Trimillennium Management; Values; Wealth Creation: The Era of Evaluation

TRIMILLENNIUM MANAGEMENT: WEALTH CREATION
The Era of Evaluation

By S. C. Condragunta

S.C. Condragunta, Consultant, Stern Stewart & Co. Amultitude of CEOs claim allegiance to the mantra of managing for shareholder value. Naturally, this raises the issue whether creating shareholder value is really all that it is being made out to be. Is the primary responsibility of the management in this millennium to maximise shareholder wealth by getting the stock-price as high as possible? Wouldn't such a single-minded approach to maximise shareholder wealth be socially and economically irresponsible?

Indeed, opponents of maximising shareholder value advocate that the true responsibility of the corporation is to balance the interests of all stakeholders, and that shareholders are not the primary claimants to the wealth created by business enterprises. Refuting this, thinkers like Milton Freidman and Peter Drucker have argued that the sole duty of business is to generate profits for shareholders. For Freidman, governments exist to meet civic needs, philanthropies to meet social needs, and businesses to meet economic needs. Thus, any business that strays from its objective of generating economic profits for shareholders duplicates the work of philanthropy or government, and is being inefficient in creating wealth.

Why should managers and boards of directors put shareholders ahead of other claimants? The obvious reason is because the shareholders own the place. But there are more compelling, and less obvious reasons to maximise shareholder wealth. Maximising shareholder wealth is the best way to effectively serve the long-term interests of all stakeholders. It is the only policy that is genuinely fair to employees and society. Maximising shareholder wealth is the action that, actually, takes Adam Smith's invisible hand out of the pocket and puts it to work, guiding scarce and limited resources of society to their most productive and highly-valued uses. Business is the greatest engine of wealth-creation in society, and the process of creating shareholder wealth is the same as that which creates greater wealth for everyone in an economy. Creating wealth is the only real source of social security.

Managers can't create shareholder wealth by disservicing other stakeholders. This is because, as economist Ronald Coase pointed out, the business firm is nothing more than a nexus of contracts. Written or implied, these are covenants between the company and its stakeholders. Labour, management, and suppliers come together voluntarily, and use capital put up by investors to create the products that customers buy. If the management of the company deals shabbily with any constituency-that is, if it violates a contract-the victim will simply stop volunteering.

Managers have another reason to put shareholders first. All corporations, regardless of what they produce and where they produce it, have to compete for capital. A company's ability to acquire capital at attractive prices depends on how well it performs as a steward of the capital it already has. It is now imperative for companies to achieve higher returns for their shareholders. Not being able to do so will choke off the capital supply a company needs, and its shares would trade at a discount.

Because creating shareholder value is the fundamental goal of every corporation, measuring corporations on the basis of value-created is the objective measure of their overall performance. The best measure of wealth-creation is Market Value Added (MVA). MVA is an absolute measure of wealth-creation, and is obtained by subtracting the economic capital of a corporation (book capital after adjusting for accounting anomalies) from its total market value (MVA = Market Value--Capital). Because MVA represents the value added by management to the resources provided by the investors of the firm, it is the significant summary assessment of corporate performance.

Maximising shareholder wealth is not the same as maximising the company's total market value. Absolute market value or changes in it are not the best measures since a company can, theoretically, increase its value by just increasing its capital-base. Earnings are a flawed measure since one can gain a rise in earnings even by inefficiently employing huge amounts of capital. The right question to ask is: how productively has the corporation used all its capital and resources?

While MVA is the best measure of corporate performance, it is not useful as a tool for wealth-creation since the absence of specific market-values for divisions within a company implies that one cannot identify MVA for divisions within a company. Moreover, the daily volatility of share-prices would result in daily changes in MVA, and preclude it from being an effective management tool. Economic Value Added (EVA) is the parameter that best explains changes in the MVA of a company. Industry studies have shown a remarkable 70 to 80 per cent correlation between MVA and EVA. Simply put, EVA is the net operating profits after tax of a business minus a charge for the economic capital employed. The cost of capital is the weighted average of the after-tax costs of debt and costs of equity employed. Improving the period-by-period EVA results in improvements in MVA, and adds to shareholder wealth-creation.

EVA is more than just a financial performance- measure. Its real purpose is to serve as the centrepiece of an integrated management and compensation-system. Improving EVA becomes the focal point of an integrated management system-one that unites the various fiefdoms and functions within a company, and makes them accountable to the creation of lasting shareholder value. Measures like customer satisfaction, employee morale, quality, and productivity are vital value drivers for an enterprise. Only by improving upon them can a company maximise its EVA. Successful EVA companies have identified the value-drivers in their business and linked them back to their EVA. And they have developed these links in ways that do not send conflicting signals against the overall pursuit of wealth-creation.

In addition to these links, a long-term vision develops among the employees of EVA companies because of the EVA bonus programme. An EVA-based incentive plan rewards employees for the current and the cumulative rise in EVA over time with a performance-based bonus. This serves to keep everyone focused on longer-term value-building rather than trying to game the system through short-term efforts. Thus, an EVA system, by providing an integrated decision-making framework, can refocus energies and redirect resources to create sustainable value for companies, customers, employees, management, shareholders, and society.

S.C. Condragunta is the CEO (India) of Stern Stewart & Co.

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