Winning Performance Measures to Manage Your Business
In today’s business environment, business owners/managers have been overwhelmed with advice about performance measures: Total Return to Shareholders (“TRS”), Discounted Cash Flows (“DCF”), Economic Profit, Economic Value Added (“EVA”), Return on Invested Capital (“ROIC”), Earnings Per Share (“EPS”), Profit Margin, and many others. Oftentimes, the real purpose of using these performance measures has gotten lost in the sea of metrics. These performance measures are used to help managers make value creating decisions and to guide all company employees to value creation.
Economic Profit
Some performance measures are indeed better than others. We prefer economic measures (such as economic profit) to accounting based measures (such as earning per share). Economic Profit is the difference between the revenue received from the sale of an output and the costs of all inputs used, as well as any opportunity costs. Empirical research suggests that cash flows, not accounting earnings, are what drive business value and stock price performance. It’s also easier to understand the sources of value and short term versus long term tradeoffs, when you use economic performance.
However, there is no perfect performance measure. As a result, it is better to use a framework, that links various economic measures to various accounting based measures, to describe different aspects of performance. The ultimate output measure is shareholder value creation (i.e. stock performance) in the stock market for public companies or business value creation for privately held companies. It can be used by business owners and managers to set shareholder value creation targets. Shareholder value creation can then be linked to some measure of intrinsic value.
Intrinsic Value / Financial Indicators
Intrinsic value is a measure of an asset or company’s worth. A company’s Intrinsic value it is ultimately driven by its long term cash flow generating ability and can be measured by DCF. Intrinsic values such as DCF can then be linked to important financial indicators such as: revenue growth, gross margin, operating profit, liquidity, solvency and return on invested capital. However, because short term financial indicators may signal changes in value creation too late, we need to also use operating and strategic measures called value drivers (such as market share, cost per unit, value of R&D projects) to manage the business. Monitoring these value drivers helps avoid sacrificing long term value creation for short term financial results.
Value Drivers
There are a variety of value drivers that can be managed to improve intrinsic value, some of them include: Economies of Scale, Technology, Product and Service Offering, Access to Capital, Financial Performance, Skilled Employees, Solid Customer Base, Market Environment, Branding and Marketing Strategy, Strategic Vision. The costs per unit typically go down with an increase in production output. It may be through the spread of capacity costs over bigger volumes or through quantity discounts. A company should exploit the internal economies of scale well that would help it grow. Companies that can show technological expertise better through the development of products that address emerging customer needs, can lure customers into choosing modern high-performance products. Companies that can develop a mix of product and service offerings can appeal to a broader set of customers. Companies that have greater access to access to equity capital and debt are in a stronger position to support growth and achieve their goals.
Companies that perform regular financial analysis to measure trends, identify its assets and liabilities, and compare its financial performance with its competitors can increase intrinsic value. Skilled human capital is vital for any organization. Company employees contribute skills, creative abilities, experience, and knowledge to the business as well as the health of the company’s culture. The employees will determine the effectiveness of production and service delivery and can increase intrinsic value. Having a customer base that is solid and widespread is important for the continuing viability of a company, it reduces risk and increases intrinsic value. A company’s management needs to develop a good understanding of the impact of economic factors on their industry, their market share and market position, and their unique and niche offering. A company with strong branding will improve its sales through an increase in market recognition and also give it a clear direction that helps enhance operational efficiency. A large number of companies simply formulate yearly budgets without trying to put together long-term business plans or forecasts that are in tune with the needs of their customers. Since valuation is inclined towards future prospects, the management of the company needs to adopt a strategic vision if they want to create value.
Comprehensive Framework
Each class of measurement has a role in management decision making and performance management
Stock Performance <—- Intrinsic Value <—- Financial Indicators <—- Value Drivers
Management can set long term value creation targets in terms of the market value of the company or total return to shareholders. Alternative strategies/opportunities and the value of the business units, or the entire company, can be evaluated in terms of intrinsic value (DCF). Intrinsic value can be translated into short term and medium term financial targets and targets for operating and strategic value drivers (Market Share). Performance can be assessed by comparing results with targets on both financial indicators and key value drivers. Managerial rewards can be linked to performance on both financial measures and key value drivers. Financial Indicators can be supplemented with strategic and operating value drivers that provide insight about where a company’s performance is heading. Value drivers help companies to understand the reasons for their current performance and how their future performance will likely develop.
Business owners and managers are oftentimes overwhelmed with advice about performance measures used to manage their business. A comprehensive framework to cut through the confusion of proliferating metrics can help business owner more effectively manage their business. This framework should include long term value creation targets, intrinsic value metrics, financial targets and value drivers. Using the right business performance measures can have a positive impact of your businesses bottom line!
Please let us know if you have questions concerning financial plans or any related topics, we can be reached at (480) 980-3977!
