The idea that the primary responsibility of corporate management is to increase shareholder value has gained widespread acceptance in the United States in the last two decades or so. With the globalization of capital markets, intensification of competition, and, massive privatization initiatives, shareholder value creation is gaining the attention of executives all over the world, including India. The interest in value creation has been stimulated by several developments:
* Institutional investors, which traditionally were passive investors, have begun exerting influence on corporate managements to create value for shareholders.
* Many leading companies which have accorded value creation a central place in their corporate planning, serve as role model for others.
* The market for corporate control has made value destroyers more vulnerable to raiders.
* Business press is emphasizing shareholder value creation in performance rating exercises.
* Greater attention is being paid to link top management compensation to shareholder returns.
To help firms create value for shareholders, value based management (VBM) systems have been developed. VBM is a generic term for a set of tools helpful in managing a firms operation for enhancing shareholder value. Many regard it as one of the most important developments in corporate management. VBM represents a synthesis of various disciplines like finance, strategy, accounting, and organizational behavior.
There are various facets of VBM. It is organized into six sections as follows:
* Methods and key premises of VBM.
* Measure of value creation: MVA
* Drivers of value creation
* Economic value added
* Lessons from the experiences of VBM adopters
* Potential and hurdles for VBM in India.
Methods and key premises of VBM:
Several methods have been used in VBM. The three principal methods of VBM are:
* The free cash flow method proposed by Mckinsey and LEK/Alcar group.
* The economic value added/market value added (EVA/MVA) method pioneered by Stern Stewart and Company.
* The cash flow return on investment/cash value added (CFROI/CVA) method developed by BCG and Holt Value Associates.
Though these methods look outwardly different, the basic premises underlying them are the same. They are as follows:
* The value of any company (or its individual strategies and investments) is equal to the present value of the future cash flows the company is expected to produce.
* Conventional accounting earnings are not a sufficient indicator of value creation because they are not the same as cash flow, they do not reflect risk, they do not include an opportunity cost of capital, they do not consider time value of money and they are not calculated the same way by all firms because of variations in accounting policies.
* For managing shareholder value, firms should use metrics that are linked to value creation and employ them consistently in all facets of financial management.
* A well designed performance measurement and incentive compensation system is essential to motivate employees to focus their attention on creating shareholder value.
The key difference between these methods relates to VBM metrics. For example, the LEK/Alcar method uses shareholder value added, the Stern Stewart method emphasizes EVA and MVA, and the BCG method focuses on CFROI and CVA.
Each camp argues that its measures are the best and cites supporting evidence for the same. It is difficult to objectively assess the validity of these claims.
While the different methods to VBM have their own fan clubs, the EVA/MVA method seems to have received more attention and gained more popularity. Our discussion of VBM will also be in terms of EVA and MVA.