Finance - 4 short answer questions

Article 1

The Past Performance and Future Value of Companies

What is the best measure of shareholder value? It depends on what you are measuring and which measure’s

components you believe most (or disagree with less).

BY PETER SCHUSTER, PH.D., AND MEL JAMESON, PH.D.

The concept of shareholder value has been one of the driving forces in the change of current management practice. Since its introduction,1 the shareholder value movement has spread steadily and with growing impact, influenced by the globalization of business.2 Recent years have seen attempts to incorporate the shareholder value idea into the tools of management and financial analysis. Thus, traditional accounting numbers, such as return on investment, earnings per share, and operating profit, have been augmented by “new” measures and ratios such as Economic Value Added (EVA®), Economic Profit, Cash Value Added, or Added Value.

In this article we compare these four measures by the way they incorporate the idea of shareholder value, their flexibility in application to the valuation of companies and measurement of financial performance, and their adaptability to the particular circumstances of a variety of companies.

In varying ways and to varying degrees, these measures attempt to mimic the components of the shareholder value computation. In essence, shareholder value, as a financial measure, represents the present value of all future payments to an investor—that is, the present value of the forecasted future cash flows,3 including increases in the value of the business. Thus, the two key elements of any approximation to shareholder value will be some measure of these payments and a discount rate. A central element of the discussion of each value measure is its derivation of these quantities.

Management decisions—specifically investment, financing, and operating decisions—affect shareholder value through their influence on such value drivers as value growth duration, operating profit margin for the cash flow from operations, or the cost of capital These value drivers connect to the valuation components through the shareholder value network.4 Ideally, then, financial measures should be useful for the assessment of past managerial performance as well as current corporate value. For this reason, the usefulness of

each measure is considered both a “backward-looking” measure of managerial performance and a “forward- looking” measure of corporate value based on present value of anticipated cash flows.

Merging these outlooks is consistent with the maxim of “value-based management” that has become a catch- phrase in recent years. In the mid-1980s, companies like Coca-Cola began “value reporting” with the goal of quantifying shareholder value created. This practice has become one of the more influential developments in management theory and practice,5 linking the external with the internal view of management and identifying drivers of corporate value.

SHAREHOLDER VALUE APPROACHES Before proceeding to a detailed description of each of the four measures, we need to present a comparative overview. Table 1 lists the four measures we analyze.

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The basic idea underlying all these approaches is as simple as it is convincing: Value to the shareholders is achieved only when the residual measure of (adjusted) profit minus the cost of capital is positive—that is, when “profit” exceeds the cost of capital. The approaches differ, however, in the ways they form the basic elements needed to calculate the key measure(s), specifically measures for adjusted profit, capital (operating assets), rate of return, and cost of capital. Additional distin- guishing features of the measurements are the calculation formula, the possible inclusion or exclusion of stock prices in the financial analysis, and, of course, the appli- cation of the various financial ratios. Also, there is a difference between past- and future-oriented measure- ments. The first is the basis for financial performance measurement,10 while the latter is typically used for the valuation of a company.

One type of financial performance measurement is the so-called Economic Model. It represents accounting data seen through the eyes of the shareholder. Another type is the so-called Accounting Model, which provides the creditor’s view.11 Stock prices also provide helpful information in the analytic assessment of a company’s performance. Although they are not complete or fully explanatory indicators, they can still enrich the analysis. Table 2 compares the Economic Model and Accounting Model past and future and various other common financial ratios. We also show whether or not each permits inclusion of stock prices in the financial analysis.12

Some models and approaches are not intended for both forward- and backward-looking applications. The popular discounted cash flow method is designed for multiperiods and future-directed valuation only. The Added Value model is only for financial performance measurement. The approaches by Stern Stewart & Co., McKinsey & Co., and the Boston Consulting Group, as well as other approaches discussed here, can be applied either way. Note that the EVA approach has a distin- guishing feature: It permits the inclusion of capital market prices through the use of the closely related Market Value Added (MVA)13 ratio to provide a comparison based on market valuation. EVA also differs from the other measures in that it can be used for past and future, Cash Value Added, cash flow return on investment, and Economic Profit because it allows a more detailed and thorough adjustment and conversion from the Accounting Model data to the Economic Model data.

Next we illustrate how the four competing share- holder value measurements are calculated.

ECONOMIC VALUE ADDED The Economic Value Added approach14 uses the following basic elements to calculate its key measure(s):

• Adjusted profit = net operating profit after tax (NOPAT)

• Capital (or operating assets) = capital or net operating assets (NOA)

• Rate of return = r • Cost of capital = c*

NOPAT is intended to measure profit from business operations only. Specifically, these adjustments and conversions remove, as much as possible, the effects of investments for other than business purposes, e.g., influ- ences unrelated to regular business activities.15 Also, funding conversions aim to standardize the impact of hidden funding features.16 The tax conversions calculate the theoretical tax burden that would be borne by the company were it exclusively financed by equity and earning profits only from its business activities. Thus it

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Article 1. The Past Performance and Future Value of Companies

eliminates distortions of profit (and associated tax effects) resulting from interest payments and non-business components of profits. Shareholder value conversions17 remove further distortions caused by the reporting methods chosen for certain items on the balance sheet. Adjustments of the profit measure NOPAT are made in accordance with the asset measure: capital.

The internal rate of return, r, can be derived from NOPAT and capital: r = NOPAT/capital.

The cost of capital, c*, can be measured by the weighted average cost of capital. The weighted average cost of capital consists of the cost of equity and the cost of debt.18 At this point a circularity problem arises: The given mix of equity and debt affects the cost of capital and simultaneously must be set before the calculation.19

Then EVA can be calculated with two different equations:

• The so-called capital charge equation, which reports the difference between adjusted profit and cost of (total) capital: EVA = NOPAT - capital x c*, or

• The so-called value spread equation, which reports the spread between the rate of return and the capital costs, multiplied by the capital invested: EVA = (r - c*) x capital.

ECONOMIC PROFIT The Economic Profit (EP) measure, promoted by McKinsey & Co., has found application mainly in the measurement of financial performance. EP has a strong relationship to discounted cash flow methods. Its basic elements resemble those of the EVA approach, although the necessary conversions from the accounting data are far less intensive. In comparing EVA to EP, there’s a strong similarity in the basic calculation, with slight differences in the amount of conversions required, as mentioned, and in the definition of the capital ratio.

There are some differences between the two approaches.

The Economic Profit (EP) approach uses the following basic elements to calculate its key measure(s):

• Adjusted profit = net operating profit less adjusted taxes (NOPLAT)

• Capital (or operating assets) = invested capital • Rate of return = expected rate of return on

invested capital (ROIC) • Cost of capital = weighted average cost of

capital (WACC)

NOPLAT20 can be defined as free cash flows plus net investment. McKinsey & Co. recommends using the weighted average cost of capital to estimate the cost of capital. The capital asset pricing model or the arbitrage pricing model is used to calculate the cost of equity. Problems in the application of these methods are mentioned in the context of the theoretical correctness of each approach.21

NOPLAT is comparable to NOPAT but is based on free cash flows (referring to the discounted cash flow model). NOPAT, in contrast, is derived from the balance sheet. Invested capital consists of the working capital and the fixed assets—usually at book value but occasionally at market value when it is considerably higher than the book value. A central ratio in this approach is the return on invested capital (ROIC)—a key driver for free cash flow and thus corporate value. ROIC can be calculated by: ROIC = NOPLAT/invested capital.

The two equations are:

Capital charge: economic profit = NOPLAT - (invested capital x WACC)

Value spread: economic profit = (ROIC - WACC) x invested capital

ADDED VALUE The Added Value approach—in contrast to the other three approaches—was developed at a university, not at a consulting company. It is limited to measuring periodic financial performance and emphasizes the historic comparison of companies. Future valuation is not considered.

In contrast to the former two approaches, Added Value starts from value added to calculate added value. The connection between the two measures is:22

Added Value = Value Added - Labor Costs - Capital Charge = Operating Profit - Capital Charge.

The Added Value approach uses the following basic elements for the calculation of its key measure(s):

• Adjusted profit = operating profit • Capital (or operating assets) = capital employed • Rate of return = return on capital employed

(ROCE) • Cost of capital = normal cost of capital

Instead of book value, (inflation-adjusted) market values and replacement costs are approximated using a general inflation rate. Considering inflation in the profit and the capital measures can be seen as controversial because it requires additional effort, a general inflation rate can always be criticized, and the resulting profit measure then includes a component not based on business activities. Thus profit can now be considered distorted. Capital employed consists of net current assets and fixed assets (at replacement cost). The return on capital employed is calculated in the usual way, which is comparable to r (in EVA) and ROIC (in EP): ROCE = operating profit/capital employed.

In calculating Added Value, the authors from the London Business School prefer relative added value (rAV)23 to assess a company’s performance, where Relative added value (rAV) = Added Value/(labor costs + capital charge).

Dividing Added Value by the sum of labor costs and capital charge helps to make capital-intensive companies

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comparable with labor-intensive ones. In contrast to EVA and EP, the normal cost of capital is measured simply and clearly by using the risk-free rate of long-term government bonds. The circularity problem does not arise because a single interest rate is used for both equity and debt—that is, those two components are not considered independently. The capital charge equation (value spread does not apply) is:

Added Value = operating profit - (normal cost of capital x capital employed).

CASH VALUE ADDED The Cash Value Added (CVA) approach is marketed by the Boston Consulting Group. The chief application of Cash Value Added is valuation with cash flow return on investment as the main measure. It shows similarities to and builds on the Cash Flow Return on Investment (CFROI®)24 approach from HOLT Value Associates consulting company (which was acquired by Credit Suisse First Boston last year and merged with CSFB’s online research service). Cash Value Added also can be used for periodic analysis. Yet CFROI can be objec- tionable. The necessary estimation of replacement costs can be problematic because the expected service life assumed for fixed assets tremendously influences the results and because the assumption of constant cash flows during the whole investment cycle seems to be unrealistic. Consequently, CFROI and Cash Value Added are less unbiased than those key measures of the other approaches.

Similar to Economic Value Added, Cash Value Added is based on the belief that value is achieved only when total capital costs are exceeded by the gross cash flows. While this approach resembles EVA and EP in many respects, it presents many differences in the estimation of shareholder value. It links the cash value added to an excess of investment and cash flow rather than to the adjusted profit. It is the value gained measured on a cash flow basis.

The Cash Value Added approach uses the following basic elements to calculate its key measure(s):

• Adjusted profit = gross cash flow • Capital (or operating assets) = gross investment

base • Rate of return = cash flow return on investment

(CFROI) • Cost of capital = capital costs (cc)

Gross cash flow is the component replacing adjusted profit; gross investment base is the capital measure. The capital charge equation is not used, and the value spread equation takes the following form: CVA = (CFROI - capital costs) x gross investment. Value is added when CFROI exceeds capital costs. The CFROI represents the internal rate of return—that is, the time-adjusted rate that will produce a net present value of zero (considering the investment, related gross cash flows, and the net value of

nondepreciable assets). Gross cash flow is derived from the income statement and adapted by several adjust- ments—extraordinary and nonperiodic income, reserves, and provisions, where:

Net income (from income statement) + extraordinary and nonperiodic income - expenses + adjustments in fixed assets + adjustments in reserves and accrued liabilities + adjustments of tax expenses. On this basis, depreciation, interest, capitalized

rental expenses, and inflation adjustments to the net liquidity positions are added. The gross investment base represents the amount of assets needed to generate the cash flow and is the total of the capital invested at the beginning of the year plus accumulated depreciation and inflation adjustments of fixed assets (in order to make historic investments comparable with today’s cash flow):

Gross investment base = net current assets + fixed assets + accumulated depreciation + inflation adjust- ments of fixed assets.

The cash flow return on investment,25 which is the described internal rate of return of the investment minus the cash flow profile, is derived from data about:

• Gross investment, • Expected service life of fixed assets, • Nondepreciable assets at the beginning of the

year, and • The “typical” gross cash flow of the period.

In order to compare and assess the rate of return of the four approaches, it is necessary to remember that the CFROI is based on a multiple-period idea so cannot be compared to r (in EVA), ROIC (in Economic Profit), or ROCE (in Added Value), which are all derived from a period-by-period view.

The capital costs in this approach, cc, are estimated in an unusual way: The Boston Consulting Group suggests defining interest rates per country—that is, they are estimated for the fictitious “country xy Inc.,” derived from estimated CFROI rates of about 60 companies from that country. From “country xy Inc.” a standardized cash flow projection is made, and the resulting value is compared to the market value represented by capital market stock prices. Then the capital costs, cc, are calcu- lated as the interest rate that will lead to the actual capital market valuation if the estimated future typical gross cash flows are discounted by that rate. Thus the capital charge equation is not applicable because the profit measure in this approach, the gross cash flow, is of minor importance. The main target is to calculate the CFROI as the internal rate of return.

COMPARING THE FOUR APPROACHES As we wrote at the outset, measures such as those considered here can be used either as a forward-looking company valuation or backward to measure financial performance. For an additional financial evaluation,

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MVA ex post and MVA ex ante can be calculated. The MVA ex post is the difference between the total value of a company and the total capital invested, or accumulated goodwill of the company at a specific time. A positive MVA ex post is an indicator of value generated in the past. To compare this to our other methods, note that EVA, for example, is the value generated during a specific period. Thus, a comparable future-oriented valuation measure, MVA ex ante, may be defined as the discounted value of future EVAs. The analysis can be further enriched by considering additional ratios building on EVA (repre- senting liquidity), such as relEVA,26 the value spread (for the risk-adjusted return of capital), or EVA/ROS27 (for the attractiveness of growth).

Now we will compare the backward-looking use of the four approaches as measures of financial performance using an example based on fictitious and simplified data.28 The key measures are Economic Value Added, Economic Profit, Added Value, and Cash Value Added. The cost of capital and rate of return are calculated to illustrate the procedure and to permit a basic assessment of the competing models. We cannot show the complexity of the conversions associated with the Economic Value Added method in this small example, but we included part of it to facilitate a comparison of the different approaches.

The example is based on several simplifying assump- tions: No investment was made before the year 2002, so starting fixed assets are zero. This implies no historical costs need be adjusted for inflation and no cumulative depreciation need be considered. The assumed financial information underlying the example is reported in Table 3.

EVA NOPAT removes from taxes the effects of expenses or income from nonbusiness activities. (In the example, the financial income of-80 resulted in a tax deduction of 40.) Thus, in the example:

• NOPAT = 380 - 150 - (50% of 80) = 190. The operating income of 380 is reduced by theoretical

tax expenses totaling 190, which consist of the reported taxes on income (150) + tax shields of 40 (50% of 80). Conceptually, the theoretical tax is the payment that the company would have had to make if all of its income came from business activities and it were completely financed by equity.

Capital excludes marketable securities and is, in the example:

• Capital = 450 + 500 = 950. It is also possible to calculate this quantity as the

arithmetical mean of capital with and without marketable securities (= 1,050). This substitution would also affect the subsequent measures.

The internal rate of return is: • r = NOPAT/capital = 190/950 = 20.0% (or, if the

The cost of capital, c*, is estimated using the weighted average cost of capital method. In addition to assumptions about interest rates, the strong simplifying assumption of a target mix of 70% equity and 30% debt is applied:

• Interest rate on debt: 5%, equity rate: 8%, tax: 50% • Therefore, c* = 8% x 70% + 5% x 50% x 30% = 6.4%

Because the profit measure NOPAT looks at the after-tax situation, the tax deductibility of interest must be considered in evaluating the cost of debt, in the

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example: 50% of 5%. Thus, the weighted average, c*, comes to 6.4%.

The two equations are: Capital Charge equation

• EVA = NOPAT - capital x c* • EVA = 190 - 950 x 6.4% = 129.20

Value Spread equation • EVA = (r - c*) x NOA • EVA = (20% - 6.4%) x 950 = 129.20

ECONOMIC PROFIT The profit measure NOPLAT is based on the operating free cash flow (FCF), the difference between operating income and expenses. Adjusted cash flow affecting taxes and gross investment in working capital and fixed assets is deducted. It is:

• FGF = 2,700 - 2,100 - 150 + 50% x (- 80) - (600 - 500) - (450 - 450) - 220 = 90

• NOPLAT = FCF - depreciation + gross investment,

or • NOPLAT = FCF + net investment • NOPLAT = 90 + (600 - 500) - (450 - 450) = 190 (=

NOPAT in the EVA approach)

Invested capital is based on book value,29 as intensive conversions are not usual in this approach. Invested capital is built on the arithmetic mean, which leads it to differ from the capital measure of the EVA approach.

• Invested capital = the arithmetic mean of fixed and current assets (without marketable securities)

• Invested capital: (600 + 500)/2 + (450 + 450) 2 = 1,000

The return on invested capital gains a central position in the McKinsey approach and can be calculated in this example in a manner similar to the r (of EVA):

• ROIC = NOPLAT/Invested capital • ROIC = 190/1,000 = 19.0%

The cost of capital is, in principle, derived using the weighted average cost of capital (WACC) method, with the equity cost determined by the capital asset pricing model, arbitrage pricing theory, or by using special bond rates. In the example, the calculation is made as in the EVA section:

• WACC = 6.4% Thus, the two equations are: Capital Charge equation

• Economic profit = NOPLAT - (Invested capital x WACC)

• Economic profit = 190 - (1,000 x 6.4%) = 126 Value Spread equation

• Economic profit = (ROIC - WACC) x invested capital

• Economic profit = (19.0% - 6.4%) x 1,000 = 126

ADDED VALUE The profit measure operating profit considers inflation to maintain the real value of assets. It thus requires an involved side calculation shown as Table 4. In addition, the London Business School suggests that inflation is adjusted to convert assets to fixed terms.

The resulting key figure is calculated as:

• Operating profit (position 18): 184.39 • Capital employed (position 22): 1,054.71

As previously noted, one assumption of this example is that there were no investments before year 2002— that is, the amount 500 + 200 = 700 equals the new investment in 2002. The depreciation on inflation-corrected value is calculated by applying the depreciation rate (depreci- ation/fixed assets before depreciation of the previous year, in the example, 28.57%) to the 2.0% price increase (position 2). The new value of fixed assets in 2002 can finally be calculated: 510 x 0.02/1.02 = 10.0. Investment for the present year (positions 6 - 10) can be computed analogously.

Operating profit (position 18) differs from NOPAT by an increased depreciation of 21.89 (positions 15 and 16) and a revaluation of fixed assets leading to a growth in asset value of 16.27. This “profit,” however, is not free of controversy. Although it leads to the consistency between profit and the asset measure, it can be stated that part of the profit is not caused by business activities but by inflation adjustments.

The capital employed is shown in position 22 and is measured at the end of the observed period. The return on capital employed can be calculated by:

• ROCE = operating profit/capital employed • ROCE = 184.39/1,054.71 = 17.48%

The normal cost of capital in this example is taken from the risk-free long-term government bond rate with:

• Normal cost of capital = 5.0%

The calculation of Added Value can only be done using the capital charge equation:

• Capital charge = normal cost of capital x capital employed

• Capital charge = 5.0% x 1,054.71 = 52.74 • Added Value = operating profit - capital charge • Added Value = 184.39 - 52.74 = 131.65

CASH VALUE ADDED The calculation of Cash Value Added from the Boston Consulting Group mainly targets the investment and the resulting cash flow using cash flow return on investment as the key measure rather than concentrating on the profit measure. Gross cash flow cannot be regarded as compa- rable to the profit measures in the other approaches. In the example it is:

• Gross cash flow: 150 - (-80) + 220 - 2% of 450 = 441

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Article 1. The Past Performance and Future Value of Companies

The gross investment base represent the assets at the beginning of the year plus accumulated depreciation and inflation-adjusted fixed assets (in order to have a compa- rable basis between former investment and present cash flow). It is:

• Gross investment base: 600 + 450 + 220 + 200 + (700 x 1.022) - 700 + (600 - 500 + 220) x 1.02 - 320 = 1,504.68

The cash flow return on investment, being the time- adjusted rate that will produce a net present value of zero, involves the problem that a “typical” gross cash flow is used. In the example, this is the gross cash flow of the observed year 2003. It depends on the expected service life of the fixed assets, which is six years in the example.

In making comparisons, remember that CFROI results from a more periodic view in contrast to r (EVA). ROIC (Economic Profit), or ROCE (Added Value).

The CFROI can be calculated as seen in Table 5:

• CFROI = 21.15%

The capital costs are estimated for the fictitious “country xy Inc.” derived from the standardized cash flow projection compared to the market value repre- sented by capital market stock prices. In this example, an interest rate of 6.0% is assumed.30

The capital charge equation cannot be applied in the Cash Value Added approach. The value spread equation in the example is:

• Cash Value Added = (CFROI - capital costs) x gross investment base

• Cash Value Added = (21.15% - 6.0%) x 1,504.68 = 227.96

See Table 6 for a summary of the comparisons. Table 7 compares selected features of the four

approaches.

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MAJOR RESULTS OF THE COMPARISON As we noted at the beginning of this article, these measures can be applied either in a forward-looking manner for company valuation or in a backward-looking manner to assess financial performance. Because a clear distinction usually is not made between the two views of these approaches and can hardly be found in the literature, we believe that our noting this distinction as illustrated in our example may be viewed as a valuable contribution.

The EVA approach can be adapted for either forward- or backward-looking measures, while some of the other approaches focus on one or the other. For example, discounted cash flow methods (not included here) focus only on valuation. Economic Profit, too, is mainly concerned with valuation (performance measurement can be carried out only indirectly through the CFROI ratio). The Added Value approach is suited only for performance measurement. Only the EVA approach envisions the use of stock price data to assist in valuation through the inclusion of the further ratio, Market Value Added.

The Added Value and Cash Value Added approaches are somewhat distinctive in that they incorporate inflation adjustments but exclude depreciation in their asset and profit measures. These features can be controversial and preclude comparison of the results with those of other models. These two approaches also use strictly simplified estimates of the cost of capital that may limit the accuracy or application of their results. The Cash Value Added approach is also unique in that it takes a more periodic view. It requires the assumption of a constant cash flow and a preset and known service life for fixed assets, so its key measures may not be comparable to those of the other approaches. Given these considerations, the highest overlap occurs between the Economic Value Added and Economic Profit approaches.

Finally, we observe that EVA requires the most intensive conversions so is better tailored to company-specific situa- tions, that it can be used for both backward-looking and forward-looking assessment, and that it estimates an appro- priate cost of capital, which is advantageous.

NOTES 1. Alfred Rappaport, “Selecting Strategies that Create Shareholder

Value,” Harvard Business Review, May–June 1981, pp. S. 139–149; Wil- liam F. Fruhan, “Studies in Creation, Transfer, and Destruction of Shareholder Value,” McGraw-Hill/Irwin, New York, N.Y., 1979.

2. In Europe it achieved recognition with a timely delay as the merg- ers-and-acquisition issue—and, for instance, hostile takeovers— played a minor role until the latter half of the last decade.

3. For a comparison of earnings vs. cash flows and their relevance for valuations in the context of Anglo-Saxon countries traditionally raising capital from the capital markets vs. some other countries traditionally raising capital from private sources, see: Eli Bartov, Stephen R. Goldberg, and Myung-Sun Kim, “The Valuation-Rele- vance of Earnings and Cash Flows: An International Perspective,” Journal of International Financial Management & Accounting, No. 2, 2001, pp. 103–132;

For testing the relevance of EVA vs. earnings, see Gary C. Biddle, Robert M. Brown, and James S. Wallace, “Does EVA Beat Earnings? Evidence on Associations with Stock Returns and Firm Values,” Journal of Accounting and Economics, December 1997, pp. 301-336; or

Stephen O’Byrne, “EVA and its Critics,” Journal of Applied Corporate Finance, No. 2, 1999, pp. 92–96.

4. Alfred Rappaport, Creating Shareholder Value, The Free Press, New York, N.Y., 1986, p. 76–77.

5. For further references, see Thomas M. Fischer, “Value Reporting,” Zeitschrift fuer Planung. Journal of Planning, December 2002, pp. 211– 216; or Robert G. Eccles, Robert H. Herz, E. Mary Keegan, and David M.H. Phillips, The Value Reporting Revolution, John Wiley & Sons, Inc., New York, N.Y, 2001.

6. Evan Davis and John Kay, “Assessing Corporate Performance,” Busi- ness Strategy Review, Summer 1990, pp. 1–16; or Evan Davis, Stefanie Flanders, and Jonathan Star, “Who Are the World’s Most Successful Companies?,” Business Review Strategy, Summer 1991, pp. 1–33.

7. G. Bennett Stewart, The Quest for Value, HarperBusiness, New York, N.Y, 1990.

8. Tom Copeland, Tim Koller, and Jack Murrin, Valuation, Second Edi- tion, John Wiley & Sons, Inc., New York, N.Y, 1995.

9. Thomas G. Lewis, Steigerung des Unternehmenswertes, Verlag Mod- erne Industrie, Landsberg, Germany, 1994.

10. About the link between financial performance measurement and strate- gic planning, see Anthony A. Atkinson, John H. Waterhouse, and Rob- ert B. Wells, “A Stakeholder Approach to Strategic Performance Measurement,” Sloan Management Review, Spring 1997, pp. 25–37.

11. Germany’s generally accepted accounting principles (GAAP) tradi- tionally emphasize the creditor’s view in slight contrast to the U.S. GAAP. With the internationally developing principles following a strong tendency to converge, the shareholder view meets growing popularity in countries such as Germany.

12. For a similar survey and explanations, see Stephan Hostettler, Eco- nomic Value Added, 4th ed., Haupt Verlag Bern, Stuttgart, Germany, 2001, pp. 34–37.

13. Market Value Added can be regarded ex ante as the net present value of future EVA or ex post as the difference between the market value of the company and the book value of assets. For MVA, see Stephen O’Byrne, “EVA® and Market Value,” Journal of Applied Corporate Finance, Spring 1996, pp. S. 116–125.

14. Trademarked by Stern Stewart & Co. 15. For example, tangible assets under construction or marketable se-

curities (current assets) are subtracted from the invested capital. 16. For example, noninterest-bearing liabilities and deferred tax re-

serves are deducted from liabilities and added to the so-called eq- uity equivalents. Capitalized leases—e.g., the present value of operating lease expenses—are added to the liabilities.

17. For example, adding unrecorded goodwill or the LIFO reserve to the equity equivalents.

18. Stern Stewart suggests the use of the capital asset pricing model to estimate the cost of equity.

19. This circularity problem can be resolved by an iterative procedure or by using a preset target combination of equity and debt. For fur- ther information, see Bernhard Schwetzler and Niklas Darijtschuk, “Unternehmensbewertung mit Hilfe der DCF-Methode—eine An- merkung zum Zirkularitaetsproblem,” Zeitschriftfuer Betrieb- swirtschaft, June 1999, pp. 295–318.

20. See Copeland, Koller, and Murrin, pp. 155–156. 21. See Copeland, Koller, and Murrin, p. 257. 22. For a similar illustration, see Evan Davis and John Kay, p. l. 23. A similar approach can be used with EVA, where relEVA is = EVA/

(labor costs + capital x c*). This is used as one of the additional ra- tios of the model.

24. CFROI was a trademark of HOLT Value Associates, LP, now Credit Suisse First Boston.

25. For an improved understanding of these calculations, see the illus- trative example in the article.

26. EVA/(labor costs + cost of capital). 27. EVA/return on sales. 28. The other application, valuation, is not included in the example. For

further references about performance measurement and a survey of trends and research implications, see Christopher D. Ittner and

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David F. Larcker, “Innovations in Performance Measurement: Trends and Research Implications,” Journal of Management Account- ing Research, Vol. 10, 1998, pp. 205–237.

29. A market-price-based procedure is possible and would require fur- ther calculations.

30. Determination is not used as part of the example.

FOR FURTHER READING John Argenti, “Stakeholders: the Case Against,” Long Range Planning,

No. 3, 1997, pp. 442–445. Jeffrey M. Bacidore, John A. Boquist, Todd T. Milbourn, and Anjan V.

Thakor, “The Search for the Best Financial Performance Measure,” Financial Analysts Journal, May–June 1997, pp. 11–20.

Jack C. Bailes and Assada Takayuki, “Empirical Differences Between Japanese and American Budget and Performance Evaluation Sys- tems,” International Journal of Accounting, 1991, pp. 131–142.

John E. Balkcom, Christopher D. Ittner, and David F. Larcker, “Strategic Performance Measurement: Lessons Learned and Future Directions,” Journal of Strategic Performance Measurement, No. 2, 1997, pp. 22–32.

Gary C. Biddle and Robert M. Brown, “Evidence on EVA,” Journal of Ap- plied Corporate Finance, No. 2, 1999, pp. 69–79.

Andrew Black, Phillip Wright, and John Davies, In Search of Shareholder Value, Pearson Education, London, England, 1998.

Mark L. Blyth, Elizabeth A. Friskey, and Alfred Rappaport, “Imple- menting the Shareholder Value Approach,” Journal of Business Strat- egy, Winter 1986, pp. 48–58.

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Peter Schuster, Ph.D., is professor of management accounting and management control at Schmalkalden University of Applied Sciences, Schmalkalden, Germany. He can be reached at (0049) 368-688-3112 or Schuster@Fh.Schmalkalden.de.

Mel Jameson, Ph.D., is associate professor of finance at the University of Nevada Las Vegas. He can be reached at (702) 895-1025 or at jameson @ccmail.nevada.edu.

The authors are greatful to Professor Michael Sullivan for his helpful comments.

From Management Accounting Quarterly, Vol. 4, No. 4, Summer 2003, pp. 41-52. Copyright © 2003 by Management Accounting Quarterly. Reprinted by permission via Copyright Clearance Center.

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