Measure for Measure

The universe of value-based performance metrics is rapidly expanding. How can CFOs determine which metric is best for their companies?
Randy MyersNovember 1, 1997

Armstrong World In-dustries Inc. has a proud history dating back to 1860, but it has spent the past few decades cranking out financial returns considerably more uneven than the rolling plains surrounding its rural Lancaster County, Pennsylvania, headquarters. Today, the $2.2 billion maker of ceiling tiles and floor coverings is following a new strategic direction it believes will smooth out its inconsistent financial performance. Armstrong’s compass for the journey: economic value added (EVA), the performance measure trademarked by consulting firm Stern Stewart & Co. Since implementing EVA on January 1, 1995, Armstrong has sold off its Thomasville furniture subsidiary, merged its American Olean ceramic tile business with a larger company, and rethought the way it runs its remaining operations.

“We’re much more attentive to the use of capital and the amount of capital in each business,” says Warren Posey, assistant treasurer and director of investor relations. “We have pushed EVA down to all salaried employees worldwide.”

Armstrong is one of hundreds of companies that have gotten religion–the value-based metrics religion. Armstrong’s particular creed, EVA, is easily the most glamorous of these metrics, all of which are aimed at measuring the degree to which a company’s aftertax operating profits exceed or fall short of the cost of the capital it has invested in its business.

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Implemented into every facet of corporate decision making, proponents say, value-based performance metrics can help transform ill- performing companies from wastrels into wealth creators, and turn good performers into great ones. Even their harshest critics concede that they can be valuable in helping line managers link the balance sheet to the profit-and-loss statement–something that performance and incentive compensation programs based on earnings per share could never do.

Many companies have concluded that the choice they face is not whether to adopt one of these new metrics, but which one to choose. The choices are multiplying; as noted in these pages last year (“Metric Wars,” CFO, October 1996), many management consultants now have a value-metrics practice. The most prominent ones, in addition to Stern Stewart, are The Boston Consulting Group, which offers TBR (total business return); The LEK/Alcar Consulting Group LLC and SVA (shareholder value added); and HOLT Value Associates LP and CFROI (cash flow return on investment). Stern Stewart boasts more than 250 corporate clients, while The Boston Consulting Group says it has worked with about that many companies over the past five years. LEK/Alcar reports having between 50 and 100 clients, while HOLT has only a handful of corporate clients (as opposed to institutional investors).

Meanwhile, older performance metrics are coming back into style. General Motors Corp., for instance, is a well-known proponent of using neither EVA nor TBR but good old RONA (return on net assets)–a measure which, it is safe to say, is in the toolbox of every MBA graduate in the country. General Motors liked the idea that it could, in its view, apply RONA both to its North American operations, which were in a classic turnaround mode, and its international operations, which were operating in a classic growth environment.

The problem is, every purveyor of a performance metric can trot out arguments that favor its acronym at the expense of rivals’. With so many choices and competing claims, how can CFOs determine which metric is best for their business? It’s a question of no little consequence. For one thing, the consultants charge steep fees, which reach six figures for larger customers. (Some companies, such as Valmont Industries Inc., have concocted cheaper home-brew versions of EVA for their particular tastes.) But far more important, companies launch ambitious initiatives under the aegis of a performance metric– particularly when the metric is closely tied to executive compensation.

Take Centura Bank, in Rocky Mount, North Carolina. Since implementing EVA on January 1, 1994, the $7 billion (assets) bank has spent in excess of $30 million to develop alternative delivery channels and new products- -essentially “reinventing the company,” confirms a bank spokesperson. “We are convinced that under our old earnings-per- share methodology we wouldn’t have taken these steps, because the measurement system would have punished our incentive system so tremendously.”


Given that so much potentially rides on a performance metric, it’s easy to see why companies would opt for the market leader. Many companies have decided that selecting Stern Stewart’s EVA is the safe and easy choice, akin to selecting Microsoft software for your PCs.

For Minneapolis-based International Multifoods Corp. CFO and senior vice president of finance Bill Trubeck, choosing Stern Stewart was a matter of “going for the gold.” “Bring in the best,” Trubeck advises. “It may cost more than people want to spend, but in terms of potential return, I think you’re way ahead by bringing in the experts to help you. They get you focused and keep you on track.”

But independent observers with no ax to grind insist there’s no one metric that’s right for all companies in all circumstances. “I’d calculate a variety of measures,” recommends Carl Noble Jr., adjunct professor of finance at Northwestern University and chairman and CEO of The Alcar Group Inc., a financial software firm he co-founded with another well- known academic, Alfred Rappaport. (Alcar Group is not affiliated with metrics consultants LEK/Alcar Consulting Group.) Says Noble, “I’ve seen excellent results from all of these consulting firms.”

“The world is full of people beating the drum for EVA, but for almost any company you can’t apply a cookie-cutter solution,” agrees James Knight, vice president and managing partner of the performance measurement and value management practice at SCA Consulting LLC, in Chicago. “Like people, companies are different. You have to ask yourself what your company is about, what business you are in, what your strategy is, and what you are trying to achieve in both the short term and the long term. Then you customize a performance measure for your company.”


It’s not that these metrics lack flexibility. Stern Stewart, for instance, allows clients to make more than 160 standard adjustments to its EVA calculation, although in practice companies typically make 5 to 15 adjustments. Still, start tinkering with off-the-shelf metrics to suit your tastes and you may quickly conclude that choosing the right measure has more to do with how much financial legerdemain you wish to perform, and which consultant is best equipped to help you do it, than with which metric is intellectually superior for your application.

If you don’t believe that, just look at the debate over whether these new metrics make sense for natural resource companies. These companies must spend vast sums identifying and acquiring inventories whose values can fluctuate wildly because of external economic forces, even as they are contributing nothing to current profits or cash flow. Viewed through the lens of a value metric, such inventories are wasteful.

“The problem with oil, and it’s true of both EVA and CFROI,” says Knight, “is that there’s an incentive to pull your reserves out of the ground along with an embedded incentive to have a minimum amount of reserves–which is not necessarily the right long-term business decision. You wouldn’t want a performance measure that incents you to go out of business.”

Stern Stewart vice president Al Ehrbar counters that EVA is entirely appropriate for natural resource companies despite the “special difficulties” involved with accounting for inventories such as crude oil reserves. “That gets exceedingly complicated to do really well, and entails using option pricing theory in valuing reserves,” he concedes. “But done correctly, it can be very revealing.”

Phillips Petroleum Co., for one, is counting on EVA to shed light on its business. “We looked at quite a few metrics going back several years now, and took a real hard look at HOLT’s CFROI, which we thought was a pretty good measure but a little complex,” says Donald Wallette Jr., manager of corporate planning and development for the $16 billion integrated oil company. “We also looked at ROCE [return on capital employed], ROGI [return on gross investment], and a couple of others, all of which have their advantages. But EVA is the one that got our attention. More than any other, it seemed to combine the capital invested in the business and the cost of that capital with operating income in one relatively simple measure that was a pretty good reflection of economic performance.”

Phillips began implementing EVA in 1995. To discourage its managers from halting drilling operations and simultaneously opening up the taps on the company’s oil reserves, the company customized its EVA methodology in a way that credits its exploration and production unit with the value of an oil discovery when its reserves become bookable– that is, when the company has a development plan for the oil field and the funding to pursue it.

“Essentially, they [exploration and production managers] earn the net present value of that development, and then have the obligation to deliver on the promised results,” says Wallette. “If they overdeliver, if development exceeds expectations or promise, then their future EVAs will be positively impacted. If they underdeliver, they will be penalized.” He adds, “I’d say the jury is still out on the practicality and effectiveness of this system, but we’re testing it this year.”


Another company that made a hard choice between EVA and CFROI is Millennium Chemicals Inc., based in Iselin, New Jersey. In 1995, Millennium was a classic candidate for a value- based performance metric. Its longtime planning and incentive compensation system was aimed at improving return on capital employed and operating profit. This led to a variety of projects that increased profits–but didn’t necessarily generate greater value for shareholders. As Millennium faced the likelihood of being spun off from parent Hanson Plc, the big British conglomerate, senior managers began to look for alternative metrics that would promote growth.

“We thought return-on-asset formulas drove organizations to high returns, but didn’t necessarily increase the value of the company,” recalls senior vice president and CFO John Lushefski. “We had too many divisional executives who failed to spend money on capital projects with more than satisfactory returns because those projects would have lowered the average return [on assets] of their particular business.”

At the beginning of 1996, the year that it was split off from Hanson, the company shifted the long-term portion of its incentive compensation plan to a CFROI model. Later, it became convinced that Stern Stewart’s EVA- based compensation scheme made more sense. “We thought [Stern Stewart] had great resource capability and experience,” Lushefski says. The company hired Stern Stewart to implement its plan beginning in 1998, but continues to consult with CFROI mavens HOLT Value Associates to help management understand how investors are assessing the company’s performance and valuing its stock.

Already, Lushefski credits the company’s new focus on shareholder value with convincing Millennium’s high-return fragrance chemicals business, headquartered in Jacksonville, Florida, to take a new approach to capital spending that emphasizes long-term growth. The unit, which had sales last year of $113 million, has been authorized to make capital expenditures of nearly $40 million over three years to increase capacity.

“That’s a big number for us,” says George Robbins, chief executive officer of Millennium Specialty Chemicals (the formal name of the fragrance chemicals group). “This isn’t hard data, but I bet our capital spending from 1988 to 1993 was less than $5 million a year.”

Robbins claims that the old Hanson incentive system simply wouldn’t have steered management toward massive capital spending. “The easiest way to improve ROCE is to not add the ‘C,’” Robbins says. “We were successful in not spending our depreciation over a number of years, which meant we got more out of our existing capital. That forces up productivity, but it’s a short-term phenomenon. Now we can look out over a longer period of time and figure out if we’re smarter to put in a big piece of equipment because it maximizes long- term cash flows.”

Case in point: Robbins’s group recently installed a new 30,000-gallon vessel at the company’s Brunswick, Georgia, plant, rather than continuing to work around a bottleneck that had long constrained output. Today the plant has twice the capacity it had five years ago and, given its high margins, is EVA- positive even running at less than 80 percent capacity.

“Now when there’s a surge in demand, we can take care of our customers,” boasts Robbins.


Assuming that the folks running Phillips and Millennium aren’t stupid–and it’s tough to work your way into the executive suite of a Fortune 500 firm without being pretty smart– you have to conclude there’s more than a smidgen of truth to the notion that choosing the right performance metric for your firm is less like deciding between a car and a motorcycle and much more like choosing between a Lincoln and a Cadillac.

As it happens, of course, it is possible to prefer a Cadillac over a Lincoln, or vice versa. In choosing between metrics, most experts agree, corporations can legitimately prefer one over another because of the nature of their business or their objective in using the metric.

For example, companies that merely wish to begin promoting balance sheet efficiency, control working capital, increase asset turnover, and improve receivables management might want to introduce basic measures such as RONA or free cash flow, or even make the jump to EVA, according to Eric Olsen, vice president and value-management practice leader for The Boston Consulting Group. All will link profits to the balance sheet. If the company is saddled with an intense level of depreciating assets, though, it may want to introduce CFROI instead (or ROGI, which is a simpler version of CFROI), since its calculation recognizes and adjusts for the finite life of depreciating assets.

Companies that have already completed cost- cutting, reengineering, or restructuring programs and now wish to emphasize growth, or that simply have extraordinary growth opportunities (such as many high-tech firms), may want to steer clear of return measures such as ROE, ROCE, RONA, ROGI, and CFROI, Olsen says. “They give no credit for growth, and will bias managers to seek additional efficiency improvements or revenue growth without capital spending.” Instead, he argues, such companies should choose from EVA, CVA (cash value added), net present value, or his own firm’s TBR, since they don’t have an efficiency bias.

“Another issue with high-tech businesses relates to the assets you’re using to compute these value-based measures,” observes Knight of SCA Consulting. “A lot of their assets are in the form of intellectual capital, and you run up against a fascinating set of issues in figuring out how to value that talent.” The result, he says, is that value-based performance metrics make little sense for companies without significant hard assets.

One of the prime reasons for adopting value- based performance metrics is, of course, to help managers decide where they should allocate their resources, whether it be to bricks and mortar, research and development, more software developers, or any of a variety of potential acquisitions. EVA critics argue that it performs miserably at this task, because the metric, which is expressed in dollars, is extraordinarily dependent on the size of a business. Big operations and big projects tend to have big EVAs, while small operations and small projects tend to produce small EVAs. “You can’t say that a positive EVA of $100 is five points or one point above the cost of capital,” complains Olsen, “because it depends on the size of the business.”

But EVA supporters cite this as a benefit rather than a liability.

“I think an absolute measure is very important as companies get larger, because strategies and investments must be big enough to have an impact,” says Roy Johnson, a partner with Ridgefield, Connecticut-based consults Vanguard Partners. “This would favor economic profit [a generic term for EVA] over many other metrics. ROI, CFROI, and RONA all lack the size perspective. Managements can waste their time on a lot of small projects that look good but have little impact on value creation.”

Sufficiently confused? Then consider this analogy: Much as hitting a good golf shot depends more on how you strike the ball than on which brand of club you use, achieving success through the use of any performance metric will depend more on how well you apply it than which one you use. Even then, it’s not going to provide every answer you need on how to run your company.

“Because we’re living in a multiperiod world, the key to management is to make decisions that will change the future, and these single- period measures don’t do that for you,” says Northwestern’s Noble. “They might provide some insights and some signals, but there’s no magic in the world.”


Academics are unimpressed by the consultants’ marketing

Although metrics mavens are quick to disagree over which performance measure makes most sense, they all concur that the ultimate objective in using them is to enhance shareholder value. Unfortu-nately, the jury is still out– way out–on which of the new metrics best tracks shareholder returns and whether any of them link more tightly to shareholder return than traditional measures do.

Stern Stewart & Co. and its peers all claim that their preferred metrics correlate more closely to shareholder re-turns than traditional measures do. But what do independent observers say? Academic re-search to date has focused almost exclusively on the claims made for EVA, in part because it has captured the lion’s share of attention over the past few years. The findings have not been encouraging.

Writing in the spring/summer 1997 edition of the journal Financial Practice and Education, finance professors Jonathan Kramer of Kutztown University and George Pushner of the University of New Haven looked at how EVA and various other measures correlated to shareholder returns from 1982 through 1992 for 1,000 companies, using data supplied by Stern Stewart. They came up with answers that closely mirrored other academic research to date.

“We found that a traditional internal measure of performance like NOPAT [net operating profit after taxes] actually did a better job of tracking market value added than did EVA,” says Kramer. “We found essentially no marginal benefit from calculating EVA versus NOPAT. And if there’s no marginal benefit of using EVA, then why incur the marginal cost of calculating EVA and educating your managers, employees, and analysts on how to use it?” While affirming that the concept of economic profit is strongly grounded in economic theory, Kramer adds, “I just think some of the marketing claims for EVA appear to be overstated.”

Questionable adjustments

Stern Stewart senior vice president Stephen O’Byrne published a spirited defense of EVA in the same issue of that journal. In it he outlined a series of adjustments to the EVA model (such as using separate variables for positive and negative EVA)–which, he said, made it track market values for a stock much more closely. But his diatribe left academics unconvinced.

“I think our evidence is stronger, and I think some of his adjustments were a little arbitrary or unfair,” says Pushner. “We tried to use a simple and clear methodology similar to what people being compensated under an EVA system would use.”

“O’Byrne is almost hostile in his dismissal of anything that doesn’t agree with his inclinations,” adds James Owers, professor of finance at Georgia State University and co- author of another Financial Practice and Education paper, which summarized earlier academic studies doubting the effectiveness of EVA in tracking shareholder returns. “I don’t think anybody [in academia] is out to get these guys,” he says. “It’s just that they’re making incredible claims, and it’s up to us to make sure that practitioners aren’t being misled.

“If metrics were medicines,” Owers concludes, “then the FDA would be giving close scrutiny to claims made for these performance measures.”


Garbage in, garbage out, say consultants

Planning to adopt a value-based performance metric? Think it will help you make smarter acquisition decisions? Okay, chew on this: If EVA is so smart, how come it didn’t prevent EVA poster child The Quaker Oats Co. from making its disastrous $1.7 billion purchase of Snapple Beverages Co. in late 1994–which it was forced to sell two years later for a mere $300 million?

Answer: Quaker didn’t use EVA to calculate its $14-per-share offering price for Snapple. According to company spokesman Mark Dollins, Quaker uses a discounted cash flow model to evaluate acquisitions and divestitures, and merely uses EVA as an incentive compensation tool.

“EVA does not take into account, in mergers and acquisitions, things such as market conditions,” Dollins says.

Not surprisingly, Stern Stewart & Co. says EVA is a wonderful tool for valuing acquisitions. “Whether it had been an EVA analysis or a discounted cash flow or price-to- earnings analysis, it’s really the old adage– garbage in, garbage out,” says Stern Stewart senior partner and co-founder G. Bennett Stewart III. “It all depends on the assumptions.”

To see just how good some of the new metrics are at valuing acquisitions, we asked both Stern Stewart and HOLT Value Associates LP to calculate a fair value for Snapple at the time of its acquisition by Quaker, using only data that was publicly available at that time. Stern Stewart declined, citing its former consulting relationship with Quaker, but HOLT agreed to take on the assignment using its CFROI (cash flow return on investment) methodology.

First, some background. In valuing a company whose CFROI is higher than average, HOLT assumes those returns will gradually fade toward the market norm because of competitive pressures. The rate of fade is determined in part by the volatility of the company’s historic CFROI levels. That’s important because HOLT’s valuation methodology is based on projecting how the company will be performing (in terms of its CFROI level and the real rate of growth in its assets) five years into the future.

In Snapple’s case, HOLT was confronted with a very high CFROI and a very high asset growth rate–25.5 percent and 35 percent, respectively. With little company history by which to judge volatility in those numbers, HOLT director of research Sam Eddins calculated a value for Snapple’s stock as if its CFROI would fade at an average rate, and calculated Snapple’s asset growth rate at a slightly above-average rate. That would have left it with a CFROI of 17 percent and an asset growth rate of 21 percent by 1999. Discounting those values back to 1994, it suggested a price for Snapple of $19.55 per share–or $5.55 per share more than Quaker actually paid.

Funny numbers

But as HOLT partner Bart Madden explains, his firm advises clients not to use current CFROI and growth rates as a starting point when the company being evaluated has an abbreviated history, as was the case with Snapple. “This was more like a hot IPO with a couple of peak years under its belt. If you extrapolate from that, you get funny numbers,” Madden says.

Adds Eddins: “In this assumption, Snapple would have been maintaining a CFROI of 17 percent five years after the acquisition, which would have put them in line with the best companies in Corporate America. In fact, we would have expected a fairly rapid fade rate for Snapple. Even at $14 a share, Quaker would have been assuming that Snapple would have a 14.5 percent CFROI in five years, which is absolutely a preeminent level. I would have told them this was a crazy acquisition.”

Is the CFROI methodology useless, then? Absolutely not, according to HOLT. In valuing young companies, it says, clients are advised to compare projected growth rates for the firm over the next five years with those of other companies in similar lines of business. Perhaps more than anything else, HOLT’s exercise illustrates that using value-based metrics to put a price tag on acquisitions can be as much art as science.