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The Idea in Cursory

Many firms sacrifice sustained growth for brusque-term financial gain. For instance, a whopping 80% of executives would intentionally limit disquisitional R&D spending just to meet quarterly earnings benchmarks. Upshot? They miss opportunities to create enduring value for their companies and their shareholders.

How to cultivate the time to come growth your business firm needs to succeed? Rappaport identifies ten powerful practices. Commencement among them: Don't get sucked into the short-term earnings-expectation game—information technology only tempts you to forgo value-creating investments to written report rosy earnings now. Another practice: Ensure that executives bear the same risks of ownership that shareholders do—by requiring them to own stock in the house. At eBay, for example, executives accept to own company shares equivalent to 3 times their almanac base of operations salary. eBay's rationale? When executives have significant pare in the game, they tend to make decisions with long-term value in mind.

The Idea in Practice

Rappaport recommends these boosted practices to create long-term growth for your company:

  • Brand strategic decisions that maximize expected future value—fifty-fifty at the expense of lower well-nigh-term earnings. In comparing strategic options, enquire: Which operating units' potential to create long-term growth warrants boosted capital investments? Which take limited potential and therefore should exist restructured or divested? What mix of investments across operating units should produce the almost long-term value?
  • Carry assets only if they maximize the long-term value of your firm. Focus on activities that contribute virtually to long-term value, such as research and strategic hiring. Outsource lower value activities such as manufacturing. Consider Dell Calculator's well-chronicled straight-to-consumer custom PC associates business organization model. Dell invests extensively in marketing and phone sales while minimizing its investments in distribution, manufacturing, and inventory-conveying facilities.
  • Render excess cash to shareholders when there are no value-creating opportunities in which to invest. Disburse excess cash reserves to shareholders through dividends and share buybacks. You'll give shareholders a take a chance to earn meliorate returns elsewhere—and prevent management from using the cash to make misguided value-destroying investments.
  • Reward senior executives for delivering superior long-term returns. Standard stock options diminish long-term motivation, since many executives cash out early. Instead, employ . These options reward executives only if shares outperform a stock index of the company's peers, not simply because the market equally a whole is ascent.
  • Reward operating-unit of measurement executives for adding superior multiyear value. Instead of linking bonuses to budgets (a practice that induces managers to lowball performance possibilities), develop metrics that capture the shareholder value created by the operating unit. And extend the performance evaluation menstruation to at least a rolling three-yr bicycle.
  • Reward middle managers and frontline employees for delivering superior performance on primal value drivers they influence directly. Focus on three to five leading value-based metrics, such every bit time to market for new production launches, employee turnover, customer retention, and timely opening of new stores.
  • Provide investors with value-relevant information. Counter brusk-term earnings obsession and investor incertitude by improving the grade and content of financial reports. Ready a corporate functioning statement that allows analysts and shareholders to readily understand the fundamental performance indicators that drive your company's long-term value.

Information technology's become stylish to blame the pursuit of shareholder value for the ills besetting corporate America: managers and investors obsessed with next quarter's results, failure to invest in long-term growth, and fifty-fifty the accounting scandals that have grabbed headlines. When executives destroy the value they are supposed to be creating, they almost always claim that stock market pressure level made them do it.

The reality is that the shareholder value principle has not failed management; rather, information technology is management that has betrayed the principle. In the 1990s, for case, many companies introduced stock options equally a major component of executive compensation. The idea was to align the interests of management with those of shareholders. Simply the generous distribution of options largely failed to motivate value-friendly behavior considering their design almost guaranteed that they would produce the opposite upshot. To start with, relatively short vesting periods, combined with a belief that short-term earnings fuel stock prices, encouraged executives to manage earnings, do their options early, and greenbacks out opportunistically. The common practice of accelerating the vesting date for a CEO'due south options at retirement added withal some other incentive to focus on short-term performance.

Of course, these shortcomings were obscured during much of that decade, and corporate governance took a backseat as investors watched stock prices ascent at a double-digit clip. The climate changed dramatically in the new millennium, withal, as accounting scandals and a steep stock market place refuse triggered a rash of corporate collapses. The ensuing erosion of public trust prompted a swift regulatory response—most notably, the 2002 passage of the Sarbanes-Oxley Human activity (SOX), which requires companies to institute elaborate internal controls and makes corporate executives direct accountable for the accurateness of financial statements. Nonetheless, despite SOX and other measures, the focus on short-term functioning persists.

In their defense, some executives debate that they have no choice but to adopt a brusk-term orientation, given that the average holding period for stocks in professionally managed funds has dropped from about vii years in the 1960s to less than one twelvemonth today. Why consider the interests of long-term shareholders when there are none? This reasoning is deeply flawed. What matters is not investor holding periods but rather the market's valuation horizon—the number of years of expected cash flows required to justify the stock price. While investors may focus unduly on well-nigh-term goals and hold shares for a relatively short time, stock prices reflect the marketplace's long view. Studies suggest that it takes more than than ten years of value-creating greenbacks flows to justify the stock prices of nigh companies. Management's responsibility, therefore, is to deliver those flows—that is, to pursue long-term value maximization regardless of the mix of high- and low-turnover shareholders. And no 1 could reasonably argue that an absence of long-term shareholders gives management the license to maximize short-term performance and risk endangering the company's time to come. The competitive landscape, not the shareholder list, should shape business organization strategies.

The competitive landscape, not the shareholder list, should shape business concern strategies.

What do companies have to do if they are to be serious almost creating value? In this article, I depict on my research and several decades of consulting feel to set out ten basic governance principles for value creation that collectively will help whatever visitor with a sound, well-executed business model to better realize its potential for creating shareholder value. Though the principles volition not surprise readers, applying some of them calls for practices that run deeply counter to prevailing norms. I should signal out that no company—with the possible exception of Berkshire Hathaway—gets anywhere nigh to implementing all these principles. That's a pity for investors considering, as CEO Warren Buffett's fellow shareholders have found, there's a lot to exist gained from owning shares in what I call a level 10 company—one that applies all ten principles. (For more on Berkshire Hathaway's awarding of the x principles, please read my colleague Michael Mauboussin's assay in the sidebar "Approaching Level ten: The Story of Berkshire Hathaway.")

past Michael J. Mauboussin

Practice any companies in America make decisions consequent with all ten shareholder value principles? Berkshire Hathaway, controlled past the legendary Warren Buffett, may come up the closest. Not only is Buffett the company's largest shareholder, simply he is also in the rare position of viewing the drivers of shareholder value through the eyes of a major investor and executive. He observes, "I'chiliad a better businessman considering I am an investor and a better investor because I am a man of affairs. If you have the mentality of both, it aids you in each field."one

In Berkshire's communications, for case, Buffett makes it clear that the company does non "follow the usual practice of giving earnings 'guidance,'" recognizing that "reported earnings may reveal relatively little about our truthful economic performance" (see Principle one). Instead, the company vows to be "candid in our reporting to you, emphasizing the pluses and minuses important in appraising business organization value. Our guideline is to tell you the business concern facts that nosotros would want to know if our positions were reversed. We owe you no less" (Principle 10).

Berkshire'south majuscule resource allotment decisions, especially when earnings growth and value creation conflict, are also consonant with the shareholder value principle. Writes Buffett, "Bookkeeping consequences do non influence our operating or uppercase-allocation decisions. When conquering costs are like, we much adopt to purchase $two of earnings that are non reportable by the states under standard accounting principles than to purchase $one of earnings that is reportable" (Principles 2 and 3).

Shareholder-value companies recognize the importance of generating long-term cash flows and hence avert actions designed to boost short-term performance at the expense of the long view. Berkshire's 2005 almanac report explains the company's position: "If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-brawl…, no amount of subsequent brilliance will overcome the impairment that has been inflicted."

Berkshire is also exceptional with regard to its corporate governance and compensation. There'south no doubt that Buffett's wealth and that of the company'due south vice chairman, Charlie Munger, rise and fall with that of the other shareholders: Berkshire stock represents the vast majority of their substantial net worth (Principle nine). As Buffett notes, "Charlie and I cannot hope you results. But we tin can guarantee that your financial fortunes will movement in lockstep with ours for whatever flow of fourth dimension you elect to be our partner."

The company's compensation arroyo is besides consequent with the shareholder value principle and stands in stark contrast to common U.Due south. bounty practices. Buffett'due south $100,000 almanac salary places him in the cellar of Fortune 500 CEO pay, where median compensation exceeds $8 1000000. Further, Berkshire is the rare company that does not grant any employee stock options or restricted stock. Buffett is non confronting equity-based pay per se, but he does debate that too few companies properly link pay and operation (Principle half-dozen).

Buffett uses Geico, Berkshire's auto insurance business organization, to illustrate the company's compensation philosophy. The goals of the program, Buffett explains, "should be (1) tailored to the economics of the specific operating concern; (2) simple in character so that the caste to which they are being realized can be hands measured; and (three) direct related to the daily activities of plan participants." He states that "we shun 'lottery ticket' arrangements…whose ultimate value…is totally out of the command of the person whose beliefs nosotros would like to affect" (Principles 7 and 8).

So far, Berkshire looks similar a complete level 10 value-creation company—one that applies all x principles. But it doesn't closely adhere to Principle iv (carry but assets that maximize value) and has never acted on Principle 5 (return greenbacks to shareholders). In both cases, still, Buffett and Munger's writings and comments suggest that Berkshire evaluates its investments in light of these principles even if it doesn't directly apply them to itself.

Principle iv advises selling operations if a heir-apparent offers a meaningful premium to estimated value. Buffett states flatly, "Regardless of price, we have no involvement at all in selling any good businesses that Berkshire owns," noting that this attitude "hurts our financial performance."

And despite sitting on more than $40 billion in excess cash at year-end 2005, Berkshire has not returned whatsoever cash to its shareholders to date. Yet, the company does apply a clear exam to determine the virtue of retaining, versus distributing, cash: Direction assesses "whether retention, over fourth dimension, delivers shareholders at least $1 of market value for each $1 retained." This examination, of course, is a restatement of the cadre shareholder value concept that all investments should generate a return in backlog of the price of majuscule. Consequent with Principle 5, Buffett is articulate nigh the consequence of failing this test. He says, "If we reach the point that we tin can't create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds."

Buffett's influence extends beyond Berkshire to companies for which he has served as a board member. For case, the Washington Post and Coca-Cola were among the start companies to voluntarily expense employee stock options in 2002. Companies with which Buffett has been involved also accept a history of repurchasing stock.

1. Sources for quotations include Berkshire Hathaway's own publications and various public news outlets.

Michael J. Mauboussin is the chief investment strategist at Legg Mason Majuscule Management, based in Baltimore. He is a shareholder in Berkshire Hathaway.

Principle i

Do not manage earnings or provide earnings guidance.

Companies that fail to embrace this start principle of shareholder value will virtually certainly exist unable to follow the rest. Unfortunately, that rules out most corporations because nearly all public companies play the earnings expectations game. A 2006 National Investor Relations Plant written report found that 66% of 654 surveyed companies provide regular turn a profit guidance to Wall Street analysts. A 2005 survey of 401 fiscal executives by Duke Academy's John Graham and Campbell R. Harvey, and University of Washington'southward Shivaram Rajgopal, reveals that companies manage earnings with more than just bookkeeping gimmicks: A startling 80% of respondents said they would decrease value-creating spending on inquiry and evolution, advertisement, maintenance, and hiring in order to meet earnings benchmarks. More half the executives would filibuster a new project fifty-fifty if it entailed sacrificing value.

What's then bad nearly focusing on earnings? Starting time, the auditor's bottom line approximates neither a company'southward value nor its change in value over the reporting menstruation. 2d, organizations compromise value when they invest at rates beneath the price of upper-case letter (overinvestment) or forgo investment in value-creating opportunities (underinvestment) in an attempt to heave short-term earnings. Third, the practice of reporting rosy earnings via value-destroying operating decisions or past stretching permissible bookkeeping to the limit somewhen catches up with companies. Those that can no longer run into investor expectations cease upwardly destroying a substantial portion, if not all, of their market value. WorldCom, Enron, and Nortel Networks are notable examples.

Principle 2

Make strategic decisions that maximize expected value, even at the expense of lowering almost-term earnings.

Companies that manage earnings are almost spring to intermission this second cardinal principle. Indeed, most companies evaluate and compare strategic decisions in terms of the estimated affect on reported earnings when they should exist measuring against the expected incremental value of time to come cash flows instead. Expected value is the weighted average value for a range of plausible scenarios. (To calculate information technology, multiply the value added for each scenario past the probability that that scenario will materialize, then sum up the results.) A sound strategic analysis by a visitor's operating units should produce informed responses to three questions: First, how do alternative strategies affect value? Second, which strategy is most likely to create the greatest value? Third, for the selected strategy, how sensitive is the value of the virtually likely scenario to potential shifts in competitive dynamics and assumptions nearly engineering science life cycles, the regulatory environment, and other relevant variables?

At the corporate level, executives must also accost three questions: Do whatever of the operating units take sufficient value-creation potential to warrant additional capital? Which units have limited potential and therefore should be candidates for restructuring or divestiture? And what mix of investments in operating units is likely to produce the most overall value?

Principle 3

Brand acquisitions that maximize expected value, even at the expense of lowering about-term earnings.

Companies typically create most of their value through day-to-day operations, simply a major acquisition can create or destroy value faster than any other corporate activeness. With record levels of greenbacks and relatively low debt levels, companies increasingly use mergers and acquisitions to improve their competitive positions: M&A announcements worldwide exceeded $ii.seven trillion in 2005.

Companies (even those that follow Principle 2 in other respects) and their investment bankers usually consider price/earnings multiples for comparable acquisitions and the immediate impact of earnings per share (EPS) to assess the attractiveness of a deal. They view EPS accretion as good news and its dilution as bad news. When it comes to commutation-of-shares mergers, a narrow focus on EPS poses an additional trouble on peak of the normal shortcomings of earnings. Whenever the acquiring company'south price/earnings multiple is greater than the selling company'south multiple, EPS rises. The inverse is likewise true. If the acquiring company'southward multiple is lower than the selling company's multiple, earnings per share pass up. In neither case does EPS tell us anything about the deal's long-term potential to add together value.

Sound decisions nearly M&A deals are based on their prospects for creating value, non on their immediate EPS bear on, and this is the foundation for the third principle of value creation. Management needs to place clearly where, when, and how it can accomplish existent operation gains by estimating the nowadays value of the resulting incremental greenbacks flows and and so subtracting the conquering premium.

Value-oriented managements and boards also carefully evaluate the risk that anticipated synergies may not materialize. They recognize the challenge of postmerger integration and the likelihood that competitors will not stand idly past while the acquiring visitor attempts to generate synergies at their expense. If it is financially feasible, acquiring companies confident of achieving synergies greater than the premium will pay cash and so that their shareholders will not have to surrender whatsoever anticipated merger gains to the selling companies' shareholders. If management is uncertain whether the deal will generate synergies, information technology tin hedge its bets by offering stock. This reduces potential losses for the acquiring visitor's shareholders past diluting their ownership interest in the postmerger company.

Principle 4

Carry merely avails that maximize value.

The fourth principle takes value creation to a new level because information technology guides the choice of concern model that value-witting companies will prefer. There are two parts to this principle.

Kickoff, value-oriented companies regularly monitor whether at that place are buyers willing to pay a meaningful premium over the estimated greenbacks menses value to the company for its business units, brands, real estate, and other detachable avails. Such an assay is clearly a political minefield for businesses that are performing relatively well confronting projections or competitors but are clearly more than valuable in the hands of others. Yet failure to exploit such opportunities can seriously compromise shareholder value.

A recent example is Kmart. ESL Investments, a hedge fund operated by Edward Lampert, gained control of Kmart for less than $i billion when it was under bankruptcy protection in 2002 and when its shares were trading at less than $1. Lampert was able to recoup almost his entire investment by selling stores to Home Depot and Sears, Roebuck. In addition, he airtight underperforming stores, focused on profitability by reducing capital spending and inventory levels, and eliminated Kmart's traditional clearance sales. By the end of 2003, shares were trading at about $xxx; in the post-obit year they surged to $100; and, in a deal announced in November 2004, they were used to acquire Sears. Former shareholders of Kmart are justifiably asking why the previous management was unable to similarly reinvigorate the company and why they had to liquidate their shares at distressed prices.

Second, companies tin can reduce the upper-case letter they employ and increase value in 2 ways: by focusing on loftier value-added activities (such as research, design, and marketing) where they savour a comparative advantage and by outsourcing low value-added activities (similar manufacturing) when these activities can be reliably performed past others at lower price. Examples that come to mind include Apple Figurer, whose iPod is designed in Cupertino, California, and manufactured in Taiwan, and hotel companies such as Hilton Hospitality and Marriott International, which manage hotels without owning them. So there's Dell'southward well-chronicled directly-to-customer, custom PC assembly business model, which minimizes the capital the company needs to invest in a sales force and distribution, too as the need to carry inventories and invest in manufacturing facilities.

Principle 5

Return cash to shareholders when in that location are no credible value-creating opportunities to invest in the business.

Even companies that base of operations their strategic conclusion making on audio value-creation principles can skid up when it comes to decisions about cash distribution. The importance of adhering to the 5th principle has never been greater: Every bit of the first quarter of 2006, industrial companies in the South&P 500 were sitting on more than than $643 billion in cash—an amount that is likely to grow as companies continue to generate positive complimentary greenbacks flows at record levels.

Value-conscious companies with large amounts of excess cash and just limited value-creating investment opportunities return the coin to shareholders through dividends and share buybacks. Non just does this give shareholders a take chances to earn better returns elsewhere, merely it also reduces the risk that management will use the excess cash to make value-destroying investments—in item, ill-advised, overpriced acquisitions.

Simply considering a company engages in share buybacks, nevertheless, doesn't mean that information technology abides past this principle. Many companies buy back shares purely to heave EPS, and, merely as in the instance of mergers and acquisitions, EPS accretion or dilution has nothing to practise with whether or not a buyback makes economic sense. When an immediate heave to EPS rather than value creation dictates share buyback decisions, the selling shareholders proceeds at the expense of the nontendering shareholders if overvalued shares are repurchased. Especially widespread are buyback programs that offset the EPS dilution from employee stock choice programs. In those kinds of situations, employee option exercises, rather than valuation, determine the number of shares the company purchases and the prices it pays.

Value-conscious companies repurchase shares only when the company'southward stock is trading below management's best estimate of value and no better return is available from investing in the business. Companies that follow this guideline serve the interests of the nontendering shareholders, who, if management's valuation cess is correct, proceeds at the expense of the tendering shareholders.

When a company'due south shares are expensive and there's no good long-term value to be had from investing in the business organisation, paying dividends is probably the all-time option.

Principle 6

Reward CEOs and other senior executives for delivering superior long-term returns.

Companies need effective pay incentives at every level to maximize the potential for superior returns. Principles 6, 7, and 8 set out appropriate guidelines for top, eye, and lower management compensation. I'll brainstorm with senior executives. As I've already observed, stock options were once widely touted equally show of a healthy value ethos. The standard option, however, is an imperfect vehicle for motivating long-term, value-maximizing behavior. Start, standard stock options reward performance well beneath superior-return levels. As became painfully evident in the 1990s, in a rising market, executives realize gains from whatever increase in share price—even ane substantially beneath gains reaped past their competitors or the broad marketplace. Second, the typical vesting period of three or four years, coupled with executives' propensity to cash out early, significantly diminishes the long-term motivation that options are intended to provide. Finally, when options are hopelessly underwater, they lose their ability to motivate at all. And that happens more ofttimes than is generally believed. For example, about i-third of all options held by U. Southward. executives were below strike prices in 1999 at the superlative of the balderdash market. Simply the supposed remedies—increasing cash compensation, granting restricted stock or more options, or lowering the exercise price of existing options—are shareholder-unfriendly responses that rewrite the rules in midstream.

Value-witting companies can overcome the shortcomings of standard employee stock options by adopting either a discounted indexed-pick plan or a discounted equity risk option (DERO) plan. Indexed options advantage executives only if the company'south shares outperform the alphabetize of the company's peers—not but considering the market is rise. To provide management with a continuing incentive to maximize value, companies can lower practice prices for indexed options so that executives profit from performance levels modestly beneath the index. Companies can address the other shortcoming of standard options—holding periods that are too brusque—by extending vesting periods and requiring executives to hang on to a meaningful fraction of the equity stakes they obtain from exercising their options.

For companies unable to develop a reasonable peer index, DEROs are a suitable alternative. The DERO exercise price rises annually past the yield to maturity on the x-year U.S. Treasury notation plus a fraction of the expected equity gamble premium minus dividends paid to the holders of the underlying shares. Equity investors expect a minimum render consisting of the hazard-gratis rate plus the equity risk premium. But this threshold level of performance may cause many executives to concur underwater options. Past incorporating only a fraction of the estimated equity risk premium into the exercise price growth charge per unit, a board is betting that the value added by management volition more outset the costlier options granted. Dividends are deducted from the exercise toll to remove the incentive for companies to concord back dividends when they have no value-creating investment opportunities.

Principle 7

Reward operating-unit executives for adding superior multiyear value.

While properly structured stock options are useful for corporate executives, whose mandate is to raise the operation of the company as a whole—and thus, ultimately, the stock price—such options are ordinarily inappropriate for rewarding operating-unit executives, who accept a express impact on overall operation. A stock cost that declines because of disappointing performance in other parts of the company may unfairly penalize the executives of the operating units that are doing uncommonly well. Alternatively, if an operating unit does poorly just the visitor's shares rise because of superior performance by other units, the executives of that unit of measurement volition savour an unearned windfall. In neither case practice option grants motivate executives to create long-term value. Only when a visitor's operating units are truly interdependent can the share price serve as a fair and useful indicator of operating performance.

Companies typically have both annual and long-term (almost oft three-twelvemonth) incentive plans that reward operating executives for exceeding goals for financial metrics, such every bit acquirement and operating income, and sometimes for beating nonfinancial targets as well. The problem is that linking bonuses to the budgeting process induces managers to lowball performance possibilities. More important, the usual earnings and other accounting metrics, particularly when used as quarterly and annual measures, are non reliably linked to the long-term cash flows that produce shareholder value.

To create incentives for an operating unit, companies need to develop metrics such equally shareholder value added (SVA). To calculate SVA, apply standard discounting techniques to forecasted operating greenbacks flows that are driven past sales growth and operating margins, so subtract the investments made during the catamenia. Considering SVA is based entirely on cash flows, information technology does not introduce accounting distortions, which gives information technology a clear advantage over traditional measures. To ensure that the metric captures long-term performance, companies should extend the functioning evaluation period to at to the lowest degree, say, a rolling three-year cycle. The program tin can then retain a portion of the incentive payouts to comprehend possible future underperformance. This approach eliminates the need for two plans by combining the annual and long-term incentive plans into i. Instead of setting upkeep-based thresholds for incentive compensation, companies can develop standards for superior year-to-year performance improvement, peer benchmarking, and even performance expectations implied by the share toll.

Principle 8

Reward middle managers and frontline employees for delivering superior performance on the key value drivers that they influence directly.

Although sales growth, operating margins, and capital expenditures are useful financial indicators for tracking operating-unit of measurement SVA, they are too broad to provide much twenty-four hours-to-day guidance for middle managers and frontline employees, who need to know what specific actions they should take to increment SVA. For more than specific measures, companies tin develop leading indicators of value, which are quantifiable, easily communicated electric current accomplishments that frontline employees can influence straight and that significantly bear on the long-term value of the business in a positive fashion. Examples might include time to market for new product launches, employee turnover rate, customer memory rate, and the timely opening of new stores or manufacturing facilities.

My own experience suggests that nigh businesses can focus on three to five leading indicators and capture an of import office of their long-term value-creation potential. The process of identifying leading indicators can exist challenging, just improving leading-indicator operation is the foundation for achieving superior SVA, which in turn serves to increment long-term shareholder returns.

Principle nine

Require senior executives to bear the risks of buying just equally shareholders do.

For the most part, option grants take not successfully aligned the long-term interests of senior executives and shareholders because the onetime routinely cash out vested options. The power to sell shares early may in fact motivate them to focus on almost-term earnings results rather than on long-term value in order to boost the current stock cost.

To ameliorate align these interests, many companies have adopted stock ownership guidelines for senior management. Minimum ownership is ordinarily expressed every bit a multiple of base salary, which is so converted to a specified number of shares. For instance, eBay's guidelines require the CEO to ain stock in the company equivalent to five times almanac base salary. For other executives, the corresponding number is three times bacon. Height managers are further required to retain a per centum of shares resulting from the exercise of stock options until they amass the stipulated number of shares.

But in well-nigh cases, stock ownership plans fail to betrayal executives to the same levels of risk that shareholders bear. One reason is that some companies forgive stock purchase loans when shares underperform, claiming that the arrangement no longer provides an incentive for top management. Such companies, just as those that reprice options, risk institutionalizing a pay delivery system that subverts the spirit and objectives of the incentive compensation program. Some other reason is that outright grants of restricted stock, which are substantially options with an do cost of $0, typically count equally shares toward satisfaction of minimum ownership levels. Stock grants motivate fundamental executives to stay with the company until the restrictions lapse, typically within iii or four years, and they tin can cash in their shares. These grants create a stiff incentive for CEOs and other elevation managers to play information technology condom, protect existing value, and avoid getting fired. Not surprisingly, restricted stock plans are commonly referred to as "pay for pulse," rather than pay for operation.

In an effort to deflect the criticism that restricted stock plans are a giveaway, many companies offer performance shares that require non only that the executive remain on the payroll but also that the company achieve predetermined performance goals tied to EPS growth, revenue targets, or return-on-uppercase-employed thresholds. While operation shares do demand performance, it's mostly not the right kind of performance for delivering long-term value because the metrics are usually not closely linked to value.

Companies need to residuum the benefits of requiring senior executives to concord continuing ownership stakes and the resulting restrictions on their liquidity and diversification.

Companies seeking to better align the interests of executives and shareholders demand to find a proper balance between the benefits of requiring senior executives to have meaningful and continuing ownership stakes and the resulting restrictions on their liquidity and diversification. Without disinterestedness-based incentives, executives may become excessively risk balky to avoid failure and possible dismissal. If they own too much disinterestedness, however, they may also eschew adventure to preserve the value of their largely undiversified portfolios. Extending the menses earlier executives can unload shares from the exercise of options and not counting restricted stock grants as shares toward minimum buying levels would certainly help equalize executives' and shareholders' risks.

Principle 10

Provide investors with value-relevant information.

The final principle governs investor communications, such as a company'due south financial reports. Better disclosure non only offers an antidote to short-term earnings obsession but likewise serves to lessen investor uncertainty and so potentially reduce the cost of capital and increase the share price.

1 way to do this, equally described in my article "The Economics of Brusk-Term Performance Obsession" in the May–June 2005 issue of Financial Analysts Journal, is to ready a corporate performance argument. (See the showroom "The Corporate Performance Statement" for a template.) This argument:

  • separates out greenbacks flows and accruals, providing a historical baseline for estimating a company's greenbacks period prospects and enabling analysts to evaluate how reasonable accrual estimates are;
  • classifies accruals with long greenbacks-conversion cycles into medium and high levels of uncertainty;
  • provides a range and the well-nigh likely estimate for each accrual rather than traditional unmarried-point estimates that ignore the wide variability of possible outcomes;
  • excludes capricious, value-irrelevant accruals, such as depreciation and amortization; and
  • details assumptions and risks for each line item while presenting key performance indicators that drive the company's value.

Investors demand a baseline for assessing a visitor's cash flow prospects and a clear view of their potential volatility. The corporate performance statement provides a way to estimate both things by separating realized cash flows from forrard-looking accruals.

Operating cash flows.

The beginning part of this statement tracks only operating cash flows. It does not replace the traditional cash flow statement because it excludes cash flows from financing activities—new issues of stocks, stock buybacks, new borrowing, repayment of previous borrowing, and interest payments.

Acquirement and expense accruals.

The 2nd part of the statement presents revenue and expense accruals, which judge time to come cash receipts and payments triggered past current sales and purchase transactions. Management estimates three scenarios—near likely, optimistic, and pessimistic—for accruals of varying levels of uncertainty characterized by long cash-conversion cycles and broad ranges of plausible outcomes.

Management discussion and assay.

In the third section, management presents the company's business concern model, key performance indicators (both financial and nonfinancial), and the critical assumptions supporting each accrual estimate.

Could such specific disclosure show likewise costly? The reality is that executives in well-managed companies already apply the blazon of information contained in a corporate operation statement. Indeed, the absenteeism of such data should crusade shareholders to question whether management has a comprehensive grasp of the business organization and whether the lath is properly exercising its oversight responsibility. In the present unforgiving climate for accounting shenanigans, value-driven companies have an unprecedented opportunity to create value simply by improving the grade and content of corporate reports.

The Rewards—and the Risks

The crucial question, of course, is whether following these ten principles serves the long-term interests of shareholders. For most companies, the answer is a resounding yeah. But eliminating the do of delaying or forgoing value-creating investments to see quarterly earnings targets can make a significant difference. Further, exiting the earnings-management game of accelerating revenues into the current menstruum and deferring expenses to hereafter periods reduces the risk that, over time, a visitor will be unable to come across market expectations and trigger a meltdown in its stock. Only the real payoff comes in the difference that a true shareholder-value orientation makes to a company'southward long-term growth strategy.

For most organizations, value-creating growth is the strategic claiming, and to succeed, companies must be good at developing new, potentially disruptive businesses. Here'south why. The bulk of the typical visitor'southward share toll reflects expectations for the growth of current businesses. If companies encounter those expectations, shareholders will earn only a normal render. But to deliver superior long-term returns—that is, to abound the share price faster than competitors' share prices—management must either repeatedly exceed marketplace expectations for its current businesses or develop new value-creating businesses. It's almost impossible to repeatedly beat expectations for current businesses, because if you lot practice, investors simply raise the bar. So the but reasonable mode to deliver superior long-term returns is to focus on new business organization opportunities. (Of course, if a company's stock cost already reflects expectations with regard to new businesses—which it may do if management has a runway record of delivering such value-creating growth—then the task of generating superior returns becomes daunting; it's all managers can do to meet the expectations that be.)

Value-creating growth is the strategic challenge, and to succeed, companies must be proficient at developing new, potentially disruptive businesses.

Companies focused on brusk-term performance measures are doomed to fail in delivering on a value-creating growth strategy considering they are forced to concentrate on existing businesses rather than on developing new ones for the longer term. When managers spend too much time on core businesses, they end upward with no new opportunities in the pipeline. And when they become into trouble—every bit they inevitably do—they have little choice simply to try to pull a rabbit out of the lid. The dynamic of this failure has been very accurately described by Clay Christensen and Michael Raynor in their volume The Innovator's Solution: Creating and Sustaining Successful Growth (Harvard Business School Press, 2003). With a little adaptation, it plays out like this:

  • Despite a slowdown in growth and margin erosion in the company's maturing core business, management continues to focus on developing it at the expense of launching new growth businesses.
  • Eventually, investments in the core can no longer produce the growth that investors expect, and the stock cost takes a striking.
  • To revitalize the stock price, management announces a targeted growth rate that is well beyond what the cadre can evangelize, thus introducing a larger growth gap.
  • Confronted with this gap, the company limits funding to projects that promise very large, very fast growth. Appropriately, the company refuses to fund new growth businesses that could ultimately fuel the visitor's expansion but couldn't get large enough fast enough.
  • Managers then respond with overly optimistic projections to gain funding for initiatives in large existing markets that are potentially capable of generating sufficient revenue quickly enough to satisfy investor expectations.
  • To meet the planned timetable for rollout, the company puts a sizable cost structure in identify before realizing whatsoever revenues.
  • As revenue increases fall brusque and losses persist, the market once again hammers the stock toll and a new CEO is brought in to shore it up.
  • Seeing that the new growth business pipeline is virtually empty, the incoming CEO tries to quickly stem losses past approving only expenditures that bolster the mature core.
  • The company has now come up total circle and has lost substantial shareholder value.

Companies that have shareholder value seriously avoid this cocky-reinforcing pattern of behavior. Because they practice not dwell on the marketplace's near-term expectations, they don't wait for the core to deteriorate before they invest in new growth opportunities. They are, therefore, more likely to go first movers in a market and cock formidable barriers to entry through scale or learning economies, positive network effects, or reputational advantages. Their direction teams are forward-looking and sensitive to strategic opportunities. Over time, they get better than their competitors at seizing opportunities to attain competitive advantage.

Although applying the ten principles will improve long-term prospects for many companies, a few volition still experience bug if investors remain fixated on near-term earnings, because in certain situations a weak stock price can actually affect operating performance. The run a risk is specially astute for companies such as loftier-tech showtime-ups, which depend heavily on a good for you stock price to finance growth and transport positive signals to employees, customers, and suppliers. When share prices are depressed, selling new shares either prohibitively dilutes current shareholders' stakes or, in some cases, makes the company unattractive to prospective investors. Every bit a outcome, direction may accept to defer or scrap its value-creating growth plans. Then, as investors get aware of the situation, the stock price continues to slide, possibly leading to a takeover at a fire-sale price or to bankruptcy.

Severely capital letter-constrained companies tin can also be vulnerable, specially if labor markets are tight, customers are few, or suppliers are peculiarly powerful. A depression share price means that these organizations cannot offer credible prospects of large stock-option or restricted-stock gains, which makes it difficult to attract and retain the talent whose knowledge, ideas, and skills accept increasingly become a ascendant source of value. From the perspective of customers, a low valuation raises doubts about the company's competitive and financial forcefulness equally well as its ability to continue producing high-quality, leading-edge products and reliable postsale back up. Suppliers and distributors may too react by offering less favorable contractual terms, or, if they sense an unacceptable probability of financial distress, they may simply turn down to do business with the company. In all cases, the visitor'due south woes are compounded when lenders consider the operation risks arising from a weak stock price and demand higher interest rates and more restrictive loan terms.

Conspicuously, if a company is vulnerable in these respects, and then responsible managers cannot beget to ignore market pressures for brusk-term performance, and adoption of the ten principles needs to be somewhat tempered. But the reality is that these extreme atmospheric condition practice non apply to most established, publicly traded companies. Few rely on equity issues to finance growth. Near generate enough greenbacks to pay their top employees well without resorting to disinterestedness incentives. Nearly also accept a large universe of customers and suppliers to deal with, and at that place are enough of banks after their concern.

It'south time, therefore, for boards and CEOs to step up and seize the moment. The sooner you make your house a level 10 company, the more you and your shareholders stand up to proceeds. And what better moment than now for institutional investors to human action on behalf of the shareholders and beneficiaries they stand for and insist that long-term shareholder value become the governing principle for all the companies in their portfolios?

A version of this article appeared in the September 2006 effect of Harvard Business organisation Review.