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
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.
Pre-tax ROIC
Cash tax rate
on EBIT 30%
capital 2.25
Net PPE/sales
Operating working
capital/sales 12%
Other assets/sales
FIGURE 9.1 ROIC value tree

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