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Value-based management (VBM) is a management approach that focuses all decision-making on the fundamental drivers of value. It involves the improvement of decision-making at all levels of an organization to ensure that line managers align their objectives toward the maximization of shareholder value. The best way to accomplish this would be to adopt performance measures that set corporate objectives in terms of discounted cash flow value, the best measure of value creation currently available.
Value Based Management (VBM) as the process of continuously maximizing the value of a firm. According to them shareholder value creation is the main objective when applying VBM techniques. They argue that VBM is based on discounted cash flow (DCF) concepts (Copeland et al., 1994: 93). The value of the firm is determined by the present value of its future cash flows. Investing in projects where the return exceeds the cost of capital results in value creation, while investing in projects with returns below the cost of capital destroys value. Young and O’Byrne (2001: 468) indicate that it is important to realize that the value of a firm is eventually determined by capital markets’ perception of its ability to generate future cash flows. They point out that when a VBM approach is adopted the future cash flows, as well as the cost of capital, of all investment opportunities should be carefully scrutinized. The interpretation of cash flow figures when used to evaluate historical financial performance, however, should be carefully conducted. Negative cash flows are not necessarily an indication of poor financial performance but may be the result of large investments required to generate future cash flows. VBM is a combination of two elements. On the one hand, it consists of adopting a value-creation mindset throughout a firm. Each employee should understand that the financial objective is to maximize the value of the firm. They should understand that all their actions should be directed towards achieving this objective. They also indicate that this value-creation mindset should be combined with the necessary management processes and systems to ensure that the employees would actually behave in a manner that creates value. Important factors to consider include the performance measures applied to evaluate employees, targets set, as well as the necessary incentive systems. Employees need to know exactly what targets they are trying to achieve.
TRADITIONAL PERFORMANCE MEASURES
Financial performance measures provide a valuable tool to the different stakeholders of a firm. Internally these measures may be utilized by the management and existing shareholders to evaluate the past financial performance and the current financial position of a firm. Alternatively, it can also be used by potential shareholders and financial analysts to predict future financial performance (Brigham & Houston, 2001: 89). Yook (1999: 36) and Yook and McCabe (2001: 77) point out that traditional accounting measures are often criticized because they are not able to guide a firm’s strategic decisions in such a way that shareholder value is maximized. Mixed results are obtained when evaluating the ability of these traditional performance measures to quantify shareholder value creation. In some studies little or no relationship between traditional accounting measures and future share performance is reported. In other studies these measures are found to provide valuable information regarding expected performance (Peterson & Peterson, 1996: 45). Mixed results are also obtained when comparing the ability of the traditional measures to predict share prices with that of the value based measures (Peterson & Peterson, 1996: 38; Young & O’Byrne, 2001: 431). It is argued that the traditional measures of financial performance, such as earnings, cash flow values, various profitability, turnover, liquidity and solvency ratios, etc, are not suitable as measures of value creation in general. In most cases they are single-period measures. Furthermore they are based on accounting figures, exposing them to the distorting effects of GAAP.
According to Martin and Petty (2000: 8) these traditional measures are exposed to two major weaknesses:
1. They exclude the opportunity cost of the capital invested in the firm. Only the cost of the debt capital is included in their calculation while the cost of the shareholders’ equity is ignored.
2. The measures are calculated by considering historical values. There is no guarantee that these values provide an accurate indication of the expected future performance of the firm.
Numerous criticisms against the use of the traditional financial performance measures have been reported. One of the major criticisms levied against the use of these measures is that they are based on accounting data (Ehrbar, 1998: 80; Peterson & Peterson, 1996: 10). These accounting figures may not be an accurate indication of the actual financial situation of a firm. For instance, the accounting values of property, plant and equipment may be distorted as a result of inflation and may not represent their current replacement value. The valuation and inclusion of intangible assets (including items like goodwill, patent rights and licenses) in financial statements also presents a problem when evaluating a firm. When calculating and interpreting financial performance measures it is consequently of great importance that the possible influence of different accounting methods should be considered. It is also possible to manipulate accounting figures in such a way that they provide a false indication of a firm’s actual financial position (Young & O’Byrne, 2001: 431; Obrycki & Resendes, 2000: 158; Stern, Stewart & Chew, 1995: 33). Peterson and Peterson (1996: 10) also criticise the application of predominantly historic accounting data to explain current and future share prices. For certain firms there may be absolutely no relationship between these historic items and their ability to generate future profits. For instance, if a firm is applying relatively old equipment in its production processes these items may be shown at very low carrying (book) values while still providing a major contribution to its revenues. Calculating a financial performance measure based on this questionable value could provide the analyst with an inaccurate impression of the firm’s performance. One of the most popular traditional performance measures is the earnings per share (EPS). This measure is used extensively, both internally and externally, as a proxy for the financial success of a firm over a specific period of time. Management compensation is often linked to the EPS achieved by a firm. Investors also seem to value the informational content of the measure (Stewart, 1991: 35; Ehrbar, 1998: 41). When valuing a firm the discounted value of all its expected future cash flows is normally considered. Accounting earnings, however, does not represent the expected future cash flows generated by a firm. Instead, it considers the historical earnings generated by the firm. As a result, the maximization of a firm’s EPS does not necessarily result in the maximization of its share value (Martin & Petty, 2000: 8). Additional problems associated with the traditional measures identified by Martin and Petty (2000: 36) include that they are not cash flow values, they do not incorporate the risk of a firm’s activities, they do not focus on the time value of money, and that the value of a measure may differ from firm to firm due to different accounting practices being applied.
