Corporate Performance Measurement Strategic Analysis Series Primer July 2010

Corporate Performance Measurement Strategic Analysis Series Primer July 2010

Agenda • Executive Summary • Objectives • Background • Performance Measurement Framework • Market Value Added (MVA) • Economic Profit (EP) • Cash Flow Return on Investment (CFROI) • Exercises • MVA • Economic Profit • Case Study - Diageo CorporatePerformanceMeasurement

Executive Summary (1 of 2) • Corporate performance evaluation has evolved from the 1960s focus on ROE to the current variations of economic profit that measure impact on shareholder value • many firms have devised their own variations of economic profit • Stern Stewart’s Economic Value Added (EVA)TM is best known of these measures • Holt/BCG’s Cash Flow Return on Investment (CFROI) is a similar concept presented in % return format • Both ROE and EP are business metrics, tools used to measure the performance of the business • separate from fundamental business drivers, the actual factors that influence shareholder value, and output measures the backward-looking records of overall company performance • Focusing on EP instead of ROE decreases the likelihood of destructive behavior by managers • By evaluating managers based on EP, manager behavior can be altered such that only projects that add value (with NPV>0) are undertaken, which does not always occur with ROE CorporatePerformanceMeasurement

Executive Summary (2 of 2) • End goal of EPexercises is consistent with traditional XXX focus of maximising shareholder value • XXX has measured historical performance with Total Shareholder Return • Stern Stewart devised Market Value Added (MVA)TM as means of measuring market expectations of EP that managers will add in the future • managers’ objective should be to maximise MVA • All economic profit measures deduct charge for use of equity capital from accounting’s typical net income or profit after tax to reflect the opportunity cost associated with equity investments • Stern Stewart has trademarked EVATM by specifying adjustments to make to EP CorporatePerformanceMeasurement

Objectives There are three objectives of the Corporate Performance Measures Module: • To define the most popular measures of corporate performance • To explain the significance of these measures in the corporate environment and potential applications in XXX’s strategy work • To outline calculations of each performance measure CorporatePerformanceMeasurement

Background Corporate Performance Evaluation Corporate performance evaluation has evolved from the 1960s focus on ROE to the current variations of economic profit (EP) that measure impact on shareholder value 1960s/70s • With the rise of conglomerates, most companies focused on Return on Equity, or ROE, as their primary measure of performance • led most managers to undertake acquisitions solely to manipulate accounting figures 1980s/90s • With the increased focus on delivering shareholder value, managers have accepted systems that measure the change in value • managers realised equity is not free • economic profit (EP) meets these needs by telling managers where value has been created and where it has been destroyed • As aligning interests between owners and managers has become more important, tying management compensation to EP provided a popular solution CorporatePerformanceMeasurement

Background Relevance to XXX • XXX was the first of major consulting firms to focus on creating shareholder value • To achieve this, XXX has used the output measure of Total Shareholder Return and the accounting measures of ROE and ROI • Modified accounting measures, such as EP, provide an alternative means of measuring the creation of shareholder value CorporatePerformanceMeasurement

Background Link to Strategy Marakon has made economic profit (EP) the central focus of the ‘program’ they apply to every case • To illustrate the role of corporate performance measures and resource allocation to strategy work, an examination of Marakon’s “program” is useful • Marakon applies the following program, which can take several years to complete, to all of its clients: • assess the economic profit of all customer segments and product lines • compare company performance to industry performance • investigate three or more strategies for each business every planning cycle • shift resource allocation from economically unprofitable products/customers to economically profitable • leads to yield loss for Marakon and clients since additional scenarios frequently evaluated CorporatePerformanceMeasurement

Background Economic Value Added EVATM is one variation of EP How new is Economic Value Added (EVA)? • A century ago, Alfred Marshall explained that for a company to have genuine profits, the profits must be sufficient to cover the cost of capital as well as the firm’s operating costs • Stern Stewart has re-packaged the concept into EVA, which is essentially a more palatable form of the same idea • McKinsey has been using economic profit for many years • BCG uses Cash Flow Return on Investment (CFROI) for a similar analysis • To avoid infringing upon Stern Stewart’s trademark, many consulting firms have developed their own terms for the same concept CorporatePerformanceMeasurement EVA is a registered trademark of Stern Stewart

Framework Measures EVA/MVA,EP,and CFROI are modified accounting measures used to measure the performance of the business Fundamental Business Drivers Business Metrics Output Measures Description: • Primary business-specific factors influencing shareholder value • Tools used to measure performance of business • Backward-looking measures of overall company performance as viewed by market Inputs/ Measures: • Operating profits • volume • price • costs • Financial Cost of Capital Employed • fixed assets • working capital • WACC* • Accounting • ROE • ROA • Modified accounting • EVA/MVA • EP • CFROI • CVA • Total Shareholder Return (TSR) • Total Business Return (TBR) CorporatePerformanceMeasurement * For a discussion of WACC and discount rates, please see the Investment Appraisal Module in the BVU

Framework Fundamental Business Drivers The fundamental business drivers provide a framework for identifying the sources of shareholder value creation or destruction Shareholder Value Creation/Destruction Cost of Capital Operating Profit Fixed Assets Working Capital Volume Price Costs + WACC X X Components: • # of units sold • Average selling price • Direct costs • material • labour • Indirect costs • SG & A • Depreciation • Property, plant & equipment • Intangibles • Current assets less current liabilities • Weighted average cost of capital based on market values of debt and equity • Use after-tax cost of debt • LIFO vs FIFO • Depreciation estimates • Intangible measurement • Cost of equity for private firms Issues: CorporatePerformanceMeasurement

Framework Accounting Business Metrics ROE measures returns to shareholders, while ROA measures returns to investors of all forms of capital Return on Assets (ROA)* Return on Equity (ROE) Formula: Net Income Net Income ROA = ROE = Assets Equity Measures: Profitability of all capital employed, including debt Profitability of equity invested in business (net equity issued plus retained earnings) Uses: Returns of enterprise as a whole Returns to shareholders CorporatePerformanceMeasurement * Sometimes referred to as Return on Investment (ROI)

Framework Accounting Business Metrics - DuPont Formula The DuPont formula is used to separate ROE into its components in order to assess the performance of the business Net Income Net Income Sales Assets ROE = = X X Equity Sales Assets Equity ROS Asset Turnover Leverage ROA ROE = = Profitability X Asset Turnover X Leverage CorporatePerformanceMeasurement

Framework Modified Accounting Business Metrics Many consulting companies attempt to brand the modified accounting business metrics they use Measure Consulting Companies • Economic Profit • XXX • McKinsey • Marakon (through Value-Based Management) • LEK • EVA  / MVA  • Stern Stewart • AT Kearney • Accounting firms • Cash Value Added* (CVA) • BCG • Cash Flow Return on Investment (CFROI) • Holt • BCG CorporatePerformanceMeasurement * EVA=EVA with depreciation added back

Framework Role in Organisation The modified accounting business metrics, which include EP, enable relatively accurate levels of corporate performance measurement at lower levels of decision making in the organisation High TSR* MVA Modified Accounting Business Metrics Accuracy as Measure of Corporate Performance EP/EVA/CFROI ROE/ROA Fundamental Business Drivers Low Low High Level of Decision Making CorporatePerformanceMeasurement * only backward -looking

Framework Output Measures While TSR calculates return to shareholders for publicly-listed companies, BCG’s TBR calculation estimates equivalent returns for privately-held firms 1 Market value of share at end of period * number of years Total Shareholder Return (TSR) in CAGR Format 1 = Market value of share at beginning of period 1 Estimated market value of shares of privately-held company at end of period* number of years 1 Total Business Return (TBR) = Estimated market value of shares of privately-held company at beginning of period* CorporatePerformanceMeasurement * Adjusted for all stock splits and assuming all dividends reinvested

Framework Output Measures XXX’s client stock performance slide is calculated using TSR, which is used to measure the shareholder value created CorporatePerformanceMeasurement

Market Value Added Definition (1 of 2) XXX’s focus has always been to help the management of the firm to maximise shareholder value, which is equivalent to maximising MVA Goal of Managers should always be to create more shareholder value, or maximise MVA Market Value Added (MVA) Invested Capital Total Market Value of Firm(includes all debt and equity) CorporatePerformanceMeasurement

Market Value Added Definition (2 of 2) MVA equals the total market value of the company less invested capital or net assets. Either the Operating or Financing Approach can be used, but XXX typically uses the Operating approach Operating Approach (Typically used by XXX) Financing Approach CorporatePerformanceMeasurement Note: *Short-term non-interest bearing liabilities

Market Value Added Operating Approach - Excess Cash The first step required to calculate Net Assets with the Operating Approach is to identify excess cash, which is total cash less cash required in the operating cycle Amount ($) CorporatePerformanceMeasurement Note: *Short-term non-interest bearing liabilities

Market Value Added Operating Approach - Working Capital Requirements Next, The working capital requirements are the firm’s net investments in the operating cycle, or the net amount of short-term investment required to fund operations Amount ($) WorkingCapitalRequirements CorporatePerformanceMeasurement

Market Value Added Operating Approach - Net Fixed Assets When calculating MVA, Net Fixed Assets is defined as Net PP&E plus other Investment (tangible and intangible). The third and final step to calculate Net Assets is Net PP&E, which is the amount of long-term investment required to fund operations Amount $ Net PP&E CorporatePerformanceMeasurement

Market Value Added Link to EP Market value added (MVA) reflects the markets expectations of the EP managers will add in the future MVA is the market’s expectation of discounted future EPs Percent of Total CorporatePerformanceMeasurement

Market Value Added Link to EP - Example After extensive work by a diligent XXX team, Acme Industries is expected to generate $25M in economic profits next year, which is expected to grow at 3% forever. If the cost of capital is 13% and the invested Capital is $100M, what is the MVA and the market value of the company? CorporatePerformanceMeasurement

Market Value Added Link to EP - Solution After extensive work by a diligent XXX team, Acme Industries is expected to generate $25M in economic profits next year, which is expected to grow at 3% forever. If the cost of capital is 13% and the invested Capital is $100M, what is the MVA and the market value of the company? Market Value of the Company MVA = PV of EPs = MVA + Invested Capital = $ 25 M = $ 250 M + $100 M 13% - 3% = $350M = $ 250 M CorporatePerformanceMeasurement

Market Value Added Link to EP (1 of 2) EP measures managers’ performance in the past, since it represents the market value added created over one year Note: *Assumes Invested Capital Constant CorporatePerformanceMeasurement

Market Value Added Link to EP (2 of 2) EP is used to evaluate manager performance because the change in MVA over a period of time is measured • Goal of company’s managers should always be to maximise MVA • When managers make any investment decisions, if the project is: • value-creating NPV >0 MVA increases • value-destroying NPV <0 MVA decreases • Reason that EP is the focus of most attention is because MVA is a stock or wealth measure, so MVA will show how much value has been added at that point in time • EP measures the amount of value added over a period of time, which is far more useful when measuring manager performance CorporatePerformanceMeasurement

Market Value Added Actual Performance • Which UK sectors would you expect to have the highest market value added? • and the lowest? • Which UK companies would you expect to have the highest market value added? • and the lowest? CorporatePerformanceMeasurement

Market Value Added UK Sector Performance - 10 Best Banks, integrated oil and drugs were the UK sectors with the highest market value added Sector Market Value Added (Sept 98) Source: Stern Stewart, Sunday Times CorporatePerformanceMeasurement

Market Value Added UK Sector Performance - 10 Worst Distributors, print and packaging and construction had the lowest market value added in the UK Sector Market Value Added (Sept 98) Source: Stern Stewart, Sunday Times CorporatePerformanceMeasurement

Market Value Added UK Company Performance - 10 Best Shell’s £69.5B of market value added is the largest in the UK Company Market Value Added (Sept 98) 1998 EVA (£B) (1.506) 0.416 0.803 0.710 0.402 (0.024) 1.400 0.231 n/a 0.098 Source: Stern Stewart, Sunday Times CorporatePerformanceMeasurement

Market Value Added UK Company Performance - 10 Worst British Steel’s £3B of market value destroyed was the worst of Britain’s 200 largest companies Company Market Value Added (Sept 98) 1998 EVA (£B) (0.071) (0.012) (0.054) (0.087) (0.050) (0.108) (0.120) (0.320) (0.284) (0.352) Source: Stern Stewart, Sunday Times CorporatePerformanceMeasurement

Economic Profit Agenda • Definition • Advantages/Disadvantages • Framework • Use in Strategy Work CorporatePerformanceMeasurement

Economic Profit Definition (1 of 2) Economic Profit (EP) is a residual profit concept accounting for the opportunity cost of holding capital Traditional accounting concept of profits Amount ($) CorporatePerformanceMeasurement Note: Economic Profit (EP) =Operating Profit - (Cost of Capital * Amount of Equity Capital Invested)

Economic Profit Definition (2 of 2) Economic Profit determines a company’s value creation or destruction • Easy to use, based on accounting records (for historical values) • Not prisoners of GAAP • Can be used to show relative performance of products, segments, regions, etc. in a given year • Can be calculated for future years and discounted to show value creation • When Economic Profits are positive over time • value creation is positive • market price per share is more than book value per share • growth creates value Gross Profit OperatingProfit A&P NOPAT EffectiveTaxation Overheads EP Net WorkingCapital InvestedCapital $ Charge forCapitalEmployed Net FixedAssets WACC CorporatePerformanceMeasurement Note: NOPAT = Net Operating Profit After Tax (See Appendix for details) WACC = Weighted Average Cost of Capital

Economic Profit Key Principles: Access to Company Earnings In order to understand EP it is important to go back to the basic income statement Observations Interest • Debt providers have first access to the interest payments due on money lent $100 $100 Tax • Governments tax corporate profits Income Statement (%) EBIT • Shareholders (equity providers) have access to all residual profits (after paying interest and tax) PAT What did we earn?(using what we own) Who gets access to these earnings? CorporatePerformanceMeasurement Note: Economic Profit (EP) = Operating Profit - (Cost of Capital * Amount of Capital Invested)

Economic Profit Understanding the Balance Sheet The balance sheet separates what is owned by the firm from how it was paid for Balance Sheet Makeup Key Observations • Assets are a company’s economic resources, items which have the potential to provide future benefits to the organisation • NIBLs represent a free source of funds to the company. It is money lent to a firm with no charge or expected return • Debt is any interest bearing capital, including preferred stock • Shareholder's Equity is the accountant's estimate of the value of the shareholder's investment in the company • total assets less total liabilities $500 $500 100% NIBLs Balance Sheet Debt Assets Shareholder's Equity How did we pay for it? What do we own? CorporatePerformanceMeasurement Note: NIBL = Non-interest bearing liabilities

Economic Profit Economic Profit Balance Sheet In order to develop the EP balance sheet, short-term non-interest bearing liabilities must be removed and adjustments for accounting distortions must be made • Short-term NIBL are removed from the EP balance sheet since capital returns are not expected on the amounts owed (e.g. wages payable) • EP Balance Sheet Net Assets amount may be much larger than the traditional accounting value after adjustments for accounting distortions (e.g., adding internally-generated intangible assets) are made Operating Approach Financing Approach Regular Balance Sheet EP Balance Sheet CorporatePerformanceMeasurement Note: NIBL= Non-interest bearing liabilities

Economic Profit Income Statement and Balance Sheet Traditional Link (1 of 2) The traditional linkage of the Income Statement and Balance Sheet is the connection between net income and retained earnings or dividends Reinvest it in the Company Dividend Policy Retained Earnings • Cash “out” from shareholders perspective Management Decision Net Income • Income attributable to shareholders (EBIT - Interest - Tax) Distribute it to Shareholders Dividends • Cash “in” from shareholders perspective CorporatePerformanceMeasurement

Economic Profit Income Statement and Balance Sheet Traditional Link (2 of 2) The traditional linkage of the Income Statement and Balance Sheet is the connection between net income and retained earnings or dividends Balance Sheet Income Statement Economic Consequence Assets Liabilities Revenue - Costs NIBLs CurrentAssets = Net Income Debt - Dividends Net FixedAssets = Retained Earnings Equity OtherAssets CorporatePerformanceMeasurement

Economic Profit Break-Even Example - 70% Debt / 30% Equity Revisited • If you could buy the same factory for £100K, but could only finance 70% with debt and required equity for the remaining 30%, how much after-tax profit would you require to break-even? • assume tax rate = 40% • assume cost of equity = 15% CorporatePerformanceMeasurement

Economic Profit Break-Even Example - 70% Debt / 30% Equity - Solution • If you could buy the same factory for £100K, but could only finance 70% with debt and required equity for the remaining 30%, how much after-tax profit would you require to break-even? • assume tax rate = 40% • assume cost of equity = 15% Debt: £70K @ 7% £4.9K (cover interest payments) Equity: (£30 @ 15%) (1 -40%) £7.5K (cover equity charge, which is not tax-deductible)  £12.4K • Therefore £12.4K is required to break-even with 30% equity, compared to £7K with 100% debt financing • Any after-tax profits beyond £12.4K will be economic profits CorporatePerformanceMeasurement

Economic Profit Agenda • Definition • Advantages/Disadvantages • Framework • Use in Strategy Work CorporatePerformanceMeasurement

Economic Profit Advantages EP is more successful than other measures in explaining shareholder returns TM CorporatePerformanceMeasurement Source: Stern Stewart

Economic Profit Advantages (1 of 3) A manager with high ROE will not undertake projects with ROE greater than required but lower than current ROE, creating missed opportunities • Managers are typically evaluated based on maximising ROE • A manager with ROE level of R will not undertake any projects with ROE < R1 • Any projects with ROE > R0 but ROE < R, will still have positive NPV but will not be undertaken by manager • creates missed opportunities NPV 0 R0(after equity charge) 0 R1 EP > 0 ROE CorporatePerformanceMeasurement

Corporate Performance Measurement Strategic Analysis Series Primer July 2010