Corporate Moneyball: Why the Right Metrics Do Matter
Sunday, November 6, 2011
POSTED BY D. N. Aust
Guest Post by Clyde Rettig, Director, CharterMast Partners LLC
The popular movie, Moneyball, based on Michael Lewis’s equally popular 2003 book of the same name, tells the true story of how the 2002 Oakland Athletics nearly made it to the World Series after applying nontraditional criteria to select new players. GM Billy Beane was trying to rebuild a team that had been decimated by departures of its best players to richer, big-market teams. The criteria the Athletics used, which can be characterized as actual performance metrics, were based on statistical analyses of target players’ historical on-base and run-scoring results and their ability to “control the strike zone” (i.e. get walks) during a game. These statistics produced an entirely different and less expensive roster than one based on the subjective, nonquantitative measures long used by scouts and coaches such as “Good Face,” “Great Body,” “Foot Speed,” and the relative attractiveness of wives and girlfriends. This new approach has now taken hold in major league baseball, although remnants of the traditional hodgepodge of subjective biases are still around. The new metrics are even credited with overcoming the Boston Red Sox’s long curse of the Bambino with a World Series win in 2004.
What is crucial in both corporate business and baseball is using metrics that maximize the chances for competitive success. In baseball, metrics that identify players who can get on base and then score runs are the most critical. For the corporation, the metric that can highlight businesses that generate real returns in excess of the cost-of-capital while providing value-adding growth opportunities can make the biggest difference in an enterprise’s value.
Unfortunately, the metrics commonly used to evaluate the performance and direct the strategy and operations of many large companies are as misguided and defective as the ridiculous, but time-honored biases of baseball scouts and coaches. Like baseball’s traditional practices, most accounting-based metrics are at best irrelevant and often totally misleading and damaging, both for the operating managements of companies as well as their boards of directors and shareholders.
On the other hand, CharterMast Partners (CMP) has pioneered a real-world measure that accurately explains stock price performance, enterprise value, and shareholders’ returns using rigorous financial data and analysis. Corporate managements can use this metric to guide many important strategic decisions, such as which business units to back with capital (or not), determining what acquisitions are really worth, and assessing the real value of various initiatives, business plans, and growth opportunities. CMP’s metric has proven to be statistically superior to the set of classic, but ineffective, measures that includes RONA, EBITDA multiples, EPS, P/E, and EVA, measures that are commonly applied in many businesses today.
Why the “Classic” Performance Measures are Flawed
One of the best examples of a flawed business metric is Return on Net Assets (RONA) and its variants such as ROIC. It is not an exaggeration to say that RONA helped destroy the US steel industry and dulled the competitive edge of the once-dominant US chemicals industry. How can this be? Simple. Rigorously employing RONA to make capital allocation decisions systematically drives companies to under-invest in their most promising new business opportunities. It favors mature businesses by valuing their highly depreciated capital assets rather than the high future revenue growth of currently less profitable fledgling enterprises that require the latest (often expensive) equipment to compete. As a result, RONA can often guarantee a going-out-of-business scenario.
Why this is true is quite obvious. First RONA uses net assets rather than gross assets as its denominator. This, of course, distorts its perspective by including tax-purposed depreciation calculated according to one of several approved standards. Second, RONA never adjusts its asset component to account for currency inflation’s impact on the value of existing assets. Hence, in the RONA world, old assets generate increasing return values over time as they become both worn out and obsolete in reality. Also, RONA’s numerator uses GAAP profits rather than cash profits, further distorting the report of actual performance with an accounting artifact: depreciation.
Finally, and amazingly, RONA contains no factor to capture the obviously different value of high-growth versus low-growth enterprises thereby reinforcing its bias for the outmoded. A zero revenue growth business with a 10% GAAP return on highly depreciated, fully utilized assets appears more valuable than a business growing 25% per annum while delivering an 8% return from a brand new, technically advanced plant with plenty of available production capacity.
Another example of a familiar, but ineffective metric is the EBITDA multiple frequently used by investment bankers as a tool for valuing private companies and business units. EBITDA itself (earnings before interest, taxes, depreciation, and amortization) is really not a bad measure of earnings although the logic for removing cash taxes from the total is questionable (since taxes are unrecoverable cash going out the door).
To create an “EBITDA multiple,” however, requires both an EBITDA calculation and the creation of a multiplier. The technique for doing so is to find several “peer” companies, calculate an average of their implied multiples (from their stock prices), and use that number to value the target company. The problem is, in a world of corporate complexity, what is a “peer?” What companies today have the same or even similar business models, growth prospects, capital structures, costs-of-capital, strategic environments, asset profiles, competitive environments, technology patent estates, etc.? And, why should a company’s multiple be the average of its “peers” if it is a better performer than most?
The whole peer group multiplier exercise delivers what one would expect: the standard deviation around the calculated average is often very high. Hence, the accuracy of the calculated average multiplier is highly suspect. Thus, in spite of the intensive efforts by the investment bankers to measure EBITDA to the gnat’s eyelash, a value calculation is only as accurate as its least accurate parameter. The typical EBITDA multiplier-based valuation estimate is, at best, a shot in the dark.
The metrics commonly used to provide a market value perspective are equally uninformative and often misleading. For example, EPS is purely a particularly empty metric. It simply states GAAP net earnings divided by shares of stock outstanding. EPS can’t be used to compare one company with another because the number of shares is arbitrary. Furthermore, EPS has nothing to do with performance: both Berkshire Hathaway’s share price and its earnings-per-share are very high because Berkshire hasn’t split its shares or issued more of them.
The much touted P/E ratio is also irrelevant. As with the RONA metric, P/E’s use of GAAP earnings means that it does not measure true economic performance, which is presumably what folks investing in stocks are after in the first place.
Finally, the very popular and heavily touted metric, EVA, again fails to deliver insight into real value. It does not take revenue growth into account, it operates with GAAP rather than cash profits, and it makes no inflation adjustments. And, EVA provides little direct linkage to stock price and its statistical accuracy in estimating share prices is very low.
The Right Metric: “CMP-Q”
CharterMast Partners has developed a direct measure of enterprise value that is markedly superior to all the more common metrics. Just four variables drive the algorithm: cash profits, real fixed assets, growth, and an accurate, not a discredited CAPM, cost-of-capital. This metric, CMP-Q, equals the market value of a company’s debt plus its equity divided by the amount of its real net assets. It is highly accurate whether explaining past, current, or future valuations.
Cash profits are not artificially inflated by the deduction of accounting artifacts such as depreciation and amortization. An inflation adjustment to fixed assets takes into account the impact of inflation on the current real value of that asset base. The asset growth factor recognizes that stagnant businesses with zero or limited revenue growth don’t create value over time especially in very competitive environments. And, finally, a company-specific cost-of-capital employs the market’s implied discount rate on future earnings to account for perceived differential financial and business risk.
The proof of CMP-Q’s superiority, however, is really in the pudding. Statistics show that predicted CMP-Q is highly correlated with actual market value across companies, industries, and time:
At the corporate level, CMP-Q makes it possible to assess overall company shareholder value performance over time as well as in comparison to competitors at any given time. At the business unit level, CMP-Q provides an accurate picture of individual business unit differences versus the company averages, current versus desired or forecasted performance, and estimates of the actual corporate value that will be added by specific investments in each unit.
CMP-Q provides the means to assess strategic options, to accurately price acquisitions and ventures, and to value new business opportunities and operational improvement initiatives by comparing incremental corporate value-added with the incremental investments involved. It also makes it possible to objectively allocate capital resources among business units and other investment options based on their relative contributions to corporate value.
Finally, the CMP-Q metric can be approximated in a simplified form so that line managers can use it to both manage their businesses in a manner consistent with corporate value objectives and to assess subordinates’ performance contributions against personal, business unit, and corporate goals.
Just as in baseball, in corporate business, the right metrics do matter!
Contact: Clyde E. Rettig, Director