Samuel Weaver (College of Business and Economics, Lehigh University) J. Weston (Anderson School of Management)
Abstract
We identify four alternative performance metrics used in value based management (VBM). (1) Basic is an intrinsic value analysis (IVA), the discounted cash flow (DCF) methodology. (2) We show that this framework will be consistent with returns to shareholder (RTS, capital gains plus dividends) measured over appropriate time horizons. (3) Economic profit (EP) [also called economic value added (EVA®)] takes from the DCF free cash flow valuation, net operating profits after taxes (NOPAT), divided by invested capital to obtain the return on operating invested capital (ROIC) less a cost of capital estimate (k); the difference multiplied times operating capital. (4) The relationship between the market value of the firm's financial instruments and the book value of the firm's operating assets can be expressed equivalently as market value added (MVA), the q ratio, and the market-to-book ratio. We test the relationships of alternative financial accounting performance metrics versus market metrics on a historical basis as well as on a prospective basis. We find that the alternative financial performance metrics discounted cash flow valuation, returns to shareholders, economic profit, the market to book ratio [equivalently, the q ratio and market value added (MVA)] are highly correlated. We also find that standard financial ratio analysis as expressed in the DuPont formulation are also significantly related to market performance metrics and in the implementation of VBM. In implementation, each approach to value based management (VBM) starts with strategic planning processes, ties performance to incentive compensation, requires top management involvement, as well as information and training programs for employees. The four approaches to VBM also take into account other stakeholders (employees, consumers, community). VBM must also evaluate changing economic, cultural, and political environments. The strategic planning process analyzes long term trends, cyclical economic changes, competitive forces, and effective development of managerial capabilities and other resources. Our clinical analysis centers on Hershey Foods Corporation.
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