S. David Young
Professor of Accounting and Control
Value-Based Management, Incentive Compensation, Eva; Corporate Governance; Board Process and Remuneration at the Top;
Most finance academics, along with many corporate practitioners, believe that discounted cash flow, or DCF, is the most reliable method for calculating the market vale of a company’s shares. The use of DCF in turn implies that shareholders are better off when companies invest only in projects that are expected to earn more than the cost of capital—and when they pay out, through dividends or stock buybacks, capital that is expected to earn less than the shareholders’ opportunity cost.Despite the wide acceptance of these principles, very few companies use performance measures that focus on corporate efficiency in using capital—measures such as return on capital (ROC) or economic value added (EVA)—as the main basis for their top management incentive programs.In this article, the authors start by documenting the limited use of capital efficiency measures in top management incentive plans. Second, the authors analyze three often cited problems with capital efficiency measures that may well account for their limited use.Third and last, the authors suggest a number of adjustments to standard capital efficiency measures that are designed to address these problems and, in so doing, to give corporate directors more confidence in using measures like EVA to reward and hold managers accountable for value-adding performance.