History of Value Based Management
Value Based management traces its theoretical and academic roots in general to modern discounted cash flow (DCF) methods of valuation, and in particular to the Miller-Modigliani approach to enterprise valuation (1961). VBM applied as an actual management practice came later, and can be broadly divided into three phases:
- Phase One 1980s: Companies begin to include the cost of capital in their performance measurement systems through new Value Based metrics that measure economic profit. Alfred Rappaport publishes Creating Shareholder Value in 1986. The shareholder revolution empowers "corporate raiders", who ensure that company management focuses on value generation, contributing to the economic boom of the late 1980s.
- Phase Two 1990s: Consultants Joel Stern and Bennett Stewart popularize EVA (Economic Value Added) as a leading Value Based performance metric, and focus on EVA-based incentive compensation plans, which become a widespread specific application of VBM theory. Academic research confirms the efficacy of VBM, and its growing use parallels the economic boom of the 1990s.
- Phase Three 2000s: Hermann Stern publishes his theory of market-oriented Competitive Value Management and develops the corresponding method of financial benchmarking with Peer Universes of capital market peers. Stern and Keating Coffey create the new metric Operating Alpha (Ω α) as a measure of operating outperformance. They propose their theory of Indexing Operating Performance to measure operating performance independent of external economic variables, and also to standardize performance measurements as percentile ranks for comparison. Their finance research firm Obermatt develops new VBM applications for indexed operating performance and expands the use of Operating Alpha beyond corporations to include private equity and investors.
Value Based Management
Value Based management, or VBM, is an approach to performance management that evolved over the past twenty to thirty years. It is closely related to what is often called the shareholder revolution and arose from the recognition that traditional measures of accounting profit, based on GAAP (Generally Accepted Accounting Principles), do not always accurately represent true economic profit. Thus traditional performance management may not always lead to increasing shareholder value.
Value Based management is an attempt to rectify this situation. VBM aims to accurately measure financial performance in order to successfully integrate financial performance with the ultimate goal of improving economic profit and increasing shareholder value.
In order to accomplish this task, Value Based management requires new financial metrics for measuring performance, profit, and value creation. Most importantly, the new metrics take into account the economic cost of capital employed in the business, which traditional accounting ignores. One particularly popular Value Based metric is EVA (Economic Value Added).
VBM also aims to more closely align the financial interests of managers with those of shareholders. In addition to advocating performance measurement metrics and performance management practices that create shareholder value, VBM involves motivating managers to create value by instituting incentive compensation systems that explicitly link executive bonuses, or performance pay, with those very same Value Based metrics.
Value Based management coordinates all of the elements of a comprehensive performance management system toward the goal of increasing shareholder value, as measured by share price increase and Value Based metrics. Next in this section is more information on the history of VBM and its metrics, followed by a detailed account of EVA in particular, and the disaggregation of Value Based metrics into their sub-metrics: the value drivers of operating performance. This section concludes with a review of Value Based incentive compensation systems.