Four Options for Measuring Value Creation
Strategies for managers to avoid potential flaws in accounting measures of performance.
In casual, everyday language, it is often said a corporation’s primary role is to generate profits. However, the primary role of a corporation is not to generate profits; it is to create shareholder value. When corporations focus their internal performance measurement systems on short-term profits or accounting returns — not shareholder value — bad things often happen. Their managers can fail to identify real problems on a timely basis. They can also become shortsighted and prone to gamesmanship.
Fortunately, many smart managers take steps to de-emphasize the management roles of accounting measures of performance to keep the focus on value creation. This article first clarifies the problem — the reasons accounting performance measures are often not good indicators of value creation — and then describes four main alternatives managers can use.
Flawed Measures of Value Creation
Ideally, the performance measures that managers monitor and use for management decision-making should go up when economic value is created and down when economic value is destroyed. But short-term profit measures and accounting returns often do not do that. This has been shown consistently in research over various periods.
A review of these studies shows that the coefficient of determination between annual accounting profits and annual shareholder returns is small, ranging from two percent to 10 percent across numerous studies. Statisticians interpret this figure by saying that the annual accounting profit measures explain between two percent and 10 percent of the variance in annual value changes. This means that having access to a business entity’s annual or quarterly profit figures tells you very little about the value the business entity created in that measurement period.
This low correlation should not come as a surprise. Many things affect accounting profits but not economic values, and vice versa:
This article has been excerpted from the Journal of Accountancy. View the full article here.