Will we ever find the financial Holy Grail?
Richard Phillips tracks company efforts to create new benchmarks for measuring performance
Sunday 26 January 1997
The question may seem daft, but there is a dawning realisation among some firms - and investors - that the routine calendar of quarterly, interim and final results, rounded off with a glossy report and accounts, may say very little about what is really happening in a business.
Of course, as a legal requirement, the report and accounts will never be ditched. But profit can be an elastic concept, to say the least, and has always been subject to manipulation. And the focus on year-on-year earnings per share (eps) growth espoused by many companies, especially in the Eighties, has often failed to guarantee future performance. Just look at some of the former high-flyers of the Eighties which lived and died by eps growth: Coloroll, Polly Peck, or on a less dramatic plane, Hanson.
Likewise, so what if return on capital has fallen below 10 per cent? The company may know why, but purely financial ratios say little about the causes, or, more importantly, what the company will do to improve matters. As an old adage has it, the financial figures are a way of driving using the rear view mirror.
In the UK, the gospel of better performance measurement has been seized on by management consultants; auditors too are getting in on the act, and The Foundation for Performance Measurement has been established to debate the issues. Robert Bittlestone, who helped establish the Foundation, says: "You would be surprised at how many businesses lack measures in areas of their business that are absolutely critical." He says, in many cases, it is "because it has always ticked along nicely, thank you, and it isn't until it is threatened that management realises it lacks sufficient information to support its decision-making process".
The Holy Grail of shareholder value was the starting point for many new attempts to measure how companies create wealth for their shareholders. Inevitably, most of these initiatives have been spawned in the US. As with all attempts to discover the secrets of success, however, quackery, faddishness, me-too-ism, and the search for the next quick-fix philosophy has often obscured the germ of a good idea.
Since shareholder value took off in the late Eighties, most companies and chief executive officers have paid lip service to the creed. But the Holy Grail is not all it is cracked up to be. At one level it is, after all, a statement of the blindingly obvious: that chief executives and their directors should seek to create value for their investors, not destroy it. As a term, it has always been slightly nebulous, but total shareholder return is the base line: capital gains plus dividends.
It is of course true that shares go up and down on the back of market cycles, but the broad aim of increasing share prices within those cycles is generally accepted.
How should a company work to maximise the return to shareholders? Individual companies can measure performance in their own ways. For example manufacturers can track quality, productivity and speed of delivery, while service companies can measure how long it takes for the phone to be answered.
But to be able to compare companies, we have to extract common elements for measurements. They do exist: in the stakeholder society, all groups within a company's ambit - employees, community, shareholders, suppliers and customers need - can have measures linking success and objectives.
For example, few would argue that good employee morale is an essential component of most successful businesses - ask any high-street retailer. But measuring that has been of little concern to many businesses, while it has also often seemed too difficult to pin down.
Honda, the car maker, was one company that saw it as critical. A few years ago, it introduced a solution for testing morale, on a regular, simple, and inexpensive footing. Once a month, employees are required to pick up a card as they report to work, fill it in, and drop it into a collection box.
On the card are three faces: a smiley face, no expression, and sad. The employee simply ticks the face that best expresses how he has felt over the past month at work.
It means Honda has a moving picture of how employee morale is changing, month by month. Often the dips follow events like production problems - but where there is no evident explanation, management can then talk to employees to discover and try and sort out the problem on the shopfloor.
Robert Bittlestone says instead of measures which rely solely on the financial information, companies should be trying to find measurements which relate more directly to their business. And they should set direct, simple goals which are readily understood, by investors, employees and any other audiences they have to construct a dialogue with.
Nor is the debate confined to the private sector. The upheavals in the public sector, for competitive tendering, the private finance initiative and the like, have all created a climate where better ways to measure performance and value for money are essential. The National Audit Office is working on a major exercise with government departments to figure out requirements for a new annual review of Output and Performance Analysis. The NAO's Gavin Lidderdale says it is early days, but the aim is similar to the private sector: better, more informed measurement gives a more informed view of the value for money in any project, and of setting targets for departments and agencies. The measures need not be purely financial.
Meanwhile, companies are trying to find ways of spreading the concept of shareholder value throughout their organisations. In one of the most direct and simple efforts, US household goods giant Procter & Gamble has taken the concept of total shareholder return as the platform for running all of its businesses, even at the shopfloor level. Two years ago, it embarked on a quest to bring the concept of TSR to all employees, including a 15-page booklet, titled, surprisingly enough, Employee Guide to Total
At a more sophisticated level, there is Economic Value Added, the progeny of management consultancy Stern Stewart, which has achieved a mantra-like status in the US. EVA - acronyms sprout rapidly in these waters - measures the difference between a company's after-tax operating profit, and the cost of the capital invested in the business. Stern Stewart, boasting a client list from the Fortune 500, is eagerly proselytising the wonders of EVA far and wide. One big attraction is its simplicity.
But some wonder if this is not just a rehash of historical financial information, and equally hamstrings companies when it comes to looking forward. GrandMet, the food and drinks giant, in its latest move, has set a target for return on capital.
"All well and good, but return on capital is a one-dimensional measure, and on its own is not enough," says Mr Bittlestone. And, of course, return on capital, dependent on profits, is open to short-term fudge. The company replies it is early days, and that refining the techniques used to assess strategy will continue for some time yet.
Zeneca, the pharmaceuticals group demerged from ICI, is among the UK companies that has sought a measure to link what, say, a research director may be doing, and the vagaries of the stock market. It has turned to Value Based Management. Instead of profitability, VBM relies more on cash- flow returns than on investment.
Laurent Condomine, chief planning officer of the group, says: "EVA was attractive, but we found different measures of profitability in different territories would have made it too complicated to introduce." It also failed to address the issue of how profits can be manipulated. It is relatively simple to cut R&D costs in one year - thereby boosting profitability. That, however, takes no account of the long-term benefit to a group such as Zeneca of its R&D investment.
Mr Condomine, however, is emphatic that Value Based Management is not the Holy Grail. "All it can be is one tool out of many, which can help you make decisions. But it cannot replace judgement."
Having decided over the past two years that VBM has been of real use at the higher echelons, this year will see it being rolled out as a tool for Zeneca management around the world. The theme is similar to efforts at other companies: to link management efforts more directly to the share price. John Allen, an associate of the consultancy, says the objective of EVA is to get management to think like owners. "A lot of measures: margins, earnings, or sales, are conflicting. EVA is a universal metric that everybody can use, so that people from the shopfloor all the way to the top can enforce its principles."
Stern Stewart is very keen to promote the long-term reliability of EVA, and its sister, Market Value Added - another Stern Stewart measure, of the difference between a company's market value, and the total capital invested - in guiding and helping to set future strategy. The firm denies that EVA fails to take account of cash: over the long-term, the impact of free cash flow to a business should equate to the long-term EVA in a business.
But companies can have a good EVA, or Market Value Added one year, and a disastrous one the next. One of the most glaring examples is British Gas which, according to Stern Stewart, was the 22nd best-performing company in the UK in 1995 judged by its MVA.
Sadly, for 1996, the company had collapsed to 468th out of 500 companies - a massive change over a relatively short period. The collapse reflected another disastrous year in the company's relationship with its regulator.
Stern Stewart believes that such matters are best left to the company to determine, although it claims issues such as employee morale are addressed by EVA, through its influence on remuneration.
City approval came from merchant bank Dresdner when Kleinwort Benson launched its "Tomorrow's Company" fund in November. "Tomorrow's Company" is an initiative of the Royal Society of the Arts, to raise the debate on management issues facing companies as they enter the new millennium. One of the core debates was performance measurement, and those areas which really drive the creation of shareholder value.
Paul Sheehan, the fund manager in charge of the fund at Kleinwort's, says the financial figures are not overlooked. "Quite the reverse," he says. "Financial information is examined rigorously, but we then look at customer satisfaction, and employee morale. EVA and the like is all well and good, but there is absolutely no evidence whatsoever that it is a guide to whether companies can sustain good performance. What we are looking for is the measures which really create added value and shareholder value over the long-term."
He will grill management over levels of staff turnover, or how the company handles environmental issues. "It's not just to be nice, but as a fuller understanding of their business risks," he emphasises.
That reflects the City's concern not to be tarred with the same brush as the moralists. But inside performance measures, there are also moral debates being explored. Performance measurement has been accused of being just another stick to beat employees with. However, it can also be a means of democratising a company. If employees are given the figures to manage themselves, it can often be a liberating experience, freeing them from the random tyranny of head office.
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