The corporate interpretation of the theory of value: value-based management explained

From: Jurriaan Bendien (andromeda246@HETNET.NL)
Date: Wed May 19 2004 - 18:38:52 EDT

(Just when the post-Marxist economists have told us value theory is
nonsense, corporate financial officers have taken it up. Value theory
is necessary especially in large corporations, because as I mentioned
in an earlier article, very large resources are being managed which
are withdrawn from the market, i.e. they are held without being
bought or sold, and consequently, they only have theoretical
prices, i.e. prices which rely on a combination of internal price
relativities and external price relativities. This would not be
understood by Ian Steedman, who suggested once that Marx
is logically committed to the idea that a product has two
different prices depending on whether it is purchased, or
whether it is sold, but corporate finance officers know quite well
that there is something that happens in between purchase and
sale. If M is the investment capital, and M' is that capital
plus realised profit, then in between M and M' is something
called P in which means of production (MP) and labor
capacity (LP) are combined as (C) to create new value.
The process can thus be described as M-C-P-C'-M'
(see further Capital Vomume 2 by Karl Marx).
I have edited excerpts of this article down for relevance
- the complete article is available at: - JB).

The value creation equation (Corporate Finance Magazine, March 2004)

Mathematically MVA is the difference between market value - calculated as
the sum of the market value of equity, debt and the market value of
outstanding stock options - and the company's invested capital - the cash
investors, both equity- and debt-holders, contributed to the company's
operations. A high MVA indicates the company has created substantial wealth
for shareholders. MVA is equivalent to the present value of all future
expected EVAs. A positive MVA indicates that investors expect the company to
generate significant amounts of EVA in the future. A company with a negative
EVA but positive MVA can mean one of several things: the market expects it
to turnaround; that it may be a potential takeover candidate; or that it is
following a business cycle.

Economic value added (EVA) is an estimate of true "economic" profit, or the
amount by which earnings exceed or fall short of the required minimum rate
of return that shareholders and lenders could get by investing in securities
of comparable risk. In its simplest form it's a company's trading profit -
net operating profit after taxes paid (NOPAT) minus a capital charge for
both debt and equity. Stern Stewart has made changes in the caluculation of
profit and capital to make the result more realistic. It capitalises
investments in intangible assets placing them on the balance sheet where
they belong. (...)

Value Based Management, based on MVA/EVA, is a management approach that
ensures corporations are run consistently on value - and normally on
maximising shareholder value. It includes creating value, managing for value
and measuring value. It uses simple transparent metrics that not only
highlight where a company has added or destroyed shareholder value but gives
investors a good indication of how capable the management team is.

Nurturing the conditions to best create shareholder wealth is harder than
you might think. Boards can often lack a shared perspective on how stock
markets evaluates corporate performance. Equally, they may not fully
understand the key strategic factors for creating value in today's market.
That's where the CFO is meant to step in. (...)

But what is shareholder value? "Shareholder value is why we come to work
everyday," says Pat Mulva, head of IR at Exxon Mobil, the world's largest
oil company (which does not have a CFO, by the way). "Everyday we compete
for that investment dollar and it is our job to provide value to the people
making that investment decision everyday."

Mulva defines shareholder value as the appreciation of the share price and
the long-term impact of dividends and share buy-backs. In 2002, Exxon
distributed more than $10 billion to shareholders through dividends and
share buybacks. In 2002, its dividend increased for the 20th consecutive
year. (...) Ladislas Paszkiewicz, head of IR at oil company Total, agrees
with Mulva's definition of shareholder value as the sum of a contribution
of stock performance and yield through dividend. Likewise, a spokesman
at Novartis, the Swiss-based pharmaceutical giant asserts that, "The
ultimate measure [of shareholder value] is the development of the
share price, dividend pay outs and value of spin offs."

But Paszkiewicz also says that shareholder value is simply a by-product of
how well (or badly) a company performs. "At Total, shareholder value is the
result of our emphasis to improve company performance. We control what we
deliver through the company's internal plans that focus on growth and
productivity. This translates into shareholder value creation. The two are

Exxon's overriding objective is to create sustainable shareholder value by
seeking high returns at low risk and focussing on the long-term, says Mulva.
(...) An analysis of investments in the shares of Stern Stewart's
publicly-owned US clients showed they produced 49% more wealth
after five years than equal investments in shares of competitors with
similar market capitalisations. How? As a company you are committed
to shareholder value creation. But do you understand where and how
value is being created and where opportunities for value creation lie?
MVA, EVA and value-based management companies do, says
Kondragunta, and that is why those US companies produce 49% wealth.

Managers, and this essentially means the CFO, at value-based management
companies believe that there are only three basic ways to increase and
manage value. The first is to increase the returns from the assets already
in the business by running the income statement more efficiently without
investing new capital. The second is to invest additional capital and
aggressively build the business so long as expected returns on new
investments exceed the cost of capital. And the third is to release capital
from existing operations, both by selling assets that are worth more to
others and by increasing the efficiency of capital by such measures as
turning working capital faster and speeding up cycle times.

Total and Exxon do not subscribe to value-based management, but both firmly
believe that the culture, strategy and financial controls of value-based
management are firmly in place at their companies. "We have a global
functional organisation operationally consistent throughout. It is this
consistent approach that embraces the core principles at Exxon,"
says Mulva. (...) So how does Exxon measure the value its core principles
bring? Through return on capital employed (ROCE - income
before financial items relative to average capital employed). (...)

It is a similar tale at Total. "We run the company from an industrial
viewpoint. We allocate cash in an efficient manner and measure through
return on average capital employed." (ROACE - operating profit before
amortization of goodwill x 100/ average invested capital, accumulated
amortization of goodwill). "It is a consistent measure of shareholder value
in our industry and allows our investors to compare like with like." (...)

Value-based management has been credited with many things: increased
transparency, lower capital costs, more accurate forecasting and improved
decision making. But Exxon Mobil's Mulva says that the real key to improving
shareholder value is communicating with shareholders, investors, and the
market. In fact just about everyone. (...)

Royal Philips Electronics, the third largest global consumer electronics
maker, has been using EVA as an instrument to measure financial performance
since 1997. Philips recognized that the normal net income profit and loss
account didn't account for a company's cost of capital, says group
controller Gerard Ruizendaal. "We wanted to make it visible so
we could understand this cost."

EVA has since been ingrained in the company's standards and is based on the
cost of capital that in each activity, reflects the risk related to the
business, geography and effective tax rates. "The main idea is to improve
our EVA every year so our return of capital is more than our cost of
capital," says Ruizendaal. (...) "All the decision making tools must be
consistent for driving value creation within the company, and with
every year, with every process, it becomes a way of life. Philips
also looks at how to integrate EVA into its staff incentive
structure, with EVA accounting for approximately 50% of the criteria for
yearly bonus incentives. "The amount of share options offered to employees
depends on the share performance versus 24 benchmarked companies, and the
incentives are less if we don't outperform against our benchmark peers."

Over the last two years, Philips has systematically changed its portfolios
to businesses with return of capital greater than the cost of capital.
Gerard Kleisterlee, president, emphasized this in his message in the
company's 2003 annual report, saying, that over the past year Philips had
made considerable progress on its journey to create One Philips - a single,
focused and clearly identifiable company geared to sustained value creation.

Siemens introduced EVA in 1997. "It requires managers to radically rethink
all business decisions and to forget ROI and measure profitability with an
eye on the cost of capital," said Dr Karl Hermann Baumann, CFO back in 1997.
(...) "Shareholder value is about a strong performance oriented culture and
creating a sustainable economic value - not only on a day-to-day-level - but
on a sustainable basis in the long term," says Sabine Kromer, corporate
communications officer at Siemens. (...) "Global competitiveness to us means
that we plan to expand our presence at lower cost locations. This
means purchasing, manufacturing, software development and
administrative services."

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