Are new valuation models are ready for prime time?
California winery Paul Masson made a splash with an ad campaign boasting the company 'will serve no wine before its time.' Delivered in a crisp, baritone voice-over by fabled actor and director Orson Welles, the advertisements became a cultural phenomenon and made Paul Masson a household name.
But it was the message and not the messenger that struck a chord with consumers. Through a simple seven-word line, the virtues of patience and craftsmanship rang clear. Left unspoken were the ramifications of what happens to a wine served before its time. One look at the arched-eyebrow of the formidable Welles after sniffing an offending competitor's bubbly in one memorable ad left viewers in no doubt of the horrors that awaited wine aficionados.
There's a lesson in the Masson advertisements for corporate finance professionals. Case in point: the current campaign to supplant traditional modes of gauging corporate value, like price-to-earnings, with newer, relatively untested methods like economic value added (EVA) and cash flow return on investments (CFROI). Developed by New York consulting firm Stern Stewart, EVA is basically the difference between a company's post-tax operating profit and the cost of capital invested in the business. Companies tie EVA goals to executive compensation and then sit back and watch as senior managers try to keep earnings in line with cost of capital, thus generating shareholder wealth. If the cost of capital rises, executive bonuses are in jeopardy. If it stays within preset parameters, then it's off to the Hamptons.
CFROI, championed by Holt Value Associates, a Chicago-based valuation consultant, is a return-on-investment benchmark that takes into account varying factors like inflation, asset-held time frames and a litany of different depreciation formulas. CFROI differs from EVA in that it compares a firm's cash flows with the inflation-adjusted capital used to generate those cash flows.
Another, more recent measure - market value added (MVA), also produced by Stern Stewart - takes the total capital of a firm, including equity, loans and earnings, and deducts that total from the firm's combined share capital and debt. The big accounting firms have taken notice: KPMG has a value-based plan similar to Stern Stewart's and Price Waterhouse offers a software package in Europe that identifies share price drivers. (Not surprisingly, Stern Stewart is making a killing by holding seminars on value-based systems and charging upwards of $1,000-per-head.)
'Why are different modes of valuation appearing with greater regularity?' demands Chris Dixon, a top analyst at PaineWebber in New York. 'Because we're all trying to come up with ways to calculate return on capital by looking at management policy.' Dixon, who says there are a multitude of ways to determine the cost of capital - the key to new-age valuations - adds that some forms of EVA work well in corporate environs because companies are used to dealing with cost of capital issues. 'EVA is terrific for developing benchmarks for internal measurements as to how a company is doing,' he explains. 'But it's somewhat unproved as a measure of the market. That's because the cost of equity to a company is equal to the expected return to the company's equity investors, and that expected return will vary depending on the stock price.'
Growing pains
Nonetheless, such 'Alphabet Soup' measuring sticks - or 'value-based pay systems' as many call them - are proving trendy as a method of gauging pure performance and pumping up shareholder value. Siemens, Coca-Cola and Proctor & Gamble, among others, have already climbed aboard the bandwagon and others are sure to follow.
But a strange thing has happened on the way to bigger year-end bonuses and fatter profits: reports from the corporate hinterlands are starting to trickle in and the returns are less than advocates of value-based pay systems might expect.
- At CSX Corp, the Richmond, Virginia-based transportation powerhouse, operating managers with EVA-influenced compensation schemes spent so much time trying to lure new business into the shop that a big, existing client left the company.
- AT&T's chairman Robert Allen, a frequent advocate for value-based systems, was forced to slash employment rolls and split his company into pieces after AT&T's stock underperformed in the mid-1990s. The company's EVA plan is reportedly now under review.
- Monsanto Corp, while an advocate and active user of EVA, is proceeding cautiously. The St Louis-based company is using a combination of EVA and CFROI in its new $3 mn compensation-plan program. In 1996, EVA only accounted for 10 percent of company bonuses.
Beating the rush
So why the headlong rush to value-based schemes? Many proponents believe that traditional valuation models adhering to basic accounting principles are archaic and easily manipulated. They complain that bedrock benchmarks like P/E ratios and cash flow don't present a true picture of a company's financial health, and thus render a disservice to shareholders. From an investor's vantage point, value-based advocates maintain, performance measures like EVA make senior executives much more accountable for company performance.
Bullfeathers, say the unconverted. 'We're reluctant participants in new valuation models,' explains Andrew Engel, a principal at the Minneapolis-based Leuthold Group, a research and money management group. 'We have data going back to 1926 and we still consider a lot of that data meaningful. For a limited time, I think, you can survive in overvalued markets using newer valuation models, but in the end P/E will come back and be meaningful.' Engel adds that his company uses 170 different indicators and about 35 valuation measures that track market performance over 40 years. 'It might take a bear market, but EVA will give way to P/E. The trouble with EVA is that it's all new stuff. There's no history there.'
Other valuation experts point out that valuation models like EVA and CFROI aren't new - they've actually been around in some manifestation for years. 'If you think about it, EVA was preceded by 'residual income', which basically meant earning a return equal to the cost of capital,' says Mark Ubelhart, practice leader for corporate finance and compensation at Lincolnshire, Illinois-based Hewitt Associates. 'Critics disparage EVA as being rebottled wine, but it does stem from fundamental economics.'
Independent thought
Ubelhart advocates a valuation approach that blends traditional formulas like P/E or earnings before taxes and depreciation amortization (EBITDA) with old-fashioned, analytical know-how. 'What a good valuation consultant does is look at earnings multiples through a jewelry appraiser's magnifying glass. When you look at P/E ratios and see that one set of companies has higher P/E's than another group of companies - like when more growth exists or earnings are higher - you are taking some of these valuations onto a higher plain using your own expertise. A lot of analysts acknowledge that P/E isn't a magic bullet, but it works fine when you inject your own strengths and knowledge into the equation. The newer measures might be better, though we don't know that, but they are worse if they are not used right or are used without any intellectual thought involved. I think some people are being led down the wrong path.'
Hewitt is taking a novel approach to educating clients on shareholder value. Tapping actors at Chicago-based Second City, an improvisational comedy group that launched the careers of John Belushi, Dan Ackroyd, and Gilda Radner, among others, Hewitt hosts an all-day course called 'Creating Value' featuring skits of how employees at a local pizzeria learn how to create and measure value. The course borrows from varying valuation models: it uses forms of EVA to show how employees can directly impact company value and teaches them to think and act like owners. It also shows participants how to measure shareholder value using common measures such as total shareholder return, earnings per share, return on investment, and economic value added.
'I think the idea of employee ownership is increasingly prevalent in organizations today,' said Ubelhart. 'Employees collectively own more than six percent of all corporate equity and by the year 2000 over 25 percent of all publicly-traded companies will be more than 15 percent employee owned.' On that level alone, he added, it's a good idea to get employees thinking about shareholder value. In that sense, new models like EVA and CFROI are on the mark. But does that make the new measures better? 'I don't think so,' says Ubelhardt. Older measures like EBITDA can get you to the same place quite easily.
Does anybody want 'rebottled wine' when they can have the vintage with less of a chance of a hangover in the morning? EVA & Co might indeed be a powerful brew but, as Paul Masson might have said, it might have been served before its time. In the meantime, palatable performance measures like P/E and EPS will continue to flow.