April Journal



APRIL 2021






  1. WACronyms
  2. Creating a Flexible Financial Model
  3. Slow Adoption of Real Options





Boston Consulting Group (BCG), an international consulting organization, has developed an approach to shareholder value management that builds on the pioneering work of their specialist group HOLT Value Associates.

Two concepts are at the foundation of the BCG approach: total shareholder return and total business return. For applying these concepts, two performance metrics are used: cash flow return on investment and cash value-added.

Total Shareholder Return

The total shareholder return (TSR) is the rate of return shareholders earn from owning a company’s stock over a period of time.

The TSR for a single holding period is computed as follows:

The TSR for a multiple holding period is computed using the conventional internal rate of return computation.

Beginning Market Value=

There are several reasons why BCG regards TSR as the most useful measure of value creation:

  • (i) TSR is comprehensive as it includes dividends as well as capital gains.
  • (ii) TSR is widely used by the investment community and also required by the Securities Exchange Commission.11.
  • (iii) TSR can be easily benchmarked against the market or peer groups.
  • (iv) TSR is not biased by size.
  • (v) TSR is difficult to manipulate.

Total Business Return

If TSR is what matters to investors, an internal counterpart to it is needed for managerial purposes. For BCG, the total business return (TBR) is the internal counterpart of TSR. The link between TSR, TBR, and value drivers is shown in Exhibit1.

Exhibit 1 TSR, TBR and the Value Drivers

The TBR for a single holding period is computed as follows:

The TBR for a multiple holding period is measured using the conventional internal rate of return computation:

The beginning and ending values are estimates of the market values of the firm or business unit at the beginning and end of the period. They are estimated using one or more of the following:

  • Value = Earnings x P/E multiple
  • Value = Book value x M/B multiple
  • Value = Free cash flow ÷ cost of capital
  • Value = NPV of expected cash flow

BCG calculates TBR using a time fade model which assumes that a firm’s return on invested capital and its growth rate will fade over time toward a national average due to competitive pressures. Bartley Madden of HOLT Value Associates explains as follows: “When businesses succeed in achieving above-average returns, competitors are attracted by above-average returns and try to serve the customer ever more effectively. create value.

Strategic Planning

Strategic planning involves choosing strategies and plans that create value. Alternative strategies and plans must be evaluated in terms of their TBR. This is the only measure that accurately reflects the tradeoffs among profitability, growth, and cash flows, the three drivers of value.

Resource Allocation

In multi-business firms, resource allocation has a critical bearing on value creation. Resource allocation decisions should be based on the track record of various businesses and the promise of their strategic plans. BCG employs a perspective, depicted in Exhibit 2, to guide resource allocation decisions.

Exhibit 2 Resource Allocation Perspective

Incentive Compensation

A well-founded incentive compensation system aligns the interest of managers with that of shareholders and promotes value creation. The TBR measure can be used for incentive compensation in two ways. First, TBR can be used as a comprehensive measure of value creation over a multi-year horizon (three to five years). Second, TBR can be employed as the basis for setting annual targets for traditional performance measures.

Cash Flow Return on Investment (CFROI)

The TBR incorporates the returns (CFROIs) both for the assets in place and the assets to be created. Thus CFROI has an important bearing on TBR.

What is CFROI and how is it measured? BCG defines CFROI as “the sustainable cash flow a business generates in a given year as a percentage of the cash invested in the firm’s assets”. Sustainable cash flow is gross cash flow less economic depreciation. Thus,

Note that economic depreciation is the amount of annual sinking fund payment earning cost of capital required to replace assets12.

To illustrate the calculation of CFROI, let us consider an example. A new plant entails an initial investment of 300,000, 250,000 toward fixed assets and the balance toward net working capital. The plant has an economic life of 14 years.

At the end of 14 years, fixed assets will fetch nothing but net working capital will be recovered in full. The annual depreciation charge on fixed assets will be 250,000/14 = 17,857. The plant is expected to produce a NOPAT of 21,080 each year. The cost of capital is 10 percent. It will cost 250,000 to replace the fixed assets.

Exhibit 3 shows the CFROI of the project for three sample years, assuming that the actual performance is in line with forecast performance. It also shows two other return measures popularly used, viz.:

Exhibit 3 Annual Measurement of the Project in Three Sample Years

How accurate are the various measures of return? To judge the accuracy of these measures, they may be compared with the internal rate of return (IRR), the measure most commonly employed to assess investment projects. The IRR for the project is the value of r in the following equation.

r works out to 10 percent.

Comparing the three measures with IRR we find that:

  • ROCE understates IRR in the initial years and overstates IRR in the later years. ROCE shows a rising trend over time, though the project is a constant cost-ofcapital performer.
  • Unlike ROCE, ROGI does not show a rising trend. However, it has a constant upward bias of about 3 percent as it does not take into account what must be withheld to replace the asset at the end of its economic life.
  • • CFROI equals IRR throughout. It takes into account the replacement need and provides the correct signal each year.

Cash Value Added (CVA)

The CFROI is the key metric used by BCG for measuring performance and valuing a company. However, BCG has also developed a measure of economic profit: cash value added (CVA). BCG claims that CVA is superior to EVA because it removes the accounting distortion that may bias EVA.

CVA is measured as operating cash flow less economic depreciation less a capital charge on gross investment. Thus,

CVA= Operating Cash Flow - Economic Depreciation – Capital Charge on Investment

Exhibit 4 shows the EVA and CVA for the new plant example.

Looking at Exhibit 4 we find that while EVA rises over time—from minus 8,920 for year 1 to plus 10,723 for year 12—CVA is zero for each year and this reflects properly the economic performance of the plant. Remember that this plant earns a rate of return that just equals the cost of capital. Hence it neither generates value nor destroys value.

Exhibit 4 EVA and CVA Calculation



Wall Street spews out acronyms prolifically. Its acronymic output ranges all the way from ABS and ARMs; CARDS and DECS; CBOs, CDS, CLOs, CMBS, and CMOs; EIAs; ETFs, HLTs; IPOs; LBOs, MBOs, and BIMBOs; MBS; PERCs; PINEs, PIPEs; REMICs; RIBS; SAMs; SPACs; SPARQS; STRYPES and TANS; ELKs, LYONs, PRIDEs, TIGRs, STEERS, and ZEBRAs; to NINAs, NINJAs, and so on.

Jason Zweig calls these Wall Street acronyms “WACronyms,” because they sound innocuous although many of them are full of wacky complications and hidden risks. A WACronym is a sign that someone is trying to sweet- talk you into buying something that is not suitable for you. Using a cute shorthand name, Wall Street marketers are exploiting a quick of the human mind called “fluency” – we find familiar or easily processed ideas more appealing than unusual or cumbersome ones.

No wonder Wall Street peddles ‘CMOs” instead of collateralized mortgage obligations (an intimidating 11- syllable mouthful), “HTLs” instead of highly leveraged transactions, “SPACs” instead of special purpose acquisition companies, and so on. Says Jason Zweig “In fact, investment bankers put a great deal of energy and effort into coming up with product names that can somehow be reduced to a catchy WACronym- because Wall Street knows that a fluent name automatically makes investors more comfortable with risks they don’t understand.”

Fluency applies to stock tickers as well as company names. Stocks with tickers (the trading symbols that serve as shorthand for identifying the shares) that are readily pronounceable or evoke positive images (such as CASH, LUV, or BUD) outperform with clumsy, meaningful tickers like VXM or DHZ, at least in the short run.

In August 2006, when Harley- Davidson, Inc, changed its stock ticker from HDI to HOG (motorcyclists have for a long time nicknamed Harleys as “hogs”), Harley’s stock gained 5 percent in two days.

Guard yourself against catchy WACronyms. Listen to the advice of Jason Zweig: “Being on your guard is as easy as ABC: Always Be cautious. Ask what the WACronym stands for. If you can neither pronounce nor understand the abbreviated terms, don’t invest in it.”

2. Creating a Flexible Financial Model

To survive and even rejuvenate in a downturn a company requires a flexible financial framework. According to Marti Subrahmanyam, the key determinants of financial flexibility are:

  • Low operating leverage
  • Low financial leverage
  • High liquidity
  • High operating margin
  • High agility in augmenting revenues
  • Total transparency in financial transactions

While all of these factors may not be completely within the control of a company, corporate managers enjoy considerable latitude in structuring their business to enhance flexibility in each of these domains.

3. Slow Adoption of Real Options

In a 2002 survey of 205 Fortune 1,000 CFOs Dr Patricia A. Ryan found that real option analysis was trailing a field of 13 ‘Supplementary Capital Budgeting Tools.” As compared to 85.1% for sensitivity analysis and 66.8% for scenario analysis, only 11.4% of the respondents said that they used real option analysis. As far as the ‘Basic capital Budgeting Tools” are concerned, NPV topped the list with 96%. Champions of real option analysis who have touted it as the most important new development in capital budgeting in decades may find this sobering. Says Alexander J. Trantis, “It took decades for NPV to become widely accepted in practice. Real options is an even more sophisticated tool. It’s going to take a few decades as well to be well integrated in corporations.”

Here are some obstacles to the use of real option analysis:

  • Unlike financial options, most real options do not expire at a specific date. So managers are not likely to exercise the ‘abandonment option’ when they should.
  • Projects assume a life of their own. So, it is not easy to terminate them.
  • There is a love for the ideation of new projects. People are excited by all the options they are creating.
  • A manager is not likely to exercise growth option if he is being compensated for keeping costs down.

Until we tackle these sorts of organisational process and governance issues, real option analysis will face obstacles.



  • A management trainee joins a big company. On the first day of work, he dials the pantry and says “Get me a tea, immediately. ”The person receiving the call shouts at him, “You fool, you have dialled the wrong number. Do you know who you’re talking to.” “No,” says the trainee. “It is the CEO of the company, you idiot!” Enraged, the trainee shouts back, “And do you know who you are talking to, you rascal?” “No,” replied the CEO angrily. “Thank God,” replied the trainee, and terminated the call.
  • An over- sized man approached the ticket counter at Southwest Airlines and asked for a reservation from Miami to New York. Since the plane was already filled with baggage and passengers, the clerk asked him “What is your weight, sir?” The passenger asked, “With or without clothes.” The clerk said, “How do you intend to travel, Sir?”


  • The only adequate way to endure large evils is to find large consolations. :Russell.
  • Passions, prejudices, fears, neuroses, spring from ignorance and take the form of myths and illusions. :Isaiah Berlin.