Comment: Measure Performance Like an Investor

challenges -- and great opportunities -- for financial institutions on a global scale.

As if to underline this, energetic newcomers to banking and securities, such as MBNA and E-Trade in the United States and ConSors in Germany, are threatening incumbent giants, revolutionizing financial businesses, and generating some of the industry's best returns.

But a few established players, such as Mellon Financial of Pittsburgh and Lloyds TSB of London, are achieving returns that outstrip those of their banking peers and of some successful newcomers.

Executives at such institutions see themselves as shareholder-value managers. They think and act more like investors than traditional managers do, and they rigorously pursue strategies that build shareholder value.

The best approach to shareholder value management uses a suite of economic measures to track the true performance and prospects of the businesses in a company's portfolio and the company as a whole. By true performance we mean that which affects shareholder value.

Instead of tracking earnings, these measures focus on the underlying cash flows that a business generates and the equity investment needed to achieve them.

The measures directly relate the return on risk-based capital to the cost of capital, allowing management to see clearly how much value a particular business is creating and how much more it may generate.

This helps managers identify the growth opportunities and the potential turnarounds that can produce the highest shareholder returns, as well as the unpromising businesses that it might be best to exit.

More banks are employing such measures in rigorous pursuit of shareholder value. Lloyds TSB even has an explicit commitment to double its share price every three years. And since the Chase-Chemical merger, Chase Manhattan has increasingly used value measures to assess its various businesses. It includes such data in its annual report.

Pressure is mounting on other banks to follow suit. Institutional investors increasingly scan the world for the best investment opportunities. This means that banks must compete for the same investment dollar. That effect is amplified in continental Europe, where the new common currency is rapidly creating a unified investment market. Financial institutions everywhere have to look beyond national borders and compare themselves with their regional and global peers.

Those firms that can sustain a position in the top tier will command a better price for their shares: a powerful currency for acquisitions in a consolidating industry.

A high and rising stock price will also give them the edge in attracting and retaining the best executives. Success, however, is all too often temporary; staying at the top is very difficult even for the best companies.

Most banking leaders still manage by traditional measures such as earnings per share and risk-adjusted return on capital.

Because they are relatively static, these measures are not the best for tracking a company's success in improving shareholder value.

They overlook changes in value and underestimate the value created when managers turn around and grow businesses.

Total shareholder return, the annual percentage return to common shareholders from investing in a company's shares, is the true measure of a company's success in creating value. Because broad economic factors affect all share prices, actual total shareholder returns should be calculated relative to a market index or a group of peers.

In addition, managers need internal measures that gauge their success in building the value of specific businesses and help them assess the value their strategic actions may produce. They must be able to understand the relationship between these measures and the external market in order to bridge the two effectively. This suite of internal value-based measures should include total business return, added value on equity, delta (change in) added value on equity, and operating cash flow.

Such measures allow for a simulation of an internal capital market that compares the current and prospective performance of each business in a company's portfolio. The firm's management can then fashion and monitor customized solutions for its individual businesses -- promoting growth, cutting costs, and reallocating capital when appropriate to achieve the overall goal of generating superior returns to shareholders.

One large U.S. commercial bank recently used such a simulation model from Boston Consulting Group to gain a better understanding of the true economic performance of its mortgage and credit card businesses. The model showed that although the returns were below the cost of capital, the rapid rate of profitability improvement created significant shareholder value.

Similarly, a midsize European commercial bank discovered that its treasury division was earning a mediocre return that barely matched the cost of the $1.6 billion committed to the division. Traditional accounting measures for operating profits implied that the business was highly profitable.

But after deducting capital costs, the division was in fact making little or no economic profit.

That insight persuaded the bank to securitize and sell off many treasury assets, freeing up capital for investment in more productive parts of its business.

Banks should adopt certain fundamental approaches as they set out to build their strategies for shareholder value management.

They should, for example, compare their total shareholder returns regularly with those of their peers, including the successful newcomers to their businesses. They should also be explicit about value-creation targets.

They should implement value management step by step. First, they should perform a value audit to determine which businesses have the potential to create value. Then they should weigh the conclusions against other strategic considerations and decide which businesses to build, which to try to turn around, and which to downplay or sell. Finally, they should analyze and break down the various drivers of value so that line management knows what to focus on in order to meet the value-creation objectives.

They should ensure that everyone in the organization understands his or her role in the value-creation strategy. That requires driving the measures down through the organization and involving everyone in the effort to build shareholder value. Top-level managers should commission audits to discover what creates and what destroys value in each of the individual businesses.

They should tie managers' incentives to the value-based measures linked to the economic performance of both individual business units and the company as a whole.

They should use the insights that value-based measures provide to find and exploit promising opportunities in both new and traditional businesses.

With strategies grounded in the principles of value management, companies will be better able to achieve and maintain leadership positions -- and they will earn richer returns for their shareholders.

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