• Tweet

  • Mail service

  • Share

  • Save

  • Get PDF

  • Purchase Copies

  • Impress

The Idea in Cursory

Many firms sacrifice sustained growth for brusque-term financial proceeds. For example, a whopping fourscore% of executives would intentionally limit critical R&D spending just to encounter quarterly earnings benchmarks. Result? They miss opportunities to create enduring value for their companies and their shareholders.

How to cultivate the future growth your firm needs to succeed? Rappaport identifies x powerful practices. Beginning among them: Don't get sucked into the short-term earnings-expectation game—it just tempts you to forgo value-creating investments to report rosy earnings now. Some other practice: Ensure that executives bear the same risks of ownership that shareholders do—by requiring them to own stock in the business firm. At eBay, for example, executives take to ain company shares equivalent to three times their annual base of operations salary. eBay'southward rationale? When executives have significant pare in the game, they tend to make decisions with long-term value in mind.

The Idea in Practice

Rappaport recommends these additional practices to create long-term growth for your company:

  • Make strategic decisions that maximize expected futurity value—even at the expense of lower nigh-term earnings. In comparing strategic options, ask: Which operating units' potential to create long-term growth warrants additional capital investments? Which have limited potential and therefore should be restructured or divested? What mix of investments across operating units should produce the almost long-term value?
  • Comport assets just if they maximize the long-term value of your firm. Focus on activities that contribute most to long-term value, such as enquiry and strategic hiring. Outsource lower value activities such equally manufacturing. Consider Dell Estimator's well-chronicled direct-to-consumer custom PC assembly business model. Dell invests extensively in marketing and telephone sales while minimizing its investments in distribution, manufacturing, and inventory-carrying facilities.
  • Return excess cash to shareholders when there are no value-creating opportunities in which to invest. Disburse excess cash reserves to shareholders through dividends and share buybacks. You'll give shareholders a run a risk to earn better returns elsewhere—and prevent management from using the cash to make misguided value-destroying investments.
  • Advantage senior executives for delivering superior long-term returns. Standard stock options diminish long-term motivation, since many executives cash out early on. Instead, use . These options advantage executives only if shares outperform a stock index of the company'southward peers, non simply because the marketplace as a whole is ascent.
  • Reward operating-unit executives for adding superior multiyear value. Instead of linking bonuses to budgets (a practice that induces managers to lowball performance possibilities), develop metrics that capture the shareholder value created past the operating unit. And extend the performance evaluation period to at least a rolling 3-year cycle.
  • Advantage center managers and frontline employees for delivering superior performance on key value drivers they influence directly. Focus on iii to five leading value-based metrics, such as fourth dimension to market for new production launches, employee turnover, client retention, and timely opening of new stores.
  • Provide investors with value-relevant data. Counter short-term earnings obsession and investor uncertainty by improving the class and content of financial reports. Prepare a corporate performance statement that allows analysts and shareholders to readily understand the key functioning indicators that drive your company's long-term value.

It's go fashionable to blame the pursuit of shareholder value for the ills besetting corporate America: managers and investors obsessed with next quarter's results, failure to invest in long-term growth, and even the accounting scandals that have grabbed headlines. When executives destroy the value they are supposed to be creating, they near e'er claim that stock marketplace pressure made them practice it.

The reality is that the shareholder value principle has not failed management; rather, information technology is management that has betrayed the principle. In the 1990s, for instance, many companies introduced stock options equally a major component of executive bounty. The idea was to align the interests of management with those of shareholders. Just the generous distribution of options largely failed to motivate value-friendly behavior considering their pattern about guaranteed that they would produce the opposite result. To starting time with, relatively short vesting periods, combined with a belief that short-term earnings fuel stock prices, encouraged executives to manage earnings, practice their options early, and cash out opportunistically. The common practice of accelerating the vesting date for a CEO's options at retirement added yet another incentive to focus on short-term performance.

Of course, these shortcomings were obscured during much of that decade, and corporate governance took a backseat as investors watched stock prices rise at a double-digit prune. The climate changed dramatically in the new millennium, still, equally accounting scandals and a steep stock market decline triggered a rash of corporate collapses. The ensuing erosion of public trust prompted a swift regulatory response—most notably, the 2002 passage of the Sarbanes-Oxley Act (SOX), which requires companies to plant elaborate internal controls and makes corporate executives directly answerable for the accuracy of financial statements. Yet, despite SOX and other measures, the focus on short-term performance persists.

In their defense, some executives argue that they have no choice merely to adopt a short-term orientation, given that the average holding period for stocks in professionally managed funds has dropped from nigh 7 years in the 1960s to less than one yr today. Why consider the interests of long-term shareholders when there are none? This reasoning is securely flawed. What matters is non investor holding periods but rather the market's valuation horizon—the number of years of expected cash flows required to justify the stock price. While investors may focus disproportionately on near-term goals and agree shares for a relatively brusk time, stock prices reflect the market's long view. Studies suggest that it takes more than ten years of value-creating greenbacks flows to justify the stock prices of most companies. Management's responsibility, therefore, is to deliver those flows—that is, to pursue long-term value maximization regardless of the mix of high- and depression-turnover shareholders. And no i could reasonably argue that an absence of long-term shareholders gives direction the license to maximize short-term performance and risk endangering the visitor's future. The competitive mural, not the shareholder list, should shape business organization strategies.

The competitive landscape, not the shareholder list, should shape business concern strategies.

What practice companies have to do if they are to exist serious about creating value? In this article, I draw on my research and several decades of consulting experience to set out x basic governance principles for value creation that collectively will aid whatever company with a sound, well-executed business model to amend realize its potential for creating shareholder value. Though the principles will not surprise readers, applying some of them calls for practices that run securely counter to prevailing norms. I should point out that no visitor—with the possible exception of Berkshire Hathaway—gets anywhere near to implementing all these principles. That's a pity for investors considering, as CEO Warren Buffett's swain shareholders take found, at that place'southward a lot to be gained from owning shares in what I call a level 10 company—one that applies all ten principles. (For more than on Berkshire Hathaway'south awarding of the ten principles, delight read my colleague Michael Mauboussin's analysis in the sidebar "Budgeted Level 10: The Story of Berkshire Hathaway.")

by Michael J. Mauboussin

Do whatsoever companies in America make decisions consistent with all ten shareholder value principles? Berkshire Hathaway, controlled by the legendary Warren Buffett, may come the closest. Not merely is Buffett the company'southward largest shareholder, but he is also in the rare position of viewing the drivers of shareholder value through the eyes of a major investor and executive. He observes, "I'm a meliorate businessman because I am an investor and a amend investor because I am a businessman. If you have the mentality of both, information technology aids you in each field."1

In Berkshire'south communications, for example, Buffett makes it clear that the visitor does not "follow the usual practice of giving earnings 'guidance,'" recognizing that "reported earnings may reveal relatively fiddling about our true economic performance" (run into Principle 1). Instead, the company vows to exist "candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you lot no less" (Principle x).

Berkshire's capital letter resource allotment decisions, especially when earnings growth and value creation disharmonize, are also consonant with the shareholder value principle. Writes Buffett, "Accounting consequences practise not influence our operating or capital-allocation decisions. When acquisition costs are like, we much adopt to purchase $2 of earnings that are not reportable by us under standard bookkeeping principles than to buy $1 of earnings that is reportable" (Principles ii and three).

Shareholder-value companies recognize the importance of generating long-term cash flows and hence avoid actions designed to boost brusk-term functioning at the expense of the long view. Berkshire'south 2005 annual report explains the visitor'southward position: "If a management makes bad decisions in order to striking short-term earnings targets, and consequently gets behind the eight-brawl…, no amount of subsequent brilliance volition overcome the impairment that has been inflicted."

Berkshire is also exceptional with regard to its corporate governance and compensation. There's no uncertainty that Buffett's wealth and that of the company's vice chairman, Charlie Munger, rising and fall with that of the other shareholders: Berkshire stock represents the vast majority of their substantial cyberspace worth (Principle 9). Every bit Buffett notes, "Charlie and I cannot hope you results. Simply nosotros tin can guarantee that your financial fortunes will move in lockstep with ours for whatever menstruum of fourth dimension you elect to be our partner."

The company's compensation approach is also consistent with the shareholder value principle and stands in stark contrast to common U.S. compensation practices. Buffett's $100,000 almanac salary places him in the cellar of Fortune 500 CEO pay, where median bounty exceeds $eight million. Further, Berkshire is the rare company that does not grant any employee stock options or restricted stock. Buffett is not confronting equity-based pay per se, just he does argue that too few companies properly link pay and performance (Principle 6).

Buffett uses Geico, Berkshire's automobile insurance business, to illustrate the company'south compensation philosophy. The goals of the plan, Buffett explains, "should be (1) tailored to the economics of the specific operating business organization; (2) simple in graphic symbol so that the caste to which they are beingness realized can be hands measured; and (3) directly related to the daily activities of plan participants." He states that "nosotros shun 'lottery ticket' arrangements…whose ultimate value…is totally out of the control of the person whose behavior we would like to affect" (Principles 7 and 8).

And so far, Berkshire looks similar a complete level 10 value-creation company—ane that applies all ten principles. But information technology doesn't closely adhere to Principle iv (acquit but assets that maximize value) and has never acted on Principle 5 (render cash to shareholders). In both cases, nonetheless, Buffett and Munger's writings and comments advise that Berkshire evaluates its investments in light of these principles fifty-fifty if it doesn't straight apply them to itself.

Principle four advises selling operations if a buyer offers a meaningful premium to estimated value. Buffett states flatly, "Regardless of price, nosotros accept no involvement at all in selling any good businesses that Berkshire owns," noting that this attitude "hurts our financial performance."

And despite sitting on more than than $twoscore billion in backlog cash at year-finish 2005, Berkshire has not returned any cash to its shareholders to date. However, the company does utilize a clear test to determine the virtue of retaining, versus distributing, cash: Management assesses "whether retention, over time, delivers shareholders at least $one of market value for each $1 retained." This test, of grade, is a restatement of the core shareholder value concept that all investments should generate a render in backlog of the cost of upper-case letter. Consistent with Principle 5, Buffett is clear near the outcome of declining this test. He says, "If we achieve the point that we tin't create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds."

Buffett'south influence extends beyond Berkshire to companies for which he has served as a lath member. For example, the Washington Postal service and Coca-Cola were among the first companies to voluntarily expense employee stock options in 2002. Companies with which Buffett has been involved also accept a history of repurchasing stock.

1. Sources for quotations include Berkshire Hathaway's own publications and various public news outlets.

Michael J. Mauboussin is the chief investment strategist at Legg Mason Capital Direction, based in Baltimore. He is a shareholder in Berkshire Hathaway.

Principle 1

Do not manage earnings or provide earnings guidance.

Companies that fail to encompass this first principle of shareholder value will almost certainly be unable to follow the rest. Unfortunately, that rules out almost corporations because nearly all public companies play the earnings expectations game. A 2006 National Investor Relations Establish report constitute that 66% of 654 surveyed companies provide regular turn a profit guidance to Wall Street analysts. A 2005 survey of 401 financial executives by Knuckles University's John Graham and Campbell R. Harvey, and Academy of Washington'south Shivaram Rajgopal, reveals that companies manage earnings with more than than just accounting gimmicks: A startling eighty% of respondents said they would decrease value-creating spending on research and evolution, advertizing, maintenance, and hiring in lodge to come across earnings benchmarks. More half the executives would delay a new project even if information technology entailed sacrificing value.

What's so bad nigh focusing on earnings? First, the accountant's lesser line approximates neither a company's value nor its change in value over the reporting period. Second, organizations compromise value when they invest at rates beneath the cost of capital letter (overinvestment) or forgo investment in value-creating opportunities (underinvestment) in an attempt to boost short-term earnings. Third, the practice of reporting rosy earnings via value-destroying operating decisions or by stretching permissible bookkeeping to the limit eventually catches upward with companies. Those that tin can no longer come across investor expectations end up destroying a substantial portion, if non all, of their market value. WorldCom, Enron, and Nortel Networks are notable examples.

Principle 2

Make strategic decisions that maximize expected value, even at the expense of lowering nigh-term earnings.

Companies that manage earnings are almost spring to pause this second cardinal principle. Indeed, most companies evaluate and compare strategic decisions in terms of the estimated impact on reported earnings when they should be measuring against the expected incremental value of future cash flows instead. Expected value is the weighted boilerplate value for a range of plausible scenarios. (To calculate it, multiply the value added for each scenario by the probability that that scenario will materialize, then sum upwards the results.) A sound strategic analysis past a company's operating units should produce informed responses to three questions: First, how do alternative strategies affect value? Second, which strategy is most likely to create the greatest value? Third, for the selected strategy, how sensitive is the value of the near likely scenario to potential shifts in competitive dynamics and assumptions about technology life cycles, the regulatory environs, and other relevant variables?

At the corporate level, executives must as well address iii questions: Do any of the operating units have sufficient value-creation potential to warrant boosted capital? Which units take limited potential and therefore should exist candidates for restructuring or divestiture? And what mix of investments in operating units is likely to produce the nigh overall value?

Principle three

Make acquisitions that maximize expected value, even at the expense of lowering most-term earnings.

Companies typically create well-nigh of their value through day-to-day operations, but a major acquisition tin can create or destroy value faster than any other corporate activeness. With record levels of greenbacks and relatively low debt levels, companies increasingly use mergers and acquisitions to improve their competitive positions: M&A announcements worldwide exceeded $two.7 trillion in 2005.

Companies (even those that follow Principle 2 in other respects) and their investment bankers usually consider price/earnings multiples for comparable acquisitions and the immediate touch on of earnings per share (EPS) to assess the attractiveness of a deal. They view EPS accession equally practiced news and its dilution as bad news. When it comes to exchange-of-shares mergers, a narrow focus on EPS poses an boosted trouble on top of the normal shortcomings of earnings. Whenever the acquiring company's toll/earnings multiple is greater than the selling company'due south multiple, EPS rises. The inverse is also true. If the acquiring visitor's multiple is lower than the selling company's multiple, earnings per share turn down. In neither case does EPS tell us anything near the deal's long-term potential to add value.

Sound decisions near M&A deals are based on their prospects for creating value, not on their immediate EPS impact, and this is the foundation for the third principle of value creation. Direction needs to identify clearly where, when, and how it can accomplish existent performance gains by estimating the present value of the resulting incremental cash flows and and so subtracting the acquisition premium.

Value-oriented managements and boards also carefully evaluate the risk that predictable synergies may not materialize. They recognize the challenge of postmerger integration and the likelihood that competitors will not stand up idly by while the acquiring company attempts to generate synergies at their expense. If it is financially viable, acquiring companies confident of achieving synergies greater than the premium will pay cash and then that their shareholders will non take to surrender any anticipated merger gains to the selling companies' shareholders. If management is uncertain whether the bargain will generate synergies, it can hedge its bets by offering stock. This reduces potential losses for the acquiring company'south shareholders by diluting their ownership involvement in the postmerger company.

Principle 4

Carry only avails that maximize value.

The quaternary principle takes value creation to a new level because it guides the selection of concern model that value-witting companies will prefer. There are two parts to this principle.

First, value-oriented companies regularly monitor whether there are buyers willing to pay a meaningful premium over the estimated cash flow value to the visitor for its concern units, brands, existent estate, and other detachable assets. Such an assay is clearly a political minefield for businesses that are performing relatively well against projections or competitors only are clearly more than valuable in the hands of others. Yet failure to exploit such opportunities tin can seriously compromise shareholder value.

A recent example is Kmart. ESL Investments, a hedge fund operated past Edward Lampert, gained control of Kmart for less than $1 billion when it was under bankruptcy protection in 2002 and when its shares were trading at less than $1. Lampert was able to recoup almost his entire investment past selling stores to Home Depot and Sears, Roebuck. In improver, he closed underperforming stores, focused on profitability by reducing majuscule spending and inventory levels, and eliminated Kmart's traditional clearance sales. By the end of 2003, shares were trading at almost $xxx; in the following yr they surged to $100; and, in a deal appear in November 2004, they were used to acquire Sears. Quondam shareholders of Kmart are justifiably asking why the previous management was unable to similarly reinvigorate the company and why they had to liquidate their shares at distressed prices.

Second, companies can reduce the capital they employ and increment value in 2 ways: past focusing on high value-added activities (such as research, design, and marketing) where they enjoy a comparative advantage and by outsourcing low value-added activities (like manufacturing) when these activities tin can be reliably performed by others at lower cost. Examples that come to mind include Apple tree Calculator, whose iPod is designed in Cupertino, California, and manufactured in Taiwan, and hotel companies such as Hilton Hospitality and Marriott International, which manage hotels without owning them. And and then at that place's Dell'southward well-chronicled direct-to-customer, custom PC assembly business model, which minimizes the capital the company needs to invest in a sales force and distribution, every bit well as the need to carry inventories and invest in manufacturing facilities.

Principle 5

Return cash to shareholders when there are no credible value-creating opportunities to invest in the business.

Even companies that base their strategic conclusion making on sound value-creation principles can skid upwardly when it comes to decisions about cash distribution. The importance of adhering to the 5th principle has never been greater: As of the first quarter of 2006, industrial companies in the Due south&P 500 were sitting on more than $643 billion in cash—an corporeality that is probable to grow equally companies continue to generate positive costless greenbacks flows at record levels.

Value-conscious companies with large amounts of backlog greenbacks and just limited value-creating investment opportunities return the money to shareholders through dividends and share buybacks. Non only does this give shareholders a chance to earn better returns elsewhere, only it as well reduces the risk that management will employ the excess cash to make value-destroying investments—in particular, ill-advised, overpriced acquisitions.

Just because a visitor engages in share buybacks, however, doesn't mean that it abides by this principle. Many companies buy back shares purely to boost EPS, and, just as in the case of mergers and acquisitions, EPS accretion or dilution has zippo to do with whether or not a buyback makes economic sense. When an firsthand boost to EPS rather than value cosmos dictates share buyback decisions, the selling shareholders proceeds at the expense of the nontendering shareholders if overvalued shares are repurchased. Especially widespread are buyback programs that starting time the EPS dilution from employee stock option programs. In those kinds of situations, employee selection exercises, rather than valuation, make up one's mind the number of shares the company purchases and the prices it pays.

Value-conscious companies repurchase shares just when the visitor's stock is trading below management's best estimate of value and no better render is available from investing in the business. Companies that follow this guideline serve the interests of the nontendering shareholders, who, if direction's valuation cess is correct, gain at the expense of the tendering shareholders.

When a company's shares are expensive and there's no adept long-term value to be had from investing in the business, paying dividends is probably the all-time option.

Principle 6

Reward CEOs and other senior executives for delivering superior long-term returns.

Companies demand constructive pay incentives at every level to maximize the potential for superior returns. Principles 6, 7, and 8 set out advisable guidelines for height, centre, and lower direction compensation. I'll begin with senior executives. As I've already observed, stock options were once widely touted as evidence of a good for you value ethos. The standard option, even so, is an imperfect vehicle for motivating long-term, value-maximizing behavior. Outset, standard stock options reward performance well beneath superior-return levels. As became painfully evident in the 1990s, in a ascent market, executives realize gains from whatsoever increase in share cost—even ane substantially below gains reaped by their competitors or the broad marketplace. Second, the typical vesting period of iii or 4 years, coupled with executives' propensity to cash out early, significantly diminishes the long-term motivation that options are intended to provide. Finally, when options are hopelessly underwater, they lose their ability to motivate at all. And that happens more than oftentimes than is more often than not believed. For example, nearly one-third of all options held by U. Southward. executives were beneath strike prices in 1999 at the meridian of the bull market. Just the supposed remedies—increasing cash compensation, granting restricted stock or more options, or lowering the exercise price of existing options—are shareholder-unfriendly responses that rewrite the rules in midstream.

Value-witting companies can overcome the shortcomings of standard employee stock options by adopting either a discounted indexed-option plan or a discounted disinterestedness gamble option (DERO) program. Indexed options reward executives just if the company's shares outperform the alphabetize of the company's peers—not simply because the marketplace is ascent. To provide direction with a continuing incentive to maximize value, companies can lower exercise prices for indexed options so that executives profit from performance levels modestly below the index. Companies can address the other shortcoming of standard options—property periods that are likewise short—by extending vesting periods and requiring executives to hang on to a meaningful fraction of the equity stakes they obtain from exercising their options.

For companies unable to develop a reasonable peer index, DEROs are a suitable culling. The DERO exercise toll rises annually by the yield to maturity on the 10-year U.S. Treasury note plus a fraction of the expected equity risk premium minus dividends paid to the holders of the underlying shares. Equity investors expect a minimum return consisting of the risk-free rate plus the equity risk premium. Merely this threshold level of operation may cause many executives to hold underwater options. By incorporating only a fraction of the estimated equity chance premium into the exercise price growth charge per unit, a board is betting that the value added by management will more than than beginning the costlier options granted. Dividends are deducted from the exercise price to remove the incentive for companies to hold dorsum dividends when they have no value-creating investment opportunities.

Principle seven

Reward operating-unit of measurement executives for adding superior multiyear value.

While properly structured stock options are useful for corporate executives, whose mandate is to raise the functioning of the visitor every bit a whole—and thus, ultimately, the stock price—such options are unremarkably inappropriate for rewarding operating-unit executives, who have a limited impact on overall performance. A stock cost that declines considering of disappointing performance in other parts of the company may unfairly penalize the executives of the operating units that are doing exceptionally well. Alternatively, if an operating unit does poorly but the company's shares ascension considering of superior functioning by other units, the executives of that unit will relish an unearned windfall. In neither case do pick grants motivate executives to create long-term value. Just when a visitor's operating units are truly interdependent can the share price serve as a fair and useful indicator of operating performance.

Companies typically have both annual and long-term (nigh often three-year) incentive plans that reward operating executives for exceeding goals for financial metrics, such as revenue and operating income, and sometimes for chirapsia nonfinancial targets as well. The trouble is that linking bonuses to the budgeting procedure induces managers to lowball performance possibilities. More than of import, the usual earnings and other bookkeeping metrics, particularly when used every bit quarterly and almanac measures, are non reliably linked to the long-term greenbacks flows that produce shareholder value.

To create incentives for an operating unit, companies demand to develop metrics such as shareholder value added (SVA). To calculate SVA, use standard discounting techniques to forecasted operating greenbacks flows that are driven by sales growth and operating margins, then subtract the investments made during the menses. Because SVA is based entirely on greenbacks flows, it does non innovate accounting distortions, which gives it a clear reward over traditional measures. To ensure that the metric captures long-term performance, companies should extend the performance evaluation catamenia to at least, say, a rolling three-year cycle. The plan can then retain a portion of the incentive payouts to cover possible hereafter underperformance. This arroyo eliminates the need for two plans past combining the annual and long-term incentive plans into 1. Instead of setting upkeep-based thresholds for incentive compensation, companies tin can develop standards for superior year-to-yr performance comeback, peer benchmarking, and even performance expectations implied past the share toll.

Principle viii

Reward middle managers and frontline employees for delivering superior performance on the primal value drivers that they influence straight.

Although sales growth, operating margins, and capital letter expenditures are useful fiscal indicators for tracking operating-unit SVA, they are besides broad to provide much day-to-24-hour interval guidance for middle managers and frontline employees, who need to know what specific actions they should have to increase SVA. For more specific measures, companies can develop leading indicators of value, which are quantifiable, easily communicated current accomplishments that frontline employees tin can influence directly and that significantly affect the long-term value of the business in a positive way. Examples might include time to market for new product launches, employee turnover rate, customer retention rate, and the timely opening of new stores or manufacturing facilities.

My ain experience suggests that nearly businesses can focus on 3 to 5 leading indicators and capture an of import function of their long-term value-creation potential. The process of identifying leading indicators tin can be challenging, only improving leading-indicator functioning is the foundation for achieving superior SVA, which in turn serves to increase long-term shareholder returns.

Principle 9

Require senior executives to behave the risks of ownership but every bit shareholders do.

For the virtually part, pick grants accept not successfully aligned the long-term interests of senior executives and shareholders considering the old routinely cash out vested options. The power to sell shares early may in fact motivate them to focus on near-term earnings results rather than on long-term value in gild to boost the electric current stock price.

To amend align these interests, many companies take adopted stock ownership guidelines for senior direction. Minimum buying is ordinarily expressed equally a multiple of base of operations salary, which is and so converted to a specified number of shares. For example, eBay's guidelines crave the CEO to own stock in the visitor equivalent to five times almanac base salary. For other executives, the corresponding number is three times salary. Tiptop managers are further required to retain a percent of shares resulting from the do of stock options until they amass the stipulated number of shares.

Merely in near cases, stock ownership plans neglect to betrayal executives to the same levels of take chances that shareholders bear. One reason is that some companies forgive stock buy loans when shares underperform, claiming that the system no longer provides an incentive for top management. Such companies, just as those that reprice options, take chances institutionalizing a pay delivery organization that subverts the spirit and objectives of the incentive compensation plan. Another reason is that outright grants of restricted stock, which are essentially options with an practise price of $0, typically count as shares toward satisfaction of minimum ownership levels. Stock grants motivate key executives to stay with the company until the restrictions lapse, typically inside 3 or four years, and they can cash in their shares. These grants create a strong incentive for CEOs and other top managers to play it safe, protect existing value, and avoid getting fired. Non surprisingly, restricted stock plans are usually referred to every bit "pay for pulse," rather than pay for performance.

In an effort to deflect the criticism that restricted stock plans are a giveaway, many companies offer performance shares that require not just that the executive remain on the payroll only also that the visitor achieve predetermined operation goals tied to EPS growth, revenue targets, or return-on-capital-employed thresholds. While performance shares practice demand performance, it's generally non the right kind of performance for delivering long-term value considering the metrics are ordinarily not closely linked to value.

Companies need to balance the benefits of requiring senior executives to hold continuing buying stakes and the resulting restrictions on their liquidity and diversification.

Companies seeking to ameliorate align the interests of executives and shareholders need to observe a proper balance between the benefits of requiring senior executives to have meaningful and continuing ownership stakes and the resulting restrictions on their liquidity and diversification. Without disinterestedness-based incentives, executives may become excessively adventure averse to avert failure and possible dismissal. If they own likewise much equity, however, they may also eschew risk to preserve the value of their largely undiversified portfolios. Extending the period earlier executives can unload shares from the do of options and not counting restricted stock grants as shares toward minimum buying levels would certainly aid equalize executives' and shareholders' risks.

Principle x

Provide investors with value-relevant information.

The final principle governs investor communications, such as a company'southward financial reports. Ameliorate disclosure non only offers an antidote to curt-term earnings obsession simply also serves to lessen investor uncertainty and then potentially reduce the cost of capital and increase the share price.

Ane way to practise this, every bit described in my article "The Economics of Short-Term Performance Obsession" in the May–June 2005 issue of Financial Analysts Journal, is to gear up a corporate operation statement. (See the exhibit "The Corporate Operation Argument" for a template.) This statement:

  • separates out greenbacks flows and accruals, providing a historical baseline for estimating a company'southward cash flow prospects and enabling analysts to evaluate how reasonable accrual estimates are;
  • classifies accruals with long cash-conversion cycles into medium and high levels of uncertainty;
  • provides a range and the most likely judge for each accrual rather than traditional unmarried-bespeak estimates that ignore the broad variability of possible outcomes;
  • excludes arbitrary, value-irrelevant accruals, such as depreciation and acquittal; and
  • details assumptions and risks for each line item while presenting key performance indicators that drive the company'southward value.

Investors demand a baseline for assessing a company's greenbacks catamenia prospects and a clear view of their potential volatility. The corporate performance statement provides a way to estimate both things by separating realized cash flows from frontward-looking accruals.

Operating cash flows.

The first part of this statement tracks only operating cash flows. Information technology does not replace the traditional greenbacks menses statement because it excludes cash flows from financing activities—new issues of stocks, stock buybacks, new borrowing, repayment of previous borrowing, and interest payments.

Revenue and expense accruals.

The second part of the statement presents revenue and expense accruals, which gauge future cash receipts and payments triggered by current sales and purchase transactions. Management estimates three scenarios—almost probable, optimistic, and pessimistic—for accruals of varying levels of uncertainty characterized by long cash-conversion cycles and broad ranges of plausible outcomes.

Direction discussion and assay.

In the tertiary department, management presents the company'southward business model, key performance indicators (both financial and nonfinancial), and the critical assumptions supporting each accrual estimate.

Could such specific disclosure bear witness too costly? The reality is that executives in well-managed companies already apply the type of information contained in a corporate performance statement. Indeed, the absence of such data should cause shareholders to question whether management has a comprehensive grasp of the business organization and whether the board is properly exercising its oversight responsibility. In the present unforgiving climate for bookkeeping shenanigans, value-driven companies have an unprecedented opportunity to create value only past improving the course and content of corporate reports.

The Rewards—and the Risks

The crucial question, of grade, is whether following these ten principles serves the long-term interests of shareholders. For well-nigh companies, the answer is a resounding yep. Just eliminating the practice of delaying or forgoing value-creating investments to meet quarterly earnings targets tin brand a significant difference. Further, exiting the earnings-management game of accelerating revenues into the current period and deferring expenses to hereafter periods reduces the risk that, over fourth dimension, a company volition be unable to meet market expectations and trigger a meltdown in its stock. But the real payoff comes in the difference that a true shareholder-value orientation makes to a company's long-term growth strategy.

For most organizations, value-creating growth is the strategic claiming, and to succeed, companies must exist good at developing new, potentially disruptive businesses. Hither'due south why. The majority of the typical company'due south share price reflects expectations for the growth of current businesses. If companies meet those expectations, shareholders will earn only a normal return. But to deliver superior long-term returns—that is, to grow the share price faster than competitors' share prices—management must either repeatedly exceed market expectations for its current businesses or develop new value-creating businesses. It'due south almost impossible to repeatedly beat expectations for electric current businesses, considering if you exercise, investors merely raise the bar. Then the merely reasonable way to deliver superior long-term returns is to focus on new concern opportunities. (Of course, if a company'southward stock price already reflects expectations with regard to new businesses—which information technology may practise if management has a track tape of delivering such value-creating growth—and so the chore of generating superior returns becomes daunting; it's all managers can do to come across the expectations that be.)

Value-creating growth is the strategic claiming, and to succeed, companies must be good at developing new, potentially disruptive businesses.

Companies focused on short-term performance measures are doomed to fail in delivering on a value-creating growth strategy because they are forced to concentrate on existing businesses rather than on developing new ones for the longer term. When managers spend too much fourth dimension on core businesses, they end up with no new opportunities in the pipeline. And when they go into trouble—every bit they inevitably practice—they accept footling selection but to try to pull a rabbit out of the hat. The dynamic of this failure has been very accurately described past Clay Christensen and Michael Raynor in their book The Innovator's Solution: Creating and Sustaining Successful Growth (Harvard Business School Press, 2003). With a piddling adaptation, it plays out like this:

  • Despite a slowdown in growth and margin erosion in the visitor's maturing cadre business, management continues to focus on developing it at the expense of launching new growth businesses.
  • Eventually, investments in the core tin no longer produce the growth that investors expect, and the stock price takes a hit.
  • To revitalize the stock cost, management announces a targeted growth charge per unit that is well beyond what the core tin can deliver, thus introducing a larger growth gap.
  • Confronted with this gap, the visitor limits funding to projects that promise very large, very fast growth. Appropriately, the visitor refuses to fund new growth businesses that could ultimately fuel the company's expansion but couldn't go big enough fast plenty.
  • Managers then respond with overly optimistic projections to gain funding for initiatives in large existing markets that are potentially capable of generating sufficient revenue speedily plenty to satisfy investor expectations.
  • To meet the planned timetable for rollout, the company puts a sizable price construction in place before realizing whatsoever revenues.
  • As acquirement increases fall curt and losses persist, the market again hammers the stock toll and a new CEO is brought in to shore it upwardly.
  • Seeing that the new growth business organisation pipeline is most empty, the incoming CEO tries to speedily stem losses by approving but expenditures that bolster the mature core.
  • The company has now come full circle and has lost substantial shareholder value.

Companies that accept shareholder value seriously avoid this self-reinforcing blueprint of behavior. Because they practice not dwell on the market place's near-term expectations, they don't await for the core to deteriorate earlier they invest in new growth opportunities. They are, therefore, more than likely to become first movers in a market and erect formidable barriers to entry through scale or learning economies, positive network effects, or reputational advantages. Their management teams are forward-looking and sensitive to strategic opportunities. Over fourth dimension, they become better than their competitors at seizing opportunities to achieve competitive advantage.

Although applying the ten principles will improve long-term prospects for many companies, a few volition withal experience problems if investors remain fixated on near-term earnings, because in certain situations a weak stock price can actually bear upon operating performance. The risk is particularly acute for companies such as high-tech start-ups, which depend heavily on a healthy stock price to finance growth and send positive signals to employees, customers, and suppliers. When share prices are depressed, selling new shares either prohibitively dilutes current shareholders' stakes or, in some cases, makes the company unattractive to prospective investors. Every bit a consequence, management may take to defer or scrap its value-creating growth plans. Then, as investors become enlightened of the situation, the stock cost continues to slide, perchance leading to a takeover at a fire-sale price or to bankruptcy.

Severely capital-constrained companies tin also be vulnerable, especially if labor markets are tight, customers are few, or suppliers are particularly powerful. A low share price means that these organizations cannot offer credible prospects of large stock-selection or restricted-stock gains, which makes it difficult to attract and retain the talent whose knowledge, ideas, and skills have increasingly become a dominant source of value. From the perspective of customers, a low valuation raises doubts most the visitor'south competitive and financial strength as well as its ability to proceed producing loftier-quality, leading-edge products and reliable postsale support. Suppliers and distributors may besides react by offering less favorable contractual terms, or, if they sense an unacceptable probability of financial distress, they may but refuse to do business with the visitor. In all cases, the company's woes are compounded when lenders consider the performance risks arising from a weak stock price and demand higher interest rates and more restrictive loan terms.

Clearly, if a company is vulnerable in these respects, then responsible managers cannot afford to ignore market pressures for short-term operation, and adoption of the ten principles needs to exist somewhat tempered. But the reality is that these extreme conditions do not use to most established, publicly traded companies. Few rely on equity issues to finance growth. Most generate enough cash to pay their top employees well without resorting to equity incentives. Almost as well have a large universe of customers and suppliers to deal with, and there are plenty of banks after their business organisation.

It's time, therefore, for boards and CEOs to footstep upwardly and seize the moment. The sooner you brand your business firm a level 10 company, the more you and your shareholders stand up to gain. And what ameliorate moment than at present for institutional investors to act on behalf of the shareholders and beneficiaries they correspond and insist that long-term shareholder value become the governing principle for all the companies in their portfolios?

A version of this article appeared in the September 2006 effect of Harvard Concern Review.