McKinsey on Finance

High tech’s coming consolidation 1

Perspectives on
Economic pressures to restructure high tech will eventually become
Corporate Finance
irresistible. More acquisitions loom.
and Strategy

When efficient capital and operations go hand in hand 7 Olli-

Number 11, Spring
Pekka Kallasvuo, Nokia’s head of mobile phones and a former CFO,
2004
discusses strategic organization, performance measurement, and the
value of financial transparency.

All P/Es are not created equal 12

High price-to-earnings ratios are about more than just growth.
Understanding the ingredients that go into a strong multiple can help
executives make the most of this strategic tool.

Putting value back in value-based management 16

Value-based management programs focus too much on measurement
and too little on the management activities that create shareholder value.
16 | McKinsey on Finance | Spring 2004

an anecdotal view of how the most

Putting value back successful practitioners push the principles
of VBM to achieve its real promise for
in value-based shareholders.

management Simply put, ailing VBM programs typically

settle for merely measuring value creation in
business initiatives, while successful
approaches push to link tightly the
measurement to how the business can be
Value-based management programs focus
improved. For example, some companies
too much on measurement and too little on mechanically measure historical
the management activities that create performance but then fail to apply what
shareholder value. they’ve learned to the strategies from which
value should flow. Most also neglect to
account for future growth and
Richar Value-based service guidelines
d J.
management —and
Benso
n- (VBM) burst management could
Armer, onto the scene not only pinpoint
Richar
a decade ago better projects but
d F.
Dobbs with a also better
, and revolutionary understand the
Paul
Todd promise: a value they would
company that create for
traded in shareholders.
traditional Indeed, well-
management implemented VBM
approaches in programs typically
favor of VBM deliver a 5 to 15
could align its percent increase in
aspirations, bottom-line
mind-set, and results.
management
processes with Sadly, even as
everyday VBM has
decisions that evolved, most
truly add programs are
shareholder notable more for
value. Name the their
initiative— implementation
investing in a shortfalls than
new project, say, for their
or spinning off a successes. In our
subsidiary, or ongoing work
implementing and discussions
new customer- with executives,
 Putting value back in value-based management | 17

we ts that VBM can sustainability. m of

hav deliver. We’ve also Others make this a traditional
e developed important link but n accounting
beg then set targets in a measures,
un ways that fail to g such as net
to mobilize the e income and
ide troops needed to m earnings per
ntif make VBM pay e share, to
ya off. Still others go n account for
few to great lengths to t the cost of
co implement VBM capital.
mm programs but then w Traditional
on relegate them to a managers
pitf the finance s focused far
alls department, more
that where they t intently on
hav languish without o improving
e the commitment of cost and
rep senior- level d gross
eate management. r margin and
dly a paid little if
pla Troubled VBM w any
gue programs do not attention to
d necessarily a the capital
un manifest all these t invested in
der symptoms at once. t the
per In our experience, e business.
for however, the vast n As a
min majority suffer t
g from at least one. i
VBM Moreover, the best o
progr practitioners have n
ams learned to
going overcome them t
back and can provide o
years guidance about
as how to push VBM t
well to better fulfill its h
as potential. e
some
newer Missing the f
wrink link between a
les measurement i
that and value l
stanch The original u
the breakthrough of r
benefi value-based e
 EXHIBIT 1

Metrics designed to measure value have strengths—and weaknesses

Traditional P&L and balance sheet approaches Value creation: historical metrics Value: forward-looking metrics
Revenues Return ratios DCF1-value
EBITDA1 –ROE1 Discounted EVA1
Net income –ROCE,1 ROIC1 IRR1
Book value –ROA1 CFROI1
ROS1 Economic profit or EVA1
EPS1 (diluted or not)
Relevance for management declining, but still widely used by companies for communication to investors (e.g., EPS)
Economic cost of the capital invested ignored Widely used concepts orientated towards taking into account the economic
Required
cost offorthe
active
capital
management
in the business
of company’s value
Growth, long-term performance, and sustainability not takenGrowth, long-term performance, and sustainability not taken into account
into account Explicit consideration of growth and long-term impact of decisions
High correlation to market value of company
Much harder to measure accurately and so can be gamed

epreciation, amortization; ROS = return on sales; EPS = earnings per share; ROE = return on equity; ROCE = return on capital employed; ROIC = return on invested capital; ROA = return on assets; EVA = economic value added; DCF = discoun

result, it was common to find projects in five years as measured by economic profit.
which much of the capital deployed in But because the company delivered its
businesses was wasted. growth by increasing prices, it ultimately
damaged its customer franchise and could
As managers focused on value creation and not sustain its growth rate.
the true economic cost of capital deployed
in the business, VBM proponents Companies that apply VBM at a more
introduced metrics to measure a business’s advanced level move beyond measurement
or program’s value, including return on to help the management team focus on the
invested capital (ROIC), economic profit, levers that can be used to improve the
cash flow return on investment (CFROI), or business. The best programs use value
economic value added (EVA™).1 The trees2 to identify underlying drivers of
advantages of different measures vary operating value. These have long been at
(Exhibit 1), but they all attempt to the core of VBM theory, but we find that
recognize the cost of capital in the they are still conspicuously missing in
benchmarks managers use to gauge the many applications.
value their decisions create.
Savvy VBM practitioners use these trees to
Yet many companies fall into the trap of identify areas of improvement, pushing deep
focusing their measurement too much on into a business’s operating performance and
historical returns, which are easily comparing it with others to create clear
quantified, and too little on more forward- benchmarks. These benchmarks can also be
looking contributors to value: growth and pegged to the performance of peers outside
sustainability. For instance, one consumer the company, or to the performance of
goods company (Exhibit 2) was able to similar internal businesses. One particularly
demonstrate strong economic returns for informative and credible internal benchmark
comes from analyzing the historical
EXHIBIT 2

Financial measures alone are inadequate

200 60
160 50
120 40
Profit growth due 30
20
10
0
80 company 12
to price increases enough just by focusing their
34567
Consider the experience of one global
40 Year
0 efforts on the levers that led to the most consumer goods company. When the
severe underperformance on bad days. corporate technical manager ordered that all
123 4567
Year the company’s bottling lines should achieve
The error in focusing on targets 75 percent operating efficiency, regardless
Source: McKinsey analysis rather than how they are set of their current level, some plant operators
A second common VBM pitfall stems from rebelled. Operators at one US plant,
the way executives set performance targets concluding that at 53 percent their plant
and hand them down to the individuals was running as well as it had ever run,
responsible for meeting them. These targets worked only to maintain performance at
may seem perfectly reasonable to the historical levels. Yet after the plant launched
managers who set them, but they often an inclusive process to permit the operators
performa appear arbitrary and unrealistic and convey to set their own performance goals, they
nce of the little sense of ownership to the teams that raised performance levels above the 75
same receive them. In our experience, only when percent target over a period of only 14
business those assigned to meet the targets also months.
over time. actively help in setting them is a company
For likely to generate the understanding and The most effective VBM programs fine-tune
example, commitment needed to deliver outstanding this dynamic even more. As they set targets,
one performance (Exhibit 3). Indeed, we find some build in a challenge from peers
processin the process of setting targets to be the running similar businesses. This approach
g single biggest factor in delivering superior helps to stretch targets, to highlight
company’ VBM performance. accountability in view of peers, and to
s analysis create the sense of commitment and
found that purpose that comes from collaborating on
daily tough issues. Because colleagues running
performa similar businesses will be familiar with all
nce alone the opportunities for improvement, they
varied so will be much more effective than line
widely managers at providing such challenges.
that the Companies that have excelled at VBM
managem programs arrange them not only on overall
ent team profitability but also on capital expenditure,
didn’t growth, pricing, and costs—as well as
need to performance during the year. Others create
look for formal processes that encourage mutual
outside support among colleagues to improve the
benchmar performance of the business. At one of
ks. Canada’s largest privately held companies,
Instead, for example, stronger performers are
they explicitly assigned to help their colleagues
could who are not performing as well.
improve
the Or consider how one chemical company
overall designed a more effective way to review
performa
nce of the
 EXHIBIT 3

Involve managers early in KPI1 definition process to ensure acceptance and accountability

Success factor This Not this

Guided self-discovery Managers discover the key value drivers and KPIsExternal
for themselves
team (or a staff team) does the analysis and develops value drivers and KPIs
The process, rigor, and insights will be shared between units

Strong senior management leadership• Management actions and messages

Senioremphasize
managers,value
publicly or privately, communicate or act in ways that do not reflect the value dri
creation and value-based shaping of the management agenda

Inclusive and open Relevant

communication Staff
staff is involved both in analysis and rollout, with a clear understanding of the is told objective
ultimate what the new value drivers and KPIs are

Fact-based debate and challenge Discussions and decisions are based on factsDiscussions and decisions are based on personal preferences and past actions

Link to ‘real deliverables’ KPI framework leads to clear assignment of accountabilities for targets
KPIand
work is done separately from the budget and targeting processes
actions

1 Key performance indicator.

Source: McKinsey analysis

performance. A year after introducing a the meeting shifted away from individual
VBM approach to make reported data successes and failures to a combination of
more transparent, the company had yet to shared lessons and problem solving on
see the improvements it expected. Worse, future risks and opportunities.
nearly everyone in the organization
recognized that official discussions about Next the company introduced a series of
performance were something of a sham. peer meetings among unit leaders without
Some managers misrepresented reports the division heads present. These meetings
of their actual performance in order to aimed to review plans and identify risks
create the appearance of meeting targets; and opportunities in order to set priorities
others built enough slack into future for allocating capital and resources. In the
performance targets to make sure they first year of operating under the new
would easily be met. processes, capital outlays dropped 25
percent and underlying profits, adjusted for
The company’s response: change the review
the usual modulations of the business cycle,
process. What had been a one-on-one
rose by 10 percent.
review involving the division head and unit
leader became a broader discussion
Not ingraining VBM in day-to-day
between the division head and all unit
business processes
leaders together. And rather than simply
Setting targets and committing to meet them
reviewing the data, the meeting focused on
is one thing. It’s another to make sure that
the most important lessons from the
performance targets are acted upon. This
previous reporting period, as well as the
process happens by making certain that
greatest risks and opportunities expected to
specific individuals are accountable and
appear in the coming reporting period.
responsible for making decisions and by
Emphasis at
guaranteeing a link between performance and an individual’s evaluation
 process.
One energy company, for example,
implemented a VBM program that seemed
to have all the right parts. But management
then failed to carry it over from a discrete
program in the finance department to
engage the
Until a VBM program is an entire company.
This result was
integral part of how a company despite the fact
manages, it will always be that the
company’s
simply something else to do
finance team
and will inevitably fail. developed a
first-rate
scorecard covering financial performance,
operating drivers, organizational health,
and customer service. Nearly a year later,
there was no discernible impact. Beyond
top-level conversations, few of the
company’s managers used the scorecard
— some didn’t even know what it was.
They
had had no involvement in the
program’s
development, little understanding of
why
the new scorecard was necessary, and no
incentive to use it. The few that did use it
found that targets regularly were missed.
Some companies overcome this pitfall by
using a formal performance contract to
explicitly link the key performance
indicators—such as sales, profit margin,
return on investment, and customer
satisfaction—with roles such as sales
manager, business unit manager, finance
manager, and call-center manager
respectively. This link forces an explicit
conversation to take place about whether
roles and decision rights are correctly lined
up. Other companies link their people-
evaluation system to hitting targets, with
explicit rules about dismissals for
individuals who fail to meet their targets
more than once. By tying performance
evaluation and compensation to individual
objectives, performance can also be aligned
with the objectives of the VBM program.
A rule of thumb: until a VBM program is
an integral part of how a company
manages, it will always be simply
“something else to do” and will inevitably
fail as employees continue to perform as
they always have. Finance department
input is essential, for example, but
delegating VBM to the finance department
as a discrete, isolated program is a surefire
way to snuff its potential.
Too few VBM programs have fulfilled their
early promise. But recognizing common
patterns in programs that have gone awry is
a first step in moving VBM closer to its goal
to help line managers deliver better
performance for MoF
shareholders.
Richard Benson-Armer (Richard_Benson-
Armer@McKinsey.com) is a principal in McKinsey’s
Toronto office. Richard Dobbs (Richard_Dobbs
@McKinsey.com) is a principal in the London office,
where PAUL Todd (Paul_Todd@McKinsey.com) is an
associate principal. Copyright © 2004 McKinsey &
Company. All rights reserved.
The authors wish to acknowledge the valuable
contributions of Joe Hughes, Tim Koller, and
Carlos Murrieta to the development of this article.
1
EVA is a registered trade mark of Stern, Stewart & Co.,
New York, and is synonymous with the more generic term,
“economic profit.”
2
Tom Copeland, Tim Koller, and Jack Murrin, Valuation:
Measuring and Managing the Value of Companies, third
edition, New York: John Wiley & Sons, 2000.
Copyright © 2004 McKinsey & Company