Evaluating return on management

ACCOUNTANCY

Corporate financial reporting has two objectives. The first is to provide information necessary for evaluating managers in their stewardship function. The second is to provide information necessary for estimating the value of the company.

While making decisions, managers are expected to focus on 'firm value'. A company is said to be well-governed if it pursues the objective of enhancing 'firm value' while at the same time complying with laws, respecting the rights of all stakeholders and following norms of socially responsible and ethical behaviour.

The performance of a manager has to be evaluated on all these parameters, something which cannot be done using accounting information alone.

First, accounting information cannot capture qualitative aspects of governance. Second it cannot separate the manger's performance from the company's performance. A company's performance depends on many factors which are not controllable by the manager.

Accounting does not differentiate between controllable and uncontrollable events. In fact, it is difficult to distinguish between controllable and uncontrollable factors because efficient and effective managers respond to changes in the market and business environment much faster than less efficient managers.

Moreover they endeavour to change the course of events away from directions that would be unfavourable for the firm. Therefore, what appears to be uncontrollable to one set of managers might be controllable by another set of managers.

Moreover, financial reporting is primarily transaction-based reporting, although it is slowly moving towards event-based reporting. Due to these inadequacies of accounting information, the objective of 'evaluating managers in their stewardship function' has lost importance.

In view of the limitations of accounting measurements, investors and managers have rediscovered the value of economic profit as a performance metric. Stern Stewart and Co., a consultancy firm in the USA, has popularlised the concept of economic profit. In fact, Economic Value Added (EVA), the term that is commonly used for economic profit, has been trademarked by them.

Economic profit is measured as follows:
Economic profit = Invested capital × (ROIC "� WACC)
where ROIC represents return on invested capital and WACC represents weighted average cost of capital.

Economic profit measures the value created by a company during a particular year. If the ROIC of a company is higher than its WACC, it creates value and its economic profit is positive. If ROIC of a company is lower than its WACC, it destroys value and its economic profit is negative. If ROIC of a company equals its WACC, it neither creates nor destroys value and its economic profit is zero.

Stern Stewart & Co. suggests a large number of adjustments to remove weaknesses of GAAP. Let us take the example of research and development expenses. The GAAP does not permit recognition of R&D expenditure as an asset in the balance sheet.

However, companies operating in certain industries such as the pharmaceutical industry consider R&D expenditure as investment. Therefore, it is appropriate for those companies to recognise R&D expenditure as an asset and to amortise it over a reasonable period. Recognition of R&D expenditure as an expense for the year in which the expenditure is incurred results in understatement of invested capital.

Many companies disclose economic profit in their annual reports. However, most of them do not incorporate adjustments suggested by Stern Stewart and Co. It is argued that disclosure of EVA reassures investors that the management is focused on 'firm value'.

EVA is a refinement over accounting measures such as ROIC because it does not ignore the cost of equity and measures performance in terms of absolute value rather than as a ratio.

However, it also has significant limitation. First, it has a short-term focus. Economic profit is a good metric to evaluate year-to-year performance. However, it fails to provide long-term perspective. Therefore, use of this measure as performance metric may tempt the manager to pursue sort-term strategies ignoring long term strategies that are more attractive from the investors' perspective.

The alternative and better performance metric is market value added (MVA). It is the difference between the market value of a company's debt and equity and the amount of capital invested. If we assume that the market value of debt equals its book value, MVA is the difference between the market capitalisation and the book value of equity.

As managers are expected to create firm value, the MVA could be the ideal performance metric. However, MVA has a very serious limitation. It is subject to vagaries of the capital market.

Empirical research shows that although, in the long run, intrinsic value of a company gets reflected in the market value, in the short run market value often fails to reflect the intrinsic value of the company. The market often fails to understand and appreciate the long term strategy of the company.

Moreover, in the short run, market value is strongly influenced by the manager's ability to meet market expectations. Therefore, use of MVA might lead to short-termism. Moreover, if the manager's incentive is linked to MVA, the incentive may not be effective due to volatility of MVA.

The best performance metric is the intrinsic value of the company. At the end of each year the manager must present the value of the company before the board of directors. If the intrinsic value has increased, the manger has created value. If the manager destroys value, the intrinsic value will be reduced.

Use of intrinsic value as a performance metric will compel the manager to adopt long run perspective while formulating strategy. The manager will also get an insight into the validity of assumptions underlying various strategies. It will also help her to take remedial measures if required. But this will enhance the responsibility of the board.

First, while approving a strategy or implementation plan, it should understand the impact of the strategy or the implementation of the plan on the value of the company. It has to get deep into the assumptions to evaluate reasonableness of those assumptions. Bias in valuation is not unknown.

Valuation is based on future-free cash flows and the estimated discount rates. Neither the manager nor the board has a crystal ball which can predict the future correctly. Therefore, there is huge potential that the forecast about future cash flows and estimate of the discount rate will be affected by manager's bias. Usually managers are optimistic and underplay possible crisis or bad news. Moreover, they are tempted to share good news rather than the bad news. Therefore, the board has to examine validity of projections. The board can evaluate the valuation presented before it effectively only if it understands the business and it spends adequate time to carry out this responsibility.

While the use of intrinsic value as a performance metric serves the interest of the shareholders, it does not measure the manager's performance in protecting the interests of other stakeholders and in meeting the firm's social responsiveness and ethical behaviour.

These aspects of a manager's performance must be measured by additional, most probably qualitative metrics. The board must get involved directly in setting standards for social responsiveness and ethics.

The writer is professor, finance and control, IIM-C