Commentaries

Managers in organizations will tend to deliver operating results according to metrics that maximize their rewards. Depending on the economics different metrics may apply. Most commonly used metrics such as ROA (Return-on-Assets), ROE (Return-on-Equity), Gross Margin or Revenue per Employee offer different perspectives on operating results. They are useful, if applied in alignment with corporate strategies. They can be also destructive, if misapplied.

For instance, Xerox – a firm that reaped superior profits from metered copier installations - was wrecked by an over-emphasis on ROA. The sales force found it more profitable to sell-off the most profitable copiers to maximize their commissions. The key decision-makers “made their numbers”, without the ultimate benefit to the shareholders.
In another case Peat, Marwick & Mitchell – a firm that used to deliver high value professional services – was wrecked by an over-emphasis on billable man-hours to reward its partners. The partners then found it attractive to use low-margin and low-priced labor to make their numbers, without benefiting the shareholders.

The declared objective of corporations is to grow shareholder value faster than revenues. The shareholder value of a knowledge-based enterprise can be defined as:

Shareholder Value = Shareholder Equity + Knowledge Capital

• where Shareholder Equity = Balance Sheet Valuation (“Book Value”)
• and Shareholder Value = Black Scholes Market Value estimate.

The Black Scholes pricing method can only calculate the shareholder value for the entire firm. It lacks the capacity to calculate shareholder value generated by any of the approximately Business Units.

The EVA method for calculating Knowledge Capital has merit in applying shareholder valuations at the Business Unit levels and even at lower levels of an organization, such as in regional or product groupings. A comparison between the EVA method and the Black Scholes method shows only insignificant differences. Such an approximation should be acceptable in substituting a simple and easily understood method for the complexities of Black Scholes.

The EVA method depends on the proper valuation of the cost of shareholder capital. The following discloses the method that should be used to arrive at such a valuation.

Market Valuation of the Cost of Capital

The market valuation of a firm contains an implicit valuation of the cost of capital that is attributable to knowledge capital. A calculation of the value “i” (e.g. shareholder’s cost of capital) can be derived as follows:

If,
Knowledge Capital (KC) = Market Valuation (MV) – Equity (E)

and if KC is defined as the principal of a capital fund of which the Economic Value-Added (EVA) is the current yield, then KC will be simply:

KC = Economic Value-Added (EVA) / i

Since EVA is defined as current profit (P) minus an implied “rent” for the shareholder’s equity (E), then

Economic Value-Added (EVA) = Profit (P) – i * Equity

Thus yielding the following equations:

KC = (P – iE) / i = MV – Equity

Simplifying the above terms will then give us:

i = P / MV

Calculation of the Price of Risk Capital

An alternative approach to determination of the shareholder cost of capital is to derive that value from a calculation based on published prices of the interest banks charge for their most creditworthy customers, defined as the Prime Rate.
Accordingly, the value “i” (e.g. shareholder’s cost of capital) can be derived as follows:

i = Prime Rate + β * (Risk Capital – Prime Rate)

So that:

Risk Capital = (i – Prime Rate)/β - Prime Rate

Business Unit Rankings

The primary application of Shareholder Value Metrics will be to rank business units according their Knowledge Capital Effectiveness Index and the Information Productivity Index, defined as follows:

Knowledge Capital Effectiveness Index = Knowledge Capital / Employee Salaries

The advantage of this ratio is that it would filter out the effects of uncommonly high Revenue/Employee ratios that are produced by shifting work to subcontractors. It would also filter out any adverse effects of reliance on low-margin revenues.
Since Knowledge Capital of an organization is largely generated from well placed investments that show up either as SG&A (Sales, General & Administrative) or R&D costs, it is possible to compare the efficiency of the Business Units using the following productivity measure:

Information Productivity Index = Economic Value-Added / ( SG&A + R&D)

Data Requirements

To deliver the Shareholder Value rankings for individual Business units the following information is required:

1. Business Unit P&L. The individual P&Ls (annual and or quarterly) must sum up to the Corporate Total. All P&L entries not accounted for in the Business Units to be grouped as a “Corporate” entry. The P&L details should include direct SG&A costs and all allocations plus the full costs of the employee payroll. If the costs of Purchases (payments to suppliers included in the COGS – cost of goods – is available, that would be a welcome analytic addition.

2. Business Unit Balance Sheet. In case this is an approximation the primary emphasis should be placed on Current Assets (work in process and receivables) plus any adjustments made to retained earnings from write-offs or increases in reserves.