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In his first large presentation to the board, the newly appointed CEO of a $3 billion, multibusiness company announced his intention to shift direction's focus from quarterly earnings to "shareholder value." The management team was adamant to empathize exactly how much value the corporation and each of its business units were creating for shareholders and what the options were for improving performance. Executives would restructure and manage the corporation appropriately—from top to bottom.

Like this CEO, the peak managers of many large corporations endorse the concept of shareholder value assay (SVA)—the process of analyzing how business organization decisions touch on the visitor'due south "economical value" (net present value of expected cash flows discounted at the cost of upper-case letter). They know that modern finance theory says economic value is the correct yardstick for measuring business concern operation, since it reflects take a chance and the time value of money and provides a framework for balancing P&L and remainder sheet trade-offs.

These managers are convinced that economic value is a more of import determinant of a public company's stock price or a private company's worth than earnings per share, grow thin sales or profits, or other traditional accounting measures. And in low-cal of all the contempo takeover activity, they know they take to continue economic value equally loftier equally possible to prove that they're the best stewards of the company'south assets.

But while many corporate executives talk about shareholder value in their almanac reports and speeches, most have not made it part of their everyday conclusion making. They use it to calculate breakup values or to evaluate capital investments and acquisitions, but these applications don't come shut to exploiting the full potential of the technique to guide strategy and operational improvement at both the corporate and the business-unit level.

The CEO of the multibusiness company—let's telephone call him Robert Coleman—is one of the exceptions, one of a scattering of executives who accept taken SVA to heart. He doesn't utilize it here and there to investment decisions or but pay it lip service. He is "institutionalizing" it then that managers at all levels use SVA as a touchstone when making judgments about what strategy is most promising or what product line is most attractive.

The benefits have been hit. The cost of his visitor'southward stock has climbed by 100% in ii and a one-half years—more than three times the rise in the market.

Other companies—like PepsiCo and Westinghouse—are also making SVA an integral part of the direction process. An executive at PepsiCo describes the advantages this manner: "We at present have a solid financial blueprint for the corporation. Nosotros know which divisions are worth the most to united states and how much value each will create; we know which strategies will create the about value at each partitioning; we know the value of our stock… In sum, nosotros take the tools to manage our company better from a strategic and financial standpoint."

Why haven't other companies embraced SVA? One reason is that its broad usefulness in decision making has go articulate merely as software and personal computers have made it more accessible. Another reason is that skill and motivation barriers impede its utilize in most organizations.

The experience of Coleman and a number of other managers shows the advantages of using SVA consistently to set priorities and deed on them—both in multibusiness corporations and in individual business units. Their experience as well suggests ways to break through organizational barriers.

Setting a Management Agenda

SVA tin can help top managers deal with the four fundamental questions they must respond to set a corporate calendar.

i. How well has our portfolio been doing? SVA tin can help you lot get a handle on current and past operation and pinpoint the issues that require the about attending. When Robert Coleman causeless his post every bit CEO, one of his first objectives was to understand how the company, which had begun to diversify in the mid-1970s to reduce dependence on its traditional cadre business, had performed over the previous decade. Coleman'southward predecessors and others in the company had been enthusiastic about the diversification program and, despite some setbacks over the years, considered it a success.

But Coleman sensed trouble. The program was missing its profit projections, and managers were calling for more and more capital investment and further acquisitions to "fill out" the portfolio. Since his instinct contradicted the conventional wisdom at the company, he decided to evaluate the program's performance using SVA.

He asked several people from the finance section to conduct the analysis. Start, they pinpointed when the original investments were fabricated—in some cases, as much as ten years dorsum—and the incremental cash flows into and out of each concern since its acquisition or startup. They counted corporate charges and dividends as positive greenbacks flows. And to have into account the fourth dimension value of money, they applied the appropriate costs of capital letter. (These rates varied roughly from 10% to xviii%, depending on prevailing involvement rates and each concern'southward particular adventure and fiscal structure.) They then added those investments, discounted over fourth dimension, to observe the total net investment in the portfolio.

Next they estimated the economical value (or internet nowadays value) of each business. At this stage, the analysts did not challenge the assumptions in the company's plans. They only used these plans to approximate the futurity cash flows from each business and discounted those expected greenbacks flows to the present, using each business's cost of capital letter. Then they added those values to arrive at the economical value of the corporation as a whole.

Tertiary, they calculated the departure between the corporation'southward economic value and the net investment in the portfolio.

The results were startling (run into "Did the Acquisitions Increase Shareholder Value?"). In that location was no doubt that the company had accomplished growth—just at considerable cost. In fact, the company's new business concern sectors had reduced shareholder value by more than than $500 million. In other words, the corporation's shareholders would accept been $500 million richer if the visitor had distributed cash to them through stock repurchases or dividends and permitted them to invest the capital themselves, or if information technology had fabricated better investments (assuming in both cases that the alternative investments were of equivalent risk and earned their costs of upper-case letter).

Did the Acquisitions Increment Shareholder Value?

This was in stark dissimilarity to the results of earlier evaluations using bookkeeping analyses, which causeless that if a subsidiary was profitable, it was creating value. These analyses had overlooked the toll of capital letter and essentially treated coin in the business organization as if it were free. SVA showed that the price of money for the diversification program was $600 million. What managers had considered a success was a failure for shareholders.

ii. Exercise our plans brand sense? To figure out what he should do, Coleman took a deeper wait at the individual businesses in the portfolio, this time challenging the assumptions in his managers' plans.

The starting time thing he found was that the corporation's marketplace value was merely 85% of the economic value the analysts had calculated. That meant one of two things: either the market didn't understand the company'south plans or it was skeptical of them.

He as well constitute that 3 businesses accounted for more 90% of the corporation's total economic value (encounter "How Much Value Does Each Business organization Create?"). Withal the other 12 businesses, which contributed but 12% of the value, consumed 30% of corporate assets and roughly one-half of direction's attention. Executives were spending a lot of time thinking most the three businesses in sector C, for instance, and had invested 20% of the entire corporation's market value in them, yet they deemed for only v% of the corporation's economic value.

How Much Value Does Each Business Create?

Analysis of individual businesses pinpointed those that were value destroyers and provided some insight about management risk. Some businesses had projected cash flows that, when discounted back, were below the corporeality already invested in them. So even if they should reach their plans, those businesses would take destroyed shareholder value. Worse, one business required then much continuing investment that the present value of its projected greenbacks flows was negative—and that was without because the money already invested. In addition, some business plans produced positive greenbacks flows much later on in the planning menstruation than others—a riskier strategy, since confirmation of success would be further removed from the initial investment.

When Coleman'due south staff compared these findings with judgments about the "fundamentals" of each business and with analysis of past performance relative to each business concern'south plan, Coleman was able to enquire questions that got at the heart of uncertainties in the plans. In some cases, he came to believe that the business concern could exceed its plan. In many other cases, he requested culling forecasts of fiscal performance based on different assumptions about marketplace need and competitive success.

For example, ane startup venture had projected ambitious growth in the face of a market downturn. Under scrutiny, the managers of the venture reined in their optimism and projected lower, more than realistic growth. With this assumption in place, the plan no longer seemed viable since it would destroy shareholder value. When the managers realized that, they forged a new program that reduced cost and investment.

Coleman went through the businesses one past i, encouraging managers to rethink their plans and projections in light of the economic value that was beingness created or destroyed. When the procedure was complete and the business plans had been revised, the corporation'southward estimated economic value had shrunk to very close to market value.

This baseline analysis of current plans provides real insight into your concern. Information technology helps you empathise which businesses are contributing value and which issues and uncertainties are most of import.

3. How much better could nosotros practise? Once you lot understand what performance to expect from a continuation of current business strategies, you lot need to ask whether that'southward good enough. In that location may be a gap between the performance yous're getting from the organization and the performance it could achieve. Although the definition of the gap depends on the performance y'all and your management squad aspire to, the necessity of meeting shareholder expectations defines the top and bottom of the range of aspirations.

The tiptop of the range is the corporation's "all-time value." This is the value of the company if each business were managed in an optimum way by the "all-time" possessor. The gap betwixt current performance and all-time value drives nearly takeovers.

While best value is an abstract concept and is something you may find hard to attain, it gives yous a sense of the about you can aspire to. The style to find that value is to assume that each business will be sold to the all-time possible owner. An automobile parts business might, for instance, be sold to an owner with the widest aftermarket distribution network. Adding the "breakdown" values—the values produced by those best owners—gives yous a good approximation of the best value of the whole company.

The bottom of the range is "minimum acceptable value": the everyman value at which shareholders might be satisfied with the performance of their investment. (Proxies for minimum adequate value include book value of disinterestedness and replacement or disposal value of avails.) For existing businesses, this means the net present value of future cash flows must be greater than the value of the assets employed. For new investments, the cyberspace present value of time to come cash flows must be greater than the initial investment.

Coleman'due south projection team analyzed the company'south best value. The team members looked at each business concern on a stand up-solitary footing and thought of ways to increase value through improved operations, reduced costs, lower working capital, or reduced pension funding. They likewise estimated what value other owners might place on the major assets. The full of the best values of all the businesses was indeed college than the visitor's economical value, and the analysis led management to push harder to increase shareholder value.

4. What should our priorities be? The applications of SVA discussed so far will point out the size and general management of the changes you must brand. If a gap does exist, you can besides employ SVA to identify value drivers, the factors that bear upon economical value most, and you can set priorities accordingly.

At Coleman'south request, management of the reckoner subsidiary adult several alternative strategies, ranging from ho-hum growth with maximum well-nigh-term greenbacks menstruation to aggressive growth with investment for future returns. It and so estimated and discounted the cash flows for each. It also changed certain underlying assumptions 1 at a fourth dimension to see which factors had the greatest impact on economical value.

This analysis showed that sales force productivity was the nigh important value driver (come across "What Are the Value Drivers?"). Information technology besides showed that an aggressive growth strategy was best if sales strength productivity could be improved; tiresome growth was better otherwise. The key result for the subsidiary, then, was whether sales force productivity could, in fact, be improved.

What Are the Value Drivers?

Coleman's management squad repeated this analysis to find the value drivers for the other businesses. Coleman had had a sense of which businesses to pay most attention to and had set a timetable for making decisions near them. These findings inverse his listen nigh the businesses he should concentrate on and the bug inside those businesses that were virtually important. SVA had helped provide a clear management agenda.

Restructuring the Corporation

The experiences of several companies—some of them multibusiness companies and some of them single business units—prove that SVA tin can exist a powerful tool not only for setting priorities simply likewise for deciding how to human action on them. For example, it tin help managers get a handle on the value of all three types of corporate restructuring: portfolio restructuring, asset redeployment, and financial restructuring.

Managers of a manufacturing visitor used SVA to assess the value of selling one of their subsidiaries. Although the numbers associated with various options were only estimates, they gave the company a sense of what was necessary to justify standing to own the subsidiary and how suitors might perceive its value.

The value of the subsidiary would increase if information technology improved its strategy and operations and if it exploited synergies with the company's cadre business, such as by leveraging the parent's marketing and manufacturing skills. The cost of achieving such integration, of form, had to be subtracted.

Similarly, direction assessed the subsidiary's value to a potential suitor as a standalone concern and as a unit of a larger entity. The subsidiary had a stiff market franchise, for example, with which a new owner might leverage other products and therefore derive corking value.

This "what if" analysis helped direction identify and evaluate more deeply the few issues that really mattered. Ultimately, direction decided to keep the subsidiary and used the results of its assay as a blueprint for improving information technology past redeploying manufacturing facilities, refining product plans, and strengthening marketing skills.

An electric utility company used SVA for a different kind of restructuring: a combination of asset redeployment and financial restructuring brought nigh past a sale-leaseback of assets used in electricity generation. SVA showed that the auction-leaseback would cutting the utility'south costs by allowing it to retire high-coupon debt without paying telephone call premiums and that taxation credits the company had accrued would partially offset the tax on capital gains. Just ratepayers, not shareholders, stood to do good from the transaction because regulatory agreements required all price reductions to accrue to them. Shareholders, meanwhile, would incur the capital gains tax obligation.

Management reconsidered the situation and decided to parcel the auction-leaseback program with other regulatory initiatives and to negotiate the entire parcel with regulators. It constructed a negotiating framework that showed the package's full upshot on shareholder value and on consumer electric rates and used it as a reference during negotiation (see "The Utility's Negotiating Strategy"). The framework showed, for example, that shareholders would benefit from the bundle even if it led to a rate reduction of upward to a one-half cent per kilowatt-hr, on average, over ten years.

The Utility's Negotiating Strategy

Managing Private Businesses

The priorities you ready may take more to do with managing individual businesses than with restructuring the corporation. SVA can provide a useful perspective on how to do that also. Accept, for example, a production line that reduces a company'south profitability just increases its value.

Managers at a division of an integrated packaging company encountered exactly such a situation. They were debating whether to bring a newly developed line of paper packaging products to market. Under static profit analysis, the product line showed little hope. It would command lower prices than the company's other product lines, and because it demanded superior moisture forcefulness and special tear characteristics, would require more expensive raw materials. For these reasons, managers decided not to introduce the product line because they believed it would depress the division's profits by as much equally 20%.

But several months later, during a general review of strategy using SVA, the issue resurfaced, and this time things looked different. By forcing management to consider the effect of the product line on the balance sail and to expect at its performance over time, the assay showed that the line would add well-nigh $40 meg to the business'southward economic value.

The earlier analysis had overlooked the fact that the new products would require fewer production steps and less manufacturing equipment, which meant lower capital investment. Also, the products had smaller economic lot sizes, then inventory would be lower. And prices of the new products were expected to grow more those of the company'southward other product lines because the market was less competitive. Indeed, the product line had potential to be quite assisting far into the future. The division'due south management inverse its whole strategy every bit a result.

Even if the strategy stays the same, business-unit of measurement managers can use SVA to create value by expanding their focus from bookkeeping profits and income statement furnishings solitary to all the factors that affect shareholder value. For case, management of an applied science contracting subsidiary had e'er concentrated on growth and earnings. Unnoticed for years was the subsidiary's need for appreciable working majuscule to cover the lag betwixt the time the contractor paid its suppliers and the fourth dimension information technology received payment from its customers. SVA brought the timing issues to the forefront and prompted direction to negotiate its disbursements to coincide with expected receipts, even when such a change led to somewhat higher costs.

Some other realization SVA brought was the fallacy of trying to get the last nickel in contract disputes, rather than settling such conflicts fast. Once the company had a mode to recognize the fourth dimension value of coin, priorities changed. The subsidiary began to seek early settlement through price reductions or other means if it led to net value creation.

Breaking the Barriers

SVA brings the biggest benefits when y'all establish it as the unmarried, unambiguous yardstick for measuring operation throughout the arrangement. But replacing conventional functioning measures with SVA won't work if height management ignores the barriers that be in most organizations: the lack of both the skill and the motivation to use it. Early adopters of SVA, similar PepsiCo, are nonetheless overcoming these barriers, but their experience speaks volumes.

To build the skill to utilise SVA, a few people must become expert at performing the calculations and agreement the nuances of its awarding. Many others must exist able to understand SVA well enough to make up one's mind when to go through the whole procedure and when to use value drivers like sales force productivity and inventory turns as surrogates. They must besides be able to spot problems with a given awarding and correctly interpret someone else's analysis. Only a combination of education, hands-on experience, and practice can build this skill.

Educational programs vary, but one essential element is that people involved in planning and performance evaluation nourish a training session that explains the concepts underlying SVA, how to utilise it in their functional areas, and how to translate the results. Robert Coleman sent the general managers of all his business units, along with their finance and planning staffs, through v days of formal training.

A classroom overview must be followed past easily-on experience and practice. Information technology takes a while for users to change their ingrained means of thinking. SVA failed in one visitor when managers were unwilling to brand decisions that would increase shareholder value but would as well lower the company's return on sales, long the principal mensurate of performance. They understood the theory of SVA but didn't feel comfy applying information technology.

The annual planning process is an excellent vehicle for getting people accustomed to the new arroyo. Completing a programme forces managers to develop a real understanding of SVA and gives executives an opportunity to follow up to see whether value has, in fact, been created. This hands-on awarding of SVA besides creates momentum by getting many people involved at the same time. Although most of Coleman's managers had been formally trained, SVA didn't really come alive until information technology became part of the planning procedure.

Leadership of the education and hands-on grooming effort can come up from a financial or planning vice president, only that person will demand support from a handful of technical experts and a larger group of skillful user-champions. You tin can designate or rent the technical experts, but you should enlist every bit user-champions line managers who are capable of learning the concepts and are likely to back up the thought. Considering line managers tend to exist more pragmatic in applying SVA, their peers are commonly more receptive to them than to the technical experts.

At the engineering contracting subsidiary, the full general manager became a user-champion. He led an effort to identify value drivers in the concern and aligned measurement systems with those drivers. His subordinates at present not only measure cash flows; they also routinely monitor success rates at each footstep of the contract "pipeline": identifying bonny potential contracts, qualifying as a bidder, developing proposals, and winning bids.

Creating the motivation to prefer SVA is another challenge. As with any policy change, elevation management must send an unambiguous message that the game has changed and prepare clear guidelines for when to use SVA. Coleman, for case, clearly conveyed the message that no major strategic decision would exist made without using SVA. He announced the change at a meeting of his officers, reviewed the results of the corporatewide SVA with his staff and the direction team of each business organisation unit, and followed upwardly past referring to SVA and his management agenda in a number of subsequent meetings.

Direction must likewise eliminate any disincentives. Compensation systems that reward sales growth or near-term accounting profits and personnel systems that reward managers for increasing the size of their organizations are a problem. Tiptop executives should be rewarded in a way comparable with how shareholders are rewarded; line managers should exist rewarded for managing the value drivers under their command. Incentive compensation should be a big part of whatever managing director's compensation.

Misdirected systems are non the only disincentives to the use of SVA. SVA creates new losers every bit well equally winners and provides more guidance than some managers want. Have, for example, the division head of a large business that is growing only creating niggling or no value. His pride in the division'southward growth and need to maintain his ain reputation may make him resistant to SVA. A combination of symbolic actions, new rewards, and persistent assurances that managers will not be penalized for by operation based on old rules can aid.

1 of Coleman'south business-unit of measurement managers, for instance, relished his autonomy and regarded wide-scale utilize of SVA as an incursion. He feared it would dampen prospects for investing in his emerging growth business. Just the use of SVA in the planning cycle, coupled with the CEO's insistence on using SVA in all businesses, got him started. When the corporate planning staff then worked closely with him to help him understand and utilize the value drivers in his business, he became an advocate.

The Necessity of SVA

Shareholder value is at present widely accepted equally an advisable standard for performance in U.S. business. The stock marketplace sends a clear bulletin that earnings per share is non the nigh important measure. Nor is growth for growth's sake. What matters is long-term cash generation. That'southward what drives long-term stock performance, and that'due south how nosotros should manage.

The challenge of institutionalizing shareholder value analysis is not technical. We take the technical capability to make shareholder value the foundation of all important business decisions. The key is to build the skill and the motivation to use SVA consistently and well. But then will our organizations focus their attention and resources on the kinds of improvement shareholders really value.

A version of this article appeared in the November–December 1989 issue of Harvard Business organization Review.