The Financial Times Guide to Corporate Valuation

170 The Financial Times Guide to Corporate Valuation

5 Have longer periods where the company is expected to earn a ROIC

greater than WACC.

The problem with using only economic profit or

only EVA is the possibility of generating incor-

rect short-term incentives. This is because in a

particular project, EVA or economic profit might

be negative in the first few years of the project

but have a positive net present value in total and

thereby create shareholder value. If you base an

incentive plan on EVA or economic profit alone,

it might mean that even though a project is pro-

gressing according to plan and is creating shareholder value, the employee

will receive no compensation in the first few years as the project has a

negative short-term value added. Consequently, if an employee has a time

horizon shorter than the lifetime of the project, he or she might reject

the project, even though it creates shareholder value. Hence, an incentive

system based solely on EVA or economic profit can be counter-productive

and therefore needs to be combined with other long-term measurements.

In terms of non-financial objectives, the overall goal of maximizing future

cash flow and corporate value must be transformed into concrete non-

financial key variables. Though non-financial key value drivers vary from

industry to industry and company to company, generic non-financial key

variables exist as well, as was shown in Chapter 7. It is important that the

chosen key non-financial variables are linked closely to the creation of

value. If not, one might instead destroy value. In addition, key value driv-

ers are not static and will probably change over time and it will therefore

be necessary to review them periodically.

Action plans, budgets and training

When the company has short- and long-term financial and non-financial

targets in place, it is time to map a step-by-step action plan to achieve

these goals. Since it is often easier for employees further down in the

organization to relate to other objectives than purely financial ones, it is

important not only to express action plans and budgets in financial terms

but also to connect these plans to operational measures.

However, these targets should, of course, be connected to value creation.

For example, use a ROIC tree as shown in Figure 9.1 to derive the nec-

essary operational variables to use as targets. Also, experience has shown

An incentive system

based solely on EVA

or economic profit can

be counter-productive

and therefore needs

to be combined

with other long-term

measurements

9



Value-based management 171

that it is important to devote time to designing a training programme

for the value creation process in the company. The aim of the training

programme should be to commit the organization to VBM’s success by

achieving an understanding of the concept and why it is a good method

for managing and measuring performance.

Usually, it is advisable to wait with the explanation of the new incentive

plan until a later stage since compensation discussions tend to absorb more

energy and focus and employees are more likely to buy into the incentive

programme after having seen the VBM programme at work in reality.

Also, normally, the training should be conducted in stages with a prelimi-

nary session explaining the basic rationales behind the VBM programme,

introducing the employees to the concept and why it is a useful measure-

ment of company as well as employee performance. Later, a workshop

should be designed to explore the VBM programme in more detail.

COGS/sales

52%

ROIC

30.2%

Pre-tax ROIC

43.2%

Cash tax rate

on EBIT 30%

Sales/invested

capital 2.25

EBIT/sales

19.2%

Net PPE/sales

31%

Operating working

capital/sales 12%

Depreciation/

sales

1.8%

SGA

expense/sales

27%

Other assets/sales

1.5%

+

+

+

+

×

1–

1÷

1–

×

FIGURE 9.1 ROIC value tree