Pinnacle Consultants L.L.P.

Helping Businesses Reach Their Financial Peak

Financial Review

 Are You Using the Right Performance Measures to Manage Your Business?

In today's business environment, business owners/managers have been overwhelmed with advice about performance measures: Total Return to Shareholders ("TRS"), Discounted Cash Flows ("DCF"), Economic Profit, Economic Value Added ("EVA"), Return on Invested Capital ("ROIC"), Earnings Per Share ("EPS"), Profit Margin, and many others.  Oftentimes, the real purpose of using these performance measures has gotten lost in the sea of metrics.  These performance measures are used to help managers make value creating decisions and to guide all company employees to value creation.

Some performance measures are indeed better than others.  We prefer economic measures (such as economic profit) to accounting based measures (such as earning per share).  Empirical research suggests that cash flows, not accounting earnings, are what drive stock price performance.  It's also easier to understand the sources of value and short term versus long term tradeoffs when you use economic performance

However, there is no perfect performance measure.  As a result, it is better to use a framework, that links various economic measures, to describe different aspects of performance.  The ultimate output measure is shareholder value creation (i.e. stock performance) in the stock market.  It can be used by managers to set shareholder value creation targets.  Shareholder value creation can then be linked to some measure of intrinsic value. 

Intrinsic value is ultimately driven by the long term cash flow generating ability of the company and can be measured by DCF. Intrinsic values such as DCF can then be linked to important financial indicators such as growth in operating profits and return on invested capital.  However, because short term financial indicators may signal changes in value creation too late,  we need to also use operating and strategic measures called value drivers (such as market share, cost  per unit, value of R&D projects) to manage the business. Monitoring these value drivers helps avoid sacrificing long term value creation for short term financial results. 

Each class of measure has a role in management decision making and performance management

Stock Performance <----  Intrinsic Value <----  Financial Indicators <----  Value Drivers

  • Management can set long term value creation targets in terms of the market value of the company or total return to shareholders

  • Alternative strategies/opportunities and the value of the business units, or the entire company, can be evaluated in terms of intrinsic value (DCF)

  • Intrinsic value can be translated into short term and medium term financial targets and targets for operating and strategic value drivers (Market Share)

  • Performance can be assessed by comparing results with targets on both financial indicators and key value drivers.  Managerial rewards can be linked to performance on both financial measures and key value drivers

Financial measures must be supplemented with strategic and operating value drivers that provide insight about where a company's performance is heading.  Value drivers help companies to understand the reasons for their current performance and how their future performance will likely develop.

Business owners and managers are oftentimes overwhelmed with advice about performance measures used to manage their business.   A comprehensive framework to cut through the confusion of proliferating metrics can help business owner more effectively manage their business.  This framework should include long term value creation targets, intrinsic value metrics, financial targets and value drivers.  Using the right business performance measures can have a positive impact of your businesses bottom line!

Thank you for your continued interest in Pinnacle Consultants.  If you would rather not receive e:mails with news, updates and tips from the financial world, please click the following link paul@pinnacleconsultants.org


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Special Points of Interest

  • Some performance measures are indeed better than others.  We prefer economic measures (such as economic profit) to accounting based measures (such as earning per share).   

  • However, there is no perfect performance measure.  As a result, it is better to use a framework that links various economic measures to describe different aspects of performance.

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Pinnacle Consultants L.L.P.

20704 N. 90th Place

Unit 1049

Scottsdale, AZ 85255

P: 480 980-3977

F: 480 585-1920

Website:

www.pinnacleconsultants.org

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Contact Us:

paul@pinnacleconsultants.org

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