Death by tools and metrics #1: DCF and EPS ~ Brand Mix

Monday, January 7, 2008

Death by tools and metrics #1: DCF and EPS

2007 was the year of the death of the CMO articles and blog postings. (Here's just one that refers to the frequently quoted Spencer Stuart survey on their short life expectancy.) These days, more than ever, marketing executives need tools and metrics to help them decide what to do and to demonstrate the success of what they chose to do.

But, watch out. These tools can be dangerous. Some are so alluring that you may fall in love with them and forget their inherent flaws. Others so blunt and powerful that they can kill strategically sound business initiatives. First in what will be an occasional series: DCF and EPS or Discounted Cash Flow and Earnings per Share, if you prefer English. Both of these metrics stand accused of major crimes against innovation.

Clayton Christensen, in a recent Harvard Business Review article (subscription required), shows how the misguided application of DCF and EPS can kill innovation. The problem isn't the tools themselves, just how they are used.

For DCF, one of the problems he describes is that projected cash flows of innovations are compared to how well off a company is today, assuming that a company that does nothing will thrive forever. But we all know that, in reality, if you stand still for too long your competitors are going to catch up with you and run you down. The right comparison should be between the DCF of an innovation vs. the accelerating decline of a company if it doesn't do anything. A much more difficult analysis but a much more realistic approach.

The problem with EPS is simpler to explain. Executives who focus on share price (which is driven by EPS) are going to be reluctant to invest in innovations that have long term benefits but don't pay off immediately. As Christensen points out, senior executive compensation is now heavily weighted towards share price improvement making it more difficult to get the green light for innovation projects.

That's the risk of incentives. They are powerful motivators, effective in changing behavior but they can lead to a single-minded focus on the measures being rewarded at the expense of everything else. It's a game where smart and competitive managers figure out how to win based on the rules set by the incentives program. With EPS, it's a game where innovation has been the unwitting victim.

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