Why value value?An excerpt from the second edition of Valuation: Measuring andManaging the Value of CompaniesThomas E. CopelandHEFUNDAMENTALGOALof all business is to maximize shareholder“ value.” This statement can be either commonplace or controversial,Tdepending on where you are. In the United States, top managementis traditionally expected to seek to maximize shareholder value. Failure to do so results in pressure from the board of directors and activist share-holders, or even in hostile takeover in the world, companies make diƒferent implicit tradeoƒfsamong their various stakeholders. In continental Europe and Japan,intricate weightings are given to the interests of customers, suppliers,workers, the government, debt providers, equity holders, and society atlarge. Maximizing shareholder value is oƒten seen as short-sighted,ineƒficient, simplistic, and even antisocial. Proponents of this “balancedstakeholders” approach cite the high standards of living and rapideconomic growth in Europe and Japan and the success of Japanese autoand consumer electronics companies to support their the evidence against these arguments – and in favor of shareholderwealth maximization – is mounting. This article provides evidence thatwinning companies have higher productivity, greater increases in share-holder wealth, and greater employment gains than their competitors in the long run. In other words, even in an increasingly competitive world,winning companies provide benefits for all stakeholders. There is noevidence of any conflict between shareholders and the globalization of capital markets, if countries whose economicsystems are not based on maximizing shareholder value give investorslower returns, they will slowly be starved of capital. Their fate will be to fall further and further behind in global competition and to loseemployment opportunities. A value-based system grows in importance ascapital becomes more ability to create such a system depends heavily on a number offactors: the weight companies place on the claims of their variousTHE McKINSEY QUARTERLY 1994 NUMBER 497
WHY VALUE VALUE?stakeholders; the ownership and control of sources of capital; and thenature of a country’s economy in terms of its GDP, productivity, andemployment diƒferencesEuropean and Asian managers oƒten state that they do not regardmaximizing shareholder value as the exclusive goal of their , they place much greater weight on other claims, especially that oflabor. The factors underlying this attitude have to do partly with the rolesand responsibilities that corporations adopt in society, and partly with thecomposition of capital ownership and countries balance stakeholder claims in a diƒferent way than theUnited States does. In Germany, for example, employees have the right toshare in decision making, and theyExhibit 1elect half of the representatives ofEmployee power across Europetheir company’s supervisory boardCountry
Employee power
directly. Workers councils composedGermany
Employees have up to 50% of seats on supervisory boards
of non-executive employees haveEmployees have decision-sharing the power to share decisions in per-power in personnel and social sonnel and social matters, althoughmatters
Netherlands
Workers councils have a right to not in issues related to planning information and consultation, or operations. As Exhibit 1 indicates,and the right to grant or withhold approval of certain decisions
across Europe as a whole, employeesVeto on appointment of directors
have a larger say in the manage-Belgium
CEOs must provide workers ment process than they do in thecouncils with detailed data
Workers councils give opinions United suggestions in some areas
France
Two employee representatives Ownership and controlmay attend board meetings, but have no voting rights
Another distinct diƒference betweenTrade unions and workers councils the US and Europe is the degree ofhave the right to be consulted about certain activities, but have concentration in the ownership andno right of veto
control of sources of Management has no obligation to Kingdom
consult or involve employees in debt, for instance, is dominated decision making
by institutional rather than marketDenmarkEmployees have statutory right to co-determinationsources. Debt provides roughly 85percent of all external capital, mostof it privately-placed debt with banks. There is virtually no use ofcommercial paper, a common publicly-held source of short-term debtfinancing in the United States. And publicly-traded corporate bonds makeup only of outstanding German bonds. Although banks inGermany own only percent of all equity shares for their own accounts,they administer approximately 50 percent of proxy voting rights, givingthem substantial voting McKINSEY QUARTERLY 1994 NUMBER 4
WHY VALUE VALUE?The situation is similar in Japan. The lion’s share of external funding –some 78 percent – comes from loans from private financial -traded corporate bonds provide only percent of externalcapital, and equity issues only percent. The major security holdersappear to hold shares in order to maintainbusiness relationships. They do very littleManagers are less likely to trading: banks, insurance companies, andfocus on value creation whennonfinancial business corporations collec-market prices of shares do nottively held percent of listed shares inreflect good information1983, but engaged in only oftrades. Most institutional shareholding iswithin the large business groups, the keiretsu. Cross-holding of this kindacts as a barrier to hostile takeovers and diƒferences between an economy with widely distributed ownershipand control and one where both are closely held manifest themselves in a number of ways. First, the demand for publicly available information is much lower where capital is closely held. When little information isavailable, capital markets are usually less eƒficient, and consequentlycapital is less likely to flow quickly toward new productive , in such an environment, managers are less likely to focus on value creation – a long-term performance metric – because market pricesof shares are less likely to reflect goodinformation. Therefore, the market price ofEconomies with concentratedequity is commonly disregarded as the bestownership and control inhibitindicator of management focus onshareholder value creationEconomies with concentrated ownershipand control appear to inhibit managementfocus on shareholder value creation. Not only are market prices unlikely toreflect good information; there is also no strong incentive to seek valuecreation and value creationThe unique combination of features that make up the capital markets of the United States, Germany, and Japan have distinctive eƒfects on each nation’s economy. Looking at gross domestic product, productivity,shareholder value creation, and job creation is one way to discover these eƒ domestic productAll consumption, saving, and investment in an economy are captured in itsgross domestic product. If the GDPper capita in one economy remainsTHE McKINSEY QUARTERLY 1994 NUMBER 499
WHY VALUE VALUE?higher than that in another over a long period, its population will gener-ally be better oƒf in terms of material needs. (Environmentalists, of course,have argued that GDPdoes not capture the actual quality of life.)Exhibit 2Exhibit 2 shows GDPperGDP per capita,* 1950–90capita for five countries forIndex: US = 100the period 1950–90, withUnited States100currencies converted at 1990Germanyrates using OECDpurchas-80ing power parity KingdomThe figures for the United60States are set at an index Franceof 100. Until 1980, all the40Japanother countries had beenrising toward the US then, only Japan hasbeen catching up. With its0195019551960196519701975198019851990shareholder value focus, the* Currencies converted at 1990 rates using OECD purchasing power parity estimates
Source: National Accounts,United States remains the 1978–90, Volume 1, Paris, OECD, 1992; A. Maddison, Dynamic Forces in Capitalist Development, London, Oxford University Press, recent studies by the McKinsey Global Institute shed light on theproductivity side of the picture.* The first examined productivity across the leading economies of the world in five service industries: airlines,telecommunications, retail banking, general merchandise retailing, andrestaurants. In recent years, the servicesector’s role in developed economies hasThe US maintains its lead ingrown in importance. By 1987, it representedGDPper capita because of its55 percent of employment in Germany, overall lead in productivity58 percent in Japan, and 63 percent in the United States. The labor productivitycomparisons drawn in the study reveal that the United States is moreproductive in every case, with the exception of restaurants in second study examined nine industries in the manufacturing sector in Germany, Japan, and the United States: auto assembly, auto parts,metalworking, steel, computers, consumer electronics, soaps and deter-gents, beer, and processed food. It found that the US is on a par withGermany in steel and metalworking, but ahead of it in the other leads the United States in auto assembly, auto parts, metalworking,steel, and consumer electronics, but has lower overall productivity because≠ Service Sector Productivityand Manufacturing Productivity,Washington, DC, October 1992 andOctober 1993. See the related articles in The McKinsey Quarterly:1992 Number 4, pp. 69–91and 1993 Number 4, pp. 29– McKINSEY QUARTERLY 1994 NUMBER 4
WHY VALUE VALUE?a large proportion of its employment is located in industries with lowproductivity, especially food link between material well-being and productivity is unmistakable. Ifyou want to consume, you need to produce. In manufacturing, as in theservice sector, the United States hasExhibit 3the highest productivity of all theGlobalization versus relative productivitycountries studied. Indeed, the USNational industries which are not productivity leaders
Index: Industry leader = 100
maintains its lead in GDPper˚ Germany ∫ Japan ∂ United States2capita because of its overall lead inR = 47% productivity gaps can largelyAPAA60CEbe explained by the extent to whichAA
Auto assembly
Ban industry is globalized. As ExhibitAP
Auto parts
B
Beer
40PFC
Computers
3 shows, globalization reduces theCE
Consumer electronics
M
Metalworking
diƒferences in productivity among20PF
Processed food
SD
Soap and detergent
companies in an industry. It followsSSteel0that if your company is not a productivity, and if your industryGlobalization index** Measure of intensity of exposure to competition with productivityis becoming more global, you willleader through transplants and tradeSource: Manufacturing Productivity, McKinsey Global Institute, need to increase your productivityWashington, DC, October 1993to wealth creationTo study the relationship between productivity and shareholder wealthcreation, we chose the time interval 1983 to 1991 and measured the changein market value added (MVA),* which is defined as the change in themarket value of capital (debt plus equity) minus the change in the bookvalue of invested capital. Because the book value of debt is embedded inboth the market value of total capital and the book value of investedcapital (since debt is a source offunds for invested capital), theIf your company is not a leaderchange in MVAis the change in thein productivity, and if yourdiƒference between the market andindustry is becoming morebook value of equity over a givenglobal, you will need to increaseperiod of time. And that makes it ayour productivity to survivegood measure of shareholder wealthcreation. Labor productivity wasmeasured by the McKinsey Global Institute in 1991. Ideally, we would haveused productivity estimates for both 1983 and 1991, but only the morerecent estimate was available.≠ To the best of our knowledge, MVAis a term coined by Stern, Stewart and Company, see forexample, G. Bennet Stewart II, The Quest for Value,New York, HarperCollins, McKINSEY QUARTERLY 1994 NUMBER 4101Relative productivity
WHY VALUE VALUE?Exhibit 4Exhibit 4 shows the relation-Labor productivity versus the change in MVA, 1983–91ship between productivityIndex: US = 100
and the change in MVA, ˚ Germany ∫ Japan ∂ United Statesour measure of shareholderAutoFood160160wealth creation, for fivemanufacturing industries, aswell as the retailing industry100100in the service sector, acrossthe Triad. In all six cases therelationship is positive. 2020-400120-400120Change in MVA*Higher productivity is asso-Auto parts†Retail160160ciated with greater share-holder wealth creation. Ifthere were a 50/50 chance100100of observing a positive rela-tionship, the probability ofobserving six out of six 2020-400120-400120to be positive by chance is only percent. We thusBeerSteel160160conclude that there is strongevidence that more prod-100100uctive companies creategreater wealth for theirshareholders. This is not anunexpected -400120-400120* As a percent of 1991 sales
† Information unavailable on German auto parts industry
Job creationSource: Global Vantage, McKinsey analysisIt is always possible thatincreases in productivityand shareholder wealth are achieved at the expense of labor. However,since the most productive companies in an industry gain market share,these increases benefit labor as well as sources of capital in the long , as Exhibit 5 shows, there is no evidence that labor suƒfers tobenefit shareholders. In other words, winning companies have higherproductivity, higher market share, and higher employment the auto assembly industry, Germany, Japan, and the US all experiencedgrowth in employment, but the Japanese, with the highest productivity, had the greatest. Similarly in the steel industry, where technological changehas led to overcapacity and shrinking employment, Germany had greaterchange in MVAand better employment results than the United the short term, increases in productivity may, of course, be accompaniedby falling employment, but the most successful and productive companies102THE McKINSEY QUARTERLY 1994 NUMBER 4Labor productivity
WHY VALUE VALUE?Exhibit 5within each industry are generallyEmployment growth versus the change
the first to increase MVA, 1983–91Over time, these companies gener-Percent
ate both more growth in employ-˚ Germany ∫ Japan ∂ United Statesment than their laggard rivals AutoRetail100100and greater increases in share-holder wealth. This suggests thatprotectionist government policiesthat delay productivity increases,00especially in globally competitive–40–40industries, only harm employment–40030–40030Change in MVA†in the long run. A better strategyAuto parts‡Steel‡would be to focus on retraining 100100and relocating labor, and to provide the necessary support during thetransition cross-national scorecard shows a–40–40clear link between GDPper capita,–40030–40030* Cumulative
productivity, and value creation.† As a percent of 1991 sales
‡ Information unavailable on German auto parts and Japanese steel
Productivity is the ratio of outputSource: Global Vantage, McKinsey analysisrelative to the inputs needed toproduce it. The objective is alwaysto produce more output with less input. When this is achieved, value iscreated. In a competitive environment, productivity growth is not merelythe source of increased value, but the key to survival itself. Companies thatcannot match the productivity increases of their rivals will find themselveslosing market share. Countries that cannot match the productivity ofcompeting nations will suƒfer a flight of capital, the emigration of skilledpersonnel, and a standard of living that is declining in relation to that ofmore productive value of valueEmpirical evidence indicates that increasing shareholder value does notconflict with the long-term interests of other stakeholders. The evidence isclear: “winning” companies create greater value for all stakeholders –customers, labor, the government (via taxes), and suppliers of reasons, more conceptual in nature, but equally compelling, alsosupport a system that emphasizes shareholder , value – measured in terms of discounted cash flows – is the bestmetric for company performance that we know. Second, shareholders are the only stakeholders of a corporation who, in seeking to maximizetheir own claim, simultaneously maximize everyone’s claim. And finally,THE McKINSEY QUARTERLY 1994 NUMBER 4103Employment growth*
WHY VALUE VALUE?companies that fail to perform will find that capital flows away from themand toward their best metricMaking good decisions usually depends on having good information, andvalue is the performance metric that uses the best – and most complete –information. To understand value creation, you have to adopt a long-termperspective, manage all cash flows across both income statement andbalance sheet, and understand how to compare cash flows from diƒferentperiods on a risk-adjusted basis. It is thisdependence on the full picture that makesValue is the performance value the best that uses the best – andmost complete – informationNo other measure of corporate performanceis as comprehensive or as well correlatedwith a company’s market value. Earnings per share or return on equitytend to be used myopically, looking only a few years ahead at , the earnings measure generally focuses on managing theincome statement and plays down the actual amount and timing of cashflows. Even the diƒference between return on invested capital (ROIC) andcost of capital can be a bad metric. If it is used only in the short term, ittends to encourage underinvestment in – or the harvesting of – a businessto increase you adopt instead the perspective of managing value, you will makebetter decisions and tradeoƒfs, regardless of social context. All systems,whether European, American, or Japanese, make tradeoƒfs amongstakeholders. Value allows for more transparent and accurate tradeoƒfs,since any stakeholder claim can be valued. Take labor, for example. The value of labor’s claim on a company is the discounted present value of all of the cash flows that labor expects to receive from the company nowand in the 6 illustrates a pro forma income statement and balance sheetprojected into the future. It represents the basic information needed to value the claims that variousstakeholders have on a allows for moreThe value to customers, fortransparent and accurateexample, is the present value oftradeoƒfs, since any stakeholderwhat customers would be willing claim can be valuedto pay for the company’s goods andservices minus what the companyreceives as revenues. Economists call this consumer surplus. If thecompany increases its prices, and nothing else changes, the value ofconsumer surplus falls and that of equity McKINSEY QUARTERLY 1994 NUMBER 4
WHY VALUE VALUE?Exhibit 6Pro forma financialsTodayDistant futurePresent value of…$ million
Perceived value to customers
1,1004,400
Consumer surplus
(100)(400)Income statement
Sales revenue
1,0004,000
Costs
Labor costs
Labor’s claim
(400)(1,600)
Cost of goods and services
Suppliers’ claim
(300)(1,200)
Depreciation
(100)(400)
(800)(3,200)Income
Operating income
200800
Interest expenses
Debt claim
(50)(200)
Taxable income
150600
Taxes
Government claim
(75)(300)
Net income
75300
Retained earnings
(40)(160)
Dividends
Equity claim
35140Balance sheet
Assets
Cash
50200Uses of working
Accounts receivable
200800capital
Inventories
2501,000
Net property, plant, equipment
Uses of physical capital
1,0004,000
Total assets
1,5006,000LiabilitiesAccounts payable
100400Sources of working capital
Accruals
150600Debt
Sources of debt
5002,000Retained earnings
5002,000Sources of equityCommon equity
2501,000Total liabilities1,5006,000The exhibit shows that tradeoƒfs between the various stakeholders of acompany can be made explicit by using a value-based approach. Too oƒten,these tradeoƒfs are made on an emotional or political basis, with noattempt to bring the facts to the table. The balance among claimants oƒtendetermines the very structure of a the diƒference between claims of varying capital intensity(excluding consumer surplus, which is very diƒficult to estimate). Becausethe value of labor at public accounting firms outweighs all other claims,such firms are oƒten organized as partnerships, with each partner owning asmall “equity” claim. For them, managing the value of labor’s claim isclearly the key to the opposite extreme are capital-intensive companies like those intelecommunications, electric utilities, and pulp and paper. The relativeimportance of labor is lower, and the need for capital from debt and equityholders becomes paramount. Such companies cannot survive unless theyprovide an adequate long-term return to providers of capital as well ascompetitive compensation for McKINSEY QUARTERLY 1994 NUMBER 4105
WHY VALUE VALUE?The exhibit also helps to demonstrate that value-based decision making is not short-sighted. A regulatory body that holds energy prices down for a short time but later raises them, for example, may actually reduce thepresent value of consumer surplus. A labor union that is successful inwinning abnormally high wages and benefits in the short run could, in fact,harm the value of labor’s claim if the company is eventually forced out ofbusiness or loses market company that pays below market wages to economize on its labor billwill lose productive workers and finish worse oƒf in the end. A companythat milks the market with high product prices may destroy long-termshareholder value if such prices accelerate the entry of strong newcompetitors into the market. Tradeoƒfs between current and future cashflows are never easy, but they are vital to good decision shareholders’ claimNot all stakeholders need to have complete information about a companyin order to make decisions for their own benefit. When employees decideon a wage claim, for example, they do not need, nor do they seek, a fullpicture of all the other claims on their company. But this is not the casewith equity holders, who are the “residual” claimants on a company’s cashflows. Shareholders take the greatest risk, but even more important, theyare the only group to need full details of all other claims by all other stakeholdersShareholders take the greatestbefore they can make good decisions onrisk – they are the only group totheir own full details of all otherclaims by all other stakeholdersConsumers, for example, need to know onlythe attributes and price of a product orservice in order to make their decision. Whether a particular auto maker isprofitable or not is irrelevant when they buy a new car. Shareholders are atthe opposite extreme. Before making their claim, they must know pricesand sales volumes; the cost of goods sold, including labor, materials andenergy costs; interest costs on debt; and taxes – in short, they must havecomplete information about the why should shareholders be in control? To answer this, we need toconsider why corporations are organized as they are. They are notorganized as pure Athenian democracies, with all stakeholders having anequal vote on every critical decision. Nor are they dictatorships, with asingle individual exerting total control. Neither of these extremes wouldrepresent the optimal form of organization in a competitive a group of people need to organize to perform a task in the face ofcompetition for scarce resources, what arrangement will they make among106THE McKINSEY QUARTERLY 1994 NUMBER 4
WHY VALUE VALUE?themselves? Some will choose to carry out specialized tasks requiringlimited information about the activities of the rest of the group in returnfor relatively fixed compensation protected by employment contracts. If capital is needed, some of it will be provided in return for a priority claim on cash flows, and it will be protected by covenants that restrict what the group can do. The remaining, orresidual, capital accepts the greatest risk,All claimants benefit whenbut receives decision-making use theirThis is the equity and decision-makingauthority to maximize the valueEquity holders have the strongest incentiveof their own residual claimto manage the labor and capital resourcesof the business so as to succeed in long-term competition with other companies. Though their actions areconstrained by their contracts with both labor and providers of debt, the other stakeholders grant them authority to organize scarce resources. Allclaimants benefit when shareholders use their information and theirdecision-making authority to maximize the value of their own residualclaim. In other words, shareholders maximize the value of all other claimsin attempting to maximize their own. This alignment of information andincentives within the equity claim is what makes the modern corporationthe best competitive mechanism there flow of capitalRegardless of views about the relative merits of various stakeholder claims,one thing is certain. If suppliers of capital in one country do not receive afair return to compensate them for the risks they are taking, they will movetheir capital across national borders in search of better returns – or, if thelaw prevents, they will consume more and invest less. Either way, nationsthat fail to provide global investors with adequate returns on investedcapital are doomed to fall behind in the race for global competitive-ness and to suƒfer a stagnating ordeclining standard of that fail to provideglobal investors with adequateIt is easy to see how capital flows ifreturns on invested capital arewe adopt an investor’s point of to fall behindIf a company’s return on investedcapital is less than zero, it will notbe able to generate enough cash to stay in business. Either it will gobankrupt, or it will require government support. If the ROICis greater than zero, but less than its weighted average cost of capital (WACC), thecompany may be “profitable,” but it will not deliver an adequate return toits capital providers. From their perspective, the company is destroyingvalue. If this value destruction persists, the company will no longer be ableto obtain new capital and sustain its McKINSEY QUARTERLY 1994 NUMBER 4107
WHY VALUE VALUE?A third category is where most companies might be found in a competitiveeconomy. Averaged across business cycles, their ROICshould equal thecost of capital. Over time, we might expect half the companies in a societyto earn more and half to earn less than their WACC. Since providers ofcapital can expect, on average, to earn a fairreturn, this is a sustainable task of management is tocreate value by earning moreSome companies, not many, earn a rate ofthan a company’s cost of return in excess of their cost of capital overcapital over the long terma long period. Usually their competitiveadvantage is controlled by society in oneway or another. Patents and trademarks are protected internationally, forexample, and local monopolies are regulated by task of management, then, is to create value by earning more thantheir company’s cost of capital over the long term. When capital is notearning the required rate of return, the market reduces the company’svalue until the rate of return reaches competitive levels again. In theprocess, value is management challengeThe link between productivity and maximizing shareholder value is toostrong to ignore. If more output is produced with fewer inputs, then theresidual value – the shareholder’s value – is greater. But over time allclaims, including labor’s, benefitwhen a company is a “winner” in itsOver time all claims, includingindustry. Modern corporations givelabor’s, benefit when a companycontrol over decision making tois a “winner” in its industrytheir shareholders because they arethe only stakeholders who bothrequire complete information to make decisions in their own self-interest,and have the incentive to make their companies precise form of this challenge for management varies from country to country. In particular, the consequences of failure – that is, of notmaximizing shareholder value – diƒfer in pace from the United States toEurope and from Europe to the US, for example, things happen quickly. Hostile takeovers frequentlyforce out underperforming management. Investor activism is on the and mutual funds own 53 percent of all US stock outstanding, andthey are beginning to use their clout. In March 1993, the $73 billionCalpers pension fund announced plans to spend nearly $1 billion on largestakes in companies whose managers are not measuring up, with a view to108THE McKINSEY QUARTERLY 1994 NUMBER 4
WHY VALUE VALUE?demanding better financial results. The chairman and CEOof at least onemajor firm has stepped down in the face of pressure from the New YorkCity Employees’ Retirement System. And the Securities and ExchangeCommission is sympathetic: it has relaxed rules that previously limitedcommunications between large activist Europe, chronic uncompetitiveness results in slow change – for theworse. Productivity is lower than in the US and Japan. Rates of absenteeismare far higher than elsewhere, and so are pay for time not worked and thesocial charges borne by employers. Demographic trends are placing anincreasing burden on workers in funding pension benefits for retirees. InGermany, for instance, public pension payments are expected to accountfor over 14 percent of GDPby the end of the century, and almost 25percent by 2030.*Unless Europe increases productivity by managing valuebetter, its promise of a better social system will become an empty Japan, world-class management is already highly productive and createstremendous shareholder value, although that is not its stated objective. Butthose sectors of the economy that are not competitive are holding back theentire economy. They need to be reorganized to create more wealth creation, then, does not come at the expense of otherstakeholders. Quite the opposite: when compared with their competitors,successful companies have not only greater increases in shareholderwealth, but also greater productivity and higher levels of shareholder wealth may be an overt goal, as it is for its many companies in the US, or the outcome of other correct decisions, as with many companies in Europe, and especially Japan. Either way, itcannot be ignored. Managers must measure and manage the value of their Copelandis a partner in McKinsey’s New York oƒfice. This article has been adapted from the second edition of Valuation:Measuring andManaging the Value of Companies by Tom Copeland, Tim Koller, and JackMurrin, published by John Wiley & Sons, New York, 1994. Copyright ©1994 McKinsey & Company. All rights reserved.≠ Heino Fassbender and Susan Cooper-Hedegaard, “The ticking bomb at the core of Europe,”The McKinsey Quarterly,1993 Number 3, pp. 127– McKINSEY QUARTERLY 1994 NUMBER 4109
