Professor Finds Value-Based Metrics Often Beat GAAP
Stanford Accounting Professor Stefan Reichelstein researched the techniques used by companies to deliver long-term value to shareholders. He found that effective management incentive plans are key, and a growing number of plans are tied to a new generation of performance metrics. The new metrics, known as value-based metrics, are accounting-based but differ in material ways from generally accepted accounting principles (GAAP). Examples include "economic value added," "flow return on investment," and "economic profit."
Professor Reichelstein, an accounting professor at the Stanford Graduate School of Business, says it has been estimated that around 200 of the Fortune 1000 firms are now using some value-based metric to measure the performance of their top-level managers. Most of these metrics involve adjustments to GAAP numbers. The key challenges for management are deciding which metric to use and what accounting adjustments to make.
- Which metric to use? Performance metrics are most effective when they use some variation of 'residual income.' "It's really a very simple formula," explains Professor Reichelstein, "accounting income, properly measured, less a capital charge for the assets used by that particular business or division." Unlike ordinary accounting income, he says, residual income is fundamentally compatible with present value considerations, and this is "critical in motivating managers to make long-term decisions that enhance the overall net present value of the firm." The key challenge is to select the value-based metric that is best for the company's goals and objectives.
- What adjustments to make? Another key challenge is to identify the adjustments that will best align the objectives of managers and shareholders. For example, the key adjustments in evaluating capital investments typically involve the depreciation method and risk adjustment, while the key adjustments in evaluating overall shareholder value will likely involve methods of marrying the concepts of economic value added and market value added. Stock price obviously is what shareholders ultimately care about, Professor Reichelstein explains. But "one drawback of stock price is that it aggregates all value-relevant information even though some factors are beyond the manager's control. Accounting-based performance measures can mitigate that problem, and therefore you want both."
Professor Reichelstein has co-authored several papers in this area, including one that won the Best Paper Award at the Review of Accounting Studies conference at Cornell University last year. He has concluded that there is growing evidence that value-based management does deliver for shareholders, and he predicts that further analytical and empirical research will explain why and how. Paraphrasing a timeless adage, Professor Reichelstein points out, "People in the field realize that 'whatever gets measured also gets delivered.'"