Evaluation criteria for value based performance measures

The evaluation criteria for value based performance measures are derived from the identified point of criticism from traditional key figures. The named disadvantages should be all or at least partly solved with the application of value based performance measures. In the following the evaluation criteria are presented.1031

1. Goal congruence with Shareholder Value approach

A key figure has to create the right incentives for managers. That means that an increase in a key figure reflects an increase in the Shareholder Value of company. Especially concerning key figures focusing on one period, this could be problematic as investments generate negative Cash Flows at the beginning but are in total still worthwhile for the company and should be conducted.1032 _{Ideally a}

1030 _{Cf. Günther, T. (1997), p. 59; Weber, J., Schäffer, U. (2016), p. 184.} 1031 _{Cf. Knorren, N. (1998), pp. 16-17; Zell, M. (2008), p. 152.}

key figure has the same sign in any period during the investment project as the expected present value at the beginning of the project.1033

For the purpose of evaluation of value based performance measures, this criterion does not come directly into consideration. The other criteria selected like risk consideration and present value of money are more verifiable. If they are fulfilled, sufficient goal congruence between a company’s objective and manager’s behaviour is achieved.1034

A possible way to operationalise this criterion is to define resulting values from the Discounted Cash Flow method as equal to Shareholder Value. This would lead to a comparison of every selected key figure with the DCF approach. Then the DCF approach itself could not be assessed.1035 _{In the following} assessment this criterion is considered indirectly with the criteria present value of money, future orientation and considering risk.

2. Resistance against manipulation

Managers can influence performance measures in two ways: Firstly, through their working effort so that the performance of the company improves and the key figures change accordingly. Secondly, they manipulate them. By manipulating key figures, managers harm a company twice. On the one hand, the true economic performance decreases because management is concentrated on disguising true performance and on the other hand, the remuneration is higher than justified if key figures determine a part of managements’ salaries.1036 _{If a} manager’s success is assessed on the basis of a key figure, the manager has a strong incentive to manipulate the result in order to increase its payment. It is in the company’s interest to select a key figure that is resistant to manipulation and reflects the true performance of the managers and its department.1037

Closely connected to this criterion is the criterion of future orientation. Prospective developments cannot be calculated in a completely objective way

1033 _{Cf. Mohnen, A., Bareket, M. (2007), p. 2.} 1034 _{Cf. Schultze, W., Hirsch, C. (2005), pp. 22-23.}

1035 _{Cf. Weber, J., Bramsemann, U., Heineke, C., et al. (2017), p. 72.} 1036 _{Cf. Pfaff, D., Stefani, U. (2003), pp. 65-68.}

is useful if a company establishes rules for key figure calculation which are as distinct as possible, in order to limit the range for manipulation.1039

In general, key figures based on Cash Flows are assessed as less prone to manipulation because they are not influenced as much as earnings by discretion in accounting, e.g. by different methods of deprecation. In the context of the following analysis this criterion is assessed by the data basis for calculation of a key figure.1040

3. Data basis for calculation

Due to the accounting principles and the main purpose of IFRS accounting, information delivery, the IFRS data can be assessed as relevant.1041 _Furthermore, accounting data are easily available for company internal and company external persons.1042 _{Concerning its resistance against manipulation, the IFRS offers a lot of} indirect rights of choice which are difficult to compare across companies.1043 Therefore, key figures based on book values can be influenced by utilising accounting rules and in the end the resulting value of the key figure can be manipulated.1044

A further problem in using accounting data is that the data has already become obsolete at the time of publication. This problem concerns external persons outside the company which do not have access to internal data.1045

4. Present value of money

This implies that the key figure reflects financial consequences of a project decision directly in the period of decision. This immediate reflection is only

1038 _{Cf. Kremer, P. (2008), pp. 88-89; Laux, H. (2006a), p. 91.} 1039 _{Cf. Schultze, W., Hirsch, C. (2005), p. 25.}

1040 _{Cf. Beck, R. (2003), pp. 13-14; Schmeisser, W., Rönsch, M., Zilch, I. (2009), p.} 2.

1041 _{Cf. Kremer, P. (2008), pp. 115-116; cf. also chapter 2.4.3 and the analysis of} advantages and disadvantages of IFRS.

1042 _{Cf. Fiedler, R., Gräf, J. (2012), p. 339.} 1043 _{Cf. Kremer, P. (2008), pp. 116-117.}

1044 _{Cf. Freidank, C.-C., Reibis, C. (2008), p. 293.} 1045 _{Cf. Schmeisser, W., Clausen, L. (2009), p. 73.}

possible for key figures which include present values because most projects start with negative Cash Flows at the beginning so that key figures without considering present value show negative effects.

Normally, present values are calculated on the basis of Cash Flows. Preinreich and Lücke show that under certain conditions present values can be computed with earnings and come to the same result. Some value based performance measures base on earnings instead of Cash Flows. For using key figures, it is important that a change in a key figure corresponds to a change in the present value of the company’s Cash Flows.1046 _{Assumptions for the validity} of the Lücke theorem are the clean surplus accounting and congruence principle. The IFRS rules violate these principles with e.g. the assessment of financial assets held for sale or the revaluation method for assets.1047

A disadvantage for key figures with present value is that it might induce managers to initiate projects with positive present values but there are insufficient incentives to complete these projects successfully because the positive effect has already been considered in the key figure.1048 _{A clear advantage is that managers} do not cancel prospect projects due to their negative effects at the beginning and thus increase the long-term success of the company.1049

5. Future orientation

As the main goal of investors is to predict prospective future Cash Flows and earnings, a key figure should have forward looking elements and not focus on solely historical performance.1050 _{This can be done by estimating possible} investments and resulting Cash Flows out of these projects.1051 _{A point of critique} is often that key figures foster short-term actions of managers that damage the long-term economic performance of a company. By considering both time horizons, this point of critique becomes obsolete.1052

1046 _{Cf. Herbertinger, M. (2002), pp. 36-37; Laux, H. (2006a), p. 89.} 1047 _{Cf. Kremer, P. (2008), pp. 113-114.}

1048 _{Cf. Kremer, P. (2008), pp. 87-88.} 1049 _{Cf. Kremer, P. (2008), p. 88.}

1050 _{Cf. Ittner, C. D., Larcker, D. F., Randall, T. (2003), p. 717.} 1051 _{Cf. Günther, T. (2002), p. 90.}

refer to one period is that projects are excluded due to a negative value in a single period. In total the project might be positive, so that it would be economically rational to conduct it.1053

6. Considering risk

Investors demand a higher return for a riskier investment. Key figures can include the risk by discounting earnings / Cash Flows with a risk adjusted interest rate. These discount rates are regularly the cost of capital.1054 _{The risk is} determined by the operations of a company and its capital structure.1055 _{In bigger} companies it makes sense to calculate cost of equity capital according to business segments because these segments differ in their risk and therefore have different hurdle rates which they have to fulfil.1056

7. Simplicity

An important factor of successful VBM adopters is that the majority of employees can explain and understand the composition of the value based metric.1057 _{Therefore, it is a crucial factor to keep the value based performance} measure as simple as possible in order to ensure a company-wide understanding.1058 _{Managers have to know which factors influence the value of} the key figure.1059 _{Also part of this criterion is the circumstance that users of a key} figure know in advance of an action the resulting effect on the key figure. In other words: It must be transparent in what way the key figure reacts.1060

Connected with simplicity is the cost-benefit relationship of a performance measure. It means how costly the measurement of performance is. Especially for small and medium sized enterprises, this question is important as their resources

1053 _{Cf. Weißenberger, B. E. (2003), p. 261.}

1054 _{Cf. Beck, R. (2003), p. 18; Günther, T. (2002), p. 90.} 1055 _{Cf. Rappaport, A. (1986), pp. 21-23.}

1056 _{Cf. Malmström, B. (2006), p. 641.}

1057 _{Cf. Haspeslagh, P., Noda, T., Boulos, F. (2001), p. 68; Kremer, P. (2008), p.} 82.

1058 _{Cf. Haspeslagh, P., Noda, T., Boulos, F. (2001), p. 70.} 1059 _{Cf. Schultze, W., Hirsch, C. (2005), p. 26.}

are limited. Ideally, the key figure should be easily to calculate and to be applied within the company.1061

8. Correlation with capital market development

A further criterion which is not assessed in the course of the following analysis is the correlation of single key figures to the capital market development. As empirical studies present divergent results and no uniform conclusions, the assessment of this aspect does not help to differentiate the key figures and their abilities from each other.1062

In order to give an overview, the following enumeration summarises all evaluation criteria.1063 _{The first evaluation criterion “including cost of capital” has} not been explicitly mentioned in this chapter as it is part of the definition of value based performance measure.1064

 Including cost of capital

 Data basis for calculation (availability and quality of data)  Present value of money

 Future orientation  Considering risk  Simplicity

The selection of the later presented value based performance measures has been conducted on the basis of their relevance in theory and practice.1065 _{It also}

1061 _{Cf. Neely, A., Gregory, M., Platts, K. (1995), p. 84.}

1062 _{Cf. exemplarily the empirical studies of Biddle, G. C., Bowen, R. M.,} Wallace, J. S. (1997) and Siebrecht, F., Heidorn, T., Klein, H.-D. (2001).

1063 _{Cf. exemplarily for similar criteria for assessing traditional key figures and} value based performance measures Fiedler, R., Gräf, J. (2012), p. 339; Herbertinger, M. (2002), pp. 36-41; Horster, J., Knauer, T. (2012), p. 119; Groll, K.- H. (2000), pp. 22-27; Knorren, N. (1998), pp. 16-18; Schultze, W., Hirsch, C. (2005), pp. 15-33; Schumann, J. (2008), pp. 102-112; Stührenberg, L., Streich, D., Henke Jörg (2003), p. 64; Zell, M. (2008), p. 152.

1064 _{Cf. Ewert, R., Wagenhofer, A. (2014), p. 516.}

1065 _{Cf. Fiedler, R., Gräf, J. (2012), p. 338 name EVA and CVA as most frequently} applied key figures; Freidank, C.-C., Reibis, C. (2008), p. 293 lists EVA and CFROI as the most famous key figures; Heusinger von Waldegge, S. (2009), pp. 72-73 lists

measures exist. Consequently, no uniform definition within the scientific literature is available.1066 _{This leads to the problem that companies are relatively} free in the calculation of value based key figures.1067 _{Non uniform defined key} figures limit the comparability of performance between different companies in the end so that it is difficult for investors to assess which company performs best.1068

Concluding to this chapter, it should be mentioned in advance that the following illustration and assessment of value based performance measures aims to show what divergent approaches the value concepts pursue and stress the resulting advantages and disadvantages than to find a superior concept out of the selected key figures. On the basis of the presented criteria this is problematic because apart from a theoretical discussion these criteria are difficult to operationalise.

Take as an example the criterion of resistance against manipulation. Key figures which include future periods in their calculation do not fulfil this requirement in the same manner as key figures which concentrate on past periods. The estimation of prospective developments always offers more possibilities for manipulation than the drawing on published performance data.

A further complicating factor is that the scientific literature has no uniform positions concerning many criteria.1069 _{There will be no key figure which fulfils all} criteria listed. For a company it is important to select an appropriate key figure for a specific purpose and to be aware of the advantages and disadvantages. A company will use a mixture of traditional and value based performance measures.1070 _{Beside the right mixture of key figures for companies it is also} decisive to connect the messages of single key figure with each other. In this way

EVA, EP, ERIC, CVA and CFROI as well-known concepts of value based performance measurement; Junginger, M. (2005), p. 61 names DCF, EVA and CFROI; Schumann, J. (2008), p. 101, who lists among others EVA, ERIC, CVA and SVA as important value based performance measures.

1066 _{Cf. Freidank, C.-C., Reibis, C. (2008), p. 293; Günther, T. (2002), p. 92.} 1067 _{Cf. Freidank, C.-C., Reibis, C. (2008), p. 293.}

1068 _{Cf. Hauschildt, J. (1996), pp. 8-9.} 1069 _{Cf. Schumann, J. (2008), pp. 105-108.}

the analysis of key figures delivers an overall image of the company’s performance.1071

3.3 VALUE BASED PERFORMANCE MEASURES FOCUSSING ON A SINGLE