Value-based management metrics - Linking metrics to strategy...

Learning Outcomes

After reading this article, you will be able to explain the purpose and types of value-based management (VBM) metrics, such as Economic Value Added (EVA) and Shareholder Value Added (SVA). You will understand how these metrics are used to align management incentives with company strategy, discuss the advantages and disadvantages of each metric, and evaluate how they encourage goal congruence between management actions and shareholder interests.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand how value-based metrics are used in performance evaluation. This includes being able to:

• Explain the role of VBM metrics in aligning management incentives with shareholder wealth maximisation
• Evaluate the design, calculation, and practical application of metrics like EVA and SVA
• Discuss the limitations and potential behavioural impacts of these measures
• Assess the link between VBM metrics, corporate strategy, and executive remuneration

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is most directly focused on measuring the real economic benefit created for shareholders?
   1. Earnings per share
   2. Economic value added (EVA)
   3. Operating profit
   4. Return on assets

2. True or false? The primary advantage of value-based management metrics is that they cannot be manipulated by managers.

3. Briefly explain how a poorly chosen performance metric could incentivise managers to make decisions that are not in the long-term interests of shareholders.

4. Name two adjustments commonly made to accounting profit when calculating Economic Value Added.

Introduction

Management performance can be evaluated using many different metrics, but not all encourage behaviours that maximise long-term shareholder wealth. Traditional accounting measures such as profit and earnings per share may not fully reflect economic reality. Value-based management (VBM) metrics were developed to provide a direct link between decision-making, company strategy, and the main financial objective of increasing shareholder value. This article explores the main VBM metrics, the reasons for their use, and how they influence management incentives and strategic alignment.

Key Term: Value-based management (VBM)
An approach to performance measurement that focuses on generating genuine economic returns above the cost of capital, driving decisions and incentives towards increasing shareholder value.

THE PURPOSE OF VALUE-BASED METRICS

Traditional metrics such as profit or return on capital can be affected by accounting choices and may not capture the cost of the capital invested in the business. They may encourage short-term thinking or actions that boost reported figures without truly adding value for shareholders. VBM metrics, in contrast, focus on measuring and driving actions that create value after accounting for all costs, including the cost of equity and debt.

Why Traditional Metrics Can Mislead

Accounting profit can be increased by deferring necessary investments, taking on excessive risks, or manipulating accruals. This may give a misleading view of performance and does not consider the cost of the funds used to generate profits.

Key Term: Shareholder value added (SVA)
The increase in the market value of a company’s equity over a period, after accounting for dividends paid and new capital contributed.

Key Term: Economic value added (EVA)
A performance metric calculated as net operating profit after tax (NOPAT) less a charge for the total capital employed, reflecting whether the business is generating returns in excess of its cost of capital.

MAIN VALUE-BASED METRICS

The two most widely used VBM metrics are EVA and SVA, supplemented by derivative measures such as Market Value Added (MVA).

Economic Value Added (EVA)

EVA measures profit after charging for all capital used, not just debt. If a firm’s operating profits exceed the full cost of capital (including equity), it is creating value.

EVA = NOPAT – (Capital Employed × Cost of Capital)

Common adjustments when calculating EVA include ignoring non-cash accounting charges, capitalising certain investments, and adjusting for one-off items. These adjustments aim to reflect the true economic impact of management’s decisions.

Shareholder Value Added (SVA)

SVA considers the net present value of cash flows attributable to shareholders in excess of their required return. Positive SVA over time means true value is being delivered to shareholders.

Linking to Strategy and Incentives

For a VBM system to drive behaviour, the selected metric must be linked to management incentives (performance pay, bonuses, share options) and used consistently in strategic planning and evaluation. This approach aligns managers' rewards with genuine long-term value creation, reducing the risk of actions that boost accounting profits at the cost of value.

Worked Example 1.1

A listed company has a NOPAT of $15 million, total capital employed of $100 million, and a weighted average cost of capital (WACC) of 11%.

Calculate the Economic Value Added (EVA). Should the board consider this performance value-creating?

Answer:
EVA = $15 m – ($100 m × 11 %) = $15 m – $11 m = $4 m.
The company is creating $4 million of economic value this year, indicating value creation above its total capital cost.

ADVANTAGES AND LIMITATIONS OF VBM METRICS

Advantages

• Focuses on long-term value creation, not just short-term accounting gains
• Adjusts for the cost of equity, not just debt
• Promotes goal congruence between managers and shareholders when used in incentive schemes
• Reduces incentive for earnings management or excessive risk-taking solely to boost reported profits

Limitations

• Calculating VBM metrics can be complex, requiring detailed adjustments
• May focus attention heavily on financials, neglecting key non-financial drivers (e.g., customer satisfaction, innovation, employee engagement)
• Short-term EVA may penalise managers for profitable investments whose benefits occur beyond the current period
• Risk of demotivation if targets are viewed as unachievable

Worked Example 1.2

A manager’s bonus is tied to growth in accounting earnings, but not to EVA. In response, the manager delays needed maintenance and overstates closing inventory to boost reported profit this year.

Explain why this incentive scheme poses a risk to long-term shareholder value.

Answer:
Because incentives are based on accounting profit, the manager is motivated to take short-term actions that make profits look higher but do not result in real value created for shareholders. Delaying maintenance may damage future performance. VBM metrics like EVA would reduce this risk by focusing on real economic profit.

Exam Warning

Incentive schemes based on the wrong metric may lead to behaviour that harms long-term value. For the ACCA exam, always consider whether a performance measure aligns management actions with shareholder goals over the long run.

LINKING METRICS TO CORPORATE STRATEGY

VBM metrics are only effective if incorporated into strategic planning, capital allocation decisions, and management appraisal. This means:

• Using EVA or SVA as hurdles for investment evaluation
• Including VBM targets in business unit plans
• Structuring incentives so that managers benefit from sustainable value creation, not just short-term earnings spikes

Key Term: goal congruence
The alignment of managers’ incentives and actions with the long-term interests of shareholders.

Linking to Non-Financial Drivers

Although VBM metrics focus on financial outcomes, successful strategies also require attention to factors that drive long-term performance. A balanced approach integrates VBM metrics with key performance indicators tied to customer, operational, and innovation goals. This ensures value creation is sustainable, not just short-term.

Worked Example 1.3

A company introduces a multi-year incentive plan based on annual EVA improvement and customer satisfaction scores. Over three years, EVA rises steadily and client retention rates improve.

What can be inferred about the alignment of incentives, and why is this balanced approach beneficial?

Answer:
The incentive system encourages managers to make decisions that drive both financial value and customer relationships. This alignment supports sustained value creation, not just yearly profit increases.

Summary

Value-based management metrics provide a direct way to measure and reward long-term value creation. By including the cost of all capital and integrating these measures into strategic decisions and management incentives, companies encourage behaviours that benefit shareholders. While there are limitations, especially regarding complexity and the risk of neglecting non-financial factors, these metrics are essential for aligning management actions with company strategy in modern financial management.

Key Point Checklist

This article has covered the following key knowledge points:

• Understand why value-based metrics are used instead of traditional accounting measures
• Identify and explain Economic Value Added (EVA) and Shareholder Value Added (SVA)
• Recognise the importance of aligning management incentives with shareholder value creation
• Discuss the strengths and weaknesses of VBM metrics
• Explain how VBM metrics link financial strategy, incentives, and long-term corporate goals
• Appreciate the need to balance financial and non-financial performance in strategy execution

Key Terms and Concepts

• Value-based management (VBM)
• Shareholder value added (SVA)
• Economic value added (EVA)
• goal congruence