2000

CAP GEMINI ERNST & YOUNG

CENTER FOR BUSINESS INNOVATION
Measuring
the Future
The Value Creation Index
T
odays markets value new types of
assetsnamely, intangible assets.
Knowing what drives such value can help
determine how a company will perform
in the future. The Value Creation Index is
the third study in Cap Gemini Ernst &
Youngs ongoing exploration of Measuring
Intangibles. It presents a model for the
new non-financial performance that drives
value creation in todays organizations.
[ THE VALUE CREATI ON I NDEX ]
2
Value is
Changing
Valuing assets in the industrial economy
was considerably different than it is today.
Manufacturing inventory was quantifi-
able and the worth of a factory could
be determined by assessing equipment
value. But today's economyone based
on assets like knowledge, R&D, and
innovationrequires an unprecedented
challenge: valuing intangible assets.
In the Connected Economy, Financial
Performance Measures Have Grown
Less Important.
Market to book rations continue to
increase; The relationship between finan-
cial performance and stock price is
decreasing; Physical assets have become
a liability.
Non Financial Performance Measures
Have Grown More Important
Investments in brand development, train-
ing, and R&D now exceed total invest-
ments in tangible assets; at least a third of
a mature company's value is attributable
to non financial information (for smaller
cap companies, the proportion is even
larger); there is increasing demand for
global transparency.
Understanding Intangibles Can Improve
Market Value
Companies are experimenting with alter-
native performance measures. Because
corporate value is created in new ways
today, not proportional to traditional val-
uation systems, a new way of measuring
future performance must be developed.
So, as the significance of intangible assets
grows, their true value must be deter-
mined along with the characteristics that
drive thema difficult task when you
consider how elusive such intangibles are
by definition. But once you measure
them, the fact is, improvement in key
intangible drivers translates into increased
market value.
Existing measures are woefully insuffi-
cient at expressing corporate value
nowadays. And the time is right for smart
companies to recognize that the better
job they do of managing all their assets
and liabilitiesnot just the traditional
tangible onesthe more comprehensible
and positive their valuations will be.
The Cap Gemini Ernst & Young Center
for Business Innovation (CBI) has devel-
oped a tool, the Value Creation Index
(VCI), that allows managers and owners
a more complete view of the wealth cre-
ating potential of their companies; and
allows investors a more reliable, compre-
hensive way of evaluating a company's
intangible assets, and the process by
which they value their organizations.
The Value Creation Index establishes the
relationship between actual non-financial
performance and value creation by
identifying key performance measures
that drive organizational success and
the intangible actions that drive them.
In today's economy, many traditional
companies with solid market share and
robust revenues, have significantly lower
market caps than the technology start-
ups. Some dot-com IPOs are racking up
valuations in the hundredsif not bil-
lionsof dollars.
The Value Creation Index addresses this
disparity.
Because financial measures are univer-
sally less important in today's company
valuations than non-financial, intangible
But once you measure them, the fact is, improvement in key
intangible drivers translates into increased market value.
ones, even large, mature companies must
experiment with alternative performance
measures. As technology, connectivity,
and human capital play an increasingly
dominant role, the accounting systems
we have traditionally relied upon to track
corporate and economic performance
become more outdated.
As market to book value has steadily
increased over the past 80 years (reflect-
ing a shift from past to potential per-
formance as the source of shareholder
value), predicting the future is now
critical. Investments in intangible assets
which now exceed total investments in
tangible assets, skew return on invest-
ment capital from historic norms. In fact,
the percentage of a company's value that
is unaccounted for by tangible assets has
skyrocketedanywhere from 50% to as
much as 90% of its value. This is as true
for the Procter & Gambles, as it is for the
Intels and eBays.
Management teams that rely wholly on
reporting of their past and current finan-
cial performance are operating with
blinders on; they are not only getting an
incomplete view of their enterprise, but
they are missing a forward view of their
company and a significant opportunity
to improve operating and capital market
performance.
[ THE VALUE CREATI ON I NDEX ]
3
WE HAVE LONG HAD A GOOD IDEA OF HOW TO VALUE MANUFACTURING INVENTORY OR ASSESS
WHAT A FACTORY IS WORTH. BUT TODAY, THE VALUE OF R&D INVESTED IN A SOFTWARE PROGRAM
OR THE VALUE OF A USER BASE OF AN INTERNET SHOPPING SITE IS A LOT HARDER TO QUANTIFY.
AS INTANGIBLE ASSETS CONTINUE TO GROW IN BOTH SIZE AND SCOPE, MORE AND MORE PEOPLE
ARE QUESTIONING WHETHER THE TRUE VALUEAND THE DRIVERS OF THAT VALUEIS BEING
REFLECTED IN A TIMELY MANNER IN PUBLICLY AVAILABLE DISCLOSURE. "
A companys non-financial performance plays a
critical role in how the company is valued.
Strategy Execution
Management
Quality of Strategy
Innovativeness
Ability to Attract Talented People
Market Position
Management Experience
Quality of Executive Compensation
Quality of Major Processes
Research Leadership
New
Measures:
Quantifying Intangible
Value
There is increasing global recognition of
the importance of intangible assets, and
of the pressing need for a set of widely
accepted metrics by which corporate
leaders and the investment community
indeed anyone involved in measuring
and shaping corporate performancecan
account for the non-financial factors that
profoundly affect value creation in the
modern enterprise. It's all part of the
growing global demand for greater trans-
parency in the marketplace whether the
issue is privacy or foreign exchange.
Intangibles, though not historically recog-
nized as such, have always been drivers
of corporate performanceand institu-
tional investors who attribute a significant
part of a company's market value to
non-financial data, take intangibles into
account in their analysis and earnings
estimates. Managers, by the same token,
are increasingly adopting non-traditional
methodologies of measurement. Past
methods to measure intangibles have
included such approaches as Economic
Value Added, Risk Management, the
Balanced Scorecard, and Value-Based
Management.
Laying the
Foundation:
Research by
the Cap Gemini Ernst &
Young Center for
Business Innovation
The Cap Gemini Ernst & Young Center
for Business Innovation is part of the
movement to acknowledge the impor-
tance of non-financial intangibles and to
quantify their role in corporate perfor-
mance. In its 1996 Measures that Matter*
study, the CBI established that non-finan-
cial performance plays a critical role in
how public companies are valued,
accounting for as much as 35% of institu-
tional investors' valuation. It found a
strongly positive correlation between sell-
side analysts' reliance on non-financial
performance and the accuracy of their
earnings forecasts. Its next study, Success
Factors in the IPO Transformation Process*,
found that intangibles are the most signif-
icant differentiating factor between
successful and unsuccessful IPOs. The
bigger and more long-range the role
intangibles played in running the business,
the more successful the IPO. Both show
that the market at once demands and
relies on non-financial information in com-
pany evaluations and valuation decisions.
Measures That Matter Insights
Non-financial performance accounts for
35% of institutional investors valuation
The more sell-side analysts rely on
non-financial performance, the more
accurate are their earnings forecasts
Consistent set of non-financial drivers
that analysts rely on:
Arthur Levitt
Chairman, U.S. Securities & Exchange Commission
The Economic Club of New York
October 18, 1999
* To order the Measures that Matter or
Managing the Success of the IPO
Transformation Process studies call
Jill Therrien at The Cap Gemini Ernst & Young
Center for Business Innovation 617-761.4008.
[ THE VALUE CREATI ON I NDEX ]
4
The Next
Step:
AMeasurement Model
If it's true that non-financial variables
affect performance, and, in turn, affect
price, determining which ones have the
greatest impact is critical. Understanding
how intangibles correlate to the wealth of
companies; and knowing which financial
and non-financial performance measures
can be integrated into one measure to
explain a company's stock price perfor-
mance are key elements in assessing a
companys value.
These issues led the Cap Gemini Ernst &
Young researchers to develop a rigorous,
comprehensive model of value creation
for progressive companies that would
enable them to measure the impact of key
intangible asset categories on a com-
pany's market value. By devising a set of
standardized and weighted measures,
managers can better drive and monitor
their company's future perfor- mance. At
the same time, if disclosure rules change
in parallel, investors will be armed with a
more uniform, less subjective and more
robust way of evaluating companies.
As a prelude to developing the model, the
Center for Business Innovation, in con-
junction with the Wharton School of the
University of Pennsylvania and Forbes
ASAP, conducted an Internet survey to
determine the extent to which compa-
nies' performance measurements were
aligned with the decisions that their
managers make. The result? A glaring
disparity between the information a man-
ager needs to make strategic decisions
and the actual performance data the
company is able to generate. The biggest
information gaps were on the demand
side of the business, in such areas as cus-
tomer and brand. Managers, it appears,
are flying blind in some of the areas most
critical to strategic decision-making.
Intangibles such as
innovation, alliances,
management and
employees are key
drivers of value.
Value Creation Index Insights
VCI
Improvement in key intangible drivers translates
into increased market value.
Market Value
Financial Performance
The VCI is highly correlated with the market value of equity.
[ THE VALUE CREATI ON I NDEX ]
5
Innovation 1 (high) Innovation 1 (high)
Management 2 (high) Employee 2 (high)
Employee 3 (high) Management 3 (high)
Quality 4 (high) Alliances 4 (high)
Brand 7 (med) Brand 7 (med)
Technology 8 (low) Technology 8 (low)
Customer 9 (low) Customer 9 (low)
Value Driver
Category
Non-Durables Mfg.
Importance Rank
Value Driver
Category
Durables Mfg.
Importance Rank
Innovation
Quality
Customer relations
Management capabilities
Alliances
Technology
Brand value
Employee relations
Environmental and
community issues
Constructing
the Model
Our aim was to combine this list to form a
single measure of non-financial perfor-
mancea Value Creation Indexthat
represents the sum total of a company's
performance across the most critical
intangible categories.
We then divided the S&P 500 companies
(companies with at least $100 million in
market capital) in the durable and non-
durable manufacturing sectors into 9
categories. And because of the special
importance of non-financial value drivers
in the emerging knowledge-intensive
companies, drivers for e-commerce com-
panies were created.
Next, indicators had to be identified and
constructed for each of the categories.
Data from public and proprietary sources,
including company and industry reports,
expert ratings, government filings and
special studies, were collected. The team
used as many indicators from as many
different sources as possible, each reflect-
ing different aspects of the category, to
ensure a more comprehensive, more reli-
able measure.
Through regression analysis and other
advanced statistical techniques, re-
searchers assessed the ability of each
value driver category to explain market
values beyond what could be attributed
by traditional accounting of assets and
liabilities. The categories were then sta-
tistically weighted to form the Value
Creation Index. The Index measures the
relative importance of each value driver;
the more important a factor is in deter-
mining a company's market value, the
greater its weighting in the index.
Rank of Value Driver Categories
Value Driver
Category
E-Commerce
Importance Rank
Rank of Value Driver Categories
Alliances 1 (high)
Innovation 2 (high)
Eyes 3 (high)
Brand 4 (low)
Minutes per page 5 (low)
Change in usage 6 (low)
Change in % reach 7 (low)
Using findings from the Internet survey, the Measures That Matter and
IPO studies, as well as industry literature and conversations with
business and academic researchers, the research team chose the nine
most critical categories of non-financial performance that determine
corporate value creation. They are:
[ THE VALUE CREATI ON I NDEX ]
6
Methodology
Up Close
Once value categories were selected, and
indicators for each category established,
Ernst & Young researchers conducted
internal reliability tests to see whether the
hypothesized sets of indicators for each
category worked together logically. This
way, they confirmed that the indicators
for each category were indeed related
and that they captured the same value
driver. Moreover, researchers needed to
verify that each measure captured a dif-
ferent aspect of the overall company
value. The innovation measure, for exam-
ple, had to be statistically distinct from
the alliance measure.
Next, the multiple indicators were stan-
dardized to a common scale, using
weighted combinationsto reflect their
proportionally different impact on value.
Using established statistical techniques
the Value Creation Index model was then
developed. At this point, components
were weighted to create an overall score
that accounts for the greatest amount of
variation in a company's equity market
valueafter controlling for accounting
assets and liabilities. This is where the rel-
ative importance of each driver is
determined: a greater weighting means
the factor accounts for a relatively higher
market value. Finally, researchers tallied
overall VCI scores, to see which compa-
nies in the sample have the greatest
potential for creating value through intan-
gible assets. Index scores were
cross-checked against historical data.
Value Drivers Performance Account Value
VCI
Accounting
Assets
Market
Value
Accounting
Liabilities
Building the Drivers
Alliances
The VCI Difference
Unlike other attempts to measure intangible assets that are entirely subjective (relying on surveys of managers and investors' perceptions), the Value
Creation Index lets the market speak by showing the real correlation between the actual performance of value drivers and market value. The Value
Creation Index differs from other measures in its breadth of coverage: researchers examined a broad range of intangible asset categories, in order to
identify those most and least important to value creation. And because the VCI weights each category according to its impact on market value, it achieves
greater accuracy in measuring the individual impact of each driver. The ultimate score, the Value Creation Index, reflects real, not perceived effect.
Value Creation Index Model
Innovation
Quality
Customer
Management
Alliances
Technology
Brand
Employee
Environment
# of Alliances
# of Alliance Partners
# of Supplier Partners
# of Marketing Agreements
# of Joint Ventures
[ THE VALUE CREATI ON I NDEX ]
7
What Really
Matters
Perception vs. Reality and other
Surprises
The impact of some of the drivers differs
substantially from common perception.
For example, in the Internet survey which
preceded the VCI analysis, alliances were
ranked relatively low in importance as a
value driver by the self-selected execu-
tives who filled out the questionnaire. Yet
the model shows that companies with
more marketing and manufacturing
alliances, and more joint ventures and
other forms of partnerships have substan-
tially higher market valuesa testament
to the importance of connectedness in
today's economy, and a way of getting to
scale without being trapped with all of
the assets.
It also shows that even Internet-capable
managers are still unaware of, or unwil-
ling to accept the alliance-driven world
in which they must now operate.
Furthermore, while quality still counts,
the Internet survey respondents ranked it
lowest in importance of the ten factors.
And community relations and environ-
mental performance proved to be
important, particularly in the non-
durables sector, even though survey
respondents considered these among the
least important value drivers. This may be
due to the common misconception that
these factors dont matter to investors, or
that they are merely cost sinks.
Equally surprising was the lack of any sig-
nificant statistical connection to market
value for two value drivers: technology
and customer satisfaction. By way of
explanation, it may simply be that tech-
nology is so essential to any company
nowadays that its value as a driver is neu-
tralized: without it, you are not even in
the game. It may also be that technology
installed without effective organizational
design changes to leverage it is neutral-
ized. But it's especially surprising that
customer satisfaction didn't register as a
value driver, considering the great sums of
money companies spend surveying cus-
tomers and the high ranking customer
satisfaction earned in the Internet survey.
Could this mean that, while it's necessary
to have a certain level of customer satis-
faction in order to remain competitive,
maximizing satisfaction levels doesn't
seem to offer a competitive advantage, at
least not relative to the other value dri-
vers? Or might it be that customer
satisfaction is embedded in other factors,
such as process quality or innovation, or
that it is factored into financial informa-
tion already? After all, a company with
leading edge technology, or one that
churns out consistent, high-quality prod-
uct with great efficiency probably has
happy customers.
Although many believe
alliances are relatively
insignificant, analysis
shows that companies
with more joint
ventures, marketing
and manufacturing
alliances, and other
forms of partnerships
have substantially
higher market values.
It's Not Just What You Know,
It's Who You Know
[ THE VALUE CREATI ON I NDEX ]
8
The
Findings...
The Big Story
It's no surprise that improvements in the
critical intangible categories do indeed
result in increased market value. What is
surprising is the extent and which indi-
vidual categories have the greatest
impact.
Of the nine factors, "innovation"as
measured by R&D expenditures, number
of patents, and the importance of
patentshas the greatest impact on
market value. This reflects the need for
companies to innovate constantly in
order to compete in the new economy.
"Management quality" and "employee
relations" follow closely behind in their
impact in predictive market value, vali-
dating the corporate platitude that
"people are our most important asset."
As one might expect, product and
process quality in manufacturing remain a
strong predictor of value.
The VCI model demonstrated that fully
50% of a traditional company's value is
based on the nine factors. For e-com-
merce companies, a whopping 90% of
their value is based on these factors.
Small changes in a company's non-finan-
cial performance had a strong relationship
to its stock price performance.
After developing the factors and weight-
ing them statistically, researchers then
reapplied them to the sample companies.
They computed overall VCI scores to
determine which companies from the
sample have the highest level of value-
creating intangible assets. For both
durable and non-durable companies, the
Value Creation Index is highly correlated
with market value (a 0.70 correlation).
Relatively small changes in the VCI pro-
duce significant changes in market value;
a 10% change in the VCI is associated
with an approximate 5% change in the
market value of equity (after controlling
for accounting assets and liabilities). In
dollars, this means that for the average
durable manufacturing company, a 10%
increase in its VCI translates into a $3.9
billion increase in market value. For the
average non-durable company, it repre-
sents a $2.2 billion change.
Survey Insights
81% of respondents stated that their
performance measurement system is not
well aligned with their corporate strategies
45% of respondents said that the alignment
between their performance measurements
and strategies is very poor
Value drivers are not disclosed to the public
[ THE VALUE CREATI ON I NDEX ]
9
Whos on
Top?
Technology firms have no monopoly on
the effective exploitation of intangible
assets. Although technology companies
head the list of durable manufacturing
companies that are developing their
intangible assets, non-technology sector
firms, like Ford Motor Company, also
made the top 10. At the same time, high-
tech is, of course, no guarantee of
high market value. Although Compaq
Computer had the fifth highest VCI score
among durable manufacturers, its stock
has performed poorly of late. Remember,
1. Intel Corporation
2. Hewlett-Packard Company
3. Sun Microsystems, Inc.
4. Lucent Technologies Inc.
5. Cisco Systems, Inc.
6. EMC Corporation
7. Compaq Computer Corporation
8. Motorola, Inc.
9. Ford Motor Company
10. Corning, Inc.
Top Value Creating Firms:
Durable Manufacturing
Top Value Creating Firms:
Non-Durable Manufacturing
1. Procter &Gamble Company
2. Merck &Co., Inc.
3. Coca-Cola Company
4. Johnson &Johnson
5. Pfizer, Inc.
6. Bristol-Myers Squibb Company
7. Minnesota Mining and
Manufacturing Company
8. DuPont Company
9. Time Warner Inc.
10. Eli Lilly and Company
the rankings reflect capability, high-
lighting the potential power of the intan-
gible assets that must be exploited to
create value.
It's no surprise that in the non-durable
sector, pharmaceutical and consumer
product companies dominate the list.
They are joined by such mainstream
manufacturers as P&G, 3M and DuPont
three companies with a long history of
innovation and formidable brand names.
Drivers
1. Alliances
2. Employee
3. Management
4. Brand
5. Innovation
6. Technology
7. Customer
[ THE VALUE CREATI ON I NDEX ]
10
The three most important drivers to
executivesdiversification, culture and
customerdont even register with
investors. Only innovation is commonly
viewed as important. In terms of prod-
ucts, services and customer relationship
management (the 7th most critical per-
formance driver), the industry lags well
behind other industries.
Within the industry, how do the big
players VCI scores compare? In overall
non-financial performance, Morgan
Stanley Dean Witter tops the list, fol-
lowed by Merrill Lynch (#2), Citigroup
(#3) and J.P. Morgan & Company (#4).
In terms of two of the top driversqual-
ity of management and human capital
the same four companies lead the list.
Merrill Lynch scores highest for quality of
management, and J.P. Morgan wins first
place for the quality of its employees.
Disheartening though they may be, the
sometimes surprising ratings only under-
score the diagnostic value of the VCI. The
good news is that there is much room for
improvement in non-financial perfor-
mancein other words, great upside
potential in value creation throughout the
financial services industry.
Banking on
the Future:
Non-financial
measures that matter in
Financial Services
The wave of consolidations and globaliza-
tion that have been transforming the
financial services landscape, have, alas,
done little to energize the valuations of
financial services companies. In fact, their
non-financial performance has been
downright un-impressive. Growing the
asset base, a traditional driver of value,
has become less and less important, not
just in financial services, but across indus-
tries. The industrys respectable earnings
growthat 20%, higher than most key
industrieshas hardly captured the eye
of investors. Meanwhile, its market-to-
book value has substantially trailed most
other industries.
Clearly, financials dont matter like they
used to for financial services companies:
consider that as much as 45% of the
market value of financial services compa-
nies is driven by non-financial perfor-
mance. Unfortunately, investors rank the
financial services industry at the bottom
of the barrel in non-financial performance
against all other industries.
So what does matter? According to the
Value Creation Index study, the top non-
financial performance drivers for financial
services companies are alliances, human
capital and quality of management. And
in this area (the number one driver,
according to the VCI), the markets rate
the industry mediocre at best. Investors
dont quite see eye-to-eye with the VCI:
after quality of management, they per-
ceive strategy execution and innovative-
ness as the most critical performance
drivers. Heres another disconnect:
investors and senior executives bet differ-
ently on the keys to creating future value.
1. Morgan Stanley Dean Whitter
2. Merrill Lynch
3. Citigroup
4. J.P. Morgan &Company
5. American International Group
6. First Union Corporation
7. Chase Manhattan Corporation
8. Bank One Corporation
9. Wells Fargo
10. Fleet Financial Group
Top Value Creating Firms:
Financial Services
passenger legroom. With more crowded
planes and less legroom, it will be inter-
esting to see whether this correlation
changes anyespecially in light of the
recent campaign launched by American
to reduce seat rows in coach.
On the whole, how did the carriers stack
up? American Airlines was top-ranked
with a VCI of 100, followed closely by
United (92) and Delta (70). Lowest of the
top 10 were Midway (at 9th) and America
West (10th). Southwest Airlines, in
recent years, a darling of Wall Street,
ranked highly in everything but its fare
index. It far outranked other carriers in
the employee category, (the most power-
ful positive driver) at 7.32 to American's
4.91. But its relatively low fare index
scoreSouthwest competes on its low
faresdragged down its total VCI score.
America West had the lowest employee
ranking, but through its low efficiency
ranking and high fare index, squeezed into
10th position.
Cheap fares may spike tourist travel, or,
like cabin service, elicit good press, but
with a VCI correlation of .48 they are
nowhere near as powerful a value driver
as employee quality. To investors, it's not
the friendliness of the skies that's most
importantbut how well labor and man-
agement get along.
[ THE VALUE CREATI ON I NDEX ]
11
No More
Flying Blind:
How the VCI Sheds
Light on Non-Financial
Value Drivers in the
Airline Industry
More than most, the airline industry is
one where company performance is
driven by a multitude of factors whose
interrelationship is not well understood.
It's a regulated, unionized, energy-depen-
dent, and highly competitive industry.
And both the consumer and business seg-
ments are of equal importanceand
affected by different forces. Yet despite
the complex web of non-financial perfor-
mance drivers, Wall Street analysis has
continued to rely almost exclusively on
financial data to assess airline perfor-
mance. How much does an accident
affect a carrier's fortunes? How does an
airline's on-time record affect its market
value? Do service or efficiency play a big
part? Does a history of labor-manage-
ment antagonism carry much weight?
The VCI reveals some interesting facts
about these non-financial factors, lending
new clarity to this analytically complex,
rapidly changing industry. Using six dri-
versemployee quality, efficiency, safety,
alliances, fare index, cabin servicere-
searchers at the Cap Gemini Ernst &
Young Center for Business Innovation
modeled leading U.S. carriers to deter-
mine which drivers had the greatest
impact on their overall market value, as
well as to rank them on a relative scale by
total VCI score. (The VCI for the airline
industry showed a correlation to actual
market valuedefined as assets plus lia-
bilitiesof .89.)
What matters most? "Employees" and
"efficiency" are hands-down the two
most powerful drivers. The employee cat-
egory, with a positive correlation of .68,
had the single greatest impact on an
airline's market value: in the aggregate,
quality and talent of the workforce,
quality of labor-management relations,
and diversity are critically important. At
first glance this is somewhat surprising,
since one would expect variables more
closely linked to the passenger's experi-
ence to have direct impact. Conversely,
the efficiency scorereflecting such indi-
cators as ticketing and boarding, baggage
handling and the carrier's on-time
record had the highest negative corre-
lation, at -0.66; the greater these
efficiencies, the more negative an impact
on market value. But when you consider
that some of the underlying variables, like
on-time performance, are beyond the
airlines' control (weather and air traffic
dictate), it's clear that a considerable
part of the capital they invest toward
efficiencies simply doesn't show up in
market value.
At 0.04, "alliances" represented the
lowest positive correlation, most likely
because strategic partnerships and ven-
tures are less important for domestic
airlines, which were the subject of the
initial study. Cabin service (which also
includes comfort and on-ground service)
showed a correlation of .29; clearly,
investors place employee quality above
Value Driver Categories
Employee
Efficiency
Safety
Alliances
Fare Index
Cabin Service
[ THE VALUE CREATI ON I NDEX ]
12
1. America Online
2. Yahoo
3. Lycos
4. Network Associates
5. eBay
6. Amazon.com
7. RealNetworks
8. EarthLink Network
9. E*TRADE Group
10. CMGI
Top Value Creating Firms:
E-Commerce
relevance of all other industries in qualify-
ing market capitalization. E-commerce
valuations have turned tradition upside
down: companies with no accounting
track record and zero profits (even no
prospect of profits in the foreseeable
future) get valued in the billions of dollars.
The initial sample of e-commerce com-
panies in the VCI included publicly traded
firms with an internet focus; it excluded
firms that are strictly consulting, soft-
ware, equipment manufacturing and
internet service providers.
Most important among the value drivers
for e-commerce companies was the
number of alliances and alliance partners.
Next came investments in innovation,
expressed in terms of R&D and capital
expenditures. The number of "eyes"
viewing a company's web siteamong
the most talked about drivers of e-com-
merce valuealso has a significant
bearing on market value, which explains
the big push by e-commerce companies
to stimulate traffic on their web sites.
Together these three factors represent
the strength of a company's network: its
connections both to customers and sup-
pliers and alliance partners. Interestingly,
building brand awareness had no statisti-
cal association with market values for the
e-commerce companies, the recent
emphasis on expensive TV advertising
campaigns notwithstanding.
The heightened role of the VCI in evalu-
ating e-commerce companies comes as
no surprise. Yet again, what is striking
is the extent of its impact. The index
can account for nearly 80% of the
firms' market values; a 10% change, for
instance, translates into a 5% change
in market value, after factoring out
accounting assets and liabilities.
E-Commerce
Companies:
In a League of
Their Own
For the study, e-commerce companies
required their own customized set of
value drivers:
Innovation
Brand investment
Strategic alliances
Number of users, or eyes
Minutes per page
Change in usage
Market share or Change in % reach
In the brief history of e-commerce, one
fact has become strikingly clear: tradi-
tional accounting values have the least
Market values of e-commerce firms are particularly dependent upon
intangible values since these companies lack historical financials.
[ THE VALUE CREATI ON I NDEX ]
13
Why the VCI
Matters
Financial measures of performance, as
retrospective measures, tell us about a
company's past performance. Non-finan-
cial performance reflects the health and
wealth-creating potential of a company in
an entirely different way. Yet intangibles
are, by definition, elusive, and their rela-
tionship to future performance never
before truly acknowledged. Even one as
seemingly uncomplicated as the value of a
company's computer network may in fact
be hard to pin down, since it would com-
prise a number of considerations, such as
software, bandwidth and compatibility.
The Value Creation Index takes out the
fuzziness and subjectivity. It offers a yard-
stick by which to compute the impact of
non-financial variables, based on widely
Whats
Ahead...
Future research by the Center for
Business Innovation will, among other
things, assess the ability of the Value
Creation Index to predict future changes
in shareholder value. From industry to
industry, even company to company, the
key intangible value drivers vary in their
impact on market value. And in a
dynamic, rapidly changing economy,
these value drivers (and their underlying
components) are evolving, too. The Value
Creation Index represents a model by
which these changes can be observed
and reassessedin a methodologically
sound, beneficial, and real way.
Beyond the generic VCI model, applica-
ble to the broad categories of durable,
non-durable and e-commerce companies,
the Value Creation Index can be adapted
acknowledged factors whose relative
value has been rigorously tested and
proven. As a dynamic metric, the Value
Creation Index model can be adapted to
accurately reflect the changing sources of
value and uses of knowledge. Ultimately,
its successors will allow managers and
owners a more complete view of the
wealth creating potential of their compa-
nies, eliminating the partial and restricted
view of a strictly financial perspective.
For investors, the index offers a more
reliable, more comprehensive way of
evaluating a company's intangible
assetsshowing how the company is
using them to create shareholder value.
For managers, the VCI provides an
invaluable set of levers which can be
and customized. The Value Creation
Index is an evolving model; the CBI not
only continues to refine indicators but is
developing sets of industry-specific dri-
vers that more precisely capture the
dynamics unique to given industries.
Among them are the airline, financial ser-
vices and oil and gas industries -- three
industries undergoing dramatic changes,
and therefore acutely in need of improved
performance measures. The index can be
customized not only by industry, but also
by country, reflecting the unique corpo-
rate values of different economies. As
index data within the same industries
accumulates, a benchmark of value dri-
vers by industry, against which companies
may rank themselves will be created. It
will also be possible to develop company-
specific models of intangible assets.
OVER TIME, THE VALUE CREATION
INDEX WILL EVOLVE, CONTINUING TO
IDENTIFY VALUE CREATION
DRIVERS, WHILE REMAINING
SUFFICIENTLY FLEXIBLE SO IT CAN
ADAPT TO THE CONSTANTLY
CHANGING NATURE OF THE
COMPANIES THAT ARE FLOURISHING
IN THE CONNECTED ECONOMY.
adjusted to produce improvements in
organizational performance. For both, the
Value Creation Index can be the ticket to
a more efficient use of capital and
resources.
With the ability to quantify the impact of
established intangible value drivers on a
company's market value50% for tradi-
tional companies, and as much as 90% for
new companieswho could ignore this
potent measurement and management
tool?
The Value Creation Index can help corpo-
rate executives identify the drivers of their
company's value, what portion of its value
resides in intangibles and how they can
better manage it.
14
Measuring the Future
The Value Creation Index
For more information about the
Value Creation Index, contact:
The Cap Gemini Ernst & Young
Center for Business Innovation
at 617.761.4000.
CONTRIBUTORS
Chris Ittner, University of Pennsylvania,
Wharton School of Business
Pam Kalafut, The Cap Gemini Ernst & Young
Center for Business Innovation
Dave Larcker, University of Pennsylvania,
Wharton School of Business
Sean Love, The Cap Gemini Ernst & Young
Center for Business Innovation
Jon Low, The Cap Gemini Ernst & Young
Center for Business Innovation
Jim Park, Cap Gemini Ernst & Young
Tony Siesfeld, The Cap Gemini Ernst & Young
Center for Business Innovation
Stacy Zito, The Cap Gemini Ernst & Young
Center for Business Innovation
SPECIAL THANKS TO:
Carla Bedard
Faraz Hoodboy
Tom Howard
Daryl Morey
Dave Robinson
Helene Yan
CENTER FOR BUSINESS INNOVATION
The Cap Gemini Ernst & Young Center for Business Innovation anticipates and shapes the evolution of
business. By creating new service offerings and businesses, providing value for clients, and communicating
to broad audiences, we differentiate Cap Gemini Ernst & Young as a leader in business innovation. We
achieve this through our research and collaboration with a diverse network of leading thinkers and our
commitment to synthesize what we learn and catalyze change in business.
One Cambridge Center
Cambridge, MA 02142
Phone: 617.761.4000
Reproduction is not permitted without the written consent of the
Cap Gemini Ernst & Young Center for Business Innovation
www.businessinnovation.ey.com