something to smile about? - Euromoney Institutional Investor PLC

LEAD STORYVALUE CREATIONPhilipsRoyal PhilipsElectronics, the thirdlargest global consumerelectronics maker, hasbeen using EVA as aninstrument to measurefinancial performancesince 1997.Philips recognizedthat the normal netincome profit and lossaccount didn’t accountfor a company’s cost ofcapital, says groupcontroller GerardRuizendaal. “We wantedto make it visible so wecould understand thiscost.” EVA has sincebeen ingrained in thecompany’s standardsand is based on the costof capital that in eachactivity, reflects the riskrelated to the business,geography and effectivetax rates. “The mainidea is to improve ourEVA every year so ourreturn of capital is morethan our cost of capital,”says Ruizendaal.One of Ruizendaal’smain responsibilities asgroup controller isperformancemanagement, “lookingat systems, metrics, andhow to measure thevalue of our strategies.”Europe’s Kondragunta. “There is a lotmore future growth associated withcompanies with high R&D so naturallythey have a higher MVA.”Value creationAn analysis of investments in the sharesof Stern Stewart’s publicly-owned USclients showed they produced 49% morewealth after five years than equalinvestments in shares of competitorswith similar market capitalisations.Philips measuresvalue creation on astrategic level and forinvestments throughnet present valuetechniques, saysRuizendaal. At theoperating level, valuecreation is measured viaEVA. “With EVA youdon’t look to short-termmovements in shareprices, but toconsistently improvingthe returns above thecost of capital.”EVA is not theexclusive measurementtool at Philips. Thecompany also uses thebusiness balancescorecard. Ruizendaalexplains: “Currentfinancial performance isessentially aconsequence of whatyou have achieved inthe past in the business,so we try to correlatethis financialperformance withleading non-financialdrivers such ascustomer satisfactionbased measurementsand process basedmeasurements.” (eg, onsupply chainperformance).“All the decisionmaking tools must beconsistent for drivingvalue creation withinthe company, and withevery year, with everyprocess, it becomes away of life.Philips also looks athow to integrate EVAinto its staff incentivestructure, with EVAaccounting forapproximately 50% ofthe criteria for yearlybonus incentives. “Theamount of share optionsoffered to employeesdepends on the shareperformance versus 24benchmarkedcompanies, and theincentives are less if wedon’t outperformagainst our benchmarkpeers.”Over the last twoyears, Philips hassystematically changedits portfolios tobusinesses with returnof capital greater thanthe cost of capital.Gerard Kleisterlee,president, emphasizedthis in his message inthe company’s 2003annual report, saying,that over the past yearPhilips had madeconsiderable progresson its journey to createOne Philips - a single,focused and clearlyidentifiable companygeared to sustainedvalue creation.How?As a company you are committed toshareholder value creation. But do youunderstand where and how value isbeing created and whereopportunities for value creation lie?MVA, EVA and value-based managementcompanies do, saysKondragunta, and that is why those UScompanies produce 49% wealth.Managers, and this essentiallymeans the CFO, at value-based managementcompanies believe that thereare only three basic ways to increaseand manage value. The first is toincrease the returns from the assetsalready in the business by running theincome statement more efficientlywithout investing new capital. The secondis to invest additional capital andaggressively build the business so longas expected returns on new investmentsexceed the cost of capital. Andthe third is to release capital from existingoperations, both by selling assetsthat are worth more to others and byincreasing the efficiency of capital bysuch measures as turning working capitalfaster and speeding up cycle times.Total and Exxon do not subscribe tovalue-based management, but bothfirmly believe that the culture, strategyand financial controls of value-basedmanagement are firmly in place attheir companies.“We have a global functional organisationoperationally consistentthroughout. It is this consistentapproach that embraces the core principlesat Exxon,” says Mulva.Exxon subscribes to a high returnand low risk strategy, “not overcapitalisingon investment [but] being focusedon the long-term,” says Mulva. It is anapproach that has steered the companythroughout its history, and enabled it tooutperform its competitors over thepast 20 years. So how does Exxonmeasure the value its core principlesbring? Through return on capitalemployed (ROCE - income before financialitems relative to average capitalemployed). “Shareholders entrust uswith their capital and we tell them howwell we have managed it throughROCE. People understand ROCE. It is avery powerful,” says Mulva.It is a similar tale at Total. “We runthe company from an industrial viewpoint.We allocate cash in an efficientmanner and measure through returnon average capital employed.” (ROACE- operating profit before amortizationof goodwill x 100/ average invested capital,accumulated amortization ofgoodwill). “It is a consistent measure ofshareholder value in our industry andallows our investors to compare likewith like.” In its 2003 report, Total26 cf March 2004 corporatefinancemag.com