Judging Success in the New Economy

Automotive Industries,  April, 2000  by David Andrea

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We are ingrained with report cards from grade school. Every six weeks, semester, or year, we receive a scorecard as to how we have performed against the standards of penmanship, scientific understanding, and corporate budgets. Feedback is important to identify areas of weakness, encourage advancement, and promote common objectives. However, measuring and rewarding the wrong criteria results in the wrong outcomes. The auto industry, in its pursuit of respect, may be the victim of running after the wrong measures.

One measure of success -- the ever-popular stock price to earnings (p/e) ratio -- is one such measure that may be taking on a wide range of inconsistencies and inaccuracies. The numerator (the stock price) is set by what is typically seen as an efficient, although sometimes irrational, network of buyers and sellers. The big institutional players, according to surveys by Merrill Lynch, are typically influenced to buy or sell based on earnings surprises, returns on equity, analysts' earnings revisions, price-to-cash-flow ratios, and earnings momentum. The denominator (earnings per share) is the result of an equally complex chain of accounting rules, interpretations, and communication.

Baruch Lev, the Philip Bardes Professor of Accounting and Finance at the Leonard N. Stem School of Business at New York University, has been malting a case that the "new economy" requires a new set of accounting standards to accurately reflect the increasing levels of intellectual and other intangible property that companies control. The precise point that Professor Lev makes -- that innovative activities, the very root of future earnings, are "mostly in the form of investment in intangible assets, such as R&D, information technology, brands, and human resources" -- leaves the auto industry in a major predicament. The dot-coms are forcing Wall Street analysts to rationalize and hypothesize methods for valuing the future earnings potential of intangible assets. GM, Ford and DaimlerChrysler are in the process of restructuring their physical and perceived balance sheets away from tangible assets to intangible assets such as their joint internet activity, GM's Hughes, and Ford's Customer Service Group. However, with a strong track record of earnings based on tangible assets and a limited track record -- so to speak -- of intangible asset earnings' potential, the auto industry is locked into the traditional financial performance evaluations that do not allow rewards for unrealized gains.

The three-year track record of dotcoms' p/e ratios is not likely to become a 20-year year track record. But it is obvious that for the autos to sell at better than 30 percent of the overall market, a new performance criteria -- from individual projects to strategic business units and corporations -- must be derived. Work by Professor Lev is part of this. Another part of the equation might be to apply a financial option-like evaluation (like those used in commodities or currency futures markets) to projects with uncertain payouts. Using such an evaluation technique, project teams may better incorporate cash flow timing uncertainty and general business risk that are associated with the introduction of new product and infrastructure technologies.

It is becoming increasingly clear that emerging technologies such as fuel cells or e-commerce offer new revenue streams and cost structures, but do not lend themselves well to traditional discounted cashflow models. Until the automakers, suppliers, and their analysts move to experiment and implement a wider range of performance evaluation techniques, the auto industry's efforts to introduce new product and process technologies will not be justly rewarded.

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THE INSIDE LINE

Corner Module Suppliers Gain Momentum

The North American corner module market will double over the next two years, amounting to roughly 30 percent of all brakes being delivered as part of a module for the 2002 model year. Key players and their customers are: Delphi (GM), TRW (VW, Ford, DCX, GM), Continental Teves (Ford, BMW), and Bosch (Ford).

-- David Andrea
Chief Economist
CSM Worldwide, Inc.
Northville, MI

DavidAndrea@csmauto.com

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