Measuring Performance &

Value Based Management

Dr. M.V.S.Kameshwar Rao

Associate Professor, IBS, Hyderabad
Measuring Performance
• If the Goal of any organisation is to create Sustainable Long-Term Value
to Stakeholders
• Then it is important that at regular intervals one measures whether the
Value is created or not
• Organisational Performance is measured at regular intervals using
• Financial Metrics
• Non-Financial Metrics
• All the performance Metrics should be ultimately mapped to either of
• ROE or ROCE so that it can be compared against Cost of Equity or Cost of Capital
• Intrinsic Value of Equity based on Discounted Casfflow Models
• Market Value of Equity
Some Clarity!
• Measure
• A simple number with units of measurement capturing activities/operations
• Sales Rs.5 Million, 10,000 Employees, $ 10 Bn Assets,
• Metric
• A quantitative construct which brings context to a measure and develops insight
• Rs.500 Sales Per Employee, Turnover Ratio of 0.5
• Key Performance Indicator
• A quantitative expression using Metrics which is a Value Driver
• Customer Retention Rate, Revenue per Employee,
• Key Success Factor
• Usually a unobservable psychological construct determining success of business
• Customer Satisfaction, Quality, Competence, Leadership, Governance
Issues related Choice of Performance Metrics
• Metrics not related to Strategy
• The Causal Links to Financial Goals not Validated
• Appropriate Thresholds not set
• Validity Issues of the Variables chosen
• Reliability Issues of the values of Variables
• Not Actionable
• Not Simple to understand
• Not generated on timely basis
• Conflicts and Trade-offs at departmental and divisional levels
Value Based Management (VBM)
• A marriage between Value Creation Mindset and Management Processes and
Systems that translate the mindset into action is VBM
• Value Creation Mindset is
• “understanding and believing that shareholder value enhancement is the only ultimate
goal of business enterprise”
• “having complete understanding of the value drivers in every operation of the
business”
• Basic Assumptions
• Value of a Company is sum of present value of future cashflows
• Conventional accounting based measures are not adequate to measure value
• Every performance metric should be mapped to shareholder’s value
• A well designed performance measurement system, and incentivising system is a
must to nudge and motivate employees to work for shareholder value
• Value is created when the capital is invested at a return greater than the cost of capital
The Value Measure – Model – Drivers Linkage
Value Drivers Financial Metrics
Market Share; Cost
per Unit, R&D ROIC; Growth;
Projects, Employee WACOC; Invested
Productivity Capital

Value Measured by Value arrived by

Market Manager

TSR/MVA DCF Intrinsic Value

Approaches to VBM
• Shareholder Value Added – McKinsey and ALCAR group

• Economic Value Added or Market Value Added – Stern Stewart & Com

• Cash Value Added - BCG

MCKINSEY’S Generic Health
Metrics
Long-Term
Drivers
Financial Value Drivers Short-term value Medium-term value
Intrinsic Value

drivers drivers
Commercial Strategic
Long Term Growth Sales Productivity Health
Health
Operating cost Cost Structure
ROIC Core Business
Productivity Health
Capital
Cost of Capital Asset Health Growth
Productivity Opportunities
Market Based Performance Measurement
• Total Shareholder Return
• [(Ending MVOE + Dividends + Buybacks)/(Beginning MVOE + Fresh Equity
issued)]-1

• Market Value Added

• (Market Value of Equity and Debt) – (Book Value of Equity and Debt)

• Market to Capital Ratio

• Market Value of Equity / Book Value of Equity
TSR & MCR
MATRIX
TSR above
historical Recovering
average Corporate Elite
Underperformers

TSR below
historical
Corporate Emerging
average Underdogs Underperformers

MCR below MCR above

historical average historical average
MARAKON Approach
• Founded by Marakon Associates, International Management Consulting
• Key 4 Steps
• Specify Financial Determinants of Value
• Understand Strategic Drivers of Value
• Formulate Higher Value Strategies
• Develop Superior organisational capabilities
• Market to Book Value is a robust financial metric to base
• M/B = (r – g) / (k – g) (This is arrived after tweaking DDM)
• The key to creating value to shareholders is to increase the spread
between ‘r’ and ‘k’ and increasing the growth prospects of profits
MARAKON Approach
• Spread and Growth are dependent on
• Market Economics (Industry characteristics)
• All Porter’s 5 forces are supposed to be considered here
• Competitive Position
• In the above industry the firm’s position needs to be established as either
• Differentiator OR Cost Leader

• To formulate strategies at Corporate and Business unit Level

• Related Cost, Product and Pricing strategies
• Develop Superior Organisational Capabilities related to
• Competent and Energetic Chief Executive
• Good Corporate Governance
• Top Management Compensation
• Resource Allocation – Zero based allocation, Funding Strategies, No Capital Rationing, Zero
tolerance for lack of growth
• Performance Management Process agreed upon by both management and employees
ALCAR Approach
• Based on Discounted Cashflow Technique of Firm Valuation
• Terminal Value is estimated without any growth (Perpetual Annuity)
• Compare the Pre-Strategy Value and Post Strategy Value to measure Value
Creation
• Value drivers include the following
• Growth rate in Sales
• Operating Profit Margin
• Corporate Tax Rate
• Investment in Working Capital
• Investment in CAPEX
• Cost of Capital - WACOC
• Value Growth Duration – Number of Years the post tax returns (book profits based)
would be higher than the discounting rate
Economic Value Added Approach (EVA)
• Developed by Stern Stewart & Co.
• EVA = NOPAT – (WACOC * BOOK VALUE OF CAPITAL EMPLOYED)
• EVA = BOOK VALUE OF CAPITAL EMPLOYED (ROIC – WACOC)
• EVA = [(PAT + INT(1 – T)] – (WACOC*BOOK VALUE OF CAPITAL
EMPLOYED)
• EVA = PAT – (Cost Of Equity – BOOK VALUE OF EQUITY)
• The approach requires adjustments to the accounting figues of NOPAT and
Book Value of Capital Employed.
• The Stern Stewart company proposed 160 potential adjustments between
Accounting figures and converting them to Economic figures
• Real Life situation 10 – 15 instances suffice
Adjustment Capital Employed Required
• Research and Development Expenses- Considered as CAPEX
• Goodwill – Considered as Intangible asset with indefinite life
• Incomplete Strategic Investments – Excluded from Capital
• Deferred Revenue Expenditures – Considered as CAPEX
• Deferred Taxes – Excluded while calculating NOPAT
• Marketable Securities – Excluded from Capital Employed and NOPAT
BCG Approach
• Two Metrics chosen
• Total Shareholder Return
• {Dividend + (End MVOE – Beg MVOE)} / Beg MVOE
• Total Business Return
• {Free Cashflow for Firm + (End MVOF – Beg MVOF)} / Beg MVOF
• Cahflow Return on Investment (CFROI)
• Ratio of Sustainable Cashflow and Cash Invested in the Business
• (Cashflow – Economic Depreciation) / Cash Invested
• Cashflow is NOPAT + Accounting Depreciation
• Economic Depreciation = Future Replacement Cost of Assets * Sinking Fund Factor at cost of
capital.
• Return on Gross Investment (ROGI)
• Cashflow / Cash Invested
• Cahflow Value Added (CVA)
• Operating Cashflow – Economic Depreciation – Capital Charge on Gross Investment
Resource Allocation using BCG approach

Current
CFROI >
WACOC
Investigate Reinvest

Current
CFROI < Divest Investigate
WACOC

TBR < TBR >

Traget TBR Target TBR
Balance Score Card – Kaplan & Norton, 1992
• Financial (How are Investors • Customer
looking at us) Orientation (How
are customers
looking at us?)

Satisfaction
ROE; ROCE;
Index;
Cashflows
Market Share

% Revenue Employee
from New Productivity;
Products; Safety Index;
Employee Time Over
Suggestions; runs
• Innovation & Learning • Internal
(Can and Are we improving
to create more value in Business
future?) (What should
we improve?)
Balance Score Card Metrics are Related
ROCE (Financial)

Customer Loyalty
(Customer)

On-Time Delivery
Quality (Int Pro)
(Int Pro)

Process
Production
Executive
Employee Skill
Efficiency (Inno &
(Inno & Learn)
Learn)