Ten Ways to Create Shareholder Value

A R T I C L E www.hbr.org

by Alfred Rappaport

Included with this full-text Harvard Business Review article:

1 Article Summary The Idea in Brief—the core idea The Idea in Practice—putting the idea to work

2 Ten Ways to Create Shareholder Value

13 Further Reading A list of related materials, with annotations to guide further exploration of the article’s ideas and applications

Product 1069

Ten Ways to Create Shareholder Value

The Idea in Brief The Idea in Practice Many firms sacrifice sustained growth for Rappaport recommends these additional Reward operating-unit executives for short-term financial gain. For example, a practices to create long-term growth for adding superior multiyear value. whopping 80% of executives would inten- your company: Instead of linking bonuses to budgets (a prac- tionally limit critical R&D spending just to tice that induces managers to lowball perfor- Make strategic decisions that maximize meet quarterly earnings benchmarks. Re- mance possibilities), develop metrics that cap- expected future value—even at the sult? They miss opportunities to create en- ture the shareholder value created by the expense of lower near-term earnings. during value for their companies and their operating unit. And extend the performance In comparing strategic options, ask: Which shareholders. evaluation period to at least a rolling three- operating units’ potential to create long- year cycle. How to cultivate the future growth your term growth warrants additional capital in- firm needs to succeed? Rappaport identi- vestments? Which have limited potential and Reward middle managers and frontline fies 10 powerful practices. First among therefore should be restructured or divested? employees for delivering superior them: Don’t get sucked into the short-term What mix of investments across operating performance on key value drivers they earnings-expectation game—it only units should produce the most long-term influence directly. tempts you to forgo value-creating invest- value? Focus on three to five leading value-based ments to report rosy earnings now. Another metrics, such as time to market for new prod- Carry assets only if they maximize the practice: Ensure that executives bear the uct launches, employee turnover, customer long-term value of your firm. same risks of ownership that shareholders retention, and timely opening of new stores. Focus on activities that contribute most to do—by requiring them to own stock in the long-term value, such as research and strate- Provide investors with value-relevant firm. At eBay, for example, executives have gic hiring. Outsource lower value activities information. to own company shares equivalent to three such as manufacturing. Consider Dell Com- Counter short-term earnings obsession and times their annual base salary. eBay’s ratio- puter’s well-chronicled direct-to-consumer investor uncertainty by improving the form nale? When executives have significant skin custom PC assembly business model. Dell in- and content of financial reports. Prepare a cor- in the game, they tend to make decisions vests extensively in marketing and telephone porate performance statement that allows an- with long-term value in mind. sales while minimizing its investments in alysts and shareholders to readily understand

VED. distribution, manufacturing, and inventory- the key performance indicators that drive carrying facilities. your company’s long-term value. Return excess cash to shareholders when there are no value-creating opportunities

ALL RIGHTS RESER in which to invest.

TION. Disburse excess cash reserves to shareholders A

OR through dividends and share buybacks. You’ll

ORP give shareholders a chance to earn better returns elsewhere—and prevent management from using the cash to make misguided value-destroying investments. OL PUBLISHING C Reward senior executives for delivering superior long-term returns. Standard stock options diminish long-term BUSINESS SCHO

D motivation, since many executives cash out R A V early. Instead, use discount indexed options. These options reward executives only if shares outperform a stock index of the company’s peers, not simply because the market as a whole is rising. OPYRIGHT © 2006 HAR C

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Companies profess devotion to shareholder value but rarely follow the practices that maximize it. What will it take to make your company a level 10 value creator?

Ten Ways to Create Shareholder Value

by Alfred Rappaport

It’s become fashionable to blame the pursuit of their options early, and cash out opportunisti- shareholder value for the ills besetting corpo- cally. The common practice of accelerating the rate America: managers and investors obsessed vesting date for a CEO’s options at retirement

VED. with next quarter’s results, failure to invest in added yet another incentive to focus on short- long-term growth, and even the accounting scan- term performance. dals that have grabbed headlines. When execu- Of course, these shortcomings were ob- tives destroy the value they are supposed to be scured during much of that decade, and corpo-

ALL RIGHTS RESER creating, they almost always claim that stock rate governance took a backseat as investors

TION. market pressure made them do it. watched stock prices rise at a double-digit clip. A

OR The reality is that the shareholder value The climate changed dramatically in the new

ORP principle has not failed management; rather, it millennium, however, as accounting scandals is management that has betrayed the princi- and a steep stock market decline triggered a ple. In the 1990s, for example, many compa- rash of corporate collapses. The ensuing ero- nies introduced stock options as a major com- sion of public trust prompted a swift regula-

OL PUBLISHING C ponent of executive compensation. The idea tory response—most notably, the 2002 passage was to align the interests of management with of the Sarbanes-Oxley Act (SOX), which re- those of shareholders. But the generous distri- quires companies to institute elaborate inter- bution of options largely failed to motivate nal controls and makes corporate executives BUSINESS SCHO D

R value-friendly behavior because their design al- directly accountable for the accuracy of ﬁnan- A V most guaranteed that they would produce the cial statements. Nonetheless, despite SOX and opposite result. To start with, relatively short other measures, the focus on short-term per- vesting periods, combined with a belief that formance persists. short-term earnings fuel stock prices, encour- In their defense, some executives contend aged executives to manage earnings, exercise that they have no choice but to adopt a short- OPYRIGHT © 2006 HAR C

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Ten Ways to Create Shareholder Value

term orientation, given that the average hold- be unable to follow the rest. Unfortunately, ing period for stocks in professionally man- that rules out most corporations because vir- aged funds has dropped from about seven tually all public companies play the earnings years in the 1960s to less than one year today. expectations game. A 2006 National Investor Why consider the interests of long-term share- Relations Institute study found that 66% of holders when there are none? This reasoning is 654 surveyed companies provide regular profit deeply flawed. What matters is not investor guidance to Wall Street analysts. A 2005 survey holding periods but rather the market’s valua- of 401 financial executives by Duke Univer- tion horizon—the number of years of expected sity’s John Graham and Campbell R. Harvey, cash flows required to justify the stock price. and University of Washington’s Shivaram While investors may focus unduly on near- Rajgopal, reveals that companies manage term goals and hold shares for a relatively earnings with more than just accounting short time, stock prices reflect the market’s gimmicks: A startling 80% of respondents said long view. Studies suggest that it takes more they would decrease value-creating spending than ten years of value-creating cash flows to on research and development, advertising, justify the stock prices of most companies. maintenance, and hiring in order to meet Management’s responsibility, therefore, is to earnings benchmarks. More than half the ex- deliver those flows—that is, to pursue long- ecutives would delay a new project even if it term value maximization regardless of the mix entailed sacrificing value. of high- and low-turnover shareholders. And What’s so bad about focusing on earnings? no one could reasonably argue that an absence First, the accountant’s bottom line approxi- of long-term shareholders gives management mates neither a company’s value nor its change the license to maximize short-term perfor- in value over the reporting period. Second, mance and risk endangering the company’s fu- organizations compromise value when they ture. The competitive landscape, not the share- invest at rates below the cost of capital (overin- holder list, should shape business strategies. vestment) or forgo investment in value-creating What do companies have to do if they are to opportunities (underinvestment) in an at- be serious about creating value? In this article, I tempt to boost short-term earnings. Third, the draw on my research and several decades of practice of reporting rosy earnings via value- consulting experience to set out ten basic gover- destroying operating decisions or by stretching nance principles for value creation that collec- permissible accounting to the limit eventually tively will help any company with a sound, catches up with companies. Those that can no well-executed business model to better realize longer meet investor expectations end up de- its potential for creating shareholder value. stroying a substantial portion, if not all, of Though the principles will not surprise readers, their market value. WorldCom, Enron, and applying some of them calls for practices that Nortel Networks are notable examples. run deeply counter to prevailing norms. I should point out that no company—with the Principle 2: Make strategic decisions possible exception of Berkshire Hathaway— that maximize expected value, even gets anywhere near to implementing all these at the expense of lowering near- principles. That’s a pity for investors because, as term earnings. CEO Warren Buffett’s fellow shareholders have Companies that manage earnings are almost found, there’s a lot to be gained from owning bound to break this second cardinal principle. shares in what I call a level 10 company—one Indeed, most companies evaluate and com- that applies all ten principles. (For more on pare strategic decisions in terms of the esti- Berkshire Hathaway’s application of the ten mated impact on reported earnings when they principles, please read my colleague Michael should be measuring against the expected in- Mauboussin’s analysis in the sidebar “Approach- cremental value of future cash flows instead. ing Level 10: The Story of Berkshire Hathaway.”) Expected value is the weighted average value Alfred Rappaport ([email protected] for a range of plausible scenarios. (To calculate .com) is the Leonard Spacek Professor Principle 1: Do not manage earnings it, multiply the value added for each scenario Emeritus at Northwestern University’s or provide earnings guidance. by the probability that that scenario will mate- Kellogg School of Management in Companies that fail to embrace this first prin- rialize, then sum up the results.) A sound stra- Evanston, Illinois. ciple of shareholder value will almost certainly tegic analysis by a company’s operating units harvard business review • hbr.org • september 2006 page 3

Ten Ways to Create Shareholder Value

Approaching Level 10: The Story of Berkshire Hathaway by Michael J. Mauboussin and consequently gets behind the and has never acted on Principle 5 (re- Do any companies in America make eight-ball…, no amount of subsequent turn cash to shareholders). In both decisions consistent with all ten share- brilliance will overcome the damage cases, however, Buffett and Munger’s holder value principles? Berkshire that has been inflicted.” writings and comments suggest that Hathaway, controlled by the legendary Berkshire is also exceptional with re- Berkshire evaluates its investments in Warren Buffett, may come the closest. gard to its corporate governance and light of these principles even if it Not only is Buffett the company’s larg- compensation. There’s no doubt that doesn’t directly apply them to itself. est shareholder, but he is also in the Buffett’s wealth and that of the com- Principle 4 advises selling operations rare position of viewing the drivers of pany’s vice chairman, Charlie Munger, if a buyer offers a meaningful premium shareholder value through the eyes of a rise and fall with that of the other share- to estimated value. Buffett states flatly, major investor and executive. He ob- holders: Berkshire stock represents the “Regardless of price, we have no interest serves, “I’m a better businessman be- vast majority of their substantial net at all in selling any good businesses that cause I am an investor and a better in- worth (Principle 9). As Buffett notes, Berkshire owns,” noting that this atti- vestor because I am a businessman. If “Charlie and I cannot promise you re- tude “hurts our financial performance.” you have the mentality of both, it aids sults. But we can guarantee that your fi- And despite sitting on more than $40 you in each field.”1 nancial fortunes will move in lockstep billion in excess cash at year-end 2005, In Berkshire’s communications, for with ours for whatever period of time Berkshire has not returned any cash to example, Buffett makes it clear that the you elect to be our partner.” its shareholders to date. However, the company does not “follow the usual The company’s compensation ap- company does apply a clear test to de- practice of giving earnings ‘guidance,’” proach is also consistent with the share- termine the virtue of retaining, versus recognizing that “reported earnings holder value principle and stands in stark distributing, cash: Management as- may reveal relatively little about our contrast to common U.S. compensation sesses “whether retention, over time, true economic performance” (see Prin- practices. Buffett’s $100,000 annual salary delivers shareholders at least $1 of mar- ciple 1). Instead, the company vows to places him in the cellar of Fortune 500 ket value for each $1 retained.” This test, be “candid in our reporting to you, em- CEO pay, where median compensation of course, is a restatement of the core phasizing the pluses and minuses im- exceeds $8 million. Further, Berkshire is shareholder value concept that all in- portant in appraising business value. the rare company that does not grant any vestments should generate a return in Our guideline is to tell you the business employee stock options or restricted excess of the cost of capital. Consistent facts that we would want to know if our stock. Buffett is not against equity-based with Principle 5, Buffett is clear about positions were reversed. We owe you pay per se, but he does argue that too few the consequence of failing this test. He no less” (Principle 10). companies properly link pay and perfor- says, “If we reach the point that we can’t Berkshire’s capital allocation decisions, mance (Principle 6). create extra value by retaining earn- especially when earnings growth and Buffett uses Geico, Berkshire’s auto ings, we will pay them out and let our value creation conflict, are also consonant insurance business, to illustrate the shareholders deploy the funds.” with the shareholder value principle. company’s compensation philosophy. Buffett’s influence extends beyond Writes Buffett, “Accounting consequences The goals of the plan, Buffett explains, Berkshire to companies for which he do not influence our operating or capital- “should be (1) tailored to the economics has served as a board member. For ex- allocation decisions. When acquisition of the specific operating business; (2) ample, the Washington Post and Coca- costs are similar, we much prefer to pur- simple in character so that the degree Cola were among the first companies to chase $2 of earnings that are not report- to which they are being realized can be voluntarily expense employee stock op- able by us under standard accounting easily measured; and (3) directly related tions in 2002. Companies with which principles than to purchase $1 of earnings to the daily activities of plan partici- Buffett has been involved also have a that is reportable” (Principles 2 and 3). pants.” He states that “we shun ‘lottery history of repurchasing stock. Shareholder-value companies recog- ticket’ arrangements…whose ultimate nize the importance of generating long- value…is totally out of the control of Michael J. Mauboussin is the chief in- term cash flows and hence avoid ac- the person whose behavior we would vestment strategist at Legg Mason Capital tions designed to boost short-term per- like to affect” (Principles 7 and 8). Management, based in Baltimore. He is a formance at the expense of the long So far, Berkshire looks like a complete shareholder in Berkshire Hathaway. view. Berkshire’s 2005 annual report ex- level 10 value-creation company—one plains the company’s position: “If a that applies all ten principles. But it 1. Sources for quotations include Berkshire management makes bad decisions in doesn’t closely adhere to Principle 4 Hathaway’s own publications and various pub- order to hit short-term earnings targets, (carry only assets that maximize value) lic news outlets.

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should produce informed responses to three where, when, and how it can accomplish real questions: First, how do alternative strategies performance gains by estimating the present affect value? Second, which strategy is most value of the resulting incremental cash flows and likely to create the greatest value? Third, for then subtracting the acquisition premium. the selected strategy, how sensitive is the value Value-oriented managements and boards of the most likely scenario to potential shifts also carefully evaluate the risk that anticipated in competitive dynamics and assumptions synergies may not materialize. They recognize about technology life cycles, the regulatory the challenge of postmerger integration and environment, and other relevant variables? the likelihood that competitors will not stand At the corporate level, executives must also idly by while the acquiring company attempts address three questions: Do any of the operat- to generate synergies at their expense. If it is ing units have sufficient value-creation poten- financially feasible, acquiring companies tial to warrant additional capital? Which units confident of achieving synergies greater than have limited potential and therefore should be the premium will pay cash so that their share- candidates for restructuring or divestiture? And holders will not have to give up any antici- what mix of investments in operating units is pated merger gains to the selling companies’ likely to produce the most overall value? shareholders. If management is uncertain whether the deal will generate synergies, it can Principle 3: Make acquisitions that hedge its bets by offering stock. This reduces maximize expected value, even at potential losses for the acquiring company’s the expense of lowering near-term shareholders by diluting their ownership in- earnings. terest in the postmerger company. Companies typically create most of their value The competitive through day-to-day operations, but a major Principle 4: Carry only assets that acquisition can create or destroy value faster maximize value. landscape, not the than any other corporate activity. With record The fourth principle takes value creation to a shareholder list, should levels of cash and relatively low debt levels, new level because it guides the choice of busi- companies increasingly use mergers and ac- ness model that value-conscious companies shape business strategies. quisitions to improve their competitive posi- will adopt. There are two parts to this principle. tions: M&A announcements worldwide ex- First, value-oriented companies regularly ceeded $2.7 trillion in 2005. monitor whether there are buyers willing to pay Companies (even those that follow Princi- a meaningful premium over the estimated cash ple 2 in other respects) and their investment flow value to the company for its business units, bankers usually consider price/earnings multi- brands, real estate, and other detachable assets. ples for comparable acquisitions and the im- Such an analysis is clearly a political minefield mediate impact of earnings per share (EPS) to for businesses that are performing relatively assess the attractiveness of a deal. They view well against projections or competitors but are EPS accretion as good news and its dilution as clearly more valuable in the hands of others. Yet bad news. When it comes to exchange-of-shares failure to exploit such opportunities can seri- mergers, a narrow focus on EPS poses an addi- ously compromise shareholder value. tional problem on top of the normal shortcom- A recent example is Kmart. ESL Invest- ings of earnings. Whenever the acquiring comments, a hedge fund operated by Edward pany’s price/earnings multiple is greater than Lampert, gained control of Kmart for less than the selling company’s multiple, EPS rises. The $1 billion when it was under bankruptcy pro- inverse is also true. If the acquiring company’s tection in 2002 and when its shares were trad- multiple is lower than the selling company’s ing at less than $1. Lampert was able to recoup multiple, earnings per share decline. In neither almost his entire investment by selling stores case does EPS tell us anything about the deal’s to Home Depot and Sears, Roebuck. In addi- long-term potential to add value. tion, he closed underperforming stores, fo- Sound decisions about M&A deals are based cused on profitability by reducing capital on their prospects for creating value, not on spending and inventory levels, and eliminated their immediate EPS impact, and this is the Kmart’s traditional clearance sales. By the end foundation for the third principle of value cre- of 2003, shares were trading at about $30; in ation. Management needs to identify clearly the following year they surged to $100; and, in

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a deal announced in November 2004, they shares purely to boost EPS, and, just as in the were used to acquire Sears. Former share- case of mergers and acquisitions, EPS accretion holders of Kmart are justifiably asking why the or dilution has nothing to do with whether or previous management was unable to similarly not a buyback makes economic sense. When reinvigorate the company and why they had to an immediate boost to EPS rather than value liquidate their shares at distressed prices. creation dictates share buyback decisions, Second, companies can reduce the capital the selling shareholders gain at the expense of they employ and increase value in two ways: the nontendering shareholders if overvalued by focusing on high value-added activities shares are repurchased. Especially widespread (such as research, design, and marketing) are buyback programs that offset the EPS dilu- where they enjoy a comparative advantage and tion from employee stock option programs. In by outsourcing low value-added activities (like those kinds of situations, employee option ex- manufacturing) when these activities can be ercises, rather than valuation, determine the reliably performed by others at lower cost. Ex- number of shares the company purchases and amples that come to mind include Apple Com- the prices it pays. puter, whose iPod is designed in Cupertino, Value-conscious companies repurchase shares California, and manufactured in Taiwan, and only when the company’s stock is trading hotel companies such as Hilton Hospitality below management’s best estimate of value and Marriott International, which manage ho- and no better return is available from invest- tels without owning them. And then there’s ing in the business. Companies that follow Dell’s well-chronicled direct-to-customer, cus- this guideline serve the interests of the non- tom PC assembly business model, which mini- tendering shareholders, who, if management’s mizes the capital the company needs to invest valuation assessment is correct, gain at the ex- in a sales force and distribution, as well as the pense of the tendering shareholders. need to carry inventories and invest in manu- When a company’s shares are expensive and facturing facilities. there’s no good long-term value to be had from investing in the business, paying dividends is Principle 5: Return cash to share probably the best option. holders when there are no credible value-creating opportunities to Principle 6: Reward CEOs and other invest in the business. senior executives for delivering Even companies that base their strategic deci- superior long-term returns. sion making on sound value-creation principles Companies need effective pay incentives at can slip up when it comes to decisions about every level to maximize the potential for supe- cash distribution. The importance of adhering rior returns. Principles 6, 7, and 8 set out ap- to the fifth principle has never been greater: As propriate guidelines for top, middle, and of the first quarter of 2006, industrial compa- lower management compensation. I’ll begin nies in the S&P 500 were sitting on more than with senior executives. As I’ve already ob- $643 billion in cash—an amount that is likely to served, stock options were once widely touted grow as companies continue to generate posi- as evidence of a healthy value ethos. The stan- tive free cash flows at record levels. dard option, however, is an imperfect vehicle Value-conscious companies with large for motivating long-term, value-maximizing amounts of excess cash and only limited value- behavior. First, standard stock options reward creating investment opportunities return the performance well below superior-return lev- money to shareholders through dividends and els. As became painfully evident in the 1990s, share buybacks. Not only does this give share- in a rising market, executives realize gains holders a chance to earn better returns else- from any increase in share price—even one where, but it also reduces the risk that man- substantially below gains reaped by their com- agement will use the excess cash to make petitors or the broad market. Second, the typical value-destroying investments—in particular, vesting period of three or four years, coupled ill-advised, overpriced acquisitions. with executives’ propensity to cash out early, Just because a company engages in share significantly diminishes the long-term motiva- buybacks, however, doesn’t mean that it abides tion that options are intended to provide. by this principle. Many companies buy back Finally, when options are hopelessly under-

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water, they lose their ability to motivate at all. useful for corporate executives, whose mandate And that happens more frequently than is is to raise the performance of the company as a generally believed. For example, about one- whole—and thus, ultimately, the stock price— third of all options held by U. S. executives such options are usually inappropriate for re- were below strike prices in 1999 at the height warding operating-unit executives, who have a of the bull market. But the supposed reme- limited impact on overall performance. A stock dies—increasing cash compensation, granting price that declines because of disappointing restricted stock or more options, or lowering performance in other parts of the company the exercise price of existing options—are may unfairly penalize the executives of the op- shareholder-unfriendly responses that rewrite erating units that are doing exceptionally well. the rules in midstream. Alternatively, if an operating unit does poorly Value-conscious companies can overcome but the company’s shares rise because of supe- the shortcomings of standard employee stock rior performance by other units, the executives options by adopting either a discounted indexed- of that unit will enjoy an unearned windfall. In option plan or a discounted equity risk option neither case do option grants motivate execu- (DERO) plan. Indexed options reward executives to create long-term value. Only when a tives only if the company’s shares outperform company’s operating units are truly interde- the index of the company’s peers—not simply pendent can the share price serve as a fair and because the market is rising. To provide man- useful indicator of operating performance. agement with a continuing incentive to maxi- Companies typically have both annual and mize value, companies can lower exercise long-term (most often three-year) incentive prices for indexed options so that executives plans that reward operating executives for ex- profit from performance levels modestly below ceeding goals for financial metrics, such as rev- the index. Companies can address the other enue and operating income, and sometimes for shortcoming of standard options—holding pe- beating nonfinancial targets as well. The trou- riods that are too short—by extending vesting ble is that linking bonuses to the budgeting periods and requiring executives to hang on to process induces managers to lowball perfor- a meaningful fraction of the equity stakes they mance possibilities. More important, the usual obtain from exercising their options. earnings and other accounting metrics, partic- For companies unable to develop a reason- ularly when used as quarterly and annual mea- able peer index, DEROs are a suitable alterna- sures, are not reliably linked to the long-term tive. The DERO exercise price rises annually by cash flows that produce shareholder value. the yield to maturity on the ten-year U.S. Trea- To create incentives for an operating unit, sury note plus a fraction of the expected equity companies need to develop metrics such as risk premium minus dividends paid to the shareholder value added (SVA). To calculate holders of the underlying shares. Equity inves- SVA, apply standard discounting techniques tors expect a minimum return consisting of the to forecasted operating cash flows that are risk-free rate plus the equity risk premium. But driven by sales growth and operating margins, this threshold level of performance may cause then subtract the investments made during many executives to hold underwater options. the period. Because SVA is based entirely on By incorporating only a fraction of the esti- cash flows, it does not introduce accounting mated equity risk premium into the exercise distortions, which gives it a clear advantage price growth rate, a board is betting that the over traditional measures. To ensure that the value added by management will more than metric captures long-term performance, com- offset the costlier options granted. Dividends panies should extend the performance evalua- are deducted from the exercise price to remove tion period to at least, say, a rolling three-year the incentive for companies to hold back divi- cycle. The program can then retain a portion dends when they have no value-creating in- of the incentive payouts to cover possible fu- vestment opportunities. ture underperformance. This approach elimi- nates the need for two plans by combining Principle 7: Reward operating-unit the annual and long-term incentive plans into executives for adding superior one. Instead of setting budget-based thresh- multiyear value. olds for incentive compensation, companies While properly structured stock options are can develop standards for superior year-to-

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year performance improvement, peer bench- lines require the CEO to own stock in the com- marking, and even performance expectations pany equivalent to five times annual base sal- implied by the share price. ary. For other executives, the corresponding number is three times salary. Top managers Principle 8: Reward middle are further required to retain a percentage of managers and frontline employees shares resulting from the exercise of stock op- for delivering superior performance tions until they amass the stipulated number on the key value drivers that they of shares. influence directly. But in most cases, stock ownership plans fail Although sales growth, operating margins, to expose executives to the same levels of risk and capital expenditures are useful financial that shareholders bear. One reason is that indicators for tracking operating-unit SVA, some companies forgive stock purchase loans they are too broad to provide much day-to-day when shares underperform, claiming that the guidance for middle managers and frontline arrangement no longer provides an incentive employees, who need to know what specific for top management. Such companies, just as actions they should take to increase SVA. For those that reprice options, risk institutionaliz- more specific measures, companies can de- ing a pay delivery system that subverts the velop leading indicators of value, which are spirit and objectives of the incentive compen- quantifiable, easily communicated current ac- sation program. Another reason is that out- complishments that frontline employees can right grants of restricted stock, which are es- influence directly and that significantly affect sentially options with an exercise price of $0, the long-term value of the business in a posi- typically count as shares toward satisfaction of tive way. Examples might include time to mar- minimum ownership levels. Stock grants moti- ket for new product launches, employee turn- vate key executives to stay with the company over rate, customer retention rate, and the until the restrictions lapse, typically within timely opening of new stores or manufactur- three or four years, and they can cash in their ing facilities. shares. These grants create a strong incentive My own experience suggests that most busi- for CEOs and other top managers to play it nesses can focus on three to five leading indi- safe, protect existing value, and avoid getting cators and capture an important part of their fired. Not surprisingly, restricted stock plans long-term value-creation potential. The pro- are commonly referred to as “pay for pulse,” cess of identifying leading indicators can be rather than pay for performance. challenging, but improving leading-indicator In an effort to deflect the criticism that re- performance is the foundation for achieving stricted stock plans are a giveaway, many superior SVA, which in turn serves to increase companies offer performance shares that re- long-term shareholder returns. quire not only that the executive remain on the payroll but also that the company achieve Principle 9: Require senior executives predetermined performance goals tied to EPS to bear the risks of ownership just as growth, revenue targets, or return-on-capital- shareholders do. employed thresholds. While performance shares For the most part, option grants have not suc- do demand performance, it’s generally not cessfully aligned the long-term interests of se- the right kind of performance for delivering nior executives and shareholders because the long-term value because the metrics are usu- former routinely cash out vested options. The ally not closely linked to value. ability to sell shares early may in fact motivate Companies seeking to better align the inter- them to focus on near-term earnings results ests of executives and shareholders need to rather than on long-term value in order to find a proper balance between the benefits of boost the current stock price. requiring senior executives to have meaningful To better align these interests, many compa- and continuing ownership stakes and the re- nies have adopted stock ownership guidelines sulting restrictions on their liquidity and diver- for senior management. Minimum ownership sification. Without equity-based incentives, ex- is usually expressed as a multiple of base sal- ecutives may become excessively risk averse ary, which is then converted to a specified to avoid failure and possible dismissal. If they number of shares. For example, eBay’s guide- own too much equity, however, they may also

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The Corporate Performance Statement Investors need a baseline for assessing nancing activities—new issues of accruals of varying levels of uncer- a company’s cash flow prospects and a stocks, stock buybacks, new borrow- tainty characterized by long cash- clear view of their potential volatility. ing, repayment of previous borrow- conversion cycles and wide ranges of The corporate performance statement ing, and interest payments. plausible outcomes. provides a way to estimate both things Revenue and expense accruals. The Management discussion and analy- by separating realized cash flows from second part of the statement presents sis. In the third section, management forward-looking accruals. revenue and expense accruals, which presents the company’s business Operating cash flows. The first part estimate future cash receipts and pay- model, key performance indicators of this statement tracks only operat- ments triggered by current sales and (both financial and nonfinancial), and ing cash flows. It does not replace the purchase transactions. Management the critical assumptions supporting traditional cash flow statement be- estimates three scenarios—most each accrual estimate. cause it excludes cash flows from fi- likely, optimistic, and pessimistic—for

slaurccA esnepxE dna euneveRswolF hsaC gnitarepO hsaC euneveRswolF dna esnepxE slaurccA

$ Total revenue most likely optimistic pessimistic - Operating expenses:1 Medium-uncertainty accruals Production Unrealized gains on Selling and marketing long-term contracts $ Administration Uncollectible receivables Current taxes Warranty obligations Restructuring charges = “Cash” operating proﬁt after taxes Deferred income taxes ± Change in working capital

High-uncertainty accruals = Cash flow from operations Defined benefit pensions - Investments: Employee stock options Capital expenditures (minus proceeds from asset sales) Research and development Other intangible investments

= $ Free cash ﬂow (for debt holders and shareholders)

Management Discussion and Analysis

1. Excludes noncash charges, such as depreciation, amortization, deferred taxes, and asset and liability revaluations.

Source: Adapted from Alfred Rappaport,“The Economics of Short-Term Performance Obsession,” Financial Analysts Journal, May–June 2005.

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eschew risk to preserve the value of their The Rewards—and the Risks largely undiversified portfolios. Extending the The crucial question, of course, is whether period before executives can unload shares following these ten principles serves the from the exercise of options and not counting long-term interests of shareholders. For most restricted stock grants as shares toward mini- companies, the answer is a resounding yes. mum ownership levels would certainly help Just eliminating the practice of delaying or equalize executives’ and shareholders’ risks. forgoing value-creating investments to meet quarterly earnings targets can make a signifi- Principle 10: Provide investors with cant difference. Further, exiting the earnings- value-relevant information. management game of accelerating revenues The final principle governs investor communi- into the current period and deferring ex- cations, such as a company’s financial reports. penses to future periods reduces the risk that, Better disclosure not only offers an antidote to over time, a company will be unable to meet short-term earnings obsession but also serves market expectations and trigger a meltdown to lessen investor uncertainty and so poten- in its stock. But the real payoff comes in the tially reduce the cost of capital and increase difference that a true shareholder-value ori- the share price. entation makes to a company’s long-term One way to do this, as described in my arti- growth strategy. cle “The Economics of Short-Term Perfor- For most organizations, value-creating mance Obsession” in the May–June 2005 issue growth is the strategic challenge, and to suc- of Financial Analysts Journal, is to prepare a ceed, companies must be good at developing corporate performance statement. (See the ex- new, potentially disruptive businesses. Here’s hibit “The Corporate Performance Statement” why. The bulk of the typical company’s share Companies need to for a template.) This statement: price reflects expectations for the growth of • separates out cash flows and accruals, pro- current businesses. If companies meet those balance the benefits of viding a historical baseline for estimating a expectations, shareholders will earn only a nor- requiring senior company’s cash flow prospects and enabling mal return. But to deliver superior long-term analysts to evaluate how reasonable accrual returns—that is, to grow the share price faster executives to hold estimates are; than competitors’ share prices—management • classifies accruals with long cash-conversion must either repeatedly exceed market expecta- continuing ownership cycles into medium and high levels of uncertainty; tions for its current businesses or develop new stakes and the resulting •provides a range and the most likely esti- value-creating businesses. It’s almost impossi- mate for each accrual rather than traditional ble to repeatedly beat expectations for current restrictions on their single-point estimates that ignore the wide vari- businesses, because if you do, investors simply liquidity and ability of possible outcomes; raise the bar. So the only reasonable way to de- •excludes arbitrary, value-irrelevant accru- liver superior long-term returns is to focus on diversification. als, such as depreciation and amortization; and new business opportunities. (Of course, if a • details assumptions and risks for each line company’s stock price already reflects expecta- item while presenting key performance indica- tions with regard to new businesses—which it tors that drive the company’s value. may do if management has a track record of Could such specific disclosure prove too delivering such value-creating growth—then costly? The reality is that executives in well- the task of generating superior returns be- managed companies already use the type of comes daunting; it’s all managers can do to information contained in a corporate perfor- meet the expectations that exist.) mance statement. Indeed, the absence of such Companies focused on short-term perfor- information should cause shareholders to ques- mance measures are doomed to fail in deliver- tion whether management has a comprehen- ing on a value-creating growth strategy be- sive grasp of the business and whether the cause they are forced to concentrate on board is properly exercising its oversight re- existing businesses rather than on developing sponsibility. In the present unforgiving climate new ones for the longer term. When managers for accounting shenanigans, value-driven com- spend too much time on core businesses, they panies have an unprecedented opportunity to end up with no new opportunities in the pipe- create value simply by improving the form and line. And when they get into trouble—as they content of corporate reports. inevitably do—they have little choice but to

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try to pull a rabbit out of the hat. The dynamic tive to strategic opportunities. Over time, they of this failure has been very accurately de- get better than their competitors at seizing op- scribed by Clay Christensen and Michael portunities to achieve competitive advantage. Raynor in their book The Innovator’s Solution: Although applying the ten principles will Creating and Sustaining Successful Growth improve long-term prospects for many compa- (Harvard Business School Press, 2003). With a nies, a few will still experience problems if in- little adaptation, it plays out like this: vestors remain fixated on near-term earnings, • Despite a slowdown in growth and margin because in certain situations a weak stock price erosion in the company’s maturing core busi- can actually affect operating performance. The ness, management continues to focus on devel- risk is particularly acute for companies such as oping it at the expense of launching new high-tech start-ups, which depend heavily on a growth businesses. healthy stock price to finance growth and send •Eventually, investments in the core can no positive signals to employees, customers, and longer produce the growth that investors ex- suppliers. When share prices are depressed, pect, and the stock price takes a hit. selling new shares either prohibitively dilutes •To revitalize the stock price, management current shareholders’ stakes or, in some cases, announces a targeted growth rate that is well makes the company unattractive to prospec- beyond what the core can deliver, thus intro- tive investors. As a consequence, management ducing a larger growth gap. may have to defer or scrap its value-creating •Confronted with this gap, the company growth plans. Then, as investors become aware limits funding to projects that promise very of the situation, the stock price continues to large, very fast growth. Accordingly, the com- slide, possibly leading to a takeover at a fire- pany refuses to fund new growth businesses sale price or to bankruptcy. Value-creating growth is that could ultimately fuel the company’s expan- Severely capital-constrained companies can sion but couldn’t get big enough fast enough. also be vulnerable, especially if labor markets the strategic challenge, • Managers then respond with overly opti- are tight, customers are few, or suppliers are and to succeed, mistic projections to gain funding for initiatives particularly powerful. A low share price means in large existing markets that are potentially ca- that these organizations cannot offer credible companies must be good pable of generating sufficient revenue quickly prospects of large stock-option or restricted- enough to satisfy investor expectations. stock gains, which makes it difficult to attract at developing new, •To meet the planned timetable for rollout, and retain the talent whose knowledge, ideas, potentially disruptive the company puts a sizable cost structure in and skills have increasingly become a domi- place before realizing any revenues. nant source of value. From the perspective of businesses. •As revenue increases fall short and losses customers, a low valuation raises doubts about persist, the market again hammers the stock the company’s competitive and financial price and a new CEO is brought in to shore it strength as well as its ability to continue pro- up. ducing high-quality, leading-edge products and • Seeing that the new growth business pipe- reliable postsale support. Suppliers and distrib- line is virtually empty, the incoming CEO tries utors may also react by offering less favorable to quickly stem losses by approving only expen- contractual terms, or, if they sense an unac- ditures that bolster the mature core. ceptable probability of financial distress, they • The company has now come full circle and may simply refuse to do business with the com- has lost substantial shareholder value. pany. In all cases, the company’s woes are com- Companies that take shareholder value seri- pounded when lenders consider the perfor- ously avoid this self-reinforcing pattern of be- mance risks arising from a weak stock price havior. Because they do not dwell on the mar- and demand higher interest rates and more re- ket’s near-term expectations, they don’t wait strictive loan terms. for the core to deteriorate before they invest in Clearly, if a company is vulnerable in these new growth opportunities. They are, therefore, respects, then responsible managers cannot more likely to become first movers in a market afford to ignore market pressures for short- and erect formidable barriers to entry through term performance, and adoption of the ten scale or learning economies, positive network principles needs to be somewhat tempered. effects, or reputational advantages. Their man- But the reality is that these extreme condi- agement teams are forward-looking and sensi- tions do not apply to most established, pub-

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licly traded companies. Few rely on equity is- tional investors to act on behalf of the share- sues to finance growth. Most generate enough holders and beneficiaries they represent and cash to pay their top employees well without insist that long-term shareholder value be- resorting to equity incentives. Most also have come the governing principle for all the com- a large universe of customers and suppliers to panies in their portfolios? deal with, and there are plenty of banks after their business. Reprint R0609C It’s time, therefore, for boards and CEOs to Harvard Business Review OnPoint 1069 step up and seize the moment. The sooner you To order, see the next page make your firm a level 10 company, the more or call 800-988-0886 or 617-783-7500 you and your shareholders stand to gain. And or go to www.hbr.org what better moment than now for institu-

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Ten Ways to Create Shareholder Value

Further Reading ARTICLES The Balanced Scorecard: Measures That True Corporate Grit Drive Performance By Joseph Fuller, Harris Collingwood, by Robert S. Kaplan and David P. Norton H. David Sherman, and S. David Young Harvard Business Review Harvard Business Review OnPoint Collection February 2000 October 2002 Product no. 4096 Product no. 1970 To generate long-term growth for your com- This Harvard Business Review OnPoint collection pany, you need to activate a wide range of lays out the dangers that arise when executives drivers—not just immediate financial perfor- sacrifice their companies’ long-term success in mance. Kaplan and Norton suggest consider- order to meet Wall Street’s expectations. It also ing the following perspectives while identify- offers ways to resist value-destroying enslave- ing growth drivers: 1) Customer: Provide ment to quarterly earnings reports. value to customers in terms of time, quality, In “A Letter to the Chief Executive,” Joseph Fuller performance, service, and cost. 2) Internal recommends making investment decisions business: Invest in the core competencies, based on in-depth understanding of your indus- processes, decisions, and actions that exert try and company, not on outside pressures. the greatest impact ton customer satisfac- Fuller also advises refocusing stock analysts’ at- tion. 3) Innovation and learning: Continually tention away from quarterly earnings by clarify- improve existing products and processes ing your corporate strategy, its risks, and your while also introducing new offerings with ex- firm’s true investment potential. panded capabilities. 4) Financial: Use financial measures to determine whether you’ve In “The Earnings Game: Everyone Plays, No- achieved important objectives in the other body Wins,” Harris Collingwood argues that three perspectives, as well as to articulate your quarterly earnings reports say little about your company’s future direction. company’s true health. To mitigate the obsession with quarterly earnings, introduce quantifiable measures in addition to earnings reports, such as number of new product introductions, training investments, and patent royalty income. To Order In “Tread Lightly Through These Accounting Minefields,” H. David Sherman and S. David For reprints, Harvard Business Review Young examine the risky accounting practices OnPoint orders, and subscriptions spawned by pressure to meet investors’ short- to Harvard Business Review: term revenue and growth expectations. The Call 800-988-0886 or 617-783-7500. authors then suggest ways to guard against Go to www.hbr.org “creative accounting” calamities. For example, avoid posting revenues immediately that you For customized and quantity orders expect to earn over several years. Don’t under- of reprints and Harvard Business estimate future costs (such as obsolete inven- Review OnPoint products: tory). And resist any urge to inflate profits by Call Rich Gravelin at overestimating assets’ lifetime value. 617-783-7626, or e-mail him at [email protected]

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