real estate, and other detachable assets.
• Companies can reduce the capital they employ and increase value in two ways: by focusing on high value-added activities where they enjoy a comparative advantage and by outsourcing low value-added activities.

Cash Distribution

Even companies that base their strategic decision making on sound value-creation principles can slip up when it comes to decisions about cash distribution.

Rappaport suggested that value-oriented companies should repurchase shares only when the company’s stock is trading below management’s best estimate of value and no better return is available from investing in the business.

When a company’s shares are expensive and there’s no good long-term value to be had from investing in business, paying dividends is probably the best option.

Executive Incentives

Companies need effective pay incentives at every level to maximize the potential for superior long-term returns. Stock options were once widely touted as evidence of a healthy value ethos. However, the standard option is an imperfect vehicle for motivating long-term, value-maximizing behavior, because:

• Standard stock options reward performance well below superior-return levels.
• The typical vesting period of 3 or 4 years, coupled with executives’ propensity to cash out early, significantly diminishes the long-term motivation that options are intended to provide.
• When options are hopelessly underwater, they lose their ability to motivate at all.

Value-conscious companies can overcome the shortcomings of standard employee stock options by adopting a discounted indexed option-plan or a discounted equity risk option (DERO) plan. Companies can address the other shortcoming of standard options -holding periods that are too short- by extending vesting periods and requiring executives to hang on to a meaningful fraction of the equity stakes they obtain from exercising their options.

Operating-Unit Executives

Companies typically have both annual and long-term incentives plan that reward operating executives for exceeding goals for financial metrics. The trouble is that linking bonuses to the budgeting process induces managers to lowball performance possibilities. More important, the usual earnings and other accounting metrics, particularly when used as quarterly and annual measures, are not reliably linked to the long-term cash flows that produce shareholder-value.

To create incentives for an operating unit, companies need to develop metrics such as shareholder value added (SVA). To calculate SVA, apply standard discounting techniques to forecasted operating cash flows that are driven by sales growth and operating margins, then subtract the investments made during the period.

Because SVA is counting based entirely on cash flows, it does not introduce accounting distortions, which gives it a clear advantage over traditional measures.

Middle Managers & Frontliners

Value-conscious companies also need to reward middle managers and frontline employees for delivering superior performance on the key value drivers that they influence directly.

Although sales growth, operating margins, and capital expenditures are useful financial indicators for tracking operating-unit SVA, they are too broad to provide much day-to-day guidance for middle managers and frontline employees, who need to know what specific actions they should take to increase SVA. For more specific measures, companies can develop leading indicators of value, which are quantifiable, easily communicated current accomplishments that frontline employees can influence directly and that significantly affect the long-term value of the business in a positive way.

Rappaport suggests that most businesses can focus on three to five leading indicators and capture an important part of their long-term value-creation potential. The process of identifying leading indicators can be challenging, but improving leading-indicator performance is the foundation for achieving superior SVA, which in turn serves to increase long-term shareholder returns.

Stock Ownership

Rappaport also suggested that value-conscious companies should require senior executives to bear the risks of ownership just as shareholders do. To better align these interests, many companies have adopted stock ownership guidelines for senior management

But in most cases, stock ownership plans fail to expose executives to the same levels of risk that shareholders bear. One reason is that some companies forgive stock purchase loans when shares underperform, claiming that the arrangement no longer provides an incentive for top management. Another reason is that outright grants of restricted stock, which are essentially options with an exercise price of $0, typically count as shares toward satisfaction of minimum ownership levels.

Companies seeking to better align the interests of executives and shareholders need to find a proper balance between the benefits of requiring senior executives to have meaningful and continuing ownership stakes and the resulting restrictions on their liquidity and diversification. Without equity-based incentives, executives may become excessively risk averse to avoid failure and possible dismissal.

Investor Communications

The last principle said that value-oriented companies must provide investors with value-relevant information.

This final principle governs investor communications, such as a company’s financial reports. Better disclosure not only offers an antidote to short-term earnings obsession but also serves to lessen investor uncertainty and so potentially reduce the cost of capital and increase the share price.

One way to do this is to prepare a corporate performance statement. (See the exhibit below.)

Conclusion

For most organizations, value-creating growth is the strategic challenge, and to succeed, companies must be good at developing new, potentially disruptive businesses. To that way, the only reasonable way to deliver superior long-term returns is to focus on new business opportunities.

Companies focused on short-term performance measures are doomed to fail in delivering on a value-creating growth strategy because they are forced to concentrate on existing businesses rather than on developing new ones for the longer term. When managers spend too much time on core businesses, they end up with no new opportunities in the pipeline. And when they get into trouble they have little choice but to try to pull a rabbit out of the hat.

Although applying the ten principles will improve long-term prospects for many companies, a few will still experience problems if investors remain fixated on nearterm earnings, because in certain situations a weak stock price can actually affect operating performance.

Severely capital-constrained companies can also be vulnerable, especially if labor markets are tight, customers are few, or suppliers are particularly powerful. Clearly, if a company is vulnerable in these respects, then responsible managers cannot afford to ignore market pressures for short-term performance, and adoption of the ten principles needs to be somewhat tempered.

It’s time, therefore, for boards and CEOs to step up and seize the moment. The sooner you make your firm a level 10 company, the more you and your shareholders stand to gain.

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