Do not manage earnings or provide earnings guidance.

What’s so bad about focusing on earnings? First, the accountant’s bottom line approximates neither a company’s value nor its change in value over the reporting period. Second, organizations compromise value when they invest at rates below the cost of capital (overinvestment) or forgo investment in value-creating opportunities (underinvestment) in an attempt to boost short-term earnings.

Third, the practice of reporting rosy earnings via value-destroying operating decisions or by stretching permissible accounting to the limit eventually catches up with companies. Those that can no longer meet investor expectations end up destroying a substantial portion, if not all, of their market value. WorldCom, Enron, and Nortel Networks are notable examples.

Make strategic decisions that maximize expected value, even at the expense of lowering near-term earnings.

Companies that manage earnings are almost bound to break this second cardinal principle. Indeed, most companies evaluate and compare strategic decisions in terms of the estimated impact on reported earnings when they should be measuring against the expected incremental value of future cash flows instead. Expected value is the weighted average value for a range of plausible scenarios. (To calculate it, multiply the value added for each scenario by the probability that that scenario will materialize, then sum up the results.)

A sound strategic analysis by a company’s operating units should produce informed responses to three questions: First, how do alternative strategies affect value? Second, which strategy is most likely to create the greatest value? Third, for the selected strategy, how sensitive is the value of the most likely scenario to potential shifts in competitive dynamics and assumptions about technology life cycles, the regulatory environment, and other relevant variables?

Make acquisitions that maximize expected value, even at the expense of lowering near-term earnings.

Companies typically create most of their value through day-to-day operations, but a major acquisition can create or destroy value faster than any other corporate activity. With record levels of cash and relatively low debt levels, companies increasingly use mergers and acquisitions to improve their competitive position. Companies (even those that follow Principle 2 in other respects) and their investment bankers usually consider price/earnings multiples for comparable acquisitions and the immediate impact of earnings per share (EPS) to assess the attractiveness of a deal.

They view EPS accretion as good news and its dilution as bad news. When it comes to exchange-of-shares mergers, a narrow focus on EPS poses an additional problem on top of the normal shortcomings of earnings. Whenever the acquiring company’s price/earnings multiple is greater than the selling company’s multiple, EPS rises.

Carry only assets that maximize value.

The fourth principle takes value creation to a new level because it guides the choice of business model that value-conscious companies will adopt. There are two parts to this principle. First, value-oriented companies regularly monitor whether there are buyers willing to pay a meaningful premium over the estimated cash flow value to the company for its business units, brands, real estate, and other detachable assets.

Such an analysis is clearly a political minefield for businesses that are performing relatively well against projections or competitors but are clearly more valuable in the hands of others. Yet failure to exploit such opportunities can seriously compromise shareholder value.

Second, companies can reduce the capital they employ and increase value in two ways: by focusing on high value-added activities (such as research, design, and marketing) where they enjoy a comparative advantage and by outsourcing low value-added activities (like manufacturing) when these activities can be reliably performed by others at lower cost.

Return cash to shareholders when there are no credible value-creating opportunities to invest in the business.

Even companies that base their strategic decision making on sound value-creation principles can slip up when it comes to decisions about cash distribution. Value-conscious companies with large amounts of excess cash and only limited value-creating investment opportunities return the money to shareholders through dividends and share buybacks.

Not only does this give shareholders a chance to earn better returns elsewhere, but it also reduces the risk that management will use the excess cash to make value-destroying investments—in particular, ill-advised, overpriced acquisitions.

Just because a company engages in share buybacks, however, doesn’t mean that it abides by this principle. Many companies buy back shares purely to boost EPS, and, just as in the case of mergers and acquisitions, EPS accretion or dilution has nothing to do with whether or not a buyback makes economic sense.

When an immediate boost to EPS rather than value creation dictates share buyback decisions, the selling shareholders gain at the expense of the nontendering shareholders if overvalued shares are repurchased. Especially widespread are buyback programs that offset the EPS dilution from employee stock option programs. In those kinds of situations, employee option exercises, rather than valuation, determine the number of shares the company purchases and the prices it pays.

Reward CEOs and other senior executives for delivering superior long-term returns.

Companies need effective pay incentives at every level to maximize the potential for superior returns. Principles 6, 7, and 8 set out appropriate guidelines for top, middle, and lower management compensation. I’ll begin with senior executives. As I’ve already observed, stock options were once widely touted as evidence of a healthy value ethos. The standard option, however, is an imperfect vehicle for motivating long-term, value-maximizing behavior.

First, standard stock options reward performance well below superior-return levels. As became painfully evident in the 1990s, in a rising market, executives realize gains from any increase in share price—even one substantially below gains reaped by their competitors or the broad market.

Second, the typical vesting period of three or four years, coupled with executives’ propensity to cash out early, significantly diminishes the long-term motivation that options are intended to provide. Finally, when options are hopelessly underwater, they lose their ability to motivate at all.

And that happens more frequently than is generally believed. For example, about one-third of all options held by U. S. executives were below strike prices in 1999 at the height of the bull market. But the supposed remedies—increasing cash compensation, granting restricted stock or more options, or lowering the exercise price of existing options—are shareholder-unfriendly responses that rewrite the rules in midstream.

Reward operating-unit executives for adding superior multiyear value.

Even companies that base their strategic decision making on sound value-creation principles can slip up when it comes to decisions about cash distribution. Value-conscious companies with large amounts of excess cash and only limited value-creating investment opportunities return the money to shareholders through dividends and share buybacks.

Not only does this give shareholders a chance to earn better returns elsewhere, but it also reduces the risk that management will use the excess cash to make value-destroying investments—in particular, ill-advised, overpriced acquisitions. Just because a company engages in share buybacks, however, doesn’t mean that it abides by this principle. Many companies buy back shares purely to boost EPS, and, just as in the case of mergers and acquisitions, EPS accretion or dilution has nothing to do with whether or not a buyback makes economic sense.

When an immediate boost to EPS rather than value creation dictates share buyback decisions, the selling shareholders gain at the expense of the nontendering shareholders if overvalued shares are repurchased. Especially widespread are buyback programs that offset the EPS dilution from employee stock option programs. In those kinds of situations, employee option exercises, rather than valuation, determine the number of shares the company purchases and the prices it pays.

Reward middle managers and frontline employees for delivering superior performance on the key value drivers that they influence directly.

Although sales growth, operating margins, and capital expenditures are useful financial indicators for tracking operating-unit SVA, they are too broad to provide much day-to-day guidance for middle managers and frontline employees, who need to know what specific actions they should take to increase SVA.

For more specific measures, companies can develop leading indicators of value, which are quantifiable, easily communicated current accomplishments that frontline employees can influence directly and that significantly affect the long-term value of the business in a positive way. Examples might include time to market for new product launches, employee turnover rate, customer retention rate, and the timely opening of new stores or manufacturing facilities.

My own experience suggests that most businesses can focus on three to five leading indicators and capture an important part of their long-term value-creation potential. The process of identifying leading indicators can be challenging, but improving leading-indicator performance is the foundation for achieving superior SVA, which in turn serves to increase long-term shareholder returns.

For the most part, option grants have not successfully aligned the long-term interests of senior executives and shareholders because the former routinely cash out vested options. The ability to sell shares early may in fact motivate them to focus on near-term earnings results rather than on long-term value in order to boost the current stock price. To better align these interests, many companies have adopted stock ownership guidelines for senior management. Minimum ownership is usually expressed as a multiple of base salary, which is then converted to a specified number of shares.

For example, eBay’s guidelines require the CEO to own stock in the company equivalent to five times annual base salary. For other executives, the corresponding number is three times salary. Top managers are further required to retain a percentage of shares resulting from the exercise of stock options until they amass the stipulated number of shares.

But in most cases, stock ownership plans fail to expose executives to the same levels of risk that shareholders bear. One reason is that some companies forgive stock purchase loans when shares underperform, claiming that the arrangement no longer provides an incentive for top management. Such companies, just as those that reprice options, risk institutionalizing a pay delivery system that subverts the spirit and objectives of the incentive compensation program.

Provide investors with value-relevant information.

The final principle governs investor communications, such as a company’s financial reports. Better disclosure not only offers an antidote to short-term earnings obsession but also serves to lessen investor uncertainty and so potentially reduce the cost of capital and increase the share price. Although applying the ten principles will improve long-term prospects for many companies, a few will still experience problems if investors remain fixated on near-term earnings, because in certain situations a weak stock price can actually affect operating performance.

The risk is particularly acute for companies such as high-tech start-ups, which depend heavily on a healthy stock price to finance growth and send positive signals to employees, customers, and suppliers. When share prices are depressed, selling new shares either prohibitively dilutes current shareholders’ stakes or, in some cases, makes the company unattractive to prospective investors. As a consequence, management may have to defer or scrap its value-creating growth plans.

Then, as investors become aware of the situation, the stock price continues to slide, possibly leading to a takeover at a fire-sale price or to bankruptcy. Severely capital-constrained companies can also be vulnerable, especially if labor markets are tight, customers are few, or suppliers are particularly powerful. A low share price means that these organizations cannot offer credible prospects of large stock-option or restricted-stock gains, which makes it difficult to attract and retain the talent whose knowledge, ideas, and skills have increasingly become a dominant source of value.