1. © Vanguard Partners 2005 - All rights reserved. Copyright A Management Seminar The “Essence” of Value-Based Finance Presented by: Roy E. Johnson Vanguard Partners Ridgefield, Connecticut

2. © Vanguard Partners 2005 - All rights reserved. Copyright 2 Discussion Topics The “Essence” of Value-Based Finance (VBF) Page/s –Overview of VBF 3 – 6 –The “Accounting” Model 7 – 13 –Value “Indicators” 14 The “Economic” Model 15 – 17 Financial “Drivers” 18 – 21 –Value “Analysis” 22 Market Value Added (MVA) 23 The “Magnifier” Effect 24 – 28 –Allocating Resources – Based on “Value Creation” 29 – 31 –Summary 32

3. © Vanguard Partners 2005 - All rights reserved. Copyright 3 “Overview” of Value- Based Finance (VBF)

4. © Vanguard Partners 2005 - All rights reserved. Copyright 4 Overview Focused on financial performance, VBF is part of an overall corporate management system that needs to “balance” the value delivered to customers with economic performance. Therefore, Value-Based Finance (VBF) needs to “fit” within the strategic direction, level of financial sophistication and cultural environment of the corporation. Value-Based Finance (VBF) is a system to help management deliver value to “shareholders”.

5. © Vanguard Partners 2005 - All rights reserved. Copyright 5 Business Strategy Business Strategy Investment and Operations Investment and Operations Workforce Engagement Workforce Engagement Performance Measurement Performance Measurement One way to view VBF is as a sub-system of a larger value-based management (VBM) system, integrating the needs of customers and shareholders. Overview

6. © Vanguard Partners 2005 - All rights reserved. Copyright 6 Strategy “Evaluation” Strategy “Evaluation” “Hardwiring” Strategy to Budgets “Hardwiring” Strategy to Budgets “Economic” Performance “Economic” Performance Financial “Drivers” Business Analysis “Alignment” … Managers to Shareholders “Alignment” … Managers to Shareholders “Value-Based” Metrics Corporate Goals Overview Within this framework, VBF coordinates key financial activities.

7. © Vanguard Partners 2005 - All rights reserved. Copyright 7 The “Accounting” Model

8. © Vanguard Partners 2005 - All rights reserved. Copyright 8 The “Accounting” Model “Base Period” CO. ‘A’ CO. ‘B’ CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Cost of Sales 200 500 800 Gross Profit- $ 800 500 200 - % 80% 50% 20% Most “accounting” analysis begins with a determination of “Gross Profit”. This analysis indicates major differences in the relationship of selling price(s) to product cost(s) among the three companies.

9. © Vanguard Partners 2005 - All rights reserved. Copyright 9 “Base Period” CO. ‘A’ CO. ‘B’ CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Cost of Sales 200 500 800 Gross Profit 800 500 200 Operating Expenses 650 350 50 Operating Profit 150 150 150 Taxes @ 33% 50 50 50 Net Profit - $ $100 $100 $100 - % 10% 10% 10% Most “accounting” analysis ends with a determination of “Net Profit”. Factoring in Operating Expenses essentially completes the analysis. The “Accounting” Model

10. © Vanguard Partners 2005 - All rights reserved. Copyright 10 “Base Period” CO. ‘A’ CO. ‘B’ CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Net Operating Profit [NOP] - $ $100 $100 $100 - % 10% 10% 10% The Accounting (“Earnings”) model stops here. In this case, all companies are the same... and, all are “profitable”. The “accounting” analysis can be summarized as follows: The “Accounting” Model

11. © Vanguard Partners 2005 - All rights reserved. Copyright 11 Correlation of EPS to Market Value 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 Market Value / Invested Capital 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 EPS Growth K RAH OAT MCCRK SLE HNZ RAL CPC CAG TYSNANA HSY CPB GIS MSTR R 2 = 1% Source: Credit Suisse/First Boston The “Accounting” model does not do a good job, however, of explaining “Value”. The “Accounting” Model

12. © Vanguard Partners 2005 - All rights reserved. Copyright 12 Average Market Multiples – S&P Industrials 0.7 1.1 2.1 2.2 4.2 0.9 1.1 1.5 1.5 2.5 1.0 0.9 1.2 1.7 3.2 0.7 0.9 1.2 1.7 3.1 0.7 1.0 1.0 1.4 2.2 0.9 1.1 1.1 1.2 1.6 >-4% -4 to –2% -2 to 2% 2 to 4% >4% Return on Investment “Spread” … ROI less Cost of Capital Revenue CGR - % >16% 12 to 16% 8 to 12% 4 to 8% 1 to 4% > 1% Revenue Growth, ROI Spreads and Market Multiples Source: Hewitt Associates …And, revenue growth alone does not create shareholder value. There must be a “return on capital”. The “Accounting” Model

13. © Vanguard Partners 2005 - All rights reserved. Copyright 13 Why? From a financial perspective: u Accounting was not created to do value analysis … rather, its origins are in “credit” and “liquidation” analysis. u A true measure of value creation must factor in “risk” and “return” – which accounting does not do. Thus, two critical elements are missing in the “accounting” model. u Two key concepts that are critical in the understanding of “value creation” for investors will be explored, namely: F Economic Profit, and F Market Value Added. The “Accounting” Model

14. © Vanguard Partners 2005 - All rights reserved. Copyright 14 Value “Indicators”

15. © Vanguard Partners 2005 - All rights reserved. Copyright 15 “Base Period” CO. ‘A’ CO. ‘B’ CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Net Operating Profit [NOP] - $ $100 $100 $100 - % 10% 10% 10% -------------------------------------------------------------------------------------- Invested Capital [IC] $600 $800 $1,000 Cost of Capital [CCAP] 12% 12% 12% -------------------------------------------------------------------------------------- The “Economic Profit” model introduces the concept of Capital required to produce the “Accounting Profit” and the Cost of this capital. We begin to see that all the companies are not the same. Value “Indicators” – Economic Profit

16. © Vanguard Partners 2005 - All rights reserved. Copyright 16 “Base Period” CO. ‘A’ CO. ‘B’ CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Net Operating Profit [NOP] - $ $100 $100 $100 - % 10% 10% 10% Invested Capital [IC] $600 $800 $1,000 Cost of Capital [CCAP] 12% 12% 12% -------------------------------------------------------------------------------------- Economic Profit NOP [from above] $100 $100 $100 Capital Charge [CCAP] (72) (96) (120) Economic Profit [“EP”] $ 28 $ 4 $ (20) Value “Indicators” – Economic Profit

17. © Vanguard Partners 2005 - All rights reserved. Copyright 17 We can restate “EP” as “ROC” by changing the formula within our framework. “Base Period” CO. ‘A’ CO. ‘B’ CO. ‘C’ Revenue [Sales] $1,000 $1,000 $1,000 Net Operating Profit [NOP] - $ $100 $100 $100 - % 10% 10% 10% Invested Capital [IC] $600 $800 $1,000 Cost of Capital [CCAP] 12% 12% 12% -------------------------------------------------------------------------------------- Economic Profit Net Oper. Profit [NOP] $100 $100 $100 Invested Capital [IC or C] 600 800 1,000 Return on Capital [“ROC”] ~17% ~12% 10% Value “Indicators” – Economic Profit

18. © Vanguard Partners 2005 - All rights reserved. Copyright 18 l Growth Rates l Invested Capital Intensity l Value Profit Margin These “drivers” provide a foundation for the Economic Profit and Market Value Added metrics, and give managers a simple, yet powerful, template for value creation. These support measures are also the ones to focus on when evaluating business strategies and major investment programs. Value “Indicators” – Financial “Drivers” There are three major support measures for management focus.

19. © Vanguard Partners 2005 - All rights reserved. Copyright 19 l Growth Rates u “Relationship” of Revenue, Operating Profit and Invested Capital Growth.... CGR’s l Invested Capital Intensity u How much Capital to Generate One Dollar ($1.00) of Revenue (Sales).... in total or incremental.... encompasses working and fixed capital l Value Profit Margin (VPM TM * ) u Minimum Profit Margin to Create Value for Shareholders (Owners) Value “Indicators” – Financial “Drivers” * VPM is a trademark of Vanguard Partners

20. © Vanguard Partners 2005 - All rights reserved. Copyright 20 l What is it? u A “minimum” profit margin... in essence, a beginning point for value creation u A pre and/or post tax financial performance benchmark l Why use it? u Allows for profitability comparisons for businesses of different size u Simple to calculate and easy to communicate... especially to operating managers u Provides managers with a threshold... generating a positive “spread” creates shareholder value u Effective for planning... strategies, acquisitions, investments u...And, provides an “earnings” measure linked to value. Value “Indicators” – Financial “Drivers” Value Profit Margin is a very useful support measure.

21. © Vanguard Partners 2005 - All rights reserved. Copyright 21 l How is VPM calculated ? u Pre Tax Basis -- multiply ‘ICI’ by ‘CCAP’... then, divide by ‘one minus the effective tax rate’ u After Tax Basis -- multiply ‘ICI’ by ‘CCAP’ l How is VPM calculated ? u Pre Tax Basis -- multiply ‘ICI’ by ‘CCAP’... then, divide by ‘one minus the effective tax rate’ u After Tax Basis -- multiply ‘ICI’ by ‘CCAP’ l Example -- assume Co. ‘A’: Revenue (Sales) = $1,000, IC = $600 [ICI = $.60] CCAP = 12%, and the effective tax rate = 30% u “VPM” -- Pre Tax Basis.60 x 12% = 7.2% / 70% = 10.3% u “VPM” -- After Tax Basis.60 x 12% = 7.2%... vs. Actual NOP = 10% (Example) Value “Indicators” – Financial “Drivers”

22. © Vanguard Partners 2005 - All rights reserved. Copyright 22 Value “Analysis”

23. © Vanguard Partners 2005 - All rights reserved. Copyright 23 Economic Profit (‘EP’) translates into Market Value Added (‘MVA’) – closely related to Shareholder Value Creation – through a future financial forecast or outlook. Business strategy should “drive” the assumptions and rationale of a future outlook. Assume the following assumptions for the ‘A’, ‘B’, ‘C’ Example: 1. All companies maintain same invested capital to revenue ratio. 2. All companies continue to earn same profit margin on revenue. 3. All companies increase revenue by 10% per year … for 4 years. The implications of these assumptions and the future outlook’s “value” is dramatic, depending on whether a business is an ‘A’, ‘B’ or ‘C’. Value “Analysis” – Market Value Added

24. © Vanguard Partners 2005 - All rights reserved. Copyright 24 Company ‘A’ Invest capital in growth-oriented strategies / programs... with high return potential F “Go for Growth” -- instill growth as a driving force throughout the organization F Emphasize staying close to existing margins and capital intensity, with room for some deterioration if the opportunity is significant... Growth adds value -- “Bigger is Better” ! Value “Analysis” – the “Magnifier”

25. © Vanguard Partners 2005 - All rights reserved. Copyright 25 % Growth (Sales) $ “MVA” (Discounted) 20%10%15%5% $400 $300 $200 $100 $0 ILLUSTRATION For Co. “A” -- More growth adds more value ! $256 $301 $351 $408 $233 0% +10% +MVA %.... (Cumul.) +29% +51% +75% Value “Analysis” – the “Magnifier”

26. © Vanguard Partners 2005 - All rights reserved. Copyright 26 Company ‘B’ Earn more operating profit with the same capital F Squeeze additional profit from existing capital base.... Selective pricing and/or cost cutting F Emphasize margin improvement... Growth is secondary -- adds minimal value ! Value “Analysis” – the “Magnifier”

27. © Vanguard Partners 2005 - All rights reserved. Copyright 27 Company ‘C’ l Reduce the level of capital employed F Streamline / re-engineer / re-structure operations F Validate capital invested in major lines of business... Growth ‘destroys’ value ! Value “Analysis” – the “Magnifier”

28. © Vanguard Partners 2005 - All rights reserved. Copyright 28 For Co. “C” -- More growth destroys more value ! % Growth $ Value - “MVA” (Discounted) 20% 10% 15% 5% -$300 -$225 -$ 75 -$150 0 ILLUSTRATION - Sales / Earnings -$183 -$215 -$251 -$291 -$167 -10% -29% -51% -75% Value “Analysis” – the “Magnifier”

29. © Vanguard Partners 2005 - All rights reserved. Copyright 29 Allocating Resources – Based on “Value Creation”

30. © Vanguard Partners 2005 - All rights reserved. Copyright 30 The “value-based” approach takes corporate and business unit evaluations to a new level. Assume a hypothetical company with four business units. “Market” Values $70 $60 $50 $40 $30 $20 $10 -0- BU #1BU #2BU #3BU #4Total Co. ‘Total’ Value ‘Strategy’ Value ‘No Growth’ Value $15 $5 $20 $5 $15 $20 $5 $10 $15 $10 $15 $5 $35 $70 Per Share Values Allocating Resources based on “Value” “Strategy” Values can be determined for the Business Units, and should be the basis for making investment decisions.

31. © Vanguard Partners 2005 - All rights reserved. Copyright 31 Market Value / Cash Flow $70 $60 $50 $40 $30 $20 $10 -0- BU #1BU #2BU #3BU #4Total Co. $15 $5 $20 $5 $15 $20 $5 $10 $15 $10 $15 $5 $35 $70 Per Share Values Negative Cash Flow Positive Cash Flow Allocating Resources based on “Value” When “market values” and “cash flows” are integrated, corporate and business unit analysis is completed.

32. © Vanguard Partners 2005 - All rights reserved. Copyright 32 Growth “magnifies” value creation (positively or negatively) depending on whether economic returns are above or below the cost of capital. Economic Profit translates into Market Value Added through a future outlook, providing a mechanism for valuing strategy and allocating resources. The “economic” profit approach and supporting financial “drivers” provide a template to assess progress toward shareholder value goals. Operating managers can “drive” value creation by focusing on three key financial indicators: u The relationship of revenue, profit and invested capital growth u The amount of capital needed to generate one dollar of revenue u Margins (before and/or after tax) above a minimum level required for value enhancement. “Economic” Profit incorporates income statement performance, balance sheet investments and a capital cost, making it more robust than “Accounting” Profit. Summary: The “Essence” of VBF Resource allocation decisions should be based on “strategy value”.