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Manage Your Bank for Value

The increasing emphasis on shareholder returns in global financial markets presents enormous challengesand great opportunitiesfor financial institutions. As if to underline this, energetic newcomers to banking and securitiessuch as MBNA and E-Trade in the United States and Consors in Germanyare threatening incumbent banking giants, revolutionizing existing financial businesses, and generating some of the industrys best returns. But a few established players, such as Lloyds TS B and Bank of New York, are achieving returns that outstrip those of both their banking peers and some successful newcomers. Executives at such institutions see themselves as shareholder value managersthat is, they think and act more like investors than traditional managers do and they rigorously pursue strategies that build shareholder value. The best approach to shareholder value management uses a suite of economic measures to track the true performance and prospects of both the businesses in a companys portfolio and the company as a whole. (By true performance we mean the performance that affects shareholder value.) Instead of tracking earnings, these measures focus on the underlying cash flows that a business generates and the equity investment needed to achieve them. The measures directly relate the return on risk-based capital to the cost of capital, allowing management to see clearly how much value a particular business is creating and how much more it may generate. This helps managers identify the growth opportunities and the potential turnarounds that can produce the highest shareholder returns, as well as the unpromising businesses that it might be best to exit.

Banks such as Lloyds TSB and Bank of New York are exceptional in their rigorous pursuit of shareholder value. Lloyds even has an explicit commitment to double its share price every three years. Other banks, including Chase Manhattan and Deutsche Bank, have embraced this approach, too. Since its merger with Chemical Bank, Chase has increasingly used value measures to assess the performance of its various businesses, and it now even includes those data in its annual report to shareholders. As more and more banks adopt this approach, the pressure will mount on others to follow suit. Institutional investors increasingly scan the world for the best investment opportunities. This means that the major banks are having to compete for the same investment dollar. That effect is amplified in continental Europe, where the new common currency is rapidly creating a unified investment market. Financial institutions everywhere have to look beyond national borders and compare themselves with their regional and global peers. (See the chart Ranking Returns to Shareholders.) Those firms that can attain a position in the top tierand then sustain itwill be able to command a better price for their shares: a powerful currency for acquisitions in a consolidating industry. A high and rising stock price will also give them the edge in attracting and retaining the best executives. Success, however, is all too often temporary; staying at the top is very difficult even for the best companies. The Tools for Building Superior Value Most banking leaders still manage by traditional measuressuch as earnings per share and riskadjusted return on capital. But, because they are relatively static, these measures are not the best ones for tracking a companys success in improving shareholder value. They overlook changes in

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Ranking Returns to Shareholders

Average Annual Total Shareholder Return (December 1993December 1998)

Number of companies1
600

Charles Schwab (64.7) Bank of New York (45.6) MBNA (44.2) Lloyds TSB (39.0) American Express (32.9) Chase (32.7) Citigroup (32.7) Wells Fargo (30.1) Morgan Stanley (28.8) Merrill Lynch (28.2)
First quartile = 26.1%

and the external market in order to bridge the two effectively. This suite of internal value-based measures should include total business return, added value on equity, delta added value on equity, and operating cash flow. (See the Guide to Value-Based Measures at the end of this article.) Such measures allow for a simulation of an internal capital market that compares the current and prospective performance of each and every business in a companys portfolio. The firms management can then fashion and monitor the implementation of customized solutions for its individual businessespromoting growth, cutting costs, and reallocating capital when appropriate in order to achieve the overall goal of generating superior returns to shareholders.
120

500

400

Bayerische Hypound Vereinsbank (22.1) ING Groep (18.5)

Second quartile = 17.7%

ANZ (23.6) Bank of America (23.2) ABN-Amro (22.3) Standard Chartered Bank (20.5) PNC (18.2)

300 BankOne (15.7) HSBC (13.6) J.P. Morgan (13.0) 200

Third quartile = 6.7%

100

Mitsubishi Trust (8.9)

Bankers Trust (7.0) Socit Gnrale (6.6) Deutsche Bank (5.2) Sumitomo Bank (9.4)

0 80

60

40

20

20

40

60

80

100

Average annual total shareholder return (%)

Covers 652 nancial services companies listed in the Compustat database for which there are ve years of data. (Insurance companies are excluded.) SOURCES: Compustat data and BCG analysis.

value and underestimate the value created for shareholders when managers turn around, improve, and grow businesses. Total shareholder return, which is the annual percentage return to common shareholders from investing in a companys shares, is the true measure of a companys success in creating value for shareholders. Because macroeconomic factors affect the share prices of all companies, actual total shareholder returns should be calculated relative to a market index or a group of peers. In addition to such external measures, managers need internal ones that gauge their success in building the value of specific businesses and help them assess the value their strategic actions are likely to produce. They must be able to understand the relationship between these measures

The Boston Consulting Group has developed a valuation model that allows companies to simulate the external market value of their various business units and the effects that their proposed business plans may have on those values. A large U.S. commercial bank recently used this model to gain a better understanding of the true economic performance of its mortgage and credit card businesses. Although the two businesses produced returns below the cost of capital, the rapid rate of improvement in their profitability created significant shareholder value. Similarly, one midsize European commercial bank discovered that its treasury division was earning only a mediocre return that barely matched the cost of the $1.6 billion the bank had committed to the division. Traditional accounting measures for operating profits implied that the business was highly profitable. But after deducting its capital costs, the bank gradually realizeddespite the initial protests of the manager in chargethat the division was in fact making little or no economic profit. That insight persuaded the bank to securitize and sell off many 2

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treasury assets, freeing up capital for investment in more productive parts of its business and improving the returns of its treasury. Using this approach, one of Europes biggest banks determined that its corporate customer business had much greater potential for creating value than its asset management unit. Even though the corporate customer business was not making very much money, the analysis revealed that the bank could quickly turn it into a solid profit producer by reallocating capital to its cash management division. The bank is now also using value-based measures in the accounting systems that line managers use to run their businesses. Implementing Value Management Banks should adopt certain fundamental approaches as they set out to build their strategies for shareholder value management. They should compare their total shareholder returns regularly with those of their peers, including the successful newcomers to their businesses. They should also be explicit about their value-creation targets. They should implement value management step by step. First, they should perform a value audit to determine which businesses have the potential to create value. Then they should weigh the conclusions against other strategic considerations and decide which businesses to build, which to try to turn around, and which to downplay or sell. Finally, they should analyze and break down the various drivers of value so that line management knows what to focus on in order to meet the rms value-creation objectives. They should ensure that everyone in the organization understands his or her role in the value-creation strategy. That requires driving

the measures down through the organization and involving everyone in the effort to build shareholder value. Top-level managers should commission audits to discover what creates and what destroys value in each of the rms individual businesses. They should tie managers incentives to the value-based measures linked to the economic performance of both individual business units and the company as a whole. They should use the insights that value-based measures provide to nd and exploit promising opportunities in both new and traditional businesses. Shareholder value management will help banks and securities firms meet the challenges of the increasingly competitive global financial market. With strategies grounded in the principles of value management, they will be better able to achieve and maintain a leadership position and they will earn richer returns for their shareholders. Geoffrey Nicholson Hans Weiss Daniel Stelter Geoffrey Nicholson is a vice president in the New York office of The Boston Consulting Group. He can be contacted at nicholson.geoff@bcg.com. Hans Weiss is a vice president in the firms Munich office. He can be contacted at weiss.hans@bcg.com. Daniel Stelter is also a vice presi-dent in BCGs Munich office. He can be contacted at stelter.daniel@bcg.com.
The Boston Consulting Group, Inc. 1999

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Guide to Value-Based Measures Added value on equity (AVE) measures earnings that exceed the cost of capital. AVE is calculated by multiplying the difference between the return on equity and the cost of equity capital by the equity capital employed. AVE convergence valuation models simulate the market value of businesses as if the businesses were traded separately on a stock exchange. The valuation methodology relies on empirical and theoretical findings that show that returns and growth converge to long-term averages over time. The models are used for calculating total business return. Delta added value on equity (DAVE) is the change in AVE over a certain time period and is an internal measure for value creation. DAVE, which is closely correlated to relative total shareholder return, considers value creation through

change in profitability and through growth of the business. It can be used to set value targets for individual businesses. Total business return (TBR) is an internal measure for evaluating the actual or planned value creation of a business unit. TBR, which is analogous to total shareholder return, measures changes in the simulated market value of a business unit and in its free cash flow. Total shareholder return (TSR) is the annual percentage return to common shareholders from investing in a companys shares. Relative total shareholder return (RTSR) is the return shareholders earn from investing in a companys shares, relative to the return earned from an investment in a relevant benchmark index.

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