The Canadian Economic Performance and Valuation Review has been prepared by Arche Value Management to present an approach to corporate performance analysis and ideally management that addresses the current critical concerns that investors have voiced of the existing management model (financial management and incentive compensation) and record of performance of many Canadian public corporations in delivering value creation.
In our view, a common misconception is that rigorous ex ante evaluation of investments via sophisticated financial analysis is sufficient to govern resource allocation and ultimately deliver value creation. The fallacy of this conventional approach to resource allocation is playing out, unfortunately and currently, in the resource sectors of the Canadian economy. Here companies are recognizing significant writedowns / writeoffs of investments due, in no small part, to weak execution and governance of the investment making process. Without question greater ex poste management and accountability for resource allocation is needed.
Fortunately, the systematic element of the solution is quite simple. Internal financial management systems, i.e. corporate performance measurement, financial and investment planning and incentive compensation, should be based upon Economic Profit as opposed to accounting profit. While this prescription may seem sound technical and perhaps semantic, the effect of this reform would be far reaching and significant. Economic Profit is the performance measurement of value creation, defined as such because of it’s recognition of total cost, i.e. Revenue minus all operational and investment costs. The fundamental problem with conventional financial accounting based performance measurement systems is that the inherent definition of profit is incomplete in its recognition of total cost. In fact many internal financial management systems completely lack any form of accountability for capital management, i.e. EBITDA based systems. Conventional practice, therefore, reverts to the usage of multiple measurements to ensure that aspects of financial performance are covered on net. The resultant effect, however, is that financial management can become excessively complicated and oftentimes conflicting in providing information, i.e. the quickest way to double your EBITDA might be to triple your installed Capital base, but are you in fact better off?
The real problem, however, lies in the how financial management links with the management incentive compensation. Obviously if you are paying for the wrong metric, you get the wrong result. The age old adage that you get what you pay for could not be more true than when viewed from the standpoint of management incentive compensation. If the performance metrics that drive the incentive compensation system don’t systematically recognize the cost of all employed capital (most conventional systems recognize none, i.e. EBITDA based systems), then while operating might materialize, but returns might not. Ex ante review of expected investment returns, no matter how sophisticate, will have little ability to ultimately govern the deliver of return on capital and value creation, as measured by Economic Profit, over time.
Canadian corporations need to focus their financial management and incentive compensation systems on the delivery of value. Conventional financial metrics should be viewed as value drivers, but the bottom line has to be view as being Economic Profit. Focusing management, from a financial perspective, on improving their Economic Profit will, at the margin, move their Enterprise Value and share prices upwards, and thereby deliver shareholder value. It is imperative that this mandate be framed within the context of operating an ethical and responsible business that recognizes the concerns and requirements of not only shareholders but the broader community of firm stakeholders.