Incentive plans for privately held businesses: A case study

In this series of articles, we’ve looked at some of the most common mistakes that privately held companies make in approaching the question of incentives, and we’ve sketched out the common themes that owners tend to look for in an incentive plan and the five key elements that can be used in incentive plan design that will make managers think and act like owners.

Let’s wrap up this series by looking at a case study where many of these issues arose and were addressed.

Case study

The Bicycle Warehouse (the name of the business has been changed to protect its privacy) is privately owned sporting goods retailer with operations throughout regional New South Wales, the ACT and Victoria.

Recently, the owner-managers of The Bicycle Warehouse were looking for a way to attract and retain store managers in an employment market where the Group competed against highly paid public servants and mining businesses.

One plank of their strategy was to put in place a carefully designed incentive plan for store managers and head office staff.

A Working Group was formed with the owner-managers and an advisor from Juno Partners to develop a plan that would pay store managers for sustained increases in performance.

Over three months, the Working Group developed and implemented the new plan, starting with how to measure performance. After some deliberation, Economic Profit (EP) was chosen, with the aim of getting managers to think about profits and capital invested. But the Working Group recognised that EP would be a new measure to their store managers, one that would require some time for their managers to get used to.

To help speed that understanding and show managers the link between the Key Performance Indicators they were used to, like conversion rates and items per basket, and the new measure of performance, Economic Profit, a detailed EP driver tree was developed. Built in a spreadsheet, it allowed managers to simulate the impact on EP of changes in different KPIs, building understanding and confidence in the new measure.

Next, the Working Group developed an incentive plan design with the aim of rewarding sustained gains in EP.  To that end, the plan included:

  • store level, three year targets for growing EP;
  • a simple incentive formula that shared a constant amount of the sustained gains in EP with each store manager; and
  • an incentive reserve that allowed payments to be made annually, but also kept some in reserve in case gains turned out not to be sustainable.

Then the Working Group moved on to look at how much could be offered to managers under the plan.  With a number of safeguards in place that ensured only exceptional, sustained gains in performance would lead to large payments, the Working Group decided to set target variable pay, the amount declared for hitting targets, at 25% of base pay.  To pay for this increase in remuneration, the Working Group decided to offer the plan to all managers in exchange for a three year freeze on fixed pay rises.  This freeze would represent real skin in the game for managers used to 5% pay rises annually.

Finally, education material was put together ahead of a launch day, that involved all store managers coming together to go through the workings of the new incentive plan.

The plan was received well by managers, as shown by their willingness to accept the fixed pay freeze over three years, used to fund the introduction of the plan.  Key to that acceptance was the transparency and objectivity of the plan.

In the period following the implementation of the new plan, the Group has successfully attracted new talent, while minimizing unplanned departures.  Managers report being more interested and more involved in the financial performance of their store and the business and the owners have reported that managers are taking a more thoughtful approach to managing their stores, including expansion opportunities.  In short, The Bicycle Warehouse has developed more of an ownership mindset amongst their managers, without the complexity of issuing shares.

Summary

Many privately held businesses struggle to compete with the rewards on offer at larger, publicly held companies. But the truth is, while public company rewards can be generous, they are often poorly designed and undervalued by employees. This presents an opportunity to shrewd owners to design and put in place well designed incentive arrangements that attract and retain managers prepared to back their abilities and that only reward sustained gains in the value of the business.

Five elements to make managers think and act like owners #1: Reward sustained improvements in profitability

In this series of articles, we’ve looked at some of the most common mistakes that privately held companies make in approaching the question of incentives, and we’ve sketched out the common themes that owners tend to look for in an incentive plan.

Let’s now move to see how those themes can be realised in practice, by including five key elements in the incentive plan design that will make managers think and act like owners.

#1  Reward sustained, multi-year improvements in profitability
Ultimately an ‘ownership-like’ incentive plan must have financials at its heart, as it is sustained gains in financial performance that power the value of a business. Single period spikes in performance are unlikely to grow the value of the business a great deal however – buyers look for high levels of ‘repeatable earnings’. The more reliable the profit flow, the higher the premium buyers are likely to pay for a business.

I’ll discuss how to reward sustained gains in element #4, but it is worth focusing on how ‘profit’ is defined first, because, as we have seen, the most common profit measures, such as EBIT and EBITDA (or Net Profit, Earnings Per Share, Return on Equity and so forth) can actually encourage decisions that reduce, rather than grow, the value of the business.

One measure of profit that can be relied on to drive decisions that will grow the value of the business is ‘Economic Profit’. Economic Profit is the only metric that can be measured as easily as EBIT or Net Profit and yet ties reliably to wealth creation for owners. It’s measured like this:

Economic Profit calculation

Most owners know that ‘Profit’ is what is left over from sales revenue once all the costs of running the business have been taken out.  But accounting profit forgets one very important cost – the cost of using shareholder funds.  And by failing to put a price on the equity used to fund the business, accounting profit effectively says it’s free.

Pay managers to grow accounting profit and they will be encouraged to use as much of the shareholders’ money as they can put their hands on, after all its free and if they invest it at just 1%, accounting profits – and their bonuses – will grow.

But by charging for the owner’s capital used in the business at a rate that reflects what could be earned elsewhere at similar risk, managers are encouraged to treat capital like the scarce and valuable thing every business owner knows that it is.

Economic Profit puts into practice what anybody starting a new business has to think about from day one: if I put my savings into this business, will it generate more profit than I could have got elsewhere at similar risk?

For managers on an incentive plan linked to Economic Profit it forces them to think the same way: not just will this decision be profitable, but will it make enough profit to justify the owner’s investment?

In the next article we’ll discuss how to align the payoff profile of managers to that of owners.

Wealth = Quality x Quantity Part 4: Competition can be hazardous to wealth

‘The production of wealth,’ as 19th century philosopher John Stuart Mill observed, ‘has its necessary conditions’.

For senior executives and directors charged with growing the wealth of shareholders, few things could be more important to understand than the ‘necessary conditions’ for the production of wealth.

In this series of articles, we’ll share the findings of our research into wealth creation in Australian equity capital markets and layout a clear framework that describes the necessary conditions for the production of wealth.

In this article, we’ll look at impact competition has on returns on capital employed and Wealth Creation.

A quick recap
In the first article in this series, we looked at the findings of our research into why some companies create wealth, while others destroy it.

We showed that the creation of wealth is a function of ‘Quality’ and ‘Quantity’. ‘Quality’ is the rate of return that the company is able to generate on the capital entrusted to it, calculated by its sustained (say 5 year average) Economic Profit Spread ie its Return on Capital Employed (ROCE) less its Weighted Average Cost of Capital (WACC). ‘Quantity’ is the amount of capital that a company can put and is the great magnifier of Quality.

In the second article we argued that it is actually expectations of ‘Quality’ and ‘Quantity’ that are the key determinants of wealth creation, but that for most businesses, the history of the business is a good guide to the future and hence Quality and Quantity expectations.

In the third article we looked at the macro picture and showed that the top quartile of Wealth Creators combined both Quality and Quantity.  The second quartile had Quality without Quantity, the third quartile had low Quality and Quantity and the bottom quartile, those that destroyed wealth combined low quality with large quantities of capital.

Competition can be hazardous to wealth
Why are some businesses able to achieve and sustain high returns on the funds entrusted to them and create wealth while others languish with low returns?

High returns on capital are a rare achievement – just 26 of the 200 businesses we studied enjoyed average returns 10% or more above the cost of capital over the five years to 30 June 2013.

Like most of the businesses in our set, these businesses are professionally managed, offer compelling value propositions to their customers and play their part in the communities in which they operate.

The difference is the competition that they face.

For most businesses, the competition for sales, supplies or employees forces returns down to a level that just compensates investors for the risk that they take on. A short period of high returns attracts the attention of competitors and in the absence of a hard to replicate product or cost advantage, returns fall away as new players enter the market.

But a small group of businesses has been able to avoid these pressures and maintain high returns. Some, like Cochlear (#27) invest hundreds of millions in research and development and enjoy the protection of patents, allowing them to reduce competition over the life of the patent. Others, like BHP Billiton (#1) enjoy cost advantages over their competitors and pricing power in some of their businesses, while others like Reece Australia (#40) leverage brand recognition and distribution networks.

In each of these instances, the advantages have proven durable, giving investors confidence that high returns can be maintained well into the future, even in the face of competitive pressures. When these advantages can be maintained, wealth will be created, limited only by the size of the capital investment opportunity.

Key takeaway
The production of wealth has its necessary conditions. For many businesses this can be simplified into the concepts of ‘Quality’ and ‘Quantity’. Boards and senior managers can help their business create more wealth for shareholders by focusing attention on these two simple drivers and ensuring all strategic, as well as day-to-day decisions are made with this in mind.

More on how businesses can be engineered to create wealth can be found here.

Wealth = Quality x Quantity Part 3: The macro picture

‘The production of wealth,’ as 19th century philosopher John Stuart Mill observed, ‘has its necessary conditions’.

For senior executives and directors charged with growing the wealth of shareholders, few things could be more important to understand than the ‘necessary conditions’ for the production of wealth.

In this series of articles, we’ll share the findings of our research into wealth creation in Australian equity capital markets and layout a clear framework that describes the necessary conditions for the production of wealth.

In this article, we’ll look at the macro picture and how Economic Profitability links to Wealth Creation.

A quick recap
In the first article in this series, we looked at the findings of our research into why some companies create wealth, while others destroy it.

We showed that the creation of wealth is a function of ‘Quality’ and ‘Quantity’. ‘Quality’ is the rate of return that the company is able to generate on the capital entrusted to it, calculated by its sustained (say 5 year average) Economic Profit Spread ie its Return on Capital Employed (ROCE) less its Weighted Average Cost of Capital (WACC). ‘Quantity’ is the amount of capital that a company can put and is the great magnifier of Quality.

In the second article we argued that it is actually expectations of ‘Quality’ and ‘Quantity’ that are the key determinants of wealth creation, but that for most businesses, the history of the business is a good guide to the future and hence Quality and Quantity expectations.

The macro picture
Grouping the two hundred businesses in our research set into four quartiles further reinforces
the importance of quality and quantity to wealth creation.

Figure 1: Cumulative Wealth Created by Quartile

table

The total wealth created by the top 25% of businesses we analysed was $488 billion, more than 18 times as much as the next quadrant. These businesses fit the description given by Warren Buffett in his 1992 letter to fellow Berkshire Hathaway investors as the best businesses to own:

‘Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’

That is, they invest large amounts of capital at high rates of return.

Indeed by 30 June 2013, the top quartile, including the likes of BHP Billiton, Commonwealth Bank, Telstra, CSL and Woolworths, had invested $678 billion – nearly three times as much as the other quadrants put together – at the highest average returns, 3.8% above what investors could expect to earn elsewhere at comparable risk.

The second quartile created a very credible $27 billion of wealth. Their average returns were close to those in the first quartile (2.6% above the cost of capital, versus 3.8% enjoyed by the first quadrant), but these businesses, including the likes of software developed IRESS Limited (#61) and retailer, Oroton Group (#96), were not able to put large amounts of capital to work at those rates (just $62 billion in total at 30 June 2013). With the accelerator of wealth creation missing, the second quadrant created a fraction of the wealth of the first.

The third quartile created $2.5 billion of wealth. This group has averaged returns over the past five years just above what investors could expect to earn elsewhere (their median Economic Profit Spread being 0.8%). Capital invested at 30 June is the lowest of the four quartiles at just $29 billion. With quality just above average and low quantity, this quadrant has done well to amass even $2.5 billion of wealth.

The bottom quartile has destroyed $55 billion of wealth by putting large amounts of capital to work ($158 billion by 30 June 2013) at low rates of return, averaging 3% below what investors could expect to earn elsewhere. Little wonder Buffett described these kind of businesses as the worst to own.

This quartile analysis shows the strong link between quality, quantity and wealth. The top 25% of wealth creators were also the businesses with the highest quality or EP spreads and the highest quantity of capital invested. The next 25% had good EP spreads, but less invested. The third quartile had breakeven EP spreads and the smallest amounts invested and the bottom 25% destroyed $55 billion of wealth by investing the second highest amount of capital at the lowest rates of return.

But where does accounting profit sit in all this? Given the emphasis placed on accounting profits by investment banks, the media and stock brokers, many managers would be forgiven for assuming measures like EPS, Net Profit and EBITDA are reliable indicators of wealth creation: more profit is always good for shareholders.

This is not borne out by our analysis. In fact accounting profit was shown to be a very misleading measure: while the top 25% of wealth creators also made more Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) than any other quartile, the bottom quartile, who destroyed $55 billion of wealth, came second in terms of cumulative EBITDA over the five years to 30 June 2013.

The problem is accounting profit measures like EPS, Net Profit and EBITDA say nothing about the quality of the business. They do not take into account the return investors could earn elsewhere on their funds and so businesses that employ large amounts of money at low rates of return can grow their accounting profits handsomely, all the while destroying wealth for investors.

For anyone interested in wealth creation, the evidence is compelling: wealth is not a function of accounting profitability. Wealth = Quality x Quantity.

The link to Economic Profit
There is a measure of financial performance that neatly captures both quality and quantity: Economic Profit, or as it sometime referred to, Economic Value Added.

Figure 2: Economic Profit captures the key drivers of wealth creation

Economic Profit formula

In the final article in this series we’ll explore why some companies earn higher returns on their capital than others and the hazardous impact that competition can have on wealth.

Wealth = Quality x Quantity Part 2: investor expectations

‘The production of wealth,’ as 19th century philosopher John Stuart Mill observed, ‘has its necessary conditions’.

For senior executives and directors charged with growing the wealth of shareholders, few things could be more important to understand than the ‘necessary conditions’ for the production of wealth.

In this series of articles, we’ll share the findings of our research into wealth creation in Australian equity capital markets and layout a clear framework that describes the necessary conditions for the production of wealth.

In this article, we’ll look at the importance of investor expectations to wealth creation.

A quick recap
In the first article in this series, we looked at the findings of our research into why some companies create wealth, while others destroy it.  We showed that the creation of wealth is a function of ‘Quality’ and ‘Quantity’.  ‘Quality’ is the rate of return that the company is able to generate on the capital entrusted to it, calculated by its sustained (say 5 year average) Economic Profit Spread ie its Return on Capital Employed (ROCE) less its Weighted Average Cost of Capital (WACC).

‘Quantity’ is the amount of capital that a company can put and is the great magnifier of Quality.

BHP Billiton, the business that created more wealth than any other in our analysis, best exemplifies the impact of combining Quality and Quantity, not only enjoying a median return on capital employed 10% above the return required for risk over the past five years, but also employing an average of $83 billion a year at those rates, creating nearly $39 billion more profits than investors would have required for the risk associated with their investment.

But quantity can also magnify poor quality.  Newcrest Mining Limited is a good example of this. Over the past five years Newcrest suffered returns on average 2.3% below what investors required for risk. At the same time, it expanded its capital base, investing billions at low rates of return. The result was a market valuation $10.6 billion less than what investors had poured into the business as at 30 June 2013.

The final ingredient: expectations
To complete the analysis of what creates wealth, we need to bring in expectations. Ultimately it is expectations of quality and quantity that drive the creation of wealth.

If a company is expected to generate high returns on capital and employ large amounts of money doing so, the value of the company will be bid up well above the amount originally contributed by investors and wealth will be created.

But the reverse is also true. If a company is expected to invest at low rates of return its value will fall and, absent of a takeover premium, it will trade at a discount to the book value of capital employed.

Our research found that the valuation that companies trade at is a function of expectations of the quality of future returns and the quantity of funds likely to be employed at those rates. But because the future is unknowable, with a few exceptions (like oil and gas exploration and development business Oil Search Limited (#14)), in forecasting the future quality of a business and the quantity of funds it will be able to put to work, investors tend to put great store in historical performance, meaning wealth often reflects historical performance, particularly for established businesses.

For example, Cochlear (#27) had created $2.9 billion of wealth as at 30 June 2013 and an average return above that required for risk over the five years to 30 June 2013 of 14%. Unpacking Cochlear’s valuation into quality and quantity expectations shows that investors were expecting the Group to continue to enjoy returns significantly above the cost of capital even as it grows invested capital well into the future.

Contrast this with Qantas (#196), who by 30 June 2013 had destroyed $3.5 billion with an average return 3.5% below that required for risk over the past five years. Unpacking Qantas’ 30 June valuation shows that investors were expecting returns to stay well below the cost of capital no matter what growth scenario is envisaged.

In the next article we return to the themes of Quality and Quantity, examining the link between wealth created and Economic Profitability.

Wealth = Quality x Quantity Part 1: Our findings

‘The production of wealth,’ as 19th century philosopher John Stuart Mill observed, ‘has its necessary conditions’.

For senior executives and directors charged with growing the wealth of shareholders, few things could be more important to understand than the ‘necessary conditions’ for the production of wealth.

In this series of articles, we’ll share the findings of our research into wealth creation in Australian equity capital markets and layout a clear framework that describes the necessary conditions for the production of wealth.

In this article, we’ll look at the basis of our research and present the findings of our research which highlights the importance of quality and quantity.

The basis of our research
So what are the ‘necessary conditions’ for creating wealth? We set out to answer this
question by looking at a group of Australia’s largest listed companies and asking who has
created (or destroyed) wealth and then digging deeper to find the root causes [1].

We used a simple definition of wealth creation being the difference between how much has
been invested in a company and how much it is worth as at 30 June 2013. This measure has
the advantage of being a dollar measure of wealth, as opposed to a percentage measure,
like Total Shareholder Return or TSR and hence shows the true impact the business has had
on the economy.

The Wealth Created results are summarised in the tables following, ranking the two hundred
businesses in our set by Wealth Created as at 30 June 2013 and show, for example that BHP
Billiton (ranked #1 in the table) at 30 June 2013 had taken $137 billion of capital from
shareholders and lenders and turned it into a business worth $208 billion, creating a
staggering $71 billion of wealth [2].

Figure 1: The 2013 Juno Partners Wealth Creators Report

 

1-5051-100101-150151-200

By contrast, Newcrest Mining (#200) had taken $22.4 billion and turned it into $11.8 billion,
destroying $10.6 billion.

How do businesses create wealth?
How does a business like BHP Billiton create $71 billion of wealth? If you were to believe the prospectuses, annual reports and investor briefings issued by many of our listed companies, you would be left with the firm impression that what matters in creating wealth is EPS growth and EBITDA.

But our research shows that is not the case.

In fact, these metrics are unreliable at best and dangerously misleading at worst. Managers that navigate with these measures risk running their businesses off course and destroying wealth.

Our analysis shows that wealth creation is also not a function of sector. For example, some miners performed well, but some destroyed billions.

Wealth is also not just a matter of size. BHP Billiton is a very large company and created the most wealth, but Qantas (#196) is also a very large business, but its size did not save it from destroying billions.

Even growth per se does not matter. Both OZ Minerals (#198) and Westpac (#4) have grown their balance sheets in excess of 20% compound over the five years to 30 June 2013 but by the end of it, Westpac had turned $51 billion of investors’ funds into a business worth $90 billion, creating $39 billion, while OZ Minerals, turned $6.2 billion into just $1.3 billion, destroying $4.9 billion.

Instead, our research shows that the two most important conditions necessary for the creation of wealth can be characterized as ‘quality’ and ‘quantity’.

The importance of quality
Let’s look at the first condition: quality. The quality of a business is captured by the returns the business is expected to generate above what investors could expect to enjoy elsewhere at similar risk. We call this the company’s Economic Profit spread, or EP spread for short (for further detail on terminology, see our glossary of terms).

In assessing quality, we tend to give most emphasis to the EP spread the business has made over five years. This five year time frame helps iron out year-to-year fluctuations and gives a picture of sustained performance.

It shows, for example, the highest quality business in our set is Wotif.com Holdings Ltd (#57), which over the past five years has enjoyed an average return on capital employed of 56.5%, 45.5% above the rate investors could have expected to earn elsewhere at similar risk.

Intuitively, generating 45% more than the return required for risk is good performance, but when you consider a little under three quarters of the businesses covered in our research failed to generate more than 5% above what investors could expect for risk, then you begin to appreciate what are rare jewel Wotif.com is.

Quantity: the great accelerator of wealth creation
The second condition necessary for the creation of wealth is quantity, in this case the quantity of funds that can be invested at high rates of return. The more capital that can be put to work at high rates of return, the more wealth will be created.

This is best exemplified by BHP Billiton (#1) who not only enjoyed a median return on capital employed 10% above the return required for risk over the past five years, but also was able to employ an average of $83 billion a year at those rates, creating nearly $39 billion more profits than investors would require for the risk associated with their investment.

Quantity is the great accelerator of wealth creation. As good as Wotif.com’s returns are, the service nature of its business means that it does not organically generate large capital investment opportunities. It is hard to see how Wotif.com could ever employ $83 billion of capital in their business. Ultimately this restricts the wealth the business is able to generate.

But quantity without quality is a recipe for wealth destruction
But while the ability to put capital to work is important, we found quality must always come first. Investing large amounts of capital in low return, low quality businesses is a recipe for wealth destruction.

Newcrest Mining Limited (#200) is a good example of this. Over the past five years Newcrest suffered returns on average 2.3% below what investors required for risk. At the same time, it expanded its capital base, investing billions at low rates of return. The result was a valuation $10.6 billion less than what investors had poured into the business as at 30 June 2013.

Warren Buffett put it this way in his 1992 letter to fellow Berkshire Hathaway investors:

‘Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’

In the next article we’ll discuss our findings regarding the importance of expectations.

______________________________________

[1] For the purposes of this study, our database comprised the 200 largest Australian domiciled public companies as at 30 June 2013, excluding investment businesses, such as listed investment companies, insurance and real estate businesses, those with less than five years of publicly available financial reports and those who made losses in three or more of the past five years.

[2] Note that in the table of data we list the 2013 average Capital Employed balance, being the average of the year-end results for 2012 and 2013. The 2013 year-end values cited in the main text of this article and used to calculate Wealth Created, will usually be a little larger.

 

Is your business engineered to create wealth? Part 5: Incentives

Most CEOs would prefer to create more wealth for shareholders than less.

But most companies are not ‘engineered’ to create wealth – internal processes often act to hinder wealth creation, rather than encourage it.

In this article we look at the role of incentives in wealth creation and why incentive programs often do more harm to shareholders interests than good.

At-risk pay has grown to be a significant part of the way managers in Australian companies are remunerated. For many public companies, the use of share based incentives has brought a renewed focus on growing the value of the company for shareholders, but ironically, short term incentives remain anchored in measures and structures that often encourage managers to destroy, rather than create wealth.

Of course short term incentive plans differ from company to company, but let’s review some of the most damaging aspects of the more popular plans before outlining a different approach that is engineered for wealth creation.

Wealth destroying measures
As the amounts available under short term incentive plans (STIs) increase, Boards are demanding more objective and formulaic measures of performance.

Unfortunately, that too often means formulas based on EBITDA or EPS growth. As we’ve seen in parts one and two of this series, these measures and a host of similar ones encourage managers to invest large amounts of money at low rates of return, destroying wealth.

Any incentive plan that has EBITDA or EPS at its heart is actually paying managers to destroy shareholder wealth.

Many managers understand that investing funds at low rates of return will destroy wealth for shareholders, but find themselves in the invidious position of having to choose between what’s best for shareholders and what’s best for their families.

Having established an understanding of what creates wealth and put in place performance measures, investment appraisal and planning processes to match, it makes sense to cement the focus on wealth creation by structuring STI plans around Economic Profit. This has the
added benefit of increasing the value of share based rewards as well.

Incentive targets set from budget
One of the most significant barriers to wealth creation in typical incentive plans is the use of the budget as the incentive target. Any manager with a few years of experience understands that under this approach, there are two ways to increase their bonus: 1) increase performance and 2) reduce the budget.

Unfortunately reducing the budget does nothing to create wealth for shareholders and it needs to be engineered out of the incentive process.

I suggest that, rather than using the budget, the target for the incentive plan be based on shareholder expectations, as implied in the market value of the company.

As part one of this series demonstrates, when investors form the opinion that a business is capable of generating and sustaining high returns on the capital entrusted to it (ie Economic Profit), the price they are prepared to pay for the business rises well above the capital invested by shareholders and wealth is created.

Using this logic in reverse, Boards can take the market value of the firm as a starting point and derive the EP growth that is implied and use this as the target for incentive payments. Figure 1 illustrates this process.

Figure 1: Derive EP growth targets from the market value of the business

Derive growth targets from shareholder expectations

 

 

 

 

 

 

 

Crucially, setting targets based on shareholder expectations decouples the budgeting process from the incentive program. It removes the incentive to sandbag budgets and makes that process more productive and a better use of shareholder funds and management time. It puts managers back in alignment with shareholders and means managers no longer have to choose between what’s best for the company and what’s best for them and their families.

Finally, by deriving targets from shareholder expectations, high levels of rewards are only paid when those expectations are exceeded and lower rewards flow from falling short of shareholder expectations: greater alignment is achieved.

Short term focus
As we’ve seen from part one of this series, wealth is created by sustaining high returns on capital. Yet the vast majority of cash incentive plans in Australia pay for short term performance; usually just one year.

Most business people accept it takes two to three years to become confident that performance gains can be sustained and that, therefore, a reward is truly deserved.

So an incentive plan that is engineered to create wealth would pay for sustained gains in Economic Profit, not a single year spike in performance. To do so, the Board should set rolling three year targets and give managers the headroom and the accountability to improve performance within that time frame.

Don’t ratchet up targets just when the business is improving and don’t negotiate a lowering of targets when things turn sour. Instead invest the time up front to agree to a set of targets that everyone can stick to, come what may.

To further reinforce the importance of sustained gains in performance, use an incentive reserve that holds a meaningful percentage of each year’s rewards at risk and subject to loss if performance cannot be sustained.

Capped
If an incentive plan is capable of paying managers to destroy wealth, as any plan that rewards gains in EBITDA or EPS does, or it pays for short-term gains, without any reference to sustainability, then it makes sense to limit rewards with caps on payments.

But caps have unintended consequences. They send a signal to managers to take their foot off the pedal once the cap is reached and push good performance into next year (where they’ll get paid for it). Caps encourage managers to defer revenue and bring forward expenditure (because it has no impact on the current year’s rewards and may even increase next year’s) and few shareholders would ever want that.

And perhaps even more damaging than that, caps are an admission that the incentive plan does not pay for wealth creation. If it did, why would a Board ever put a cap on payments?

So it may be better to ask the Board, ‘Under what circumstances would you accept no caps on an incentive plan?’

Most directors (and institutional investors and governance advisors for that matter too, in my experience) are not fundamentally opposed to an uncapped incentive plan. But they rightly expect significant safeguards to be put in place if the plan is to be uncapped.

Safeguards like using a measure of performance that takes into account the key drivers of wealth creation, that is, the quality of the business and quantity of funds invested in it. Setting targets not from the budget, but by reference to shareholder expectations. Making some payments annually, but deferring full payment until gains have been sustained for three or more years. Calibrating the plan in such a way that outsized rewards are only available for truly outsized and sustained gains in wealth creation.

With safeguards like these in place, managers can be put on an incentive plan that truly is engineered to create wealth.

Figure 2: If the incentive plan pays for sustained wealth creation, why cap payments?

Incentive plan alternatives

Is your business engineered to create wealth? Part 3: Capital allocation

Most CEOs would prefer to create more wealth for shareholders than less.

But most companies are not ‘engineered’ to create wealth – internal processes often act to hinder wealth creation, rather than encourage it.

In this article we look at how capital allocation processes can fail shareholders and some simple steps that can be taken to drive greater accountability into investment decisions.

The big capital spends, be they investments in new markets, new products or acquisitions, often represent the signature, transforming achievements of a CEO. And for shareholders, they often have a transforming impact on wealth.

So when faced with these opportunities, CEOs need clear, reliable tools to assess investment opportunities. Unfortunately, the tools that they are most likely to use are anything but.

If wealth creation is the goal of the business, then for any investment evaluation tool to be of use it must address the quality and quantity issues we saw in part one of this series as the key determinants of wealth creation.

This rules out using EBITDA and EPS growth, which both fail to capture the funds invested in a business and say nothing of the quality of the business. Sophisticated investors know this and mark down businesses that trumpet EPS accretion, if the investment fails to deliver reasonable returns on capital invested.

Other, more sophisticated tools, like Internal Rate of Return (IRR) and Discounted Cash Flow (DCF) address the draw backs of EBITDA and EPS by forecasting all the capital required for an investment and all the cash that will be generated by it and boiling them down to a single number; a percentage in the case of Internal Rate of Return (IRR) which can then be compared with the company’s hurdle rate, and a dollar figure in the case of Discounted Cash Flow (DCF), showing how much wealth will be created from the investment.

But while IRR and DCF can be used to accurately calculate the wealth impact of an investment decision, they are only ever as useful as the forecasts used and this is where IRR and DCF analysis fall down.

The best users of DCF look to key drivers, such as margins, volumes and inventory turns to assess the reasonableness of forecasts. If the acquisition requires industry best results across all key drivers to create wealth it’s time to negotiate a better price, or walk away.

But one key reasonableness test every CEO should ask is, ‘What is the forecast ROCE of this investment, in each year of the forecast period?’ If ROCE forecasts are beyond reasonable upper limits then warning bells should sound.

As the chart below shows, drawing on our research into returns achieved by Australia’s largest companies and summarised in the table in part one of this series, only the top 25% of companies are able to sustain returns 5% or more in excess of the cost of capital over any given five year period. This analysis probably understates how rare high returns on capital are in the broader economy, given businesses that have failed or who are yet to be consistently profitable are excluded from our research.

Figure 1: Returns significantly above the cost of capital are rare

Returns above the cost of capital are rare

 

In my experience, when DCF analysis is recut to include ROCE and Economic Profit data on an annual basis it often forecasts ROCE starting low and gradually growing larger and larger, past the 75th percentile and eventually into the top decile of what companies have historically been able to achieve.

Few companies are able to generate let alone sustain these returns, due to the competitive forces they face. If one player in a market is able to invest and generate such attractive returns, others will follow and unless the investment is made behind, as Buffett would call it, a deep ‘moat’ of a hard to copy competitive advantage, returns will begin to fall, not rise, as time goes on.

Given 75% of companies fail to make returns more than 5% above the cost of capital, the default assumption for DCF analysis should be that returns will revert to the cost of capital over time, in the absence of a very clear and proven set of competitive advantages that will keep competitors, suppliers and even governments at bay.

Equipped with the forecast annual EP Spread of the investment and a thorough knowledge of the competitive forces of the industry in which the business operates, a CEO is in a much stronger position to make career defining capital investment decisions.

The second and important step in this phase is to close the accountability loop for investment decisions. And that comes back to the performance measure chosen by the CEO. EBITDA and similar measures ignore the capital invested in a business and send a signal to all managers that capital is free.

Economic Profit by contrast, constantly reminds managers of the funds invested in their business and the need to generate sufficient returns. By holding managers accountable for sustained gains in EP, the rigour of investment proposals increases: managers know while putting together their forecasts that unless the investment generates and sustains high returns, the Economic Profitability of their business will fall.

As one client put it, ‘EP is like DCF with a memory’.

Is your business engineered to create wealth? Part 2: Performance measures

Most CEOs would prefer to create more wealth for shareholders than less.

But most companies are not ‘engineered’ to create wealth – internal processes often act to hinder wealth creation, rather than encourage it.

In this article we look at one of the most pervasive barriers to wealth creation: performance measures.

As we’ve seen in part 1 of this series, wealth is created when funds are invested at high rates of return and destroyed when funds are invested at low rates of return. But incredibly, the most popular financial performance measures in use today such as Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) and Earnings Per Share (EPS) are silent on the rate of return, or quality of the business. And what’s worse, they actually encourage managers to destroy wealth by investing the money entrusted to them at low rates of return.

Consider a manager faced with an opportunity to add a new customer. If the business
goes ahead with the terms proposed by the customer, the impact on the Group’s financials
will be as follows.

Figure 1: Growing profits, destroying wealth

Growing profits destroying wealth

 

Any of the most popular performance measures, such as sales, margins, EBITDA and even ROCE improve if the manager takes this deal. But in doing so, they encourage him to invest the capital entrusted to the business at 8.2%, less than the 10% that investors could get elsewhere at equivalent risk – that is, these measures will encourage the manager to destroy wealth.

Indeed a manager can grow EBITDA or EPS, two of the most popular measures of performance in use today, by investing funds for a return as little as 1%.

As a consequence, all the creativity and hard work of a management team can unwittingly lead to wealth destruction if the compass that they use to guide decisions is a simple but misleading one, such as EBITDA.

Using EBITDA or any other measure that fails to capture quality and quantity of the business keeps the truth of the performance of the business back from managers and acts as an enormous barrier to the creation of wealth.

CEOs can remove this barrier by replacing EBITDA or similar measures with sustained gains in Economic Profit. Economic Profit is the only measure that captures both the quality of the business and the quantity of funds invested in it.

Figure 2: Economic Profit captures the key drivers of wealth creation

Economic Profit formula

 

Because EP goes down when funds are invested at low rates of return and up when they are invested at high rates of return, it guides managers, through all their efforts during a year, to create wealth, rather than destroy it. And it can be measured right down through the business, sharing responsibility for wealth creation throughout the management ranks.

Is your business engineered to create wealth? Part 1: Education

If the job of business is to create wealth, how strange it is then that so few managers really
understand how wealth creation works.

If you think this is unfair, try asking a manager this question, ‘How is it that Qantas has turned
the $15.2 billion entrusted to it into a business worth just $11.6 billion?’ Or, ‘How has
Cochlear been able to take $925 million and turn it into a company worth $3.8 billion?’

Shouldn’t every manager entrusted with other people’s life savings, be able to explain,
at least in high level terms, what has happened to these two companies and translate
those lessons into their everyday decision making?

If we expect our managers to create wealth, the first barrier we must address is education, by
giving all managers a clear and shared understanding of what is required to create wealth.

So what are the necessary conditions for creating wealth? Our research of Australia’s largest
listed companies summarised in the tables that follow, shows who has created (or
destroyed) wealth and the root causes. [1]

Figure 1: The 2013 Juno Partners Wealth Creators Report

1-5051-100101-150151-200

The data shows that, for example, BHP Billiton (ranked #1) at 30 June 2013 had taken $137 billion of capital from shareholders and lenders and turned it into a business worth $208 billion, creating a staggering $71 billion of wealth.[2]

By contrast, Newcrest Mining (#200) had taken $22.4 billion and turned it into $11.8 billion, destroying $10.6 billion.

How do businesses create wealth?
How does a business like BHP Billiton create $71 billion of wealth?

Being at the epicentre of the global mining boom would seem to help, but being a leader in the mining sector is not enough. OZ Minerals (#198) has managed to destroy $4.9 billion of wealth, turning every dollar entrusted to it into $0.20.

Wealth is also not just a matter of size. BHP Billiton is a very large company and created the most wealth, but Qantas (#196) is also a very large business, but its size did not save it from destroying billions.

Even growth per se does not matter. Both OZ Minerals (#198) and Westpac (#4) have grown their balance sheets in excess of 20% compound over the five years to 30 June 2013 but by the end of it, Westpac had turned $51 billion of investors’ funds into a business worth $90 billion, creating $39 billion, while OZ Minerals, turned $6.2 billion into just $1.3 billion, destroying $4.9 billion.

Instead, our research shows that the two most important conditions necessary for the creation of wealth can be characterized as ‘quality’ and ‘quantity’.

The importance of quality
Let’s look at the first condition: quality. Quality, of course, is a relative measure – it means something of a higher grade; better than the rest. If we apply that thinking to investing, a good quality investment is one that is capable of generating higher returns than what investors could achieve elsewhere, at similar risk.

To measure the quality of each of our sample of 200 Australian businesses, we calculated the return on capital employed (ROCE) of each and compared it to what investors could earn elsewhere at similar risk (the business’ Weighted Average Cost of Capital or WACC).

We call the net result, a business’ Economic Profit Spread, or EP Spread for short. Further explanation of these terms and others used in this article is included in this Glossary.

For example, Wotif, the on-line travel business (#57) earned 49.5% on the funds entrusted to it in 2013, compared to the 9.2% investors would expect, to justify the risks involved in the business, leaving an EP Spread of 40.3%.

Intuitively, generating 40% more than the return required for risk is good performance, but when you consider a little under three quarters of businesses covered in our research failed to generate more than 5% above what investors could expect for risk, then you begin to appreciate what a rare jewel Wotif is.

Quantity: the great accelerator of wealth creation
The second condition necessary for the creation of wealth is quantity, in this case the quantity of funds that can be invested at high rates of return. The more capital that can be put to work at high rates of return, the more wealth will be created.

This is best exemplified by BHP Billiton (#1) who not only enjoyed a median return on capital employed 10% above the return required for risk over the past five years, but also was able to employ an average of $83 billion a year at those rates, creating nearly $39 billion more profits than investors would require for the risk associated with their investment.

Quantity is the great accelerator of wealth creation. As good as Wotif’s returns are, the service nature of its business means that it does not organically generate large capital investment opportunities. It is hard to see how Wotif could ever employ $83 billion of capital in their business. Ultimately this restricts the wealth that the business is able to generate.

But quantity without quality is a recipe for wealth destruction
But while the ability to put capital to work is important, quality must always come first.

Investing large amounts of capital in low return, low quality businesses is a recipe for wealth destruction.

Newcrest Mining Limited (#200) is a good example of this. Over the past five years Newcrest suffered returns on average 2.3% below what investors required for risk. At the same time, it expanded its capital base, investing billions at low rates of return. The result was a valuation $10.6 billion less than what investors had poured into the business as at 30 June 2013.

Warren Buffett put it this way in his 1992 letter to fellow Berkshire Hathaway investors,

‘Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’

Key points

  • Competitive challenges make creating wealth difficult. That challenge can be made a little easier if all managers at least share a common and accurate understanding of how wealth is created.
  • Wealth is a function of Quality and Quantity. Can the business generate returns on the capital entrusted to it in excess of what investors could earn elsewhere (Quality), and how much money can be put to work at those rates (Quantity)?

Qantas (#196) has destroyed $2.9 billion of wealth because it has put large amounts of capital ($15.2 billion by June 2013) to work at low rates of return (on average 3.5% less than what investors require for risk) and is expected to do so well into the future.

Cochlear (#27) has created $3 billion of wealth because it has put the $925 million of capital entrusted to it to work at high rates of return (on average 14% above what investors require for risk) and is expected to do so well into the future.

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[1] For the purposes of this study, our database comprised the 200 largest Australian domiciled public companies as at 30 June 2013, excluding investment businesses, such as listed investment companies, insurance and real estate businesses, those with less than five years of publicly available financial reports and those who made losses in three or more of the past five years.

[2] Note that in the table of data we list the 2013 average Capital Employed balance, being the average of the year-end results for 2012 and 2013. The 2013 year-end values cited in the main text of this article and used to calculate Wealth Created, will usually be a little larger.