Measuring human capital

Doug Ross and Steven Dicker show how key HR practices produce shareholder value.

Few companies actively ignore human capital management. All CEOs proclaim that "people are our most important asset," or that they are "committed to winning the war for talent". But, while some human capital management practices work well and feed through to increased shareholder value, others, however well intentioned, simply drain a company's resources.

What is the cost to shareholder value of being an unattractive employer, of having key talent leaving for competitors, of having an undermotivated workforce? Which HR practices will help you attract, retain and motivate your key talent? Until recendy, measuring the value of human capital management practices was not possible. This was a major frustration not only for HR practitioners, but for all managers who intuitively understood the importance of quality HR management. Getting board level support for initiatives is always difficult when you cannot measure the value they may bring to the business.

This was the reason for Watson Wyatt's global study, specifically looking at the effect of a company's HR practices on shareholder value. First in North America and, more recently, in a separate European study, we conducted a detailed survey of leading companies across all industries. We asked them questions about their HR policies and practices for recruitment, reward, support and development. We then matched the responses to objective financial measures of each company's value, including total returns to shareholders. Through a series of complex statistical analyses, we were able to establish a relationship between a company's human capital practices and shareholder value creation. We then measured this relationship for each company and produced a summary score - expressed on a scale of I to I (X), with 100 representing the best practice found in the study. We call this the company's Watson Wyatt Human Capital Index (HCI) score. The results are fascinating.

The European study, which involved over 250 survey responses from leading companies across 16 countries, demonstrated a very strong correlation between people practices and shareholder value. Companies with a high HCI score showed similar HR management characteristics. Put the other way around, those companies that demonstrated certain HR practices were those producing the greatest value for their shareholders. It is a correlation and does not necessarily prove a causal link, but the empirical evidence is strong.

The European HCI study demonstrates that 19 key HR practices are associated with a 26% increase in market value. These 19 practices can be grouped into five dimensions, each contributing to the total as shown in the chart. For each of the first four dimensions, an increase in the HR practices in that dimension indicates an increase in value. For the fifth dimension, a reduction in the emphasis on the practices indicates an increase in value. Overall, a significant improvement in each dimension, by either increasing or decreasing the emphasis as appropriate, indicates an increase in value of 26%. A "significant improvement" in a particular practice represents a one standard deviation increase compared to the sample data. On a I to 5 scale, a significant improvement typically means a one point movement.

Resource management
The area which has the greatest potential for increasing shareholder value through superior HR management is the collection of practices grouped together as resource management. This dimension reflects the organisation's operational management of its workforce, summed up as getting the right employees, in the right place and doing the right job -with a significant increase in this dimension associated with an increase in value of 7.1%.

The use of knowledge workers is the most important element of this dimension and reflects a 2.3% increase in market value for a significant improvement. In the information age, this may not be surprising. But our data shows that all organisations can benefit from using more knowledge workers to add value to their business.

The second most important factor in this dimension is recruiting excellence. Shareholder value is added through effectively planned recruitment that places the right people in the right roles. This is reflected in a 1.5% increase in market value. Interestingly, this is a far lower increase than was suggested by the North American HCI study. That shows that a significant improvement in recruitment practice could produce a 10% increase in shareholder value, making it the number one HR issue. The difference may reflect both the "employment at will" culture and high staff turnover in the US, as well as a more fluid recruitment market.

Another important issue for European-based companies is consistency of pan-European HR practices. A significant improvement here can be associated with a 1.4% increase in market value. While a single HR policy is seldom possible because of legislative and cultural differences, those organisations that allow for local differences but can demonstrate they are striving for consistency achieve greater value than those with separate policies in each country.

Good relations between management and unions is another dimension peculiar to the European study. Where good relations are fostered with trade unions, there is a boost to value from higher take up of union membership. The data does not show the reason. Anecdotal evidence suggests this is more likely to be about working in partnership with union representatives to communicate with employees and help manage change, than avoiding lost revenue from disputes.

Integrated leadership practices
The integrated leadership practices dimension focuses on how companies manage their people practices. A significant increase in this dimension can produce a value increase of nearly 5%. These are typically the people practices over which the HR department has least direct control or influence. They relate to the management environment of an organisation.

One clear dynamic is maintaining a customer-focused environment, which is associated with a 1% increase in value. But we found that the other elements in this dimension were so tightly interrelated that it only made sense to think of them as a package. This includes the key elements of lack of hierarchy, leadership, teamwork and 360 degree feedback.

The data shows that, individually, these elements are not well correlated with financial performance. But the more a company integrates these practices, the better that company performs. Further research suggests a hypothesis. Initially, as a company introduces new leadership programmes and initiatives, it adds value. But at a certain point we see "initiative overload," and would expect companies to see diminishing returns or even an erosion of shareholder value. This fits with empirical evidence where we have witnessed good programmes inappropriately implemented. For example, developing team-based systems in a leadership environment that is not receptive to employee input would obviously be counterproductive. If, however, programme components are integrated with mutual support systems in appropriate environments, synergistic effects click in that could explain why collectively this group of leadership practices is associated with a 3.7% increase in shareholder value.

Money still matters
Paying more and paying it in the right way can improve shareholder value by 3.7%. Good basic pay and benefits are essential if a company is to be a player in its market, and are associated with an increase of 1.2% in market value. The added value generated more than outweighs the cost, so long as the package is properly designed.

Incentives are associated with an increase in market value of 2.5%. Money spent here helps companies move from playing to winning the game. Effective communication also drives higher value. Sharing information with employees and encouraging feedback is associated with a 2.2% increase in market value.

A further element of employee focus, going beyond effective communication is the concept of allowing employees to direct their own development, to test their skills on the job and work on projects that will boost their value in the market. The benefit to the employee is clear. But our study shows that these empowered and motivated people also add significant value for their companies, associated with a 1% increase in value.

Paternalistic environment
The study shows that a paternalistic working environment has a significant negative impact on shareholder value. A 7.5% decrease in shareholder value was found through what one might term "excessive" job security and through an unfocused approach to retaining employees. High job security and low staff turnover may lead to complacency and an undermotivated workforce. While there is nothing inherently wrong with retaining staff and providing job security, if it is unfocused it can be damaging. It may lead to passive learning in an environment of paternalistic control, where seniority is rewarded, rather than performance.

Some level of turnover is a good thing. It stops a company becoming stagnant, allowing for movement and progression of employees. It is critical that companies focus resources on retaining their most talented employees, rather than offering high job security across the board. Retention and security programmes can be very effective, but they need to be targeted at individuals who are performing well and who have the skills and attitude the business will require in the future. In an environment demanding constant change and improvement, inappropriate retention may actually hold organisations back.

The HCI study provides strong statistical backing for the view taken by most HR professionals that human capital is a critical and growing part of the value of companies across the world. The results are interesting at the macro level but do not provide practical solutions in themselves. It is at the micro level that the HCI is most beneficial. It offers a benchmark, enabling managers to identify areas where action could deliver enhanced shareholder value, prioritised on a return on investment basis. And by the same token, it provides a strong indication of where resources maybe under-utilised.

The HCI makes it difficult for boards to dismiss initiatives aimed at the softer people and cultural issues in favour of those with a simpler impact on bottom line shareholder value. Companies that leverage their human capital effectively are the ones that will succeed best in the future.
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Doug Ross and Steven Dicker are partners at Watson Wyatt. More information on the Human Capital Index study is available at www.watsonwyatt.com/hci