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Author: PatrickCoteContributors:KateMcGreevy JulianCritchlow

bcCorporatePerformanceMeasurementCopyright?1999Bain&Company,Inc.CorporatePerformanceMeasurementAuthor: PatrickCoteContr

ExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-DiageoAgenda2CorporatePerformanceMeasurementExecutiveSummaryAgenda2Corp

Corporateperformanceevaluationhasevolvedfromthe1960sfocusonROEtothecurrentvariationsofeconomicprofitthatmeasureimpactonshareholdervaluemanyfirmshavedevisedtheirownvariationsofeconomicprofitSternStewart’sEconomicValueAdded(EVA)TMisbestknownofthesemeasuresHolt/BCG’sCashFlowReturnonInvestment(CFROI)isasimilarconceptpresentedin%returnformatBothROEandEParebusinessmetrics,toolsusedtomeasuretheperformanceofthebusinessseparatefromfundamentalbusinessdrivers,theactualfactorsthatinfluenceshareholdervalue,andoutputmeasuresthebackward-lookingrecordsofoverallcompanyperformanceFocusingonEPinsteadofROEdecreasesthelikelihoodofdestructivebehaviorbymanagersByevaluatingmanagersbasedonEP,managerbehaviorcanbealteredsuchthatonlyprojectsthataddvalue(withNPV>0)areundertaken,whichdoesnotalwaysoccurwithROE

ExecutiveSummary(1of2)3CorporatePerformanceMeasurementCorporateperformanceevaluaExecutiveSummary(2of2)

EndgoalofEP

exercisesisconsistentwithtraditionalBainfocusofmaximisingshareholdervalueBainhasmeasuredhistoricalperformancewithTotalShareholderReturnSternStewartdevisedMarketValueAdded(MVA)TMasmeansofmeasuringmarketexpectationsofEPthatmanagerswilladdinthefuturemanagers’objectiveshouldbetomaximiseMVAAlleconomicprofitmeasuresdeductchargeforuseofequitycapitalfromaccounting’stypicalnetincomeorprofitaftertaxtoreflecttheopportunitycostassociatedwithequityinvestmentsSternStewarthastrademarkedEVATMbyspecifyingadjustmentstomaketoEP

4CorporatePerformanceMeasurementExecutiveSummary(2of2)4

AgendaExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-Diageo5CorporatePerformanceMeasurementAgendaExecutiveSummary5CorpObjectives

TherearethreeobjectivesoftheCorporatePerformanceMeasuresModule:TodefinethemostpopularmeasuresofcorporateperformanceToexplainthesignificanceofthesemeasuresinthecorporateenvironmentandpotentialapplicationsinBain’sstrategyworkTooutlinecalculationsofeachperformancemeasure6CorporatePerformanceMeasurementObjectivesTherearethreeob

AgendaExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-Diageo7CorporatePerformanceMeasurementAgendaExecutiveSummary7Corp

Withtheriseofconglomerates,mostcompaniesfocusedonReturnonEquity,orROE,astheirprimarymeasureofperformanceledmostmanagerstoundertakeacquisitionssolelytomanipulateaccountingfigures1960s/70s1980s/90sWiththeincreasedfocusondeliveringshareholdervalue,managershaveacceptedsystemsthatmeasurethechangeinvaluemanagersrealisedequityisnotfreeeconomicprofit(EP)meetstheseneedsbytellingmanagerswherevaluehasbeencreatedandwhereithasbeendestroyedAsaligninginterestsbetweenownersandmanagershasbecomemoreimportant,tyingmanagementcompensationtoEPprovidedapopularsolutionCorporateperformanceevaluationhasevolvedfromthe1960sfocusonROEtothecurrentvariationsofeconomicprofit(EP)thatmeasureimpactonshareholdervalueBackgroundCorporatePerformanceEvaluation8CorporatePerformanceMeasurementWiththeriseofconglomerat

BainwasthefirstofmajorconsultingfirmstofocusoncreatingshareholdervalueToachievethis,BainhasusedtheoutputmeasureofTotalShareholderReturnandtheaccountingmeasuresofROEandROIModifiedaccountingmeasures,suchasEP,provideanalternativemeansofmeasuringthecreationofshareholdervalueBackgroundRelevancetoBain9CorporatePerformanceMeasurementBainwasthefirstofmajorc

Toillustratetheroleofcorporateperformancemeasuresandresourceallocationtostrategywork,anexaminationofMarakon’s“program”isusefulMarakonappliesthefollowingprogram,whichcantakeseveralyearstocomplete,toallofitsclients:assesstheeconomicprofitofallcustomersegmentsandproductlinescomparecompanyperformancetoindustryperformanceinvestigatethreeormorestrategiesforeachbusinesseveryplanningcycleshiftresourceallocationfromeconomicallyunprofitableproducts/customerstoeconomicallyprofitableleadstoyieldlossforMarakonandclientssinceadditionalscenariosfrequentlyevaluatedMarakonhasmadeeconomicprofit(EP)thecentralfocusofthe‘program’theyapplytoeverycaseBackgroundLinktoStrategy10CorporatePerformanceMeasurementToillustratetheroleofcor

EVAisaregisteredtrademarkofSternStewartAcenturyago,AlfredMarshallexplainedthatforacompanytohavegenuineprofits,theprofitsmustbesufficienttocoverthecostofcapitalaswellasthefirm’soperatingcostsSternStewarthasre-packagedtheconceptintoEVA,whichisessentiallyamorepalatableformofthesameideaMcKinseyhasbeenusingeconomicprofitformanyyearsBCGusesCashFlowReturnonInvestment(CFROI)forasimilaranalysisToavoidinfringinguponSternStewart’strademark,manyconsultingfirmshavedevelopedtheirowntermsforthesameconceptHownewisEconomicValueAdded(EVA)?EVATMisonevariationofEPBackgroundEconomicValueAdded11CorporatePerformanceMeasurementEVAisaregisteredtrademar

AgendaExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-Diageo12CorporatePerformanceMeasurementAgendaExecutiveSummary12CorMeasures*ForadiscussionofWACCanddiscountrates,pleaseseetheInvestmentAppraisalModuleintheBVUDescription:EVA/MVA,EP,andCFROIaremodifiedaccountingmeasuresusedtomeasuretheperformanceofthebusinessInputs/Measures:FundamentalBusinessDriversBusinessMetricsOutputMeasuresPrimarybusiness-specificfactorsinfluencingshareholdervalueToolsusedtomeasureperformanceofbusinessBackward-lookingmeasuresofoverallcompanyperformanceasviewedbymarketOperatingprofitsvolumepricecostsFinancialCostofCapitalEmployedfixedassetsworkingcapitalWACC*AccountingROEROAModifiedaccountingEVA/MVAEPCFROICVATotalShareholderReturn(TSR)TotalBusinessReturn(TBR)Framework13CorporatePerformanceMeasurementMeasures*Foradiscussionof

ThefundamentalbusinessdriversprovideaframeworkforidentifyingthesourcesofshareholdervaluecreationordestructionShareholderValueCreation/DestructionOperatingProfitCostofCapitalVolumePriceCostsWorkingCapitalWACCFixedAssetsX+XDirectcostsmateriallabourIndirectcostsSG&ADepreciationAveragesellingprice#ofunitssoldWeightedaveragecostofcapitalbasedonmarketvaluesofdebtandequityUseafter-taxcostofdebtCurrentassetslesscurrentliabilitiesProperty,plant&equipmentIntangiblesLIFOvsFIFODepreciationestimatesCostofequityforprivatefirmsIntangiblemeasurementComponents:Issues:FrameworkFundamentalBusinessDrivers14CorporatePerformanceMeasurementThefundamentalbusinessdriv*SometimesreferredtoasReturnonInvestment(ROI)ROEmeasuresreturnstoshareholders,whileROAmeasuresreturnstoinvestorsofallformsofcapitalFormula:Measures:ROAProfitabilityofallcapitalemployed,includingdebtUses:ReturnonAssets(ROA)*ReturnonEquity(ROE)NetIncomeAssets=ROENetIncomeEquity=Profitabilityofequityinvestedinbusiness(netequityissuedplusretainedearnings)ReturnsofenterpriseasawholeReturnstoshareholdersFrameworkAccountingBusinessMetrics15CorporatePerformanceMeasurement*SometimesreferredtoasRe

TheDuPontformulaisusedtoseparateROEintoitscomponentsinordertoassesstheperformanceofthebusinessROENetIncomeEquity=NetIncomeSales=SalesAssetsAssetsEquityXXROSAssetTurnoverLeverageROE=ProfitabilityAssetTurnoverLeverageXX=ROAFrameworkAccountingBusinessMetrics-DuPontFormula16CorporatePerformanceMeasurementTheDuPontformulaisusedto*EVA=EVAwithdepreciationaddedbackManyconsultingcompaniesattempttobrandthemodifiedaccountingbusinessmetricstheyuseEconomicProfitMeasureConsultingCompaniesBainMcKinseyMarakon(throughValue-BasedManagement)LEKEVA/MVASternStewartATKearneyAccountingfirmsBCGHoltBCGCashValueAdded*(CVA)CashFlowReturnonInvestment(CFROI)FrameworkModifiedAccountingBusinessMetrics17CorporatePerformanceMeasurement*EVA=EVAwithdepreciationa*onlybackward-lookingThemodifiedaccountingbusinessmetrics,whichincludeEP,enablerelativelyaccuratelevelsofcorporateperformancemeasurementatlowerlevelsofdecisionmakingintheorganisationAccuracyasMeasureofCorporatePerformanceLevelofDecisionMakingHighLowLowHighMVAModifiedAccountingBusinessMetricsTSR*ROE/ROAFundamentalBusinessDriversEP/EVA/CFROIRoleinOrganisationFramework18CorporatePerformanceMeasurement*onlybackward-lookingThem*AdjustedforallstocksplitsandassumingalldividendsreinvestedWhileTSRcalculatesreturntoshareholdersforpublicly-listedcompanies,BCG’sTBRcalculationestimatesequivalentreturnsforprivately-heldfirmsTotalShareholderReturn(TSR)inCAGRFormatMarketvalueofshareatendofperiod*Marketvalueofshareatbeginningofperiod=TotalBusinessReturn(TBR)=Estimatedmarketvalueofsharesofprivately-heldcompanyatendofperiod*numberofyears1numberofyears111Estimatedmarketvalueofsharesofprivately-heldcompanyatbeginningofperiod*FrameworkOutputMeasures19CorporatePerformanceMeasurement*Adjustedforallstockspli

Bain’sclientstockperformanceslideiscalculatedusingTSR,whichisusedtomeasuretheshareholdervaluecreatedFrameworkOutputMeasures20CorporatePerformanceMeasurementBain’sclientstockperforman

AgendaExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-Diageo21CorporatePerformanceMeasurementAgendaExecutiveSummary21Cor

MarketValueAdded(MVA)InvestedCapitalGoalofManagersshouldalwaysbetocreatemoreshareholdervalue,ormaximiseMVATotalMarketValueofFirm

(includesalldebtandequity)Bain’sfocushasalwaysbeentohelpthemanagementofthefirmtomaximiseshareholdervalue,whichisequivalenttomaximisingMVAMarketValueAddedDefinition(1of2)22CorporatePerformanceMeasurementMarketValueAdded(MVA)Inves

MVAequalsthetotalmarketvalueofthecompanylessinvestedcapitalornetassets.EithertheOperatingorFinancingApproachcanbeused,butBaintypicallyusestheOperatingapproachNote:*Short-termnon-interestbearingliabilitiesOperatingApproach(TypicallyusedbyBain)FinancingApproachMarketValueAddedDefinition(2of2)23CorporatePerformanceMeasurementMVAequalsthetotalmarketv

ThefirststeprequiredtocalculateNetAssetswiththeOperatingApproachistoidentifyexcesscash,whichistotalcashlesscashrequiredintheoperatingcycleNote:*Short-termnon-interestbearingliabilitiesAmount($)MarketValueAddedOperatingApproach-ExcessCash24CorporatePerformanceMeasurementThefirststeprequiredtocaNext,Theworkingcapitalrequirementsarethefirm’snetinvestmentsintheoperatingcycle,orthenetamountofshort-terminvestmentrequiredtofundoperationsAmount($)Working

Capital

RequirementsMarketValueAddedOperatingApproach-WorkingCapitalRequirements25CorporatePerformanceMeasurementNext,TheworkingcapitalrequWhencalculatingMVA,NetFixedAssetsisdefinedasNetPP&EplusotherInvestment(tangibleandintangible).ThethirdandfinalsteptocalculateNetAssetsisNetPP&E,whichistheamountoflong-terminvestmentrequiredtofundoperationsAmount$NetPP&EMarketValueAddedOperatingApproach-NetFixedAssets26CorporatePerformanceMeasurementWhencalculatingMVA,NetFixe

Marketvalueadded(MVA)reflectsthemarketsexpectationsoftheEPmanagerswilladdinthefuturePercentofTotalMVAisthemarket’sexpectationofdiscountedfutureEPsMarketValueAddedLinktoEP27CorporatePerformanceMeasurementMarketvalueadded(MVA)refl

AfterextensiveworkbyadiligentBainteam,AcmeIndustriesisexpectedtogenerate$25Mineconomicprofitsnextyear,whichisexpectedtogrowat3%forever.Ifthecostofcapitalis13%andtheinvestedCapitalis$100M,whatistheMVAandthemarketvalueofthecompany?MarketValueAddedLinktoEP-Example28CorporatePerformanceMeasurementAfterextensiveworkbyadil

AfterextensiveworkbyadiligentBainteam,AcmeIndustriesisexpectedtogenerate$25Mineconomicprofitsnextyear,whichisexpectedtogrowat3%forever.Ifthecostofcapitalis13%andtheinvestedCapitalis$100M,whatistheMVAandthemarketvalueofthecompany?MVA=PVofEPs=$25M13%-3%=$250M=MVA+InvestedCapital=$250M+$100M=$350MMarketValueoftheCompanyMarketValueAddedLinktoEP-Solution29CorporatePerformanceMeasurementAfterextensiveworkbyadil

EPmeasuresmanagers’performanceinthepast,sinceitrepresentsthemarketvalueaddedcreatedoveroneyearNote:*AssumesInvestedCapitalConstantMarketValueAddedLinktoEP(1of2)30CorporatePerformanceMeasurementEPmeasuresmanagers’perform

EPisusedtoevaluatemanagerperformancebecausethechangeinMVAoveraperiodoftimeismeasuredGoalofcompany’smanagersshouldalwaysbetomaximiseMVAWhenmanagersmakeanyinvestmentdecisions,iftheprojectis:value-creating NPV>0 MVAincreasesvalue-destroying NPV<0 MVAdecreasesReasonthatEPisthefocusofmostattentionisbecauseMVAisastockorwealthmeasure,soMVAwillshowhowmuchvaluehasbeenaddedatthatpointintimeEPmeasurestheamountofvalueaddedoveraperiodoftime,whichisfarmoreusefulwhenmeasuringmanagerperformanceMarketValueAddedLinktoEP(2of2)31CorporatePerformanceMeasurementEPisusedtoevaluatemanage

WhichUKsectorswouldyouexpecttohavethehighestmarketvalueadded?andthelowest?

WhichUKcompanieswouldyouexpecttohavethehighestmarketvalueadded?andthelowest?MarketValueAddedActualPerformance32CorporatePerformanceMeasurementWhichUKsectorswouldyoue

Banks,integratedoilanddrugsweretheUKsectorswiththehighestmarketvalueadded

Source:SternStewart,SundayTimesSectorMarketValueAdded(Sept98)MarketValueAddedUKSectorPerformance-10Best33CorporatePerformanceMeasurementBanks,integratedoilanddr

Distributors,printandpackagingandconstructionhadthelowestmarketvalueaddedintheUK

Source:SternStewart,SundayTimesSectorMarketValueAdded(Sept98)MarketValueAddedUKSectorPerformance-10Worst34CorporatePerformanceMeasurementDistributors,printandpack

Shell’s￡69.5BofmarketvalueaddedisthelargestintheUK

Source:SternStewart,SundayTimesCompanyMarketValueAdded(Sept98)1998EVA(￡B)(1.506)0.4160.8030.7100.402(0.024)1.4000.231n/a0.098MarketValueAddedUKCompanyPerformance-10Best35CorporatePerformanceMeasurementShell’s￡69.5Bofmarketval

BritishSteel’s￡3BofmarketvaluedestroyedwastheworstofBritain’s200largestcompanies

Source:SternStewart,SundayTimesCompanyMarketValueAdded(Sept98)1998EVA(￡B)(0.071)(0.012)(0.054)(0.087)(0.050)(0.108)(0.120)(0.320)(0.284)(0.352)MarketValueAddedUKCompanyPerformance-10Worst36CorporatePerformanceMeasurementBritishSteel’s￡3Bofmarke

AgendaExecutiveSummaryObjectivesBackgroundPerformanceMeasurementFrameworkMarketValueAdded(MVA)EconomicProfit(EP)CashFlowReturnonInvestment(CFROI)ExercisesMVAEconomicProfitCaseStudy-Diageo37CorporatePerformanceMeasurementAgendaExecutiveSummary37Cor

DefinitionAdvantages/DisadvantagesFrameworkUseinStrategyWorkEconomicProfitAgenda38CorporatePerformanceMeasurementDefinitionEconomicProfitAgenDefinition(1of2)

Note:EconomicProfit(EP)=OperatingProfit-(CostofCapital*AmountofEquityCapitalInvested)EconomicProfit(EP)isaresidualprofitconceptaccountingfortheopportunitycostofholdingcapitalAmount($)TraditionalaccountingconceptofprofitsEconomicProfit39CorporatePerformanceMeasurementDefinition(1of2)Note:EconDefinition(2of2)Note:NOPAT=NetOperatingProfitAfterTax(SeeAppendixfordetails) WACC=WeightedAverageCostofCapitalEconomicProfitdeterminesacompany’svaluecreationordestructionEasytouse,basedonaccountingrecords(forhistoricalvalues)NotprisonersofGAAPCanbeusedtoshowrelativeperformanceofproducts,segments,regions,etc.inagivenyearCanbecalculatedforfutureyearsanddiscountedtoshowvaluecreationWhenEconomicProfitsarepositiveovertimevaluecreationispositivemarketpricepershareismorethanbookvaluepersharegrowthcreatesvalueEPNOPAT$Chargefor

Capital

EmployedOperating

ProfitEffective

TaxationInvested

CapitalWACCGrossProfitA&PNetWorking

CapitalNetFixed

AssetsOverheadsEconomicProfit40CorporatePerformanceMeasurementDefinition(2of2)Note:NOPA

InordertounderstandEPitisimportanttogobacktothebasicincomestatementWhatdidweearn?

(usingwhatweown)IncomeStatement(%)Whogetsaccesstotheseearnings?$100$100EBITPATTaxInterestObservationsDebtprovidershavefirstaccesstotheinterestpaymentsdueonmoneylentGovernmentstaxcorporateprofitsShareholders(equityproviders)haveaccesstoallresidualprofits(afterpayinginterestandtax)Note:EconomicProfit(EP)=OperatingProfit-(CostofCapital*AmountofCapitalInvested)KeyPrinciples:AccesstoCompanyEarningsEconomicProfit41CorporatePerformanceMeasurementInordertounderstandEPit

Note:NIBL=Non-interestbearingliabilitiesAssetsareacompany’seconomicresources,itemswhichhavethepotentialtoprovidefuturebenefitstotheorganisationNIBLsrepresentafreesourceoffundstothecompany.ItismoneylenttoafirmwithnochargeorexpectedreturnDebtisanyinterestbearingcapital,includingpreferredstockShareholder'sEquityistheaccountant'sestimateofthevalueoftheshareholder'sinvestmentinthecompanytotalassetslesstotalliabilitiesKeyObservationsBalanceSheetMakeupWhatdoweown?AssetsNIBLsDebtShareholder's

EquityHowdidwepayforit?$500$500100%BalanceSheetThebalancesheetseparateswhatisownedbythefirmfromhowitwaspaidforUnderstandingtheBalanceSheetEconomicProfit42CorporatePerformanceMeasurementNote:NIBL=Non-interestbeEconomicProfitBalanceSheet

Note:NIBL=Non-interestbearingliabilitiesInordertodeveloptheEPbalancesheet,short-termnon-interestbearingliabilitiesmustberemovedandadjustmentsforaccountingdistortionsmustbemadeShort-termNIBLareremovedfromtheEPbalancesheetsincecapitalreturnsarenotexpectedontheamountsowed(e.g.wagespayable)EPBalanceSheetNetAssetsamountmaybemuchlargerthanthetraditionalaccountingvalueafteradjustmentsforaccountingdistortions(e.g.,addinginternally-generatedintangibleassets)aremadeRegularBalanceSheetEPBalanceSheetFinancingApproachOperatingApproachEconomicProfit43CorporatePerformanceMeasurementEconomicProfitBalanceSheet

DividendPolicyThetraditionallinkageoftheIncomeStatementandBalanceSheetistheconnectionbetweennetincomeandretainedearningsordividendsIncomeattributabletoshareholders(EBIT-Interest-Tax)Cash“in”fromshareholdersperspectiveCash“out”fromshareholdersperspectiveNetIncomeRetainedEarningsDividendsManagement

DecisionReinvestitintheCompanyDistributeittoShareholdersIncomeStatementandBalanceSheetTraditionalLink(1of2)EconomicProfit44CorporatePerformanceMeasurementDividendPolicyThetradition

EconomicConsequenceThetraditionallinkageoftheIncomeStatementandBalanceSheetistheconnectionbetweennetincomeandretainedearningsordividends=Retained

Earnings=Net

Income-DividendsRevenue-CostsIncomeStatementBalanceSheetAssetsLiabilitiesCurrent

AssetsNetFixed

AssetsOther

AssetsNIBLsDebtEquityIncomeStatementandBalanceSheetTraditionalLink(2of2)EconomicProfit45CorporatePerformanceMeasurementEconomicConsequenceThetrad

Ifyoucouldbuythesamefactoryfor￡100K,butcouldonlyfinance70%withdebtandrequiredequityfortheremaining30%,howmuchafter-taxprofitwouldyourequiretobreak-even?assumetaxrate=40%assumecostofequity=15%Break-EvenExample-70%Debt/30%EquityRevisitedEconomicProfit46CorporatePerformanceMeasurementIfyoucouldbuythesamefa

Ifyoucouldbuythesamefactoryfor￡100K,butcouldonlyfinance70%withdebtandrequiredequityfortheremaining30%,howmuchafter-taxprofitwouldyourequiretobreak-even?assumetaxrate=40%assumecostofequity=15%Debt:Equity:￡70K@7%(￡30@15%)(1-40%)￡4.9K￡7.5K(coverinterestpayments)(coverequitycharge,whichisnottax-deductible)Therefore￡12.4Kisrequiredtobreak-evenwith30%equity,comparedto￡7Kwith100%debtfinancingAnyafter-taxprofitsbeyond￡12.4Kwillbeeconomicprofits￡12.4KBreak-EvenExample-70%Debt/30%Equity-SolutionEconomicProfit47CorporatePerformanceMeasurementIfyoucouldbuythesamefa

EconomicProfitAgendaDefinitionAdvantages/DisadvantagesFrameworkUseinStrategyWork48CorporatePerformanceMeasurementEconomicProfitAgendaDefinitiAdvantages

Source:SternStewartEPismoresuccessfulthanothermeasuresinexplainingshareholderreturnsTMEconomicProfit49CorporatePerformanceMeasurementAdvantagesSource:SternStewAdvantages(1of3)

AmanagerwithhighROEwillnotundertakeprojectswithROEgreaterthanrequiredbutlowerthancurrentROE,creatingmissedopportunitiesManagersaretypicallyevaluatedbasedonmaximisingROEAmanagerwithROElevelofRwillnotundertakeanyprojectswithROE<R1AnyprojectswithROE>R0butROE<R,willstillhavepositiveNPVbutwillnotbeundertakenbymanagercreatesmissedopportunitiesNPV00R1R0

(afterequitycharge)ROEEP>0EconomicProfit50CorporatePerformanceMeasurementAdvantages(1of3)AmanagerAdvantages(2of3)

AmanagerwithlowROEwillundertakeanyprojectthatincreasesROE,evenifitisbelowrequiredlevel.IfprojectROEisbelowrequiredlevel,valueisdestroyed00Ro(AfterequityCharge)AmanagerwithROElevelofR2willundertakeanyprojectthatincreasesROEIfanyprojectswithROE<Roareundertaken,valueisdestroyedNPVR2EP>0ROEEconomicProfit51CorporatePerformanceMeasurementAdvantages(2of3)AmanagerAdvantages(3of3)

Note:*SomeprojectsmayhavenegativeEPinearlyyearsbutlargepositiveEPinlateryears.Toadjustforthis,MVA,orPVandEPcanbeusedByevaluatingmanagersbasedonEP,theirincentiveswillbetofocusonallprojectsthatcreatevalue00Ro(AfterequityCharge)ByevaluatingmanagersbasedonEP,managerbehaviourcanbealteredsuchthatonlyprojectswithNPV>0areundertakenNPVEP<0Donotundertakeproject*EP>0UndertakeprojectROEEconomicProfit52CorporatePerformanceMeasurementAdvantages(3of3)Note:*SDisadvantages

CriticsofEPciteunder-investmentbymanagersandsizebiasasreasonstousedifferentmeasurestoevaluatemanagersUnder-investmentbyManagersSizeBiasEPdiscouragesnewinvestmentsthatdonotgeneratepositivereturnsininitialphasesbecausemanagerwillbechargedforanycapitalusedfromthestartofprojectsolutionistounder-chargecapitalatstartofprojectEPgenerallyrewardslargerdivisionsbecauseperformancemeasuredby$generated,not%Divisionalmanagersarguethat%returnisbettermeasureoftheirskillsthan$return$returnistheimportantmeasureforshareholdersDiageolooksatOperatingEconomicProfitpercaseofspiritstonormaliseROCEbasisEconomicProfit53CorporatePerformanceMeasurementDisadvantagesCriticsofEPc

Evenmeasuresthattieintheassetsideofacompany'sfinancialperformanceneedtobeunderstoodcarefully...Assetrevaluations(especiallyinAustralia)Ingeneralaccountingratioswilltendtobiasperformanceupwardsinrelationtotrueeconomicreturnsbecausetheyignoreinflation,assetlifeandassetmixROEtendstoincreaseduetoinflation,whichmaybecontrarytoactualeconomicperformanceinrealtermsFurthermore,theotherissuetobeawareofisthatolderPPEassetstendtogeneratehigherreturns(RONA,ROC,evenROE)becausetheyaremorefullydepreciatedOneconsequenceofthisisthatcompaniesgrowingassetsquicklywillappeartohavealowerreturnthanthosewithslowgrowthEconomicProfitBeware:CapitalisintheRatioFormula54CorporatePerformanceMeasurementEvenmeasuresthattieinth

ByavoidingcommonpitfallswithEP,managerscanpreventsignificantoverorunder-investmentLookingatabsoluteEPlevelsinsteadofchangesinEPbusinesswithhighEPmayunderinvestand/orbecomecomplacent

FocusingoncurrentEPlevelsinhighlycyclicalbusinessesmayleadtosignificantoverorunderinvestment

IgnoringnaturaltrendsinEPthatoccurincertainbusinesses e.g.high-techstartupwouldhavelowornegativeinitialEPthatincreasesovertimeEconomicProfitCommonPitfalls55CorporatePerformanceMeasur