Valuation: Measurement, Management

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Valuation Measurement, Management Creation

• Chris Lamoureux, PhD
• Head of Finance
• Estes/Neill Professor of Finance
• University of Arizona

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Brief Mention of the Top

• Financing Adding debt brings tax savings,
  incurs risk. The costs depend on market risk
  premia.
• Cash is King Manage the business so as to
  maximize free cash flow. (Working Capital is a
  drain on cash.)
• NPV is only as good as the forecasted cash flows.
  The incentives to manipulate these in many
  companies explain why this is in the middle of
  the pyramid.

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Method vs. Process

• The base of the value pyramid is process.
  Historically most - if not all - of the focus in
  corporate finance (top 3 cells of pyramid) was on
  method.
• But even a tiny bit of consulting with CFOs makes
  it clear that bad process can destroy the best
  method, and that with a good process, method is
• Not all that important and
• Usually optimized (i.e, it is derivative to
  process).

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Why Pay People to Lie?

• In a January 8, 2001 editorial, Michael Jensen
  argues that, we must eliminate the use of
  budget targets in compensation formulas. Only
  then can we be sure that we are paying people to
  perform, not to lie.
• What is this about?

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Budgets Induce Lying

• Jensen argues that when confronted with a
  standard budget / reward system, managers have
  incentives to play two types of games that he
  argues destroy firm value
• The Realization of Targets
• The Setting of Targets.

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Gaming the Realization of Targets

• Timing If a budget is already met, I will shift
  the realization of revenues to next year, and
  possibly front-end costs. Conversely, if it
  appears that I may come up short, I may encourage
  shifting the realization of revenues. This could
  be accomplished by marketing tricks (Price rise
  scheduled for January 2, next year), or fill the
  channel verging on fraud.

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Gaming the Realization of Targets 2

• Accounting Tricks
• Take gains on the defined benefits pension plan
  as operating revenues.
• Sell assets and realize gains lease assets
  back.
• (Internally, the timing issue is probably the
  most relevant.)

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Dueling Budgets

• Another insidious example of budget distortions
  is the use of a capital budget to manipulate
  operating results.
• This can be solved by simple measures such as EVA
  and/or careful integration of the two budgets.

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Gaming the Setting of Targets

• The key to understanding this is the notion that
  the manager has information that his superiors do
  not.
• A well-functioning budget process would entail a
  flow of valuable information up the corporate
  chain of command. When compensation is tied to
  the budget, this information flow / co-ordination
  function is corrupted.

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Eliminate Budgets as Targets

• Jensen argues that telling managers to stop lying
  will not solve very much. He concludes
• We must begin by eliminating the use of budget
  targets in compensation formulas. Only then can
  we be sure that we are paying people to perform,
  not to lie.

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A solution ?

• Jensen provokes thought, but does not propose a
  solution.
• Budgets are used in compensation schemes to
  create incentives for managers to work harder.
• An alternative to the standard methods would be
  to have a scenario budget. Managers identify
  important risks and opportunities which they may
  confront, and elaborate how results might be
  impacted by different scenarios.

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Specific Knowledge Divisional Performance

• Clearly the extent to which information is
  dispersed throughout the company is relevant to
  solution as is corporate culture.
• Performance measurement and incentives should be
  tailored to reflect the extent to which
  information is decentralized within a company.
• Thus, there is a suggestion that introducing
  disparate activities into an organization is
  costly.

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Knowledge Performance 2.

• This ties in to the question of spin-offs and
  organizational focus. If it appears that it is
  very costly to put into place an effective
  organizational design, then perhaps the problem
  lies with the corporate structure.
• (This is discussed in relationship to the
  strategic aspects of break-ups.)

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Harsh Realities?

• Wall Street places an increasingly high premium
  on transparency. The internal budgeting
  process affords a vehicle to communicate
  corporate expectations, characterize perceived
  business opportunities, and managerial ability to
  execute the business plan.
• Does Wall Streets attention to quarterly
  earnings (targets) damage long-run value
  creation?
• I place some blame on managements unwillingness
  to expand the scope of the message space in
  communications with the Street.

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Alternative Systems

1. Cost Centers
2. Revenue Centers
3. Profit Centers
4. Investment Centers EVA
5. Expense Centers

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Cost Centers

• Here, the incentives are for a divisional manager
  to minimize costs.
• This system may be gamed by
• Sub-optimal quantity manipulation
• (May lead to stock outs / excess inventory.)
• Sub-optimal quality manipulation
• (May destroy customer base / loyalty.)

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Cost Centers 2

• CFOs are often critical of what they call an
  engineering mentality. They sense that
  engineers want the latest technology and to
  show off their skills, when this may not be
  consistent with value maximization.

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Revenue Centers

• Here, incentives are to maximize revenues. This
  is often thought to be a corporate objective in a
  marketing-focused company (although sometimes
  market share is targeted).
• This system may clearly gamed by
• Mortgaging the future.
• Cannibalizing other product lines / divisions.
  (Imagine that Buick tried to maximize revenues,
  for example.)

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Profit Centers

• When the knowledge required to make decisions
  about the product mix, quantity, and quality is
  specific to the division, and therefore costly or
  impossible for managers at higher levels in the
  hierarchy to obtain, the profit center can be an
  effective performance measurement system. In
  these cases it is desirable to use profits as a
  performance measure while giving profit center
  managers rights over factors such as the product
  mix, quantity and quality.

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Profit Centers 2.

• Problems with profit centers include accounting
  for inter-division complementarities.
• Another problem is substituting capital for
  operations. (No incentive to preserve capital.)

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Investment Centers - EVA

• Here we evaluate profit after subtracting a
  capital charge. Since this is not a ratio, there
  is not a scaling problem.
• This solves the substitution of capital problem
  that exists in a profit center.
• It is still static and no panacea.

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Expense Centers

• A service function that does not charge its
  internal customers may under-produce its
  services.
• Presumably management higher in the organization
  knows exactly how much of this service is needed
  and simply creates incentives for the local
  manager to provide that level of service at
  minimum cost.

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Big Picture Dynamic Optimization

• A problem with all of the systems discussed above
  is the focus on the short-term, or static
  optimization.
• There is no easy way to trade off the competing
  needs to induce discipline, discourage shirking,
  and assess talent on the one hand from inducing
  creativity and a long-term perspective, on the
  other hand.

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Some Evidence

• From Fortune, September 17, 2001
• From survey responses companies are classified as
  aligned or non-aligned based on whether
  internal contracts are pulling for the same
  thing as their shareholders.
• Aligned companies stocks had twice the returns of
  the non-aligned group.

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Some Evidence 2

• Characteristics of aligned companies
• Focus on cash flow.
• Salient bonus plans that focus on long-term value
  maximization (multi-year plans that penalize
  short-term gains with long-term costs).
• No caps on bonuses.
• Characteristics of non-aligned companies
• Focus on accounting-based results as opposed to
  cash flow.
• Capped Bonuses.

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Review of Evidence

• Many CFOsespecially those with public accounting
  backgroundsare reluctant to expand the message
  space and let the gaap numbers fall where they
  may. But study after study shows that the market
  rewards a focus on improving cash flows and
  long-term value creation.

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Culture Example

• In speaking with a group a MAPI Finance Group
  about these issues in Spring, 2001, it was clear
  that corporate solutions vary widely.
• At one extreme is Moog. This seems to be
  organized almost like a university. It is
  assumed that all employees are working for the
  team.

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Real Options shifts Focus

• A dynamic focus means that when you make a
  decision, you do not act as if you are committing
  the company to a locked-in stream of future cash
  flows. Rather, you are positioning the company
  to make future decisions.
• A key here is identifying the optimal reaction to
  future states of nature.

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Lilly and PCS An Example

• In November, 1994, Eli Lilly acquired PCS from
  McKesson for 4.1 billion in cash. In January,
  1999 Lilly sold PCS to Rite Aid for 1.6 Billion
  in cash.
• PCS is a provider of pharmacy benefit management
  services.
• Lilly did not see this as failure.

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Real Options Case Enron

• In June 1999, Enron opened 3 natural gas-fired
  power plants in Mississippi and Tennessee (near
  pipelines). These were cheap, inefficient plants
  with operating costs 60 higher than
  state-of-the-art plants. Most of the time, they
  would be idle.
• Why? Volatility in electricity prices means
  there will be times (possibly rare), when firing
  up these plants will be very profitable.

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Enron Contd.

• Note how the optimizing solution of Enron is not
  induced by any of the 5 systems discussed above.

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Breaking Up is Good to Do

• Having reviewed the problems with designing
  optimal processes for multi-division firms, it is
  not surprising that transactions which move in
  the direction of separating a division from the
  rest of the company may create value.

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Sources of Value Creation

1. Increase in Analysts Coverage (Transparency)
2. Attract new investors
3. Improved operating performance better
   incentives / focus.
4. Improved Governance and strategic flexibility.