ROI approaches in HR have been unsophisticated and largely irrelevant to the needs of top executives and shareholders. The fundamental problem with ROI measures in HR is they are based on the assumption that HR projects should show a positive “return” in financial terms. This reveals a lack of awareness of what sorts of measures are used for other areas of the corporation. The most important strategic initiatives in a corporation are evaluated on their likely impact on the change in valuation of the corporation.
For short-term projects that are not viewed as having a strategic impact, it is true that a straight project-based measure such as cost benefit might be used. But as experienced businesspeople are aware, such short-term measures usually are irrelevant for major initiatives that are designed to make the corporation more valuable in a material way.
ROI approaches are based on cost-reduction and project-benefit methods. These approaches, however, do not address what would occur if a positive ROI did not bring about a positive change in company valuation, nor do they consider how a negative ROI should be viewed if its impact on company valuation were positive.
These are not academic issues. In any corporation, the ROI on any major initiative in product development or marketing and sales ultimately will be judged by its impact on future valuation, not whether it might make a profit (and it usually will not). Does a $10 billion corporation really care that the ROI on a training project was 15 percent positive or negative? What CEOs really want to know is whether the training project will contribute to achieving the valuation goals the board has set and the shareholders’ desire based on their investment hurdles.
Linked to this is the misguided concept that HR projects should be “profitable” in the sense that they result in a positive return defined in short-term financial terms. The true test of HR projects’ impact is that they contribute to the achievement of corporate valuation objectives, even if the projects themselves should show a negative return in both the short and long term.
The fundamental problem is ROI measures, project-based as they usually are, present a worm’s-eye view of the problem, not a shareholder’s view. HR is inappropriately applying project-based management methods to initiatives that require program-based measures. Once we change our perspective to a valuation-program view, measurement issues become much clearer.
Valuation: The Fundamental Goal of HR
It is well-understood that the process of evaluating return for HR, as for any initiative, should be linked with what the goals of the project were in the first place. Within HR there is much discussion about satisfying numerous stakeholders. These include employees and citizens (e.g. for social and environmental goals), as well as shareholders. For most boards and CEOs, however, there is one overriding goal, and that is shareholder value.
Valuation is the only measurement that a shareholder ultimately understands. If the ROI on every project that HR ever undertook were positive, and valuation and earnings per share declined, then the shareholder is worse off and will evaluate these HR programs as having failed. These same measures of valuation also ultimately will be the only ones that have real relevance and meaning to the CEO and the board.
If shareholder value declines and is reflected in lower earnings per share (EPS), then no matter what the view of other stakeholders, the shareholder will have less money in his or her pocket. In that case the CEO and management team almost certainly will lose their jobs not to mention top HR people. The company will decline in value relative to its competitors, it will lose market share, and it might even fail or be acquired in a distress sale.
HR needs to realize its mission is the building of shareholder value. This means increasing the valuation of the company on both an absolute and a share-adjusted basis. Once this is understood, it can start to build approaches and measure to evaluate ROI of HR initiatives, which is known as the valuation ROI approach.
Instead of implementing what are often irrelevant, project-based ROI measures, HR needs to adopt valuation ROI approaches, so that it will be seen as relevant to shareholder and valuation requirements.
The conventional methods of company valuation can be used to judge HR initiatives’ ROI. These include market capitalization, return on assets, price to earnings, price to sales and earnings per share. It does not matter in principle which one is used. The precise measure will depend on the type of HR initiative being evaluated, how well you can establish the linkage between the two and the sorts of data that are available.
But how do you evaluate HR programs that do not have a positive financial impact in the short term but bring about positive changes in valuation as measured by measures such as market capitalization?
In this context you might also consider and reject the conventional HR approach to profitability. The debate on ROI now often is seen as attempting to increase profitability in order to increase company value, which might or might not be a correct assumption.
High company profitability might be associated with a decreasing valuation. This occurs frequently in large companies with commodity products within mature markets, where high profitability is accompanied by ever-declining valuations, absolutely and relative to competitors. Essentially, the company is choosing short-term profitability at the expense of longer-term valuation improvement.
In such an environment HR needs to understand what the company really is trying to achieve and adjust its initiatives and ROI approaches to incorporate the enterprise’s valuation objectives. This might — or might not, according to the circumstances — imply that many HR initiatives might need to have negative short-term returns, that is, a negative ROI, in order to achieve the longer-term valuation increases that will herald a return to longer-term financial health. This is a strategic issue that needs to be decided at strategic levels not as a project-based ROI discussion.
An HR program that has a short-term negative ROI in project terms but brings about positive changes in market capitalization and earnings per share in the medium- and longer-term has a positive valuation ROI. For example, if market capitalization increased by $500 million, yet the short-term ROI — as measured in traditional terms — was negative (the program’s costs exceeded financial benefits by, say, 100 percent with total costs of $6 million and a net deficit of $3 million), it is highly positive, if you take into account its impact on valuation. In fact the valuation ROI here has a positive multiple of almost more than 100.
Some might object that using valuation ROI is applicable only to public companies. This, of course, is not true. Any company has a value, whether or not it is reflected in a public stock price. Private companies have their own, well-established (but not foolproof, just as with a public company) ways to measure their own value and valuation and thus their own valuation ROI. HR in both public and private companies has a responsibility to understand how it affects the value of both types of company.
Linking Behavioral Change and Valuation
If HR’s goal for ROI is valuation improvement, how will it know when its initiatives bring about such a result because the valuation impact will take place some time after the behavioral impact? The conventional approach again would rely on a series of project-based cost-benefit analyses to extrapolate this to a valuation contribution such as using net financial contribution combined with a price-to-earnings multiple. This is a backward-looking measure, however, because it is based on an historical event that might not be sustained. What you really need is a forward-looking measure based on behavior. This provides you with predictive power.
Conceptually this approach is very attractive. But to be able to work and to be measured, it requires an underlying model that links the behavioral changes resulting from HR programs to be linked formally with financial performance and valuation outcomes.
Research has demonstrated that executives’ financial styles can be identified and measured. Financial styles lead to systematic biases in decision-making that result in predictable impacts on both an individual’s financial performance and outcome. This allows you to make inferences about the impact on company valuation of executive and management teams. The issue is how to identify and measure these styles in a useful way that can be used in practice.
This has led to the development of assessments that identify and measure managers’ financial styles and their financial performance and valuation impact on their organizations. These can be used to reveal to executives and managers the systematic and innate biases in their financial decision-making and, as the basis for developmental approaches, to help them improve. This provides a direct linkage among individual and team behavior, financial styles and company valuation outcome.
Financial impact improvement programs allow us to show executives and managers how their financial style affects the financial performance and valuation of their organization. Such programs can compare the valuation goals of the organizations with the financial styles and valuation impact of managers to reveal the extent to which the alignment needs to be improved to achieve the requisite positive impact on valuation. In this way you can link HR programs directly with valuation ROI.
The Limits to Using Valuation in ROI
Notwithstanding the above, judgments still will need to be exercised in determining the ROI of HR programs using the valuation ROI approach. Valuation change is a complex matter that involves numerous variables. Any change in valuation will be due to numerous factors. Identifying the impact of an HR program needs to identify these other factors and to assess how much is due to the HR program.
One of the best ways to measure this impact is through surveys of executives and managers who have undergone the program to improve their financial impact. Do not reject using traditional project-based ROI measures, providing they are used appropriately and in the correct circumstances. Project-based ROI measures can be used as an important component in a valuation ROI approach.
Intangible factors will, of course, still be important. In evaluating HR programs’ valuation ROI, we need to include their direct contribution to valuation increases and their impact in building the infrastructure for future improvements, which cannot be directly measured in the short or even the medium term through valuation ROI, just as they cannot with project-based ROI measures.
Measuring the ROI of HR programs is a complex issue, and the valuation ROI approach does not provide the ultimate answer. It achieves two goals, however, that are not recognized: It defines ROI in valuation terms, the most important measure for top management, boards and shareholders, and it provides a way of linking managerial behavior to financial outcomes.
The valuation ROI approach can become another important tool in conjunction with other ROI approaches to increase the contribution of HR to the value of the company and its human capital.
E. Ted Prince is author of “The Three Financial Styles of Very Successful Leaders.” He is the founder and CEO of the Perth Leadership Institute in Gainesville, Fla., and a visiting lecturer at the Warrington College of Business Administration in the University of Florida. He can be reached at firstname.lastname@example.org.Filed under: Measurement