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Statements on Management Accounting Measuring AND NSTAR Gas Commpany d/b/a Eversource Energy D.P.U. 19-120 Attachment AG-47-2 FN 193 Page 1 of 41 Statements on Management Accounting BUSINESS PERFORMANCE MANAGEMENT TITLE Measuring and Managing Shareholder Value Creation CREDITS This statement was approved for issuance as a Prior to his becoming a member of MAC, Randolf Holst, Statement on Management Accounting by the CMA, was a SMAC staff manager and, in that capacity, Management Accounting Committee (MAC) of the supervised and monitored the project, which was brought Institute of Management Accountants (IMA). IMA appre- to conclusion by SMAC staff manager Elizabeth Bluemke. ciates the collaborative efforts of The Society of MAC member Thomas E. Huff served on the focus group Management Accountants of Canada (SMAC) and the that provided significant assistance in shaping the final work of Dr. Howard Armitage, CMA, of University of document. IMA thanks the aforementioned individuals Waterloo, and Vijay Jog, of Carelton University, who draft- and members of the Management Accounting ed the manuscript. Committee for their contributions to this effort. Published by Copyright © 1997 Institute of Management Accountants Institute of Management Accountants 10 Paragon Drive All rights reserved Montvale, NJ 07645-1760 www.imanet.org NSTAR Gas Commpany d/b/a Eversource Energy D.P.U. 19-120 Attachment AG-47-2 FN 193 Page 2 of 41 Statements on Management Accounting BUSINESS PERFORMANCE MANAGEMENT Measuring and Managing Shareholder Value Creation TABLE OF CONTENTS I. Rationale . 1 VIII. Managing for Shareholder Value . .19 II. Scope . 1 Ensuring Senior Management III. Defining Shareholder-Value and Wealth Commitment and Support . .20 Creation . .2 Creating a VBM Transition Team . .21 IV. Determinants of Shareholder-Value Aligning Incentives to Enable Change . .23 Creation . .3 lX. Organizational and Management V. The Role of the Management Accounting Challenges . 25 Accountant . .5 X. Conclusion . 25 VI. Techniques for Measuring Shareholder Appendix A: Sample Calculations for Shareholder- Value . .6 Value-Creation Measures Value-Creation Measures . .7 Appendix B: From Earnings to Operating Economic Value . .9 Performance to Value Creation The Equity Spread . .11 Bibliography Implied Value . .12 Cash Flow Return on Investment . .12 Exhibits Wealth-Creation Measures . .14 Exhibit 1: Corporate Objectives and Total Shareholder Return . .14 Value Drivers . .3 Annual Economic Return . .15 Exhibit 2: Examples of Shareholder- Value-Creation Strategies . .4 Hybrid Value/Wealth-Creation Measures 16 Comparing Traditional and Value- Market Value Added . .16 Exhibit 3: Based Income Statements . .8 VII. Additional Issues Related to Shareholder- Rate of Return on Net Value-Creation Measurement . .18 Exhibit 4: Assets (RONA) . .9 Stock Price . .18 Exhibit 5: Financial Drivers of Total Uncontrollable Factors . .18 Shareholder Return (TSR) . .15 Linkage Between Value- and Wealth- Exhibit 6: Comparison of Shareholder- 19 Creation Measures . Value-Creation Measures . .17 NSTAR Gas Commpany d/b/a Eversource Energy D.P.U. 19-120 Attachment AG-47-2 FN 193 Page 3 of 41 BUSINESS PERFORMANCE MANAGEMENT I. RATIONALE managers to make short-term dysfunctional More than ever, corporate executives are under decisions that encourage underinvestment. increasing pressure to demonstrate on a regular Furthermore, neither earnings nor return measures basis that they are creating shareholder value. appear to correlate well with actual market This pressure has led to an emergence of a values of companies. variety of measures that claim to quantify value- creating performance. II. SCOPE This Statement compares and contrasts various Why is creating shareholder value suddenly measures that claim to quantify management’s becoming a credo in corporate boardrooms? shareholder-value-creation abilities and describes There are many reasons for this renewed emphasis the issues and challenges faced in order to on measuring and managing shareholder value, implement an operating paradigm resulting prominent among which are the following: from these measures—value-based manage- G Capital markets are becoming increasingly ment (hereafter referred to as VBM1). global. Investors can readily shift investments to higher yielding, often foreign, opportunities. This Statement applies to all firms, private and G Corporate governance is shifting, with owners public, large and small, whose managers are now demanding accountability from corporate interested in creating value for their shareholders/ executives. Manifestations of the increased owners. It will help management accountants and assertiveness of shareholders include the others to: necessity for executives to justify their com- G understand the fundamental concepts of pensation levels, and well-publicized lists of shareholder-value creation; underperforming companies and overpaid G link value creation to shareholder-wealth executives. maximization; G Executives are concerned with self-preserva- G unravel financial and operational drivers that tion. Well-publicized hostile takeovers have can lead to improved performance and thereby served notice to all levels of management that improve shareholder-value creation; weak financial performance is unacceptable G understand the differences among a variety of and may precipitate a fight for corporate control. measures that assess management perfor- This potential loss of control has motivated mance within the context of shareholder-value many executives to better understand the creation and wealth maximization; importance of measuring and managing share- G appreciate the organizational and management holder expectations. accounting challenges in implementing VBM to improve shareholder-value creation; and There is also considerable dissatisfaction with G broaden shareholder and management awareness existing accounting-based earnings and return of the importance of shareholder-value creation. measures. Evidence is mounting that accounting measures such as earnings per share (EPS) and profit or growth in earnings do not take into account the cost of the investment required to run the business. Similarly, return-based meas- 1 VBM is an approach to management whereby the company’s overall aspirations, analytical techniques, and man- ures, such as return on assets, often motivate agement processes are aligned to help the company maximize its value by focusing management decision making on the key drivers of shareholder value. 1 NSTAR Gas Commpany d/b/a Eversource Energy D.P.U. 19-120 Attachment AG-47-2 FN 193 Page 4 of 41 BUSINESS PERFORMANCE MANAGEMENT The Statement recognizes that several philoso- Under this value-based view, value is only created phies exist with respect to how organizations when revenues exceed all costs including a perceive the process of shareholder-value capital charge. This value accrues mostly to creation. The approach taken here places the shareholders because they are the residual shareholder at the focal point of all economic owners of the firm. activity within the firm, with maximizing share- holder value as the objective of the organization. Shareholders expect management to generate This does not mean that, in its quest to create value over and above the costs of resources con- shareholder value, other stakeholders, such sumed, including the cost of using capital. If sup- as employees, customers, suppliers, or the pliers of capital do not receive a fair return to community, are ignored. Quite the contrary. compensate them for the risk they are taking, Value-creating firms take decisions that maintain they will withdraw their capital in search of better a proper balance between the competing returns, since value will be lost. A company that interests of all stakeholders. is destroying value will always struggle to attract further capital to finance expansion, since it will Nevertheless, the shareholder is the central be hamstrung by a share price that stands at a stakeholder. Placing the shareholder at the focal discount to the underlying value of its assets point of business activity is simply recognizing and by higher interest rates on debt or bank the fact that firms that do not satisfy shareholder loans demanded by creditors. requirements increase their risk of capital flight, higher interest rates, pressure from the board of Wealth creation refers to changes in the wealth of directors, takeovers, and lower productivity. shareholders on a periodic (annual) basis. Organizations that create long-term shareholder Applicable to exchange-listed firms, changes in value simultaneously create relatively greater shareholder wealth are inferred mostly from value for all stakeholders. Thus, value-creating changes in stock prices, dividends paid, and equity organizations appear to operate with the following raised during the period. Since stock prices reflect objective function in mind: Maximize shareholder investor expectations about future cash flows, wealth subject to satisfying remaining stakeholder creating wealth for shareholders requires that the requirements. firm undertake investment decisions that have a positive net present value (NPV). III. DEFINING SHAREHOLDER-VALUE AND-WEALTH CREATION Although used interchangeably, there is a subtle From the economist’s viewpoint, value is created difference between value creation and wealth when management generates revenues over creation. The value perspective is based on and above the economic costs to generate these measuring value directly from accounting-based revenues. Costs
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