Outperform with Expectations-Based Management E-Book

Tom Copeland

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 588

Veröffentlichungsjahr: 2011

Beschreibung

CEOs and managers live and die by delivering superior performance to shareholders. This is why expectations-based management has been developed. Outperform with Expectations-Based Management (EBM) introduces a revolutionary new performance metric that links performance standards, performance measurement, and the achievement of performance. It's easy to say that if a CEO can get performance measurement right, then performance improvement will follow. But what is the "right" measure of performance, and how do you use it to improve performance? Authors Tom Copeland and Aaron Dolgoff answer these questions and many more, as they show you how to find the measure of performance that has the strongest link to the creation of wealth for the owners of both public and private companies. They answer the puzzle of why growth in earnings is not correlated with shareholder returns and explain the under- and over-investment traps. And they explain how clear communications to investors and managers alike improve value. The bottom line is that share prices go up when companies exceed expectations -- short-term and long-term -- of income statement and balance sheet performance and daily operating value drivers. Gain a complete understanding of EBM and discover how to do this, and much more, while staying competitive in an unforgiving business environment.

Leseprobe

Contents

Preface

Dedication and Acknowledgments

Part I: Measuring Performance

Chapter 1: The Right Objective, Strategy, and Metric

Why Is Performance Measurement Top-of-Mind?

Commonly Used Performance Measures and Their Shortcomings

Expectations-Based Management

The Puzzle Explained

An EBM System

Alphabet Soup

Something Old, Something New

Summary—For Whom Is This Book Written?

Chapter 2: Expectations Count

Why Does EBM Provide a Better Tie to Shareholder Returns?

Summary of Our Findings

What Related Research Has Been Reported?

Managerial Implications of EBM

What Are We Trying to Explain?

Test of Traditional (but Incomplete) Performance Measures

What Are the Results Regarding Changes in Expectations of Earnings?

Three- to Five-Year Earnings Growth Is a Proxy for the Value of Long-Term Earnings

What Are the Additional Effects of Changes in Expectations of WACC and CAPEX?

What Is the Effect of Noise?

Summary and Conclusions

Part II: Managerial Implications

Chapter 3: Management of Existing Businesses

Measuring Business Unit Performance

Decision Rules for Allocating Capital to Investments

A Capital Budgeting Process Tied to Expectations

Can You Beat Expectations?

Value Drivers

Planning and Budgeting

Summary

Chapter 4: New Investment and Business Mix Decisions

Formal Comparison of DCF and Residual Income Valuation

New Investment

Analyzing the Mix of Businesses

EBM and M&A Planning

Divestiture

When Does New Investment Become Expected?

Real Options and EBM

Summary

Chapter 5: What About the WACC?

Introduction

The WACC Doesn’t Matter—Or Does It?

Expectations and the Calculation of the WACC

Invest or Harvest—Importance of WACC and Range of Uncertainty

Fast or Slow Growth—Importance of WACC and How to Calibrate Performance Evaluation Models

Business Unit–Level WACCs

Expectations and Capital Structure

Summary

Chapter 6: Capital Efficiency

Permanently Cut Capital Spending by 10 to 25 Percent

Seven Symptoms of an Out-of-Control Capital Budgeting System

Seven Cures for Capital Inefficiency

The Capital Efficiency Process

Summary

Chapter 7: Reverse Engineer the Value of Your Firm

Analyst Expectations Are Biased—What Should You Do?

The Process of Reverse Engineering Your Stock Price

A Case Example—Home Depot and Lowe’s

What Should Be Done About Gaps in Expectations?

Summary and Conclusions

Appendix—Tips for Reverse Engineering Stock Price

Chapter 8: Investor Relations

Investor Relations

Getting the Message Out: The Signal to Noise Ratio

What Signals Can Management Use When It Believes Its Stock Is Mispriced?

Exploiting Perceived Stock Mispricing to Shareholder Advantage

Noise

External Communications Case Studies

What Do Others Say about External Communications?

An EBM Approach to Investor Relations

Summary and Conclusions

Chapter 9: Incentive Design

The Heart of Incentive Design—The Principal-Agent Problem

The Weak Link Between the Principal’s Wealth and the Agent’s Performance

The Multiperiod Problem—Is Budgeting Just an Excuse to Lie?

Salary and Bonus—Pay at Risk

Absolute or Relative Performance?

Should Goodwill Be Charged Against Business Unit Incentive Targets?

Line versus Staff Compensation

Incentives and Middle Management

Hourly Workers

Summary

Chapter 10: Implementing an EBM System

Three-Part EBM System

Guiding Principles

EBM for Strategy

Phases of Implementation

Implementing EBM for Impact

The Art of Using Value Drivers

EBM for Small Companies and Family-Owned Businesses

Summary

Part III: Other Points of View

Chapter 11: Investor Relations: Understanding the Investor’s Perspective

First Principle—It Is Not Easy to Exceed Expectations

Second Principle—Learn from the Market

Third Principle—Listen as Much to Potential as to Current Investors: Clientele Effects

Summary

Chapter 12: Comparison of Value-Based Management Systems

General Principles

Three Competing VBM Systems

The Race for Highest R-Squared

Adjusting for Inflation

Adjustments to the GAAP Accounting Numbers

The Balanced Scorecard

Comparison of the Four Approaches to VBM

Summary and Conclusions

Chapter 13: Expectations, Noise, and Public Policy

A Market Equilibrium for Information

Examples of Compliance Cost versus Value to Investors

Thoughts on Regulation FD

Sarbanes-Oxley

Revised 8-K Disclosure Requirements

Simple Improvements to Current Disclosure Rules

Who Should Do Securities Research?

EBM for Government

Expectations, Noise, and Macroeconomic Policy

Summary

Chapter 14: Summary and Conclusions

Questions That Have Been Answered

The EBM Story

What Do the Skeptics Say?

Implementing for Impact Ensures EBM Leads to Value Creation

Final Thoughts

References

Index

Copyright © 2005 by Tom Copeland and Aaron Dolgoff. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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EVA is a registered trademark of Stern Stewart & Co.

Expectations-Based Management (EBM) is a registered trademark of the Monitor Group.

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ISBN-13 978-0-471-73875-6

ISBN-10 0-471-73875-1

Preface

Why should you read this book? Because it will improve your company’s performance by focusing your management team on what counts, namely beating your (i.e., management’s) and the market’s (i.e., investors’) expectations. We show that the correlation between the return to shareholders and changes in expectations is about ten times stronger than it is with earnings, earnings growth, economic value added (EVA®), and the growth in EVA.1 We show how Expectations-Based Management (EBM™) helps you to understand communications with potential investors, helps you to set internal performance standards, and how it can refocus your strategy.2 We believe you will find EBM to be simple, direct, and common sense. You will wonder, as we have, why it has not been part of every manager’s toolkit for a long time. Indeed, many will recognize EBM principles and practices in their own current behavior—behavior that often seems at odds with existing systems but that managers instinctively know to be correct.

One day in the early 1980s an entrepreneur by the name of David Murdock, owner of Pacific Holding Corporation, was invited to speak to a corporate finance class at UCLA’s Graduate School of Management about why he had paid $200 million—a one hundred percent premium—to buy Cannon Mills and take it private. The markeplace thought it was worth only $100 million.

Cannon Mills is a textile producer of high-quality white goods such as sheets and bath towels. Located in the town of Cannonapolis, North Carolina, it was closely held by various members of the Cannon family. Not long before, another tender offer for the company had been refused.

Listen to this story and identify the various expectations that led to the transaction and subsequent events. Certainly the market as a whole had expectations that caused it to value Cannon Mills at roughly $100 million. The members of the Cannon family had expectations that led them to turn down a substantially higher offer than the $100 million. And David Murdock had expectations that led him to believe the company was worth over $200 million.

What Murdock said in the classroom that day made the class realize that he understood very well that his own expectations had to be better founded in fact than those of the other parties. Simply put, Murdock had to have better judgment and better ideas.

He told the class that day that his first step was to buy more than five percent of the outstanding shares. According to the Williams Act this made him an insider and required him to announce the fact to the public. It also gave Murdock the right to visit the company and look over its records. After having done so, he quickly tendered for the remainder of the outstanding stock.

“How did I recover the $100 million premium?” he asked rhetorically. “Let’s review the facts. First, the company had a defined benefit pension plan that was overfunded by $80 million. Second, it had a $60 million LIFO inventory reserve.3 Third, it owned most of the housing in Cannonapolis, and carried it on the books at original purchase price. Finally, it owned 100,000 acres of prime timber land that was also undervalued on the books.” These numbers alone easily added up to more than the $100 million premium.

But then he said, “These facts are not why I bought the company. They were already publicly available information and were baked into the stock price.” The class could hardly believe what they were hearing. Murdock was right. Efficient markets do actually reflect relevant economic information in the stock price. It contains all public information about expectations of future performance—the so-called market expectations.

Murdock then continued, “Now let me tell you why I bought the company. First, I learned during my visit that the top 120 managers were all family relatives—brothers, sisters, aunts, uncles, cousins, nephews, nieces, and the like. I replaced them all with 12 carefully selected managers. Second, the plant was operating during six day shifts per week. I cut prices, gained market share, and now operate 12 shifts per week.” It is not difficult to interpret what Murdock had said. His two ideas earned him over $100 million by cutting corporate overhead by 80 to 90 percent, and nearly doubling the return on invested capital (ROIC) by dramatically increasing the ratio of sales per dollar of capital employed. Neither the family owners nor the other takeover firm had similar expectations. David Murdock created value by understanding what information was already included in the stock price and not paying for it twice. He understood the market expectations. He also understood management expectations. There was a huge disconnect between his own expectations and those of management. Murdock arbitraged the difference.

Expectations-Based Management

Expectations-Based Management is about the link between performance standards, performance measurement, and the achievement of performance. It says that stock price goes up if performance exceeds the market’s expectations. David Murdock’s takeover of Cannon Mills dramatically changed its expected performance and he eventually sold the company for a sizeable gain. We will talk about how to set and revise expectations later in the book. For now let’s stick with the challenge of defining EBM.

When a CEO defines performance measurement right, then performance improvement follows. But what are the attributes of the “right” measure of performance? Which measure comes closest to being the “ideal,” and how do you use it to improve performance? These three themes are what this book is all about.

We want the measure of performance that has the strongest link to the creation of wealth for the owners of the company—its shareholders—whether they are private or public. Chapter 1 discusses the details, but the final word is that in order to create wealth for shareholders by raising the stock price, companies must exceed expectations both short-term and long-term, expectations of both income statement and balance sheet performance, and expectations about daily operating value drivers.

In 1890 Sir Alfred Marshall explained in Principles of Economics (Vol. 1, p. 142) a concept called economic profit. It is “What remains of his [the owner’s or manager’s] profits after deducting interest on his capital at the current rate...” Marshall’s economic profit is the accounting definition of profit minus a charge for the use of capital. It requires that the rate of return on capital invested be greater than the cost of capital. It extends the definition of profitability from sole focus on the income statement to also include the balance sheet. It predicts that if two companies have the same profit, the one that uses less capital to generate said profit will have greater value for shareholders.

We agree that economic profit is an important and useful concept (especially for making capital investment decisions), but it falls short of the complete reality because it fails to include the rate of changing expectations as it affects the stock price. Consider two companies with the same economic profit. Suppose that they both earned 20 percent on $1,000 of invested capital, and that their cost of capital was 10 percent. They would both report economic profit of (20% − 10%)$1,000 = $100 to their boards of directors. Yet suppose the first company was expected to earn a 30 percent return on invested capital while the second was expected to earn 15 percent. The stock price of the first company will fall as the market revises its expectations downward, while the stock price of the second company will rise because it exceeded expectations. This example exposes the major shortcoming of economic profit—it does not compare actual with expected performance and is therefore decoupled from stock price movements.

Because EBM is based on changes in expectations of economic profit, it is more complete than other measures. Its correlation to (market-adjusted) total return to shareholders is an order of magnitude higher than traditional measures such as earnings per share and earnings growth (that do not include balance sheet information and ignore expectations), and economic profit and the growth in economic profit (that both ignore expectations.)

All measures of performance other than EBM fail to use expectations. As an example, take economic value added (EVA), which is defined as the amount of capital employed multiplied by the spread between the return on capital and its cost—the same definition as economic profit. Positive EVA results from good income statement and balance sheet management, and growth in EVA requires a multiperiod point of view. But EVA does not measure performance against expectations. It is positive when a business earns more than the cost of capital employed—an objective standard. For example, suppose your cost of capital is 10 percent and you earned 15 percent last year and 18 percent this year on $1 billion of capital employed (both years). Last year your EVA was $50 million and this year it is $80 million. Proponents of EVA argue that this performance surely implies that your stock price will increase. What if we told you that your owners expected you to earn a 20 percent return on invested capital both years and in the long run? If so, you would have failed to meet or exceed their expectations and when they revise those expectations downward, your stock price will fall.

Chapter 2 presents documentary evidence that compares earnings, earnings growth, EVA, and EVA growth to EBM in a horse race to see which of these performance measures actually provides the best link to the (market-adjusted) total return to shareholders. The results were refereed and published in The Review of Accounting Studies, a top academic journal, and indicate that EBM is roughly 10 times better at explaining the total return to shareholders (TRS) than the other performance metrics with which it was compared.

Three other results emerge as well. First, the market reaction to changes in expectations of long-term earnings growth is eight to ten times larger than its reaction to changes in expectations about next year’s earnings. Second, changes in expectations this year about this year’s earnings are not significantly related to the return to shareholders in the presence of changes in expectations about next year’s earnings and in long-term earnings growth. Third, increases in noise are associated with lower return to shareholders.

How to Use EBM

Over our 25 years as consultants, we have spent hundreds of hours with CEOs ruminating over the topic of which measure of performance is best and how to use it to run a company. EBM is not a new fad. It is common sense. We define it as a system of three mutually consistent and linked ways of measuring and managing performance. We have proved that changes in expectations have a stronger logical and statistical link to the actual total returns to shareholders than any of the alternative measures.

A simple numerical example illustrates the fundamental difference between EBM and EVA when measuring business unit performance. Suppose that we are valuing a company with two business units, each with perpetual, level cash flows. The entity value is simply the expected cash flow divided by the cost of capital, assumed to be 10 percent per year. Data for the example is given in Table P.1. Relative to the cost of capital, both divisions did well, and so did the company.

But the value of the company is defined as its expected after-tax operating income divided by the cost of capital. Expectations at the beginning of the period are given in the “E0(ROIC)” column (column 2) of Table P.1. Therefore, the beginning-of-period value of the company is 17.5 percent (the expected ROIC) times the $2,000 of capital invested (i.e $350) divided by the cost of capital of 10 percent—resulting in a current entity value of $3,500.

TABLE P.1 Numerical Example Comparing EVA and EBM

To determine the change in the value of the company from the beginning to the end of the time period, we need to know what the end-of-period expectations are. To keep the example simple, let’s assume that investors believe the actual period-one results, A1(ROIC), will continue unchanged forever. For example, they revise their expectations for business unit A downward from 20 percent to 15 percent. Consequently, column 3, the actual period-one results, becomes the new forward-looking expectations, E1(ROIC). The end-of-year value, based on the revised expectations, becomes 17.5 percent times $2,000 of capital, divided by the unchanged 10 percent cost of capital. The beginning-of-period value is $3,500 and so is the end-of-period value. There is no change in shareholders’ wealth.

If we compare EVA to EBM, we see that EBM for the company as a whole is $0 and that this is consistent with the change in value that we just calculated. On the other hand, EVA is positive $150, and presumably we should see an increase in value to accompany it. But we do not. Why? Because the market rewards management for performance that exceeds expectations and the company has failed to do so.

In review, both EVA and EBM include income and balance sheet information combined in the form of free cash flows. Both can be extended to a multiperiod context, but EVA does not include any information about the changes in expectations that drive stock prices. Therefore it is not surprising that EVA is not highly correlated with the (market-adjusted) total return to shares. EBM is highly correlated because it is based on changes in expectations.

Change in Mindset

The tone and character of companies that measure their performance relative to expectations is very different than those that measure their performance vis-à-vis the cost of capital. When the management team realizes just how important expectations are, they try to become better informed in order to better establish internal expected performance standards. They also become more investor-oriented because they believe that successful performance means understanding and exceeding investor expectations rather than earning more than the cost of capital. If we were to characterize the difference in corporate personality between companies that use EBM and those that do not, we would say that EBM companies are more extroverted and communicate better. Their standards are set by what others think of them—and they know it.

What Will I Do Differently and How Will My Company Use EBM?

A chapter in a book called The Europeans, strangely enough, is dedicated to the idiosyncracies of the Americans. They are, the book claims, incredibly enamored with what is new. In fact, to be worthwhile at all, a fashion, an idea, or a strategy must be new and distinctive. This fetish is strange to Europeans, who live in a world where thousands of years of history lead one to believe that things may be better or worse, but are rarely new. Whether the reader judges what we have to say as new or better is a matter of opinion—but you will do things differently. You will:

Understand the cause-and-effect relationship between performance and your stock price. Business unit performance should not be measured relative to the cost of capital, but rather whether actual performance is better than expected. Your stock price is handicapped like a horse race. The investor who bets on your company makes good returns when your company beats the odds. A horse that is favored to win but finishes second doesn’t earn much, while a horse that was supposed only to show but ends up winning the race earns handsome returns.

Use two hurdle rates (if investment is to increase your stock price)—not one. The market has baked its expectations for the return on existing invested capital into your share price. Maintenance investments are made to keep this existing capital performing at expected levels and therefore must earn the expected return on invested capital in order to lift your share price—at successful companies, this is usually a percentage that is greater than the cost of capital. Maintenance investments that earn less than expected but more than the cost of capital are better than no investments at all, but your stock price will not grow enough to return the cost of equity.

New investments, such as acquisitions, are unexpected and, if they are competitive, will create value as long as they earn more than the cost of capital.

Thus, to increase your stock price it is necessary to earn an ROIC greater than what the market expects on maintenance investment—one hurdle rate. And for new (unexpected) investments it is necessary to earn more than the cost of capital—a second hurdle rate.

Communicate better with potential investors. Management sets expectations, if it chooses to do so, because it is better informed about the destiny of the company. EBM provides strong empirical evidence that information about the long-run growth of the firm is much more important than information about this quarter’s earnings, and that more noise in communication with the market is associated with lower share prices.

Have stronger budgeting and planning. The budgeting process has been described as being as painful as a root canal, and less useful. EBM, however, requires that you beat expectations when you want to manage business unit performance, and they are established via the budgeting and planning process. It is a subjective process to be sure, and therefore requires active and knowledgable participation of all levels of management.

Have incentives better aligned with performance. We recast compensation. Instead of thinking about salary and bonus, we parse total compensaton into expected and unexpected components—and then define the unexpected component as pay at risk. It turns out that the median amount of pay at risk for the CEO of a U.S.–based firm is only 17 percent of total compensation. We also suggest that the pay-for-performance relationship be made more linear with skin in the game.

Be able to reverse engineer your stock price to understand what the market expects. There is a lot of information in your stock price. By reverse engineering it and working back to the set of market expectations about revenue growth, operating profit, the return on invested capital, capital turnover, and financial leverage, you will build insight about differences between what the market expects and what you can deliver.

The Three Parts of EBM

Figure P.1 shows EBM as a three-part system, but all three are tied together logically so that they form an integrated managerial perspective. There is a “golden thread” that extends from daily performance on operating value drivers to annual performance as measured by EBM, to the value of the firm that is driven by the changes in expectations over the indefinite future. An improvement in performance on a value driver, such as the number of sales calls per sales person, can, in principle, be traced through to its effect on EBM for the relevant business unit, and to the value of the firm as a whole.

FIGURE P.1 Tripartite EBM system.

What is different is that performance must exceed expectations to create shareholder value. This is a subjective criterion and to get it right you will have to put more time into getting your planning and budgeting process retuned, changing your firm’s incentive system, listening to what the market is telling you about its expectations for your company, and stressing value creation as the search for ways to exceed expectations.

Guidelines for Reading this Book

“The devil is in the details,” as they say. But the details can be thorny and tedious. If you want the top line, read Chapter 1—it compares various measures of performance and discusses their shortcomings. Your current performance standard is undoubtedly there. Read only the first four parts of Chapter 2. They summarize the rest of it. Skip to Chapters 3, 4, and 6, which discuss how to make capital expenditures wisely, then to Chapter 8 (external communications) and Chapter 9 (incentive design).

If your philosophy is “In for a pound, in for a ton,” then the whole book is a good read. Chapter 2 presents irrefutable empirical evidence that confirms the strong link between EBM and the return to shareholders. Chapter 5 discusses the weighted average cost of capital. Chapter 10 discusses training and implementation. Chapter 11 takes the investor’s perspective. Chapter 12 compares competing value-based management systems. Chapter 13 discusses public policy implications

1EVA is a registered trademark of Stern Stewart & Co.

2Expectations-Based Management (EBM) is a registered trademark of the Monitor Group.

3A last-in-first-out (LIFO) inventory reserve refers to potentially higher profits that may result in the future if the company should accelerate sales and begin to expense older layers of inventory that are carried at lower cost.

Dedication and Acknowledgmentsa

The intellectual foundations of our work go back centuries but emerged in modern times with the valuation work of Miller and Modigliani [1962], Malkiel [1963], and Gordon [1959]. These were all formula-based mathematical models, and have since been replaced by spreadsheet modeling—an approach pioneered by Al Rappaport and his partner Carl Nobel, and refined by others including Bennett Stewart and Joel Stern. The idea that expectations are important we trace back to John Maynard Keynes [1936] and Paul Samuelson [1965] and Robert Lucas [1975] in economic theory and to Al Rappaport [1986, 2001], more recently for good advice to investors. The theme of managing for value has also been around a long time and is traceable all the way back to Alfred Marshall [1890] and his notion of economic profit. In modern times Al Rappaport (ALCAR), Joel Stern (Stern Stewart), Jim McTaggert (Marakon) Bart McFadden (HOLT and BCG), and Tom Copeland, Tim Koller, and Jack Murrin (McKinsey and Monitor) are among the larger list of advocates.

We wish to thank the many people who helped make this book possible. First, our loved ones who supported us throughout—Maggie, Timothy, and Michael Copeland; and Jennifer and Maya Dolgoff. Then our colleagues: J. Fred Weston, Al Rappaport, Rob McLean, Hardy Tey, Alberto Moel, Alan Kantrow, Betsy Seybolt.

And finally the hard-working people at John Wiley & Sons: Bill Falloon, Todd Tedesco, and Jennifer MacDonald.

aSee the back of the book for details of bibliographic citations.

PART I

Measuring Performance

Chapter 1—The Right Objective, Strategy, and Metric

Chapter 2—Expectations Count: The Evidence

This section sets the stage. Chapter 1 discusses the major flaws in traditional measures of performance and points out the salient fact that they are not correlated with the total return to shareholders (TRS) because they have no information about expected outcomes. Expectations-Based Management™ (EBM™) does have high correlation with TRS because it looks at performance relative to expectations. Chapter 2 provides irrefutable empirical evidence that EBM is highly correlated with market-adjusted total return to shareholders while other measures are not.

CHAPTER 1

The Right Objective, Strategy, and Metric

We are writing about one of the most important CEO top-of-mind issues—performance measurement. The way people behave in the workplace and the value that they create depends on it. The challenge is to align performance measurement and the resulting behavior with shareholder wealth creation. There are many gurus who claim to have found the secret link, but they all fail to account for the effect of changes in expectations. Consequently, none of their own measures of performance is highly correlated with the total return to shareholders (TRS). This book introduces, for the first time, an Expectations-Based Management (EBM) system, which measures performance in a way that is highly correlated with TRS.

But this book is not just for management, although they play a fundamental role in setting expectations. It is also written for investors who believe in using fundamental information to set their expectations of company performance, and analysts who forecast financial results and make investment recommendations. It is also, incidentally, for legislators who regulate the rules that determine the cost and flow of information that affect all securities prices.

To create a TRS higher than the normal return, a company has to exceed expectations. Why? Because expectations are already baked into its stock price. In October of 1998, Intel, a company that was regularly earning a return on invested capital 30 to 40 percent more than its cost of capital, announced that its earnings were up 19 percent over the year before. Immediately thereafter, its stock price fell six percent—because analysts had been expecting a 24 percent earnings increase. Intel’s price corrected downward because it failed to meet expectations. Expectations count!