What Does it Take to Create Corporate Value?

Michael C. Ehrhardt

University of Tennessee

Consider six familiar companies: Coca-Cola, General Electric, Wal-Mart, Merck, Microsoft, and Procter & Gamble. Think about their many differences. Procter & Gamble is a manufacturer; Wal-Mart is a retailer. GE is capital intensive; Microsoft uses very little capital. Merck depends upon successful R&D programs; Wal-Mart does very little R&D. Coca-Cola is very focused and competes in only a few business segments; Procter & Gamble and General Electric are diversified and compete in many segments. Microsoft and Merck sell high-tech product lines; Coca-Cola and Procter & Gamble sell consumable products.

Despite such differences, these companies do have much in common. They are all very successful and are leaders in their industries. In fact, all six are among the companies most admired by their own employees and by others in their industries, according to Fortune magazine’s Corporate Reputations survey (1). Sales for all six grew rapidly during the last decade, indicating that they understand how to create value for their customers. In addition, a recent article in Fortune notes that these companies have excelled at creating corporate value for their owners, as measured by the value of their stock (2).

All of these companies have created value for their customers, their employees, and their shareholders. What does it take to create value? There are three primary requirements. First, the CEO must set the appropriate ultimate objective for the company. In other words, a company can’t create value unless managers and employees consciously pursue this as an objective. Second, managers and employees must understand what causes the creation of value. Understanding the root causes of value creation enables senior management to choose the optimum strategic initiatives for the company. This understanding allows other managers to identify explicitly and communicate to their employees the links between their employee’s daily activities and the creation of value. Third, the compensation system must reward managers and employees for creating value.

The Ultimate Objective: Create Value for Owners

Creating value for owners, which is the same as maximizing the stock price, must be the ultimate objective. Quaker Foods states that: "Enhancing shareholder value-- by balancing current returns and investment in our future-- is our ultimate goal. But value creation doesn’t begin there. Value creation starts with the consumer and goes on to meet the needs of our trade customers, suppliers and employees. We’re not trying to figure out which value to pursue, but how to attain value for all."(3) In other words, creating value for customers, employees, and other stakeholders is a means to achieving the ultimate goal, which is creating value for owners.

There are two major reasons why creating value for owners must be the ultimate goal. If you loaned your car to a friend, wouldn’t you expect your friend to take care of the car? It’s no different with a company. The owners of the company have entrusted their property (i.e., the portion of their wealth that is invested in the company’s stock) to the managers of the company. As such, managers have an ethical responsibility to be good stewards of the owners’ property, just as your friend has an ethical responsibility to take care of your borrowed car.

Recent studies show that the stock ownership is more widely dispersed and is held by more individuals than ever before. Although it might not be obvious, the majority of stockholders for most companies are ordinary citizens, such as yourself, your neighbors, your parents, and your grown children. You might think that you or your parents don’t own stock, but most members of the work force own stock indirectly through pension funds, life insurance annuities, and mutual funds. So when the value of stock in a company is increased, many ordinary citizens will have more secure and enjoyable retirement years.

There is a second reason why creating value for owners should be the primary goal. Pursuing stock price maximization is the key to creating value for society. Capitalist economies pursue stock value maximization more so than communist or socialist economies. Casual observation suggests that the economies and living standards of communist (or formerly communist) nations fair poorly when compared with capitalist nations. This is true for companies as well as for countries. A recent global analysis of state owned enterprises that have been sold to private investors indicates that these companies have become more efficient in their use of assets, have generated more profit, and have actually increased employment, results that are good for society.(4)

Understanding the Sources of Stock Value.

Before senior management can choose strategies that create stock value and before other managers can identify the activities of their employees that create stock value, all managers and employees must understand the underlying cause of stock value. In other words, what causes a stock price to increase? Contrary to conventional wisdom, stock prices are not driven by changes in quarterly earnings. Instead, stock value is created by the ability of a company to generate cash flows now and in the future. Perhaps surprisingly, it is the growth in future cash flows that matters more than the current cash flows or earnings.

For example, investment in R&D hurts current earnings (and current cash flows), but R&D increases future cash flows. If the stock market were short sighted and cared only about the short term quarterly earnings, then the stock price would fall for companies that announce new R&D initiatives, since these programs definitely will decrease current earnings. However, studies show that stock prices actually increase for companies that announce new R&D efforts. In other words, future cash flows matter more than current earnings. In fact, short term earnings matter only to the extent that they reveal new information about the likelihood of growth in future cash flows.

Senior management must understand the importance of future cash flows relative to current earnings, and must develop strategies that lead to the greatest increase in corporate value. Other managers must understand how their own daily decisions and the activities of their employees and affect cash flows. Sometimes these relationships are not very obvious. For example, in a wholesale market with differentiated prices, a marketing manager might encourage sales in the distribution channel that has the highest profit margin. But if this particular channel requires the manager’s company to maintain higher levels of inventory, then it is possible that the higher profits don’t compensate for the greater negative cash flows associated with inventory management. Thus, selling in the high profit distribution channel might actually decrease the value of the company.

Only if managers understand the links between cash flows and their decisions will a company’s value increase.

Not only must managers understand how their decisions affect value, they must identify for their employees how their employees’ activities affect value. For example, in many businesses the retention of a customer is one of the best ways to increase future cash flows. Therefore, in some cases it makes sense to have a loss on a single transaction if that will lead to future transactions that generate cash flows. A classic example is that of the Nordstrom sales clerk who allowed a customer to return a tire, even though Nordstrom doesn’t sell tires. Nordstrom surely lost money on that single transaction, but it is likely that Nordstrom retained that customer, and that Nordstrom retained other customers who heard the story. The future positive cash flows of additional retained customers more than compensated for the loss on that single transaction. But this type of value increasing action on the part of an employee is possible only if employees understand the links between cash flows and their daily activities. Also, employee empowerment programs are much more successful when employees understand these links.

Creating the Right Compensation System

Even if the ultimate goal is clearly articulated and all managers and employees understand how their decisions affect cash flow, there is no guarantee that the company will create value. The third necessary ingredient is a compensation system that rewards the creation of value. At the senior level, it might be appropriate to link bonuses to stock prices, but this doesn’t work for privately held companies. Also, it doesn’t work very well for individual operating units within a company. In such cases, a measurement other than stock price is needed to determine whether an operating unit has created value.

Think back to the six companies. Each created wealth for its owners, and each achieved a high score in an internal performance measure called Economic Value Added (EVA^TM, a term trademarked by Stern Stewart Co.). Coca-Cola attributes much of its success to the use of EVA as an internal performance measure and as a part of compensation programs. In fact, many other companies, such as Briggs & Stratton, Eli Lilly, and Quaker Foods, also state that the use of EVA has been a major reason for their successes.

There is considerable evidence that many traditional accounting measures, such as earnings per share growth and sales growth, are not strongly related to either the stock performance or the long-term economic viability of a firm, due to two types of problems. The first type of problem is related to distortions caused by accounting procedures. For example, a company invests in R&D because it expects to generate long term future cash flows. However, R&D expenses must be subtracted from profit in the year in which they occur, even though the expected benefits come much later. In other words, the accounting rule causes a mismatch of costs and benefits for R&D. There are many other types of accounting distortions, and each can be adjusted to better reflect economic reality. Therefore, the first step in calculating EVA is to remove these accounting distortions. The result is a measure that can be called "Adjusted Accounting Profit."

The second type of problem occurs because accounting measures of performance do not always properly reflect the costs of using assets. For example, two firms might have identical sales and identical profits, but if one firm uses half as much machinery and inventory as the other firm but produces the same results, then it is clearly the better of the two firms. Other measures, such as return on assets, account for the book value of the assets, but they do not account for the cost of using the assets (this is a particularly serious omission for companies with large inventories). Therefore, the final step in calculating EVA is to take the previously calculated "Adjusted Accounting Profit" and deduct a "capital charge" for the use of assets such as machinery and inventory. The "capital charge" reflects the return that investors would expect on the money that is tied up in assets. If the "Adjusted Accounting Profit" is larger than this "capital charge", then EVA is positive. In other words, the firm has produced a return greater than the return expected by investors, and this extra return should be reflected in stock price.

It’s not necessary for a company to use the particular performance measure called "EVA"; there are other similar performance measures presently in use by many companies. However, it is necessary to choose a performance measure that incorporates the costs of using assets and that eliminates accounting biases that are inconsistent with corporate strategies.

How Can Your Company Create Value?

The first step is to explicitly articulate the pursuit of value as a corporate goal. The second step is to determine the links between value, strategy, and activities. For senior mangers, this means choosing strategies that are most likely to increase future cash flows. A corporate valuation model for the entire company, or for individual operating units, often is a very useful tool in making these decisions. For other managers, this means defining for their employees the links between the employee’s daily activities and the creation of value. Finally, the company should implement a compensation system that is consistent with the goal of creating value.

References

(1) See Fortune, March 6, 1995, pp. 54-67.

(2) See Fortune, December 11, 1995, p. 105-116.

(3) The Quaker Oats Company, 1993 Annual Report, p. 2.

(4) "The Record on Privatization," William L. Megginson and Matthias van Randenborgh, Journal of Applied Corporate Finance, Vol. 9, No. 1, Spring 1996, pp. 23-34.

This article was originally published by the Management Development Center at the University of Tennessee. For more information, contact Professor Ehrhardt or the Management Development Center:

Professor Michael C. Ehrhardt
University of Tennessee
Finance Department, SMC 424
Knoxville, TN 37996
423-974-1717 (Phone)
423-974-1716 (Fax)

e-mail address: mehrhard@utk.edu

web page: http://web.utk.edu/~finrev/ehrhardt.htm

Management Development Center
University of Tennessee
Stokely Management Center
Knoxville, TN 37996
423-974-5001 (Phone)

web page: http://mdc.bus.utk.edu