Eisai is an example of the skillful execution of a long-term program to match the firm’s mission to employee values; create and share knowledge; deliver significant innovations that directly benefit patients and, in so doing, reinforce the firm’s culture; and ultimately, produce a track record of superior wealth creation.

Further, the history of Eisai is a reminder of the importance of the soft stuff—the culture and processes needed to deliver solid, long-term financial results. Corporate governance needs to address the soft stuff as well as the hard financial numbers. The next section outlines a new proposal for putting wealth-creation principles on center stage so that improved corporate governance can better evolve over time.

SHAREHOLDER VALUE REVIEW

The basic idea of a Shareholder Value Review (SVR) (Madden, 2007a, 2007b, 2008a) is for boards of directors to demonstrate that they are fulfilling their responsibility to shareholders—in short, to show that the board is a facilitator of wealth creation.

Broadly speaking, as noted earlier in this chapter, the board’s performance in guiding and monitoring management can be gauged via the criteria of organizational structure and culture keyed to the firm’s mission, wealth-creation tasks, and long-term financial results. What is needed is a practical tool to clearly communicate how boards are actually doing their job. That tool is an SVR.

FIGURE 7.1 Eisai Company, Ltd.

Source: Credit Suisse HOLT ValueSearch^® global database.

An SVR, consisting of the following three parts, needs to be included in annual reports:

1. A description of the valuation model that management and the board use to connect the firm’s financial performance to its market value, plus a description of how the firm is organized and managed in order to nurture a performance-oriented culture

2. Consistent with this valuation model, graphs of value-relevant track records for the firm and each of its major business units

3. Business unit analyses that lay out how value has been created or reduced by each unit, along with the board’s appraisal of management’s strategy, and planned future investments for each unit

An SVR is similar in spirit to the board-directed strategic audit proposed by Gordon Donaldson:

The mechanism is a formal strategic-review process . . . which imposes its own discipline on both the board and management, much as the financial audit process does. . . . An effective strategic-oversight process requires that the board take control not only of the criteria of performance but also of the database in which the criteria are maintained. One of the problems that outside board members often have in evaluating strategic performance is that all the information they receive passes through the filter of a management perspective. In addition, data often come with limited historical reference and in a format that does not map to the previous one. . . . The credibility of the board’s review process depends on the integrity and consistency of the statistics by which progress is measured.

(Donaldson, 1995)

As a practical matter, it will take pressure from pension fund trustees and institutional shareholders, at least initially, to convince the board and management to implement an SVR in the firm’s annual report. That is because an SVR reflects a genuine transparency of managerial skill. Although management would be deeply involved in the development of track record displays, control of SVR data ultimately needs to be the board ’s responsibility for the reasons stated by Donaldson.

Valuation Model Selection

An SVR requires specificity about how the board and management connect financial performance to stock market valuation (i.e., a valuation model). By not carefully considering the criteria for an insightful and useful valuation model (see Chapter 5), the typical default model becomes a rule of thumb consisting of a price/earnings multiple and an earnings growth rate. Observations of a high correlation between quarterly earnings surprises and short-term moves in stock prices further cement the reliance on an earnings-centric valuation model.

Should not firms’ chief financial officers (CFOs) be eager to educate management and the board as to the pitfalls of an excessive focus on short-term earnings as a wealth-creation compass? Apparently not; survey research shows that CFOs, for the most part, are committed to dancing to Wall Street’s tune for quarterly earnings. Here is a sample of some survey results:

Results . . . indicate that 80 percent of survey participants would decrease discretionary spending (e.g., R&D, advertising, maintenance) to meet an earnings target, even though many CFOs acknowledge that suboptimal maintenance and other spending can be value destroying. More than half of the CFOs (55.3 percent) said they would delay starting a new project to meet an earnings target, even if such a delay entailed a sacrifice in value. This evidence is interesting because CFOs appear to be willing to burn “real” cash flows for the sake of reporting desired accounting numbers.

(Graham, Harvey, and Rajgopal, 2006, p. 31)

The missing ingredient here is an insightful valuation model that makes transparent the value-relevant components in firms’ track records of financial performance. Absent these insights, attention gravitates toward a single earnings number. Consistent with this view, survey researchers noted: “Lacking a sense of history, analysts are prone to overreacting when the company misses an earnings target or when a new kink appears in the earnings path.”

The proposed SVR does not dictate any particular valuation model or value-relevant track record format. One would expect firms to experiment with using earnings-centric valuation models. But keep in mind that an earnings-centric framework is conceptually flawed. Its deficiencies will become apparent when boards need to actually explain to investors, in detail, performance measurement and the long-term wealth creation or dissipation that has occurred.

A management fixated on earnings will make decisions with a careful eye on the likely impact on quarterly earnings. When the primary goal is increasing earnings, management can easily lose sight of the fundamental wealth-creation goal of achieving sustained economic returns in excess of the cost of capital. There are all sorts of ways to boost near-term earnings to the detriment of long-term wealth creation such as borrowing funds to invest in below-cost-of-capital projects that exceed the borrowing rate; or cutting back on research and development expenditures, maintenance outlays, and the like.

In addition, an extreme quarterly earnings orientation is ill-suited to nurture a culture of integrity and responsibility. Motivating people to make targeted accounting numbers leads to gamesmanship and short-term expediencies—which is diametrically opposed to the five core lean principles rooted in a systems mindset for providing value to customers and reducing waste.

In contrast to the problems with an earnings-centric approach, what benefits might be achieved from implementing some version of the life-cycle valuation model? In this regard, decades of experience with institutional money managers provided valuable lessons. After adopting the life-cycle model, an investment organization’s portfolio managers and security analysts invariably improved in the following key areas:

• Clarity as to a firm’s track record and the extent of past wealth creation or dissipation.

• Evaluation of management’s resource allocation decisions (e.g., a below-cost-of-capital firm must, first and foremost, improve its economic returns).

• Quantification of the valuation impacts of alternative levels of future performance for a firm.

• Quantification of the long-term performance expectations implied in a firm’s current stock price as well as its competitors’ stock prices.

• Economic evaluation of mergers and acquisitions from the perspective of a firm’s shareholders.

• Evaluation of how well top management’s compensation is linked to wealth creation.

• Plausibility judgments of forecasts of a firm’s future financial performance by comparison to the perceived skill level of firms that have historically delivered such performance.

• Approximation of a firm’s economic returns from reported accounting data.

Many of these money management tasks are closely related to the tasks required of board members to fulfill their responsibility to shareholders. Keep in mind that money managers have their compensation and job security directly tied to the usefulness of the valuation models they choose to use. Consequently, life-cycle model adoption by these very discriminating users supports a prediction that corporations will also find this valuation model well suited to the needs of an SVR.

Finally, the first part of an SVR includes not only a description of the valuation model selected, but also a description of how the firm’s organizational structure can nurture a viable, performance-oriented culture. These topics are related. That is, it is clearly advantageous to select a life-cycle model with track records that display long-term competitive fade rates. In this manner, investors can observe a relevant metric (fade rates) that is highly related to the firm’s culture.

Value-Relevant Track Records

The second part of an SVR shows the value-relevant track records for the firm and its primary business units. If the firm chooses the life-cycle model, the complete package of variables needs to include:

• Economic asset base

• Economic returns compared to the cost of capital

• Reinvestment rates

• Fade (time series) patterns for economic returns and reinvestment rates

A board most likely would use consultants to guide their choice of a format and calculation routines for displaying the life-cycle variables. The displays serve as the launch pad for the board to handle the practical details of monitoring wealth creation. The data displays resolve Donaldson’s concern that management-controlled data “often come with limited historical reference and in a format that does not map to the previous one.”

A construction of track records begins with specifying economic assets for each business unit. Critically important intangibles that represent economic assets need to be added to a conventional accounting asset base. The capitalization of R&D expenditures is one example.

If SVRs gain widespread use, a lot of attention will be given to developing standards for handling intangibles. Eventually, this could lead to the handling of certain types of intangibles as part of conventional accounting principles. This would have the beneficial effect of standards evolving over time based on the practical experiences of those closest to the relevant data who are trying to make better wealth-creation decisions.

Economic returns and reinvestment rates for each business unit are a function of how economic assets are constructed. Although the life-cycle displays in Chapter 4 used a CFROI metric to estimate economic returns, this is not essential. Industrial firms, for example, may be more comfortable making economic adjustments to improve a conventional RONA (return-on-net-assets).

Estimating the next variable, cost of capital, poses a significant challenge. (Problems with mainstream finance’s CAPM/Beta cost of capital were discussed in Chapter 5.) One choice is to begin with the long-term average of industrial or financial (as applicable) aggregate economic return as a proxy for the opportunity cost of capital. It is important to make the estimated cost of capital a visible line, plotted on the track record display, and to be aware of the impact of different cost-of-capital estimating procedures.

The critical guidepost to long-term wealth creation is the spread of economic returns as compared to the cost of capital. The spread—positive, zero, negative—determines whether, all else equal, reinvesting in the business will create additional wealth, have a neutral effect, or dissipate wealth. Reinvestment rates, measured as asset growth rates, get a boost from acquisitions. But, for most firms, the sustainability of future reinvestment rates depends on internally generated opportunities (i.e., organic growth), and consequently careful attention must be paid to the impact of acquisitions.¹ The preferred display of reinvestment rates would identify the contribution due to acquisitions (and divestitures).

One big advantage of life-cycle track records is the visual attention paid to competitive fade rates—the trends over time of economic returns and reinvestment rates. Long-term fade rates are the result of business processes (including knowledge creation and dissemination), culture, and strategies and speak volumes as to competitive advantage. As for purportedly gaining competitive advantage and boosting shareholder value, consultants often stress value-based management that involves a mindset of doing whatever it takes to improve short-term accounting targets. A helpful counterweight to such misguided short-termism is the long-term perspective of life-cycle track records and the need to grapple with the causes of long -term fade rates. This is exactly what was highlighted in the quotes of former Medtronic CEO, Bill George, in Chapter 4.

Business Unit Analyses

Value-relevant track records that position each business unit in a life-cycle context set the stage for the board to answer basic wealth-creation questions. For example, for startup business units: Is the amount of resources reinvested justified by progress in achieving nonfinancial milestones in relation to the size of the target market opportunity? For units earning well-above-cost-of-capital economic returns: What are the plans for expanding the business and fortifying that unit’s competitive advantage? For mature businesses, stuck at a cost-of-capital plateau for economic returns: Is there a strategy in place to substantially improve economic returns that avoids the grow-the-business mindset that always gives top priority to a bigger market share regardless of the impact on wealth creation? If so, what is the strategy? For business units earning economic returns far below the cost of capital: Is downsizing planned, and, if not, why not? These questions deal with straightforward issues concerning financial results. Similar thinking is used by portfolio managers in assessing whether management really “gets” the fundamentals of shareholder value.

At a deeper level, the board should deal with the causes of long-term, financial results. The board ’s analyses of business units should communicate that they are engaged with an information system attuned to the improvement of internal processes. As said earlier, the processes that drive wealth creation are encapsulated in the five lean principles. If management’s information system is simply made up of accounting control variables, there is a clear need for board involvement so the system can be improved.

The discussion of lean principles in Chapter 6 underscores how important it is to have a commitment at all levels of the firm to the wealth-creation process as well as a supportive corporate culture. The issue is well articulated by Jeffrey Pfeffer and Robert Sutton in their insightful book, The Knowing- Doing Gap: How Smart Companies Turn Knowledge into Action:

[L]earning . . . is inhibited because companies are measuring the wrong things and not gathering data that permit them to really understand, manage, and control the process. In that regard, budgetary figures, costs, and even the balanced-scorecard measures are too far removed from processes in many instances to guide behavior and permit knowledge to be developed and turned into action.

. . . But if there is one thing we know for certain, it is that organizations are systems in which behavior is interdependent. What you are able to accomplish, and indeed, what you choose to do and how you behave, is not solely under individual control. Rather, your behavior and performance are influenced by the actions, attitudes, and behaviors of many others in the immediate environment.

. . . As long as accountants have control of internal measurements, not much will change. We have nothing against accountants, but are simply noting that they are pursuing a different set of goals. Specifically, we have seen few accountants or controllers who worry about the effect of measurement systems on turning knowledge into action or on the organization’s ability to develop and transfer skill and competence.

(Pfeffer and Sutton, 2000, p. 154-159)

Reply to SVR Objections

Board accountability to shareholders gives legitimacy to management’s power. SVRs can orchestrate a new era of heightened transparency and accountability that would improve firms’ long-term performance and investor trust. Nevertheless, CEOs who are intent on having the independence that comes with tight-fisted control of “their” boards will likely oppose SVRs, joined by those directors who are comfortable with the rituals of the status quo. The four principal objections most likely to be voiced by them are:

1. Directors lack sufficient in-depth knowledge of the firm’s business units.

2. SVRs would force directors to deal with technical complexities of performance measurement for which they lack sufficient skill.

3. SVRs would be too costly to produce.

4. Competitors would benefit from SVR business unit disclosures.

As to knowledge of the firms’ business units, management may be overly concerned with the trees and not appreciate the forest. That is, management typically is intent on producing results consistent with the existing strategy. In contrast, an SVR mindset encourages directors to raise broad, fundamental issues concerning different strategic opportunities that may deliver a more rewarding life-cycle performance for investors.

Capable directors have valuable experience that helps them focus on the big issues critical to failure or success. An SVR can lead both management and the board to a stronger conviction to take decisive actions as well as explain the rationale to investors. Directors who feel incapable of contributing to an SVR would seem to be unqualified to represent shareholder interests.

Regarding SVR technical complexities, the firm’s auditors or a skilled consulting firm can provide the needed expertise. Whoever provides the technical support needs to report directly to the board, and not management. Of course, management would be intimately involved, which is a good thing, especially for the handling of accounting adjustments to estimate economic returns. With an SVR, both management and the board would have a purpose in working with accounting data so as to better reflect economic reality and to avoid a blind reliance on conventional accounting principles as well as a tunnel focus on accounting earnings.

The third criticism implies that any additional cost is bad. Yet, the actual relevant comparison is the total cost to shareholders versus the benefit to shareholders. Think of the cost to shareholders of the ineffective board oversight at Bethlehem Steel (see Figure 4.6). The potential gains from improved corporate governance are enormous. Further, over the long term, SVR-motivated participation by managements and boards in the development of new accounting principles to handle intangibles can promote even more wealth creation for the benefit of investors.

Another SVR benefit for investors is the likelihood of a lower cost of capital for the firm. The more uncertainty there is that a firm will grow the business with wealth-destroying reinvestments, or make expensive acquisitions that are not economically justified, then the higher the demanded return (cost of capital) by investors. SVR implementation is a step in the right direction to address this problem. In fact, those firms most in need of improved corporate governance should achieve the most favorable reduction in their cost of capital from SVR implementation.

This raises the valid point that especially well managed firms might only achieve a negligible gain from an SVR. To address this possibility, the board could allow shareholders an up or down vote on SVR implementation.

The fourth criticism is that upon observing wealth-creating economic returns for a business unit and reading a board’s favorable assessment of that unit’s prospects, competitors will pour additional resources into that area. This criticism implies that competitors are now largely clueless about success in the marketplace. My sense is that this perceived need for secrecy is unwarranted but it could delay or derail an SVR implementation.

One approach to counter it would be to implement an SVR using only data for the firm as a whole. While not my preferred choice, this still could lead to significant progress by instilling a viable wealth-creation framework at the board level. After some experience with a slimmed-down SVR, a board might later expand its SVR to include business unit analyses.

SVR as an Evolutionary Process

Over time, implementing an SVR would most likely lead to the following six benefits:

1. The life-cycle valuation model would gain widespread use as the deficiencies of the earnings-centric models became more visible.

2. Because they could more effectively explain their decisions to investors, managements and boards would be more willing to make long-term, wealth-creating investments that reduce near-term quarterly earnings.

3. A top-down board priority on having a robust information system would lead to more useful internal data and a greater concern for the five lean principles of wealth creation.

4. Extensible Business Reporting Language (XBRL) would be used to make available to investors the data used to produce life-cycle track records. The SEC has mandated that XBRL be used by firms to tag data according to highly specific definitions. This is the coming big thing to enable investors to perform customized security analyses. With XBRL, investors would understand how SVR track records were calculated (e.g., capitalization and amortization of R&D) and would be able to calculate track records using different assumptions, if they so desire.

5. In mismanaged companies, there would be earlier recognition by the board of a need to change course.

6. The nominating process for directors would increasingly emphasize individuals who are both motivated and skilled in performing the SVR tasks, which are fundamentally rooted in wealth creation (Acharya, Kehoe, and Reyner, 2009).

Summary of Key Ideas

• Building anything, including long-term wealth, is better done when those involved speak a common language that facilitates the building process. Managements, boards, and investors would be well served by replacing an earnings-centric valuation language with the life-cycle language.

• The core responsibility of the board of directors is to ensure that management nurtures a culture of integrity and responsibility and focuses on continual improvement of the processes that produce superior performance. This is necessary to avoid taking actions motivated by accounting targets and by a narrow grow-the-business mentality. Instead, wealth-creating strategies for each of the firm’s business units should guide actions.

• Shareholder Value Review is a practical means for board members to demonstrate that they are fulfilling their core responsibilities. Once the need for such a demonstration in the firm’s annual report is recognized, the SVR’s three components make eminent common sense: specification of a wealth-creation framework or model, display of value-relevant track records for the firm’s business units, and explanation of how management’s strategy and reinvestment for each business unit holds good potential for creating wealth.

• SVRs represent a free-market approach to improving corporate governance. SVRs are voluntary even though, as a practical matter, pension fund trustees and institutional investors might initially need to nudge managements and boards to take action. In addition to addressing the core responsibilities of boards, SVRs would be a direct, hands-on purpose for managements and boards to better understand economic reality, to improve their decision making, and to share their experiences with accounting rule makers, thereby shaping the evolution of a new, more useful accounting system.

• By bringing heightened transparency and accountability that would improve firms’ long-term performance, SVRs would raise citizen trust in, and political support for, free-market capitalism.