Introduction To The Wealth Added Index A New Performance Measurement and Strategic Planning Platform
Introduction To The Wealth Added Index A New Performance Measurement and Strategic Planning Platform
Introduction To The Wealth Added Index A New Performance Measurement and Strategic Planning Platform
Stern Stewart & Co. Perspectives on Business
London Introduction to the Wealth Added Index (WAI)
Wealth Added Index, WAI, Future Growth Value, FGV, Current Operations Value and COV are trademarks of Stern Stewart & Co.
EVA
!
is a registered trademark of Stern Stewart & Co. " Copyright 2002. All rights reserved for Stern Stewart & Co. and Stern Stewart Europe Ltd.
11
Wealth Added 202 Practical platform
In the main body of the text of this Introduction to Wealth Added we refer to the value of
profitability and the value of prospects. For the purposes of the theory, we have dubbed these
Current Operations Value (COV) and Future Growth Value (FGV). Initially, we define
Enterprise Value in two ways:
A. Enterprise Value = Market Value of Equity + Market Value of Debt
Where: Market Value of Equity = Shares x Share Price
Market Value of Debt = Value of total net debt
B. Enterprise Value = Current Operations Value + Future Growth Value
Where: Current Operations Value = Net Operating Profit After Tax / WACC
Future Growth Value = PV ! ! (NOPAT WACC x Capital)
Since Wealth Added is the excess change in market value over the expected increase in equity
value, a few adjustments to the value equation are required. First, we subtract debt to arrive at
market value of equity. Second, we find the change in market value of equity over a specified
period and then subtract out (or add) any shares issued (or repurchased, and/or dividends),
which have nothing to do with either COV or FGV. Third, we subtract out the required return
on beginning market value of equity. The steps look like this:
C. MVE = COV + FGV - Market Value of Debt
D.! MVE = ! COV + ! FGV - ! Debt
E. WAI = ! COV + ! FGV - [! Debt + New Equity - Dividend] MVE
beg
x Ce
Wealth Added is the change in profitability of a company combined with the change in the
debt and equity. With a few adjustments, the change in the debt and equity equals the change
in the capital expenditures of the firm. As explained above, the COV is the profitability in
perpetuity, such that ! COV is the change in the profitability level assumed in perpetuity. The
! FGV is the change in the markets expectations for growth in the current level. Here is a
practical example for a company:
WAI = ! COV + ! FGV [! D + New E Div] MVE
B
x Ce
1000 = (+1500) + (200) (+1800) (+500)
All else being equal, if the above company can raise its FGV to 800, it will achieve a Wealth
Added of zero, meeting its investors expectations:
WAI = ! COV + ! FGV [! D + New E - Div] MVE
B
x Ce
0 = (+1500) + (+800) (+1800) (+500)
We can dig deeper. Changes in profitability or the markets expectations for greater future
profitability must be greater than the capital expenditures to achieve them and the required
improvement in equity. This means that a firm balances current profitability, building future
capability, and the investments necessary against a required return for shareholders on their
equity investment. In other words, profitability and capital gains are benchmarked against
investment and the minimum requirements of investors. The following reworking of the
equation may clarify.
WA = [Value of Profitability + Value of Prospects - financing] - Required Return
Stern Stewart & Co. Perspectives on Business
London Introduction to the Wealth Added Index (WAI)
Wealth Added Index, WAI, Future Growth Value, FGV, Current Operations Value and COV are trademarks of Stern Stewart & Co.
EVA
!
is a registered trademark of Stern Stewart & Co. " Copyright 2002. All rights reserved for Stern Stewart & Co. and Stern Stewart Europe Ltd.
12
2001 Global WAI Ranking
Top 50
Y
e
a
r
s
WAI = ! Value of
pofitability
+ ! Value of
prospects
Financing Required
Return
Wal-Mart 5 149,662 45,809 168,482 2,616 62,013
Microsoft 5 93,780 42,822 188,267 11,875 125,435
IBM 5 93,092 16,034 109,261 -34,090 66,294
General Electric 5 91,857 109,881 242,896 96,949 163,971
Citigroup 5 82,682 n/a n/a n/a n/a
Nokia 5 82,156 27,103 78,373 -9,494 32,814
Home Depot 5 59,378 22,814 70,566 4,732 29,269
Johnson & Johnson 5 56,017 30,396 77,377 5,048 46,708
Dell Computer 5 35,352 11,539 47,954 -1,788 25,929
Nestl 5 34,609 25,050 32,684 3,418 19,707
Pfizer 5 30,712 74,097 123,125 105,149 61,362
Royal Bank of Scotland 5 29,114 51,542 10,987 21,831 11,585
Amgen 5 29,082 7,105 35,927 -520 14,470
Sanofi-Synthlabo 5 27,399 10,587 32,309 6,727 8,770
Abbott Laboratories 5 26,627 8,683 43,232 -407 25,694
Shell 5 24,792 52,199 -3,311 -25,581 49,678
Oracle 5 23,806 16,148 28,092 -10,101 30,535
Siemens 5 23,066 -6,041 53,333 5,533 18,693
Bristol Myers Squibb 5 21,768 23,397 20,686 -19,720 42,035
Lowe's 5 21,494 8,608 23,420 4,216 6,318
Wyeth 5 21,152 13,059 33,194 -1,338 26,439
Philips 5 20,858 -20,190 50,820 -1,689 11,462
HSBC 5 20,765 23,938 35,870 16,714 22,330
Eli Lilley 5 20,728 13,673 31,293 -6,786 31,025
Medtronic 5 20,389 6,016 41,925 11,672 15,880
Target 5 19,479 9,974 21,890 3,540 8,846
Barclays 5 19,031 30,387 2,397 -1,364 15,117
L'Oreal 5 18,810 8,288 22,492 -719 12,689
Total Fina Elf 5 18,803 97,128 -3,195 54,649 20,480
Telecom Italia 5 18,136 -461 55,816 16,503 20,715
Taiwan Semiconductor Manufacturing 5 17,406 -1,081 39,621 10,845 10,289
Samsung Electronics 5 17,158 9,478 24,149 6,711 9,759
Takeda Chemical Industries 5 16,100 16,323 5,348 -3,106 8,677
PepsiCo 5 16,089 15,973 19,431 -4,170 23,484
Novartis 5 15,362 9,768 30,181 -6,340 30,927
Kohls 5 15,330 5,116 16,078 1,722 4,142
Ford 5 14,921 -68,288 77,309 -29,829 23,929
Walgreen 5 14,756 5,335 19,878 1,117 9,340
Anheuser Busch 5 14,346 9,647 12,789 -3,974 12,064
British American Tobacco 5 14,164 17,619 -17,560 -20,984 6,878
Baxter International 5 13,547 3,311 17,553 -753 8,071
Intel 5 13,476 -11,963 112,394 -409 87,364
Automatic Data Processing 5 13,440 n/a n/a n/a n/a
Fannie Mae 5 12,577 26,239 12,254 -10,582 36,498
BG Group 5 11,847 -645 -2,127 -20,882 6,263
Best Buy 5 11,733 6,666 7,612 7 2,537
BellSouth 5 11,533 10,807 33,120 688 31,706
Colgate-Palmolive 5 11,493 4,879 12,500 -4,716 10,602
NTT DoCoMo 5 11,134 -328 57,398 14,031 31,904
eBay 5 9,792 834 15,162 1,363 4,840
All figures in millions of US$
Primary data source for share data: Thomson Financial Datastream.
Primary source for accounting data: value of profitability from Company Analysis.
Wealth Added calculation, consolidation & methodology: Ewelina Stachnik, John Pigott.
Data analysis: Ricardo Camara, Caroline Boudergue, Katinka Gertz.
Support: Eugenia Rillman, CK Cheng, Geoffroy Pacault, Fredrik Gustavsson.
Stern Stewart & Co. Perspectives on Business
London Introduction to the Wealth Added Index (WAI)
Wealth Added Index, WAI, Future Growth Value, FGV, Current Operations Value and COV are trademarks of Stern Stewart & Co.
EVA
!
is a registered trademark of Stern Stewart & Co. " Copyright 2002. All rights reserved for Stern Stewart & Co. and Stern Stewart Europe Ltd.
13
Bottom 50
Y
e
a
r
s
WAI = ! Value of
pofitability
+ ! Value of
prospects
Financing Required
Return
Fujitsu 5 -12,013 14,536 -13,681 3,565 9,302
HCA 5 -12,023 -3,435 -4,725 -5,818 9,681
Seibu Railway 5 -12,071 -303 -9,667 -387 2,488
AutoNation 5 -12,434 3,758 -7,179 5,007 4,007
New World Development Company 5 -12,552 n/a n/a n/a n/a
Matsushita 5 -12,709 -59,531 61,643 4,510 10,312
Computer Associates International 5 -12,958 -7,122 9,838 -332 16,006
Cendant 5 -13,704 5,636 19,633 31,584 7,390
NTL 5 -13,793 -11,064 26,669 26,744 2,654
Marconi 5 -14,226 -33,227 24,898 -3,064 8,961
Alcatel 5 -15,633 -32,421 43,679 14,156 12,735
Sun Hung Kai Properties 5 -16,029 n/a n/a n/a n/a
Yahoo! 5 -16,571 63 8,759 13,415 11,978
Honeywell 5 -16,769 13,938 -1,465 16,674 12,568
Mitsubishi Heavy Industries 5 -17,548 -9,423 1,088 5,466 3,747
KDDI 5 -17,876 8,773 -5,050 17,683 3,916
Singapore Telecommunications 5 -17,939 2,098 -4,738 6,455 8,844
Waste Management 5 -18,043 20,941 1,439 32,419 8,003
Roche Holding 5 -18,284 7,871 -1,796 -3,621 27,979
Bank of America 5 -18,383 35,640 35,303 41,469 47,857
Cable & Wireless 5 -18,820 -10,753 4,760 1,903 10,924
Pharmacia 5 -19,222 10,665 20,495 32,954 17,429
Xerox 5 -19,514 -5,208 -4,184 -422 10,543
Verizon Communications 5 -20,072 49,141 97,670 122,114 44,768
Corning 5 -20,804 -1,524 610 10,126 9,765
DuPont 5 -20,869 -26,581 8,970 -22,589 25,846
BT 5 -21,214 -17,828 32,936 9,847 26,475
Bank One 5 -21,716 35,492 -8,335 24,329 24,544
Asahi Bank 5 -22,022 -46,506 30,028 1,653 3,892
The Gillette Co 5 -22,309 -96 -6,736 -4,139 19,616
Eastman Kodak 5 -22,457 -4,234 -10,606 -1,820 9,437
AOL Time Warner 5 -23,120 80,054 81,419 150,434 34,160
Toyota 5 -23,353 51,063 -74,914 -27,566 27,068
Cisco Systems 5 -24,092 -7,979 93,635 41,851 67,897
Pacific Century Cyberworks 5 -28,860 6,977 4,385 37,432 2,789
Compaq 5 -29,561 -6,011 4,573 11,969 16,154
The Walt Disney Company 5 -31,515 11,128 -16,627 -1,695 27,710
Boeing 5 -32,651 22,055 -17,179 16,995 20,531
SBC Communications 5 -34,160 48,638 65,317 97,565 50,550
Deutsche Telekom 5 -39,868 -16,253 69,336 51,213 41,739
Motorola 5 -40,781 -13,737 12,335 16,233 23,146
Nortel Networks 5 -48,011 -47,636 58,761 29,180 29,956
Sumitomo Banking 5 -50,190 -47,900 32,062 21,001 13,351
WorldCom 5 -67,827 51,683 -940 81,712 36,859
The Coca-Cola Company 5 -68,211 9,670 -23,250 -8,161 62,793
JDS Uniphase 5 -71,483 -170 10,918 73,210 9,021
AT&T 5 -77,653 -69,731 99,949 53,403 54,468
Lucent Technologies 5 -86,594 -93,280 87,371 38,614 42,072
NTT 5 -90,861 72,338 -123,667 281 39,252
Vodafone Group 5 -104,574 57,588 126,717 241,671 47,207
All figures in millions of US$
1. Preference shares not included unless they have equity characteristics.
2. In general no distinction is made between acquisitions and mergers. The calculation is based on the shares of the acquiring
company or in the case of a merger the main company (as determined by Datastream).
3. In some cases data for certain (typically unlisted) shares was estimated.
4. Data for Shell based on both Royal Dutch Petroleum and Shell Transport & Trading Company.
5. Insurance and financial holding companies are excluded.
6. Wealth Added calculated to 31.12.2001.
7. Numbers are shown in US$ millions, but were first calculated in local currency.
8. Companies were selected based on their Wealth Added to include the 50 best performers and the 50 poorest performers
over this period. New companies were included if they fell in the top 50 (NTT DoCoMo and eBay), but not if they fell in the
bottom as the rise and fall of the markets creates a bias against new companies. Preliminary analysis for selection was based
on the top 1000 companies by Market Value of Equity.
9. In some cases where companies have non-calendar year ends the latest data is not available. In this case n/a is shown.
Stern Stewart & Co. Perspectives on Business
London Introduction to the Wealth Added Index (WAI)
Wealth Added Index, WAI, Future Growth Value, FGV, Current Operations Value and COV are trademarks of Stern Stewart & Co.
EVA
!
is a registered trademark of Stern Stewart & Co. " Copyright 2002. All rights reserved for Stern Stewart & Co. and Stern Stewart Europe Ltd.
14
Extending Wealth Added to strategic and financial planning
Wealth Added is not only a metric for assessing historic performance. It has many more uses.
Wealth Added as previously outlined can be developed into a forward-looking template for
planning, by linking it to established measures of operational performance. Managing for
Wealth Added objectively and transparently encourages executives to keep on the straight and
narrow path of financial and operational discipline.
Using Wealth Added for planning enables executives to plot where the path should lead.
Rather than have executives focus on either particular drivers of profit, financing needs, or
strategic capital investments in isolation, Wealth Added encourages more collaboration among
managers and a greater link between normally discrete and disparate choices. It is too easy to
allow the budget to compel executives narrowly to concentrate on the short term, or for
equity-type incentives to persuade executives to make acquisitions and take on excess risk,
rather than pursue profitable and sustained organic expansion. Too often, executives prepare
for immediate and direct consequences, but they do not satisfactorily plan for indirect and
long-term outcomes of their decisions. Wealth Added encourages a broader outlook. As
stated previously, the platform requires managers to balance short-term profitability with long-
term prospects, and both with financing and investors required return.
The Wealth Added approach starts with determining the planning period. If executives start
with their estimate of their businesses comparative advantage period (CAP), they
automatically ground two assumptions:
Wealth Added equals zero for the period
All of the current prospects will be converted into profitability by definition.
Strategies that extend the CAP add real value for investors. If a company can keep pushing
back the competitive horizon the point at which there is no competitive advantage this will
keep replenishing the prospects of the company. It is fundamental to effective strategy to seek
do this, but very challenging in practice, and has often led to ill-judged diversification.
When executives engage in planning for other periods, such as for three-five years, or for the
annual budget, it is recommended to start with a Wealth Added of zero but then to try
alternatives when performing sensitivity analysis. Forecasting for periods other than the CAP
necessitates that executives annually estimate the value of the prospects they aim to build.
Adding the estimate of prospects to each year of the planning period, which the Wealth Added
process demands, introduces clarity to assumptions made for profitability and financing. In
cyclical concerns, managers will predict negative growth prospects when they are
experiencing the top of the cycle. The market price of the shares will already include an
expected fall in profitability. Thus, combining the value of profitability, prospects and
funding increases the number of variables to consider. Planning profits may prove relatively
simple. Capital expenditures required may additionally be straightforward. But then
managers must predict their prospects and balance them against the financing needed.
Competitive and finance strategies are married. Portfolio analysis becomes significant.
Managers need to determine the financing requirements. They affect the required return in
each year and the profitability or prospects that managers must deliver to cover the expected
cost. Consider the effect of financing for the Comparative Advantage Period. Issuing new
equity or debt would require an increase in cash flow to cover the financing costs, whereas
repaying loans or returning cash to shareholders by way of dividends or repurchases will
reduce the required return. It is natural that mature businesses will pay higher dividends and,
whilst this is not the only route, mature businesses that follow other strategies need to be
especially convincing to investors.
Mixing and matching financing and prospects make planning for other periods more complex.
But they bring reality to a major capital investment in research and development, or to a
strategic but expensive acquisition. Do the prospects and the financing align? When share
Planning
period
Role of
financial
strategy in
planning
Stern Stewart & Co. Perspectives on Business
London Introduction to the Wealth Added Index (WAI)
Wealth Added Index, WAI, Future Growth Value, FGV, Current Operations Value and COV are trademarks of Stern Stewart & Co.
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is a registered trademark of Stern Stewart & Co. " Copyright 2002. All rights reserved for Stern Stewart & Co. and Stern Stewart Europe Ltd.
15
prices fall on the announcement of an acquisition, the market is indicating that the future
profitability, or the prospects, will not pay for the financing of the investment. The Wealth
Added framework allows managers to view the trade-off clearly.
Naturally, specific assumptions such as sales growth and margin, as well as the requirement
for working capital and fixed assets, come next. This is where drilling down becomes
important to see whether corporate goals and divisional opportunities match. The process of
drilling down forces management to value each business and determine what each one
provides to the total enterprise value of the firm.
Benchmarking against an industry peer group will encourage managers to ask the following
questions and to ground some key assumptions:
Do some competitors have different CAP or do they have the same? What may each
player do in order to convert prospects into profitability over this period?
Who is best in class for various value drivers?
How does each company fund itself? (Debt, equity, dividend policy.)
How does comparative advantage translate into strategy and financing?
Are sales and other projections for the entire group, over the period, realistic?
The last step is sensitivity analysis. Look at different Comparative Advantage Periods,
financing alternatives, potentials for sales growth and margin, and the financing. This base
case assumes that the market price of the shares is accurate. Stretch goals look at higher share
prices. Planning for stretch goals encourages managers to consider Wealth Added above zero.
What needs to happen over the period for WAI to be higher, for the share price to double in
three years? If this happens, what does this mean for future plans? Can the company sustain
its growth? Grounding stretch goals, Wealth Added, prospects, and financing as well as the
profitability after the period under scrutiny discourages overconfidence.
Sensitivity Analysis (Examples)
CAP < 5 > years
Industry Peers v Own
Financing Retained Cash v External Financing
Debt v Equity
Dividend Policy
Profitability Sales Growth v Margin Improvements
Value Drivers Average v Best in Class
Organisational Strategy Acquired v Organic
Portfolio Strategy Buy v Keep v Sell
GDP Growth < 3% >
Industry Growth < 5% >
WAI ZERO v Stretch
None of the ideas stated here should surprise. None are revolutionary. All are based on the
principles of modern corporate finance theory. Wealth Added adds further clarity to existing
planning procedures because the prospects are highlighted in each year. Investments,
including acquisitions and long term expenditures in research and development, can be viewed
in this light. Investment and consequences for the period and the future are in front and
centre. The Wealth Added approach is the big picture. Applying the concept grounds
managers in reality. All drivers of share price are included. Nothing is left out. All parts of
the process happen together, not in isolation. The idea is simple, robust, and comprehensive.
Benefits of
drilling down
the model
Benchmarking
and sensitivity
analysis
Stern Stewart & Co. Perspectives on Business
London Introduction to the Wealth Added Index (WAI)
Wealth Added Index, WAI, Future Growth Value, FGV, Current Operations Value and COV are trademarks of Stern Stewart & Co.
EVA
!
is a registered trademark of Stern Stewart & Co. " Copyright 2002. All rights reserved for Stern Stewart & Co. and Stern Stewart Europe Ltd.
16
Wealth Added and incentive architecture
Wealth Added can be used to motivate managers to make better decisions. FTSE 100
companies regularly claim a commitment to the creation of shareholder value. However,
Stern Stewart research shows that more than half (53 per cent) of the companies surveyed did
not identify the link between value creation and incentive plans that align manager and
shareholder interests
5
.
Reward executives for creating Wealth Added, balancing all four of its factors the value of
profitability, the value of prospects, financing, and investors required return and you reward
them for creating true value. By contrast, paying for performance to achieve success on just
one of the traditional metrics may cover one aspect of wealth creation, but not others.
For instance, any metric which focuses on profit, focuses on current profitability alone. A
single-minded focus on that because that is what an executive is being paid to do may
compromise future profitability, and hence expectations of that profitability. Any incentive
scheme based on options which has no comprehensive test of operating performance,
financing and required return, as Wealth Added requires, means that in the short term,
financing may be ignored, as well as the required return. It has been in the recent past. It is
easier to dream without the anchor of financing parameters and the required return.
Of course, like other market-based metrics, Wealth Added inevitably depends on share price,
but the Wealth Added framework highlights the financing demanded to create that share price,
and encourages managers to concentrate not just on share price, but to convert the
expectations reflected in it into current profitability. Wealth Added includes the short term
and the long term, as well as all sales, margins, costs, capital expenditure and the required
return. In some respects, Wealth Added is a fully marked-to-market EVA.
It is also possible to index Wealth Added and its main drivers against peer companies. This is
valuable not only for benchmarking a companys performance, but also for creating incentive
compensation schemes.
Although Wealth Added is more of a top-level, strategic planning tool, it can be drilled
down to supplement other value-based management tools. By indexing against peers in the
share market, or depending on the industry, the commodity market, management can remove
exogenous factors and render Wealth Added available for divisional and unit managers. Like
EVA, it can become an incentive compensation tool or performance test for lower-level as
well as senior management and employees. Since many employees receive share options now
anyway, using Wealth Added would add no more market-related factors than already exist,
and the drivers would be closer and more meaningful.
5
Although 47 per cent of the companies surveyed claimed in their remuneration reports that their incentive policies aligned
the interests of their managers and owners, the corollary is that 53 per cent did not.
Stern Stewart & Co. Perspectives on Business
London Introduction to the Wealth Added Index (WAI)
Wealth Added Index, WAI, Future Growth Value, FGV, Current Operations Value and COV are trademarks of Stern Stewart & Co.
EVA
!
is a registered trademark of Stern Stewart & Co. " Copyright 2002. All rights reserved for Stern Stewart & Co. and Stern Stewart Europe Ltd.
17
Wealth Added 303 Motivating managers
Motivating managers to focus on Wealth Added through incentives would reinforce executive
commitment to the principles of managing for value. This does not cannibalise an EVA-based
incentive programme but builds heavily on similar foundations. If executives prefer shares or
options, then Wealth Added can provide a powerful performance test. In either case, Wealth
Added can be adapted to company requirements.
Since Wealth Added includes a required return for equity investors and all investors owning
shares within the period measured, holding management accountable for Wealth Added
comprehensively aligns owners and executives. During any period, companies should attempt
to have a positive and high Wealth Added, but in order to achieve a target level of
performance, zero Wealth Added should suffice. Company or industry volatility should
determine the range of outcomes between zero and twice bonus. Volatility depends on the
period, but history should act as a guide.
Exhibit 3: Wealth Added as an incentive device
Indexing against a set of industry peers would reduce the impact of exogenous industry and
macroeconomic factors on Wealth Added. This lessens the volatility resulting from decisions
outside management influence. The result is similar to when companies index their share price
against a peer set in order to isolate their performance against the peer group, yet companies
almost never adjust for financial risk (caused by leverage) in these calculations. Wealth Added
does, via the cost of equity. Remuneration committees may prefer a mix of indexed and pure
Wealth Added.
An incentive programme based on Wealth Added will raise several issues:
Some will disagree with the peers or the cost of capital. Discuss with investors. Find out
what they believe the peer list and cost of capital are. Look at peers chosen by analysts. Good
academic studies provide clues into cost of capital. Few would cheer the recent reduction in
the market risk premium. Choose a number and stick with it. Choose peers and accept them
too. Adjustments can be made to the incentives based on their history and the company.
Managers have an incentive to use debt rather than equity to reduce the required return. The
cost of equity calculation, based on the Modigliani Miller principles, increases the required
rate of return on equity if leverage is increased.
Much depends on the value of prospects. Managers could exude overconfidence and try to
manage their share price upwards. Institutional investors should use their models to perform
sensitivity analyses. Look at peers. Ask whether industry or company can actually perform.
A business may have great prospects, but good analysis should help determine true growth.
The timing of the programme could be manipulated. A good look at the history will illustrate
which adjustments can assure a robust programme.
A target of zero Wealth Added is only one choice. Stretch targets can tie to larger wealth
creation targets, equivalent to doubling share price or other goals. It is important to tie the
incentive architecture to the planning architecture, but the parameters should be objectively
and transparently chosen. Mixing with shares and options is acceptable, but using too many
metrics and incentives will undermine the overall effect. Consistency improves acceptance
internally and externally.
WAI = 0
I ndustry or Company
Volatility
}
Bonus %
Performance WAI
Stretch WAI
Stern Stewart & Co. Perspectives on Business
London Introduction to the Wealth Added Index (WAI)
Wealth Added Index, WAI, Future Growth Value, FGV, Current Operations Value and COV are trademarks of Stern Stewart & Co.
EVA
!
is a registered trademark of Stern Stewart & Co. " Copyright 2002. All rights reserved for Stern Stewart & Co. and Stern Stewart Europe Ltd.
18
EVA and Wealth Added
If correctly implemented, EVA is the best internal measure of performance within a company.
EVA starts with profits and subtracts an opportunity cost for the use of all capital, equity as
well as debt. It is a number (in $$, "", or whatever), not a percentage
6
. It is also the spread
between a companys return on and cost of capital, multiplied by the invested capital
7
. EVA
improved on Earnings per Share in that it includes equity capital, not only debt. It covers the
income statement and the balance sheet. Adjustments are made to the accounting framework
to build an economic model of performance that allows discounted EVA to equal discounted
cash flow. Hence, raise EVA, and you should raise the share price. It is the one measure that
properly accounts for all the complex trade-offs faced by a manager.
Key Issue No. 5: Why do we need two measures?
An incentive system based on Wealth Added rewards senior managers for using the influence that they
wield on share price wisely. EVA holds managers, and indeed all employees under the system,
accountable for how they spend the capital provided to the company by investors.
EVA motivates managers to deliver today and, in a well-designed incentive scheme, over the medium
term. Wealth Added encourages them to balance performance today and building capabilities for the
medium and longer term. The measures complement each other.
If a manager has clear line of sight to the share price, then Wealth Added is appropriate. But even if
not, and in almost all cases where managers are paid using shares, or share options, Wealth Added is the
best way of understanding the share price. In cases where the share price seems remote and beyond
influence then EVA will be the most appropriate measure. EVA enables managers to see whether they
are earning an adequate return on the capital they employ. Where returns are lower than might
reasonably be expected, for investments of similar risk (i.e. they are below the cost of capital), EVA is
negative, and the firm faces the flight of capital and a lower share price.
EVA has the benefit that it can be drilled down, or used to measure, motivate and reward
performance at any level throughout an organisation without, as with Wealth Added, having to
value divisions and units. However, despite this, there are limitations to the market-based
aspects of EVA. For instance, it does not recognise (and hence reward) the benefits of
building prospects in other words, building investors expectations of future growth. A
simple example will suffice. If a company invests in R&D, its prospects and hence its share
price may go up, but its EVA will not not until that investment bears fruit in terms of profits.
A chief executive paid in share options might receive a reward for that investment almost
immediately. One paid for EVA improvement would have to wait: one reason why EVA and
other incentive plans based on current financial performance require careful design and
integration into the overall compensation and motivational systems.
EVA rewards for delivering on investors expectations of future growth, not necessarily for
raising those expectations and the share price, as such. Wealth Added gives managers credit
for balancing current performance and improving medium and long-term prospects. Together,
EVA and WAI encourage the building of prospects and then delivering them. Senior
executives, and possibly divisional managers, focus on medium and longer term strategic
planning, business development, and financing. Junior managers concentrate on delivering.
Hence, for senior managers, a mix of Wealth Added and EVA is preferable to EVA alone,
implemented in tandem with EVA for more junior managers, and other employees, to
encourage pervasive value creation.
6
Whilst percentage measures are useful for comparisons they are not generally a good basis for decision making. For
example, if a business has a high percentage return on assets, managers can be discouraged from making investments that
would dilute the return on assets, even if the investments create value.
7
For example, a "1000 investment in a market stall returns five per cent, where investments of similar risk elsewhere can
earn 15 per cent. EVA here would be (5% - 15%) x "1000 = - "100
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Conclusion
Consider the strategic planning exercise and its attendant financial forecasts, whether over
three or five years, rolling or static. Taken together with the annual budget exercise, they
constitute the most significant set of business processes in which an organisation engages.
They are the blueprint for enacting the vision, mission and strategy of the organisation from
the executive suite to the shop floor, across product and service lines, across divisions and
geographies, for allocating capital, and for outlining to what extent growth will be organic or
acquired. Financial strategy how the business is financed emanates from or is beholden to
this blueprint. All other activities, investments and decisions, whether large or small, follow.
How a business develops and manages this process, and how individuals enact it, defines the
culture of the organisation. Many of the recent business scandals derive from the fact that this
process was dishonest. If the process is robust, with the right metrics and incentives, aligned
with investors, the result is good internal governance. Without it, no matter how good its
corporate governance, a company will be in bad shape.
Management and investors should analyse how companies performed during a period in
question, and how their activities affect their Wealth Added. But what that means to a
companys business plan going forward matters even more. Past choices matter. What
investors should ask now is whether managers grasp the implications particularly in terms of
accountability - and potential of the Wealth Added framework.
Before the current crisis of credibility in company management, executives managed earnings
growth, what we have called profitability. Over time, they added management of share price,
including that element that we have called prospects, to their responsibilities.
In itself, this may not be a bad thing, if management is creating real opportunities, for which
they are ready to be held accountable. However, the earnings game relying on aggressive
accounting to raise earnings quarter after quarter and the management of share price were
two of the defining, and unfortunate, aspects of the bull market of the late 20
th
century. The
spectacular turn of that rising market, following the collapse of the USs Nasdaq technology
index, left executives on the beach.
It is tempting to believe that investors understood that managers were playing the earnings
game, and accepted it because they did not realise the extreme behaviour, including fraud and
mis-representation that would result. Many in the financial community turned a blind eye to
or even encouraged aggressive earning management. Inconsistency, and any massaging of
figures, results in a corporate governance discount in the share price.
For those who played the earnings game and have suffered the consequences, Wealth Added
provides the opportunity to reform, and closes the credibility gap perceived by wary investors.
Even those companies which were neither disciplined by the markets for fraud nor which had
massive investments gone awry will most probably have used the coupling of their budget
processes and incentive systems to guide both earnings and share price, following accepted
wisdom among senior managers. Those that have been castigated unfairly have an
opportunity in Wealth Added to prove that they consistently create value.
If they do grasp the implications and potential of Wealth Added, consistently and
comprehensively, then we will be on the way to bridging the credibility gap between
managers and investors, and providing a plausible answer to one of the key business questions
of the 21
st
century.
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London Introduction to the Wealth Added Index (WAI)
Wealth Added Index, WAI, Future Growth Value, FGV, Current Operations Value and COV are trademarks of Stern Stewart & Co.
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20
APPENDIX: Wealth Added Definition Issues
Introduction
Conceptually Wealth Added is straightforward it is the difference between the actual equity
return from a company and the expected return. Inevitably there are certain technical issues
with the definition. This appendix discusses some of the main issues in the context of two
alternative definitions, the first of which has been used for ranking purposes.
Definition 1: Continuous Wealth Added
We calculate the Wealth Added created each day and accumulate these one-day Wealth
Addeds to create the one-year and five-year measures. When we accumulate we adjust for
inflation so that the value of the Wealth Added in different periods is comparable.
Definition 2: Present Value Wealth Added
We calculate the Wealth Added created for the entire period (say five years) and discount
8
it at
the cost of equity to the beginning. An alternative calculation, which is mathematically
equivalent, is to calculate for shorter periods (a year or daily periods) and discount these back
to the start date and then accumulate.
Advantages and disadvantages of each definition
The advantage of the first definition is that the Wealth Added for each sub-period is worth the
same and is independent of which time period or company is considered. It provides a good
the basis of comparison between periods and between companies. The disadvantage is that the
result is path dependent; it depends on the path the share price takes, not just the opening
and closing values.
The second definition overcomes the path dependence but weakens the basis of comparison
between periods and between companies.
These issues are considered in more detail:
Comparison between periods and between companies
By its nature the Present Value approach (definition 2) states that 1000 of Wealth Added (or
excess return) in year one is worth more than 1000 of Wealth Added in year two (even with
zero inflation). In a narrow financial sense this is true, but arguably one wants to construct a
measure that gives a meaningful comparison of management performance between the
periods.
A second issue is that the cost of equity is company dependent and thus creates effects that
may be undesirable. These are illustrated in the next example, which compares a high-risk
(high ) company and a lower-risk (low ) company:
8
Discounting is a standard technique in financial analysis used to take account of the time value of money. To discount
the 5-year wealth added one would divide it by (1 + cost of equity)
5
. This assumes the same cost of equity for all years, but
the calculation is easily adapted for a varying cost of equity.
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21
Equity Value
Y1 (Start) Y1 (End) Y2 (End) Y3 (End) Y4 (End) Y5 (End) Cost of equity
High 1,000 1,200 1,440 1,828 2,194 2,632 20%
Low 1,000 1,100 1,210 1,431 1,574 1,732 10%
Expected Return Y1 Y2 Y3 Y4 Y5 Total
High 200 240 288 366 439 1,532
Low 100 110 121 143 157 632
One-year Wealth Added
High 0 0 100 0 0
Low 0 0 100 0 0
Inflation adjusted Wealth Added
High 0 0 110 0 0 110
Low 0 0 110 0 0 110
Cost of Equity Adjusted Wealth Added (Present Value to start of Y1)
High 0 0 58 0 0 58
Low 0 0 75 0 0 75
Assumptions Inflation = 5% No dividends or share changes
Both companies exactly match investor expectations in all years except year three when they
beat expectations by 100. The inflation-adjusted approach used in the rankings evaluates their
performance as equivalent. The present value approach implies that the risky company did the
worse of the two.
One has to decide which of these outcomes is most meaningful. The higher total given to the
low-risk company using the present value approach can be rationalised by thinking in
investment appraisal terms: envisage oneself at the start of year one which of the outcomes
would be preferred? This line of thinking is appropriate if one wants to use Wealth Added in
conjunction with an incentive scheme, for example as a performance test for equity incentives.
The present value approach has the advantage that as a multi-period measure it does not suffer
from path dependence. Its disadvantage, illustrated in the above example, is that the most
reasonable assessment is to say that both companies have done equally well
9
.
Path dependency
The continuous Wealth Added measure (definition 1) is path dependent; that is, the value of
the measure is not only dependent on the opening and closing share prices, but also the route
taken between these prices. This is best explained by a simple example, in which we assume
no dividends or changes in the numbers of shares:
Equity Value
Y1 (Start) Y1 (End) Y2 (End) Y3 (End) Y4 (End) Y5 (End)
Case A 1,000 1,200 1,320 1,452 1,597 1,757
Case B 1,000 1,100 1,320 1,452 1,597 1,757
Expected Return Y1 Y2 Y3 Y4 Y5 Total
Case A 100 120 132 145 160 657
Case B 100 110 132 145 160 647
One-year Wealth Added
Case A 100 0 0 0 0 100
Case B 0 110 0 0 0 110
Assumptions Zero inflation. No dividends or share changes Cost of equity = 10%
9
In fact one can make a case that when a high company outperforms it will tend to outperform by more. The way to
normalise for this is to divide by . It is unnatural for the assessment of the degree of outperformance to depend on which
sub-period it occurs in
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22
Note that the opening and closing equity values are the same, but the Wealth Added is
different in the two cases. In Case A the excess return (or Wealth Added) is created one year
earlier. This creates a higher investor expectation in year two and a higher overall investor
expectation, thus decreasing the overall Wealth Added.
The effect can be substantial if the paths differ radically:
Equity Value
Y1 (Start) Y1 (End) Y2 (End) Y3 (End) Y4 (End) Y5 (End)
Case A 1,000 1,361 1,757 1,757 1,757 1,757
Case B 1,000 1,100 1,320 1,452 1,597 1,757
Expected Return Y1 Y2 Y3 Y4 Y5 Total
Case A 100 136 176 176 176 763
Case B 100 110 132 145 160 647
One-year Wealth Added
Case A 261 261 -176 -176 -176 -6
Case B 0 110 0 0 0 110
The effect is smaller, but still significant if there is some inflation, because this reduces the
real cost of equity:
Equity Value
Y1 (Start) Y1 (End) Y2 (End) Y3 (End) Y4 (End) Y5 (End)
Case A 1,000 1,361 1,757 1,757 1,757 1,757
Case B 1,000 1,100 1,320 1,452 1,597 1,757
Inflation adjusted Wealth Added
Case A 317 302 -194 -184 -176 64
Case B 0 127 0 0 0 128
Assumptions (Total affected by rounding) Inflation = 5%
In this example the Wealth Added is accumulated in Year five currency value (e.g. Y5 $).
Conclusion
Each approach has its advantages and disadvantages (summarised below). We believe that for
understanding the performance of companies and especially for looking at the sub-period (e.g. a
years) contribution to the total performance, the Continuous approach is most appropriate.
The Present Value approach may be more applicable for certain incentive purposes.
Advantage Disadvantage
A given amount of Wealth Added is worth
the same in each year and each company
The result is path dependent
a) Analogous to DCF investment appraisal
techniques
b) Logical for incentive use since when
specifying rules at start of period issues are
similar to DCF appraisal
c) Independent of path
a) This measure may appear to favour
low companies and does not facilitate
some comparisons between companies
of different risk
b) Out-performance in early years is
worth more than in later years, so
measure not good for comparisons
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23
FINANCIAL TIMES
Tuesday March 6 2001
VIEWPOINT ERIK STERN
Measuring executive performance in terms of share price alone is misleading.
Benchmarking against industry and national indices is much more revealing
Context is all. To measure
performance - of a chief
executive, a board, a fund
manager or a City analyst - the secret is
to put the performance into context.
This notion goes to the heart of
shareholder value in a volatile market.
The chief executive who points to a
rising share price in a rising market
should be able to say not just "we did
well" - everyone in the industry may
have been doing well - but "we
outperformed our competitors in our
country's stock market and our
industry".
The same is true when stock prices
fall. To measure the chief executive of a
company in an industry such as
commodity chemicals, with low growth
expectations, against his peers at
companies in industries with high or
volatile expectations reveals little about
his performance.
In short, chief executives should be
held accountable for their own
performance, not that of their market or
industry. To measure corporate
performance, we at Stern Stewart, the
management consultancy, emphasise
market value added (MVA) - the extra
wealth created by managers above and
beyond the total investment in a
company - and economic value added
(EVA) - the value created above and
beyond the cost of capital. However,
most of the many measures of company
performance fail to capture relative
performance. Total shareholder returns,
earnings per share and sales growth all
operate out of context. Compared with
whom?
We have set out to answer that
question in a five-year survey of 1,000
companies worldwide. Our results shed
light on the performance not only of
managers but of fund managers and
analysts too. Anyone with a large,
balanced investment portfolio will own
stocks in low-growth industries as well
as high-growth ones - but are they the
right stocks?
Our study is more than just a
corporate beauty parade. It is about pay
for performance and how much of a
company's performance is due to its
managers. Over the past few years,
performance-related pay has
increasingly been based on options and
shares. At one level, this makes good
sense. Such instruments reward
managers for decisions made today that
will create profits in the future.
Investors recognise this by bidding up
the share price.
At a deeper level, though, equity is
inadequate. Executives can affect only
about 25 per cent of the share price.
Academic studies suggest that 70-80 per
cent of the share price of a company is
the result of macro-economic, industry
and other factors, which are generally
out of the control of managers.
That is a reflection of the levers
available to managers that were
identified by Merton Miller and Franco
Modigliani, the Nobel laureates. They
argued that six factors influence a
company's market value. Two of these
are outside managers' control. It is the
market that determines the cost of
capital for business risk (including
interest rates) and the time for which
investors expect to see excess returns
(the period of comparative advantage).
That leaves managers with influence
over just four of Miller and Modigliani's
factors:
Beat cost
of equity
capital
Beat
industry
peers
Beat
country
index
No of
companies
in category Examples
1 " "" " " "" " " "" " 220 BT, Bayer, Philips, Eli Lilley, Akzo Nobel, Ford, Siemens
2 " "" " " "" " 77 Nike, Coca-Cola, VW, Hanson, Carrefour, Lafarge
3 " "" " " "" " 37 Smith & Nephew, Next, NEC, BAE Systems, SAP, Sanyo
4 " "" " 34 HP, Boeing, Texaco, Carlton Communications
5 " "" " " "" " 9 Anomalous: mostly Japanese companies
6 " "" " 72 Heinz, BAA, McDonald's, Rentokil, EDS, Blue Circle, MAN
7 " "" " 56 Japanese; also News Corporation, Cathy Pacific
8 284
Disney, BA, Rolls-Royce, Carlsberg, ICI, Marks and Spencer,
Boots, KLM, AT&T, many Japanese companies
Total 789
Sources: Stern Stewart Europe - research by Geoffroy Pacault, with support from Benjamin Madjar, Louise Turner, Antoine
Depigny, Jean Bellon-Serre, Kamil Guessous, Ludovic Garnier and Erwan Guillo Lohan
architecture produced an
average 84 per cent more wealth over five years.
Stern Stewart publishes the quarterly academic Journal of Applied Corporate Finance. G. Bennett
Stewarts revolutionary The Quest for Value launched a range of leading-edge books from Stern
Stewart, including Al Ehrbars EVA
Challenge.
Around the world, Stern Stewart also publishes rankings of the value created by publicly-owned
companies, in leading newspapers and magazines.
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