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"We spend all our time on people. The day we screw up the people thing, this company is over" Jack Welch in Fortune Magazine ["Why CEOs Fail," Jun. 21/99].

"Seventy-two percent of institutional investors ranked intellectual capital as very important but only eight percent of companies address the subject directly in their annual reports." CFO Magazine ["It's the Intellectual Capital, Stupid," Apr. 99].

One of the truisms of modern business is that "people are our most important resource." Perhaps that is why, almost from the time that companies emerged as organizational entities, managers have had to understand and quantify how the contribution that employees make is linked to a company's bottom line.

Many executives thought that it would never be possible to show that there was a relationship between the "soft" people issues and "hard" financial outcomes. Even if it could be shown that a relationship existed, it would be of no particular importance. On the other hand, some executives have genuinely wanted to believe that, by improving employee satisfaction, company fortunes would also be enriched. Until now, very little empirical evidence was available to tie people practices to corporate performance.

Over one year, Watson Wyatt Worldwide conducted a research project to understand the relationship between people practices and shareholder value. The product of this research is the Watson Wyatt Human Capital Index(TM) (HCI). Though many factors influence a company's financial performance, the HCI gives executives a means to tie certain, specific people practices to tangible outcomes. Indeed, the HCI research shows that establishing the appropriate people practices can enhance shareholder value by as much as 30 percent. We describe our research below and highlight the value of the HCI to business executives and their organizations.

RESEARCH

METHOD

We based our research on HCI on Thomas Stewart's book Intellectual Capital [1997] and Jeffrey Pfeffer's concept of "the human equation" [Jeffrey Pfeffer, The Human Equation, Building Profits by Putting People First, 1998]. We developed a survey and distributed it to the senior human resources person at publicly traded companies in the U.S. and Canada. The survey asked these executives about the people practices in their organizations. The categories included:

* recruiting and acquiring talent

* organizational environment and culture

* communications systems

* rewards

* customer capital

* company demographics.

A total of 405 companies responded to the survey (370 American and 35 Canadian), representing a broad spectrum of industries and companies traded on the Nasdaq, the New York Stock Exchange and the Toronto Stock Exchange. A comparison of the Canadian and American responses revealed no important differences between companies in the two countries; this reflected the reality that many business and people-practice issues transcend national borders.

In addition to the survey results, we collected financial information on the respondent companies. To determine the organizational contribution of various practices, we matched the survey data to financial performance. The financial indicators were market value (company share price times the number of outstanding shares), total shareholder returns and Tobin's Q, the ratio of the market value to the replacement cost of physical assets [J. Tobin, "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, 1969, 1, 15-29]. The Q value is particularly useful since, as the ratio moves beyond one, the market begins to place a greater value on intangible assets, including a company's intellectual capital and its people practices. The financial information reflects corporate performance over the past five years.

The HCI score was correlated to the financial indicators. In each case, a higher HCI score showed a higher financial value. For example, as shown in the figure below, companies demonstrating a higher HCI also exhibited a significantly higher cumulative five-year total return to shareholders (TRS).

DIMENSIONS

To examine data from the survey, we used factor analysis, multiple regression and correlation analysis. We created statistically standardized scores so that the HCI could be expressed on a scale from zero to 100. A score of zero indicated poor people-management practices, while 100 meant ideal people-management practices. We imposed controls for several critical factors, such as company size, industry, research and development budget; otherwise, factors such as these could have biased the HCI scores.

FIVE-YEAR TOTAL RETURN TO SHAREHOLDERS

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The results from these various statistical analyses revealed a strong connection between human capital management and financial outcomes. The connection was so clear that there was a direct relationship between a significant improvement in 30 key human resources practices-which can be grouped into five dimensionsand up to a 30-percent increase in shareholder value. (A significant improvement is defined as a change of one standard deviation or more in the HCI and its component scores.) The figure below shows the projected changes in market value associated with a significant improvement in the HCI dimensions.

Based on regression analysis, we determined that each of the five dimensions had a different weight-or level of association-for shareholder value. Similarly, each component of the dimensions added a weight. These weights were used to prioritize the dimensions and their respective components, with higher weights having a greater priority. The specific dimensions of the Watson Wyatt HCI are:

a) recruiting excellence

b) clear rewards and accountability

c) collegial, flexible workplace

d) communications integrity

e) prudent use of resources.

Recruiting excellence reflects the practices for hiring new employees. Of the five dimensions, it has the largest potential influence on an increase in shareholder value (up to 10 percent). The recruiting excellence dimension was comprised of six recruiting practices. The two that had the most positive impact on shareholder value were hiring professionals who were well equipped for the job, and designing recruiting efforts to support the business plan.

The clear rewards and accountability dimension combines reward and performance-management systems, and is associated with an increase in shareholder value of up to nine percent. The three rewards and accountability factors most highly associated with increased shareholder value are: making employees eligible for stock plans, helping poorly performing employees improve and terminating employees whose performance continues to be unacceptable.

A collegial, flexible workplace combines the cultural and environmental aspects of a company's people practices. A substantial increase in the collegial surroundings dimension can possibly lead to an eightpercent increase in shareholder value. Offering flexible working arrangements, encouraging teamwork and cooperation, having high employee satisfaction and using first names between employees and management are the key elements of a collegial, flexible workplace.

EXPECTED CHANGES IN MARKET VALUE ASSOCIATED WITH A SIGNIFICANT IMPROVEMENT IN HCI DIMENSIONS

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Communications integrity comprises the upward, downward and lateral transfer of information in the organization. It is associated with approximately a fourpercent increase in shareholder value. There were five communication practices, and those that showed the highest correlation were access to communication technologies, opportunity for employees to give ideas and suggestions to senior managers and sharing financial information with employees.

Surprisingly, the HCI research revealed that some practices, which many people intuitively connect with improvements in organizational value-such as 360degree feedback and developmental training programsactually had a negative impact on shareholder value, decreasing value by as much as 10 percent.

These counterintuitive results formed a fifth dimension, prudent use of resources. The findings suggest that the likely problem is not with the practices themselves, but rather with their implementation. This may contribute to weaker shareholder value.

Another potential problem is that a significant training budget will not necessarily translate into improved financial outcomes if an organization does not devote enough thought to the purposes and outcomes of training. Therefore, when implementing certain people practices, an organization must exercise care to ensure that the desired outcomes are achieved. The HCI score accounts for the prudent use of resources dimension by assigning a higher score to a company that implements the programs less widely.

We combined the five dimensions to form the HCI score by averaging the weighted scores for each dimension. As a result of using this weighted-average process, the HCI does not reflect a simple combination of scores. This may lead to instances where the HCI will be somewhat lower or higher than an average of the individual scores.

Along with other progressive management measures and techniques, the HCI offers executives numerous opportunities to increase shareholder value by developing and maintaining effective people practices. The research by itself, however, is not relevant unless it can be applied to a particular business situation. The methods and procedures for determining the HCI are more fully described in the following two case studies, both of which are based on actual findings.

HIGH AND MODERATE HCI TWO CASE STUDIES

HIGH HCI

XYZ Inc. is headquartered in Canada and has plants, laboratories, offices and outlets in many countries, including the United States. It has formed alliances with a number of similar producers around the world. XYZ Inc. employs approximately 3,000 full-time workers.

In 1998, XYZ had total sales of close to $1 billion. Although the company's financial performance over the past five years had been respectable, it failed to meet shortterm expectations. Sales were weak, due to unfavourable exchange rates and strong competitive pricing. Also, a corporate restructuring required writedowns of new operations, the closure of some plants, and the acquisition of a competitor's production division. Nevertheless, given the company's strong position in the marketplace, it is expected to improve.

HCI Profile

XYZ's high-HCI profile indicated practices that correlated to high shareholder value. The HCI and its five dimensions are shown in the figure on page 24. The overall rating was very favourable, with an HCI score in the 82nd percentile. The company demonstrated particular strengths in the areas of clear rewards and accountability, and recruiting excellence. Some of the elements contributing to these higher scores include:

* making all employees eligible for stock plan programs

* linking pay to the business strategy

* implementing a company pay scale that was higher than the market's

* designing recruiting efforts to support the corporate business plan

* equipping hourly, new hires to perform their duties.

Though the dimensions of communications integrity and a collegial/flexible workplace ranked somewhat lower, they were still higher than the HCI database norms. In particular, these factors had a positive influence on the score:

* creating opportunities for employees to provide ideas and suggestions directly to senior managers

XYZ INC. HCI PERCENTILE SCORES

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* sharing financial information with employees

* providing flexible working arrangements

* ensuring that employees were on a first-name basis with senior managers.

The prudent use of resources was relatively high. As described earlier, this finding signifies that XYZ Inc. had not widely implemented the high-risk programs associated with the dimension. As a result, it did not act to increase the overall HCI score. When we examined the individual components of each dimension, we found that fewer training programs than the norm had been used. However, 360-degree feedback programs were being applied at a rate consistent with other organizations.

Implications

XYZ Inc. demonstrated excellent use of people practices to enhance shareholder value. When we examined all of the HCI components, we noticed a number of important implications. The compensation strategy of offering innovative incentive plans and paying above the market would attract and retain high-performing employees. Concurrently, XYZ's recruiting policies ensured that the people with the right competencies were hired for the right positions. These approaches enhanced the value of the company's human capital.

The HCI for XYZ Inc. also revealed that certain areas needed to be improved. Employee satisfaction was lower than the norm, producing a negative impact on the levels of commitment. Similarly, results revealed that the culture did not encourage teamwork and co-operation, inhibiting the opportunities for collaboration among people and departments. Employees rated the opportunity for them to provide input into how their work gets done slightly lower than the HCI norm. This may have weakened their sense of connection to the job.

The results from the prudent use of resources dimension suggest that one practice could be re-examined. Although there was a positive association between participation in profit-sharing and overall company performance, there was a negative association between profit-sharing and divisional success. Hence, the program for dispensing profits according to divisional success should be reviewed. Moreover, achieving a careful balance in the prudent use areas, along with the other dimensions, might increase shareholder value.

Recommendations

Executives of XYZ Inc. were in the enviable position of employing people practices that make a positive contribution to shareholder value. By maintaining or moderately enhancing the elements related to recruiting excellence and rewards and accountability, the company will sustain the contribution associated with these practices.

However, enhancing the lower-rated practices such as a collegial workplace, communications integrity and prudent use of resources would likely result in an improved level of shareholder value for XYZ Inc. These efforts should help retain high performers, encourage teamwork and develop the human capital necessary for maintaining the company's leading position in the industry.

MODERATE HCI

Background

ABC Co. is a major retail organization with several hundred outlets across Canada. Most communities have at least one ABC-related store. The company employs about 12,000 people in its headquarters, warehouses and stores.

As with many retailers, ABC Co. experienced difficulties during the past decade, as a consequence of shifting demographics, economic recession and changing customer-buying patterns. Nevertheless, in 1998, the company had $1.1 billion in sales, up from $1 billion in 1997. Net earnings amounted to $20 million, yielding a return on equity of about 12 percent.

HCI Profile

The figure right shows the HCI and five dimensions for ABC Co. ABC's HCI rating ranks it in the 44th percentile. A collegial/flexible workplace, communications integrity and prudent use of resources are associated with the higher scores in the overall index. Some of the elements contributing to these scores include:

* providing flexible working arrangements

* encouraging employees to be on a first-name basis with senior managers

* sharing financial information and business plans with employees

* making available training and 360-degree-feedback programs that approximate the HCI norms.

The rate for the recruiting excellence dimension was comparatively lower than the norm. Although it was reported that there was a formal recruiting strategy for hiring critical positions, professional new hires were not as well equipped to perform their duties as desired. Other factors that positively influenced the HCI score include:

* designing recruiting efforts to support company business plans

* asking employees for their input on hiring decisions.

The rewards and accountability dimension definitely showed a need for improvement. In all practice areas, ABC's scores were below the norms for the HCI. The issues that had the greatest influence in producing the low overall score were:

* a low proportion of employees eligible for stock plan programs

* a small number of employees eligible to participate in profit-sharing plans

* the company's lack of attention to helping poor performers improve

* the company's failure to terminate employees whose performance was unacceptable.

Implications

In some practices, such as exhibiting a collegial-flexible workplace, ABC Co. had a comparatively good rating. Flexible work arrangements, using first names across all levels and encouraging teamwork and co-operation all promote a collegial working environment, thereby fostering a cohesive organizational culture. Recruiting strategies for hiring people for critical positions and including the opinions of current employees should enhance the company's ability to select top performers. At the same time; high employee satisfaction can be critical in retaining these same high performers. Finally, the prudent and cautious use of training and assessment programs means that the likelihood of squandering competitive advantage will be minimized.

ABC CO. HCI PERCENTILE SCORES

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Given retail's large number of part-time employees and relatively high turnover, the clear rewards and accountability dimension presents unique challenges. By not helping poor performers improve and by not dealing with consistently poor performers, the organization risks sending a negative message to other employees who perceive the company as not being serious about fostering corporate excellence. Similarly, paying employees below the market and not paying top performers more than average performers could further diminish the level of commitment of top-performing employees.

Recommendations

Although the HCI scores for ABC Co. show a moderate use of practices with a positive effect on shareholder value, some actions can be undertaken to improve the situation. As with most organizations, people practices that yield high results should be maintained and strengthened. For example, continuing to employ practices such as flexible working arrangements and encouraging teamwork and cooperation can be expected to nurture the level of people's commitment to ABC. In addition, sustaining high employee satisfaction and striving for a more complete sharing of information can create an environment for retaining key employee talent.

By focusing on the rewards, recognition and accountability systems, the company can significantly strengthen its people-practice strategies. Developing and implementing the means to deal with poor performers and restructuring the pay system would enhance the rewards and accountability scores. In addition, ensuring that people hired for professional positions have the requisite skills will improve the recruiting excellence scores.

Identifying and quantifying the link between human capital and value creation is one of the most compelling issues executives are facing today The HCI research provides a reliable means of quantifying the contribution that particular "people practices" can make to improving shareholder value.

The last three decades have seen workforces experience enormous degrees of change. While the proper responses to these many changes have been necessary to meet the needs of an increasingly competitive, global and informationintense marketplace, they have also fundamentally altered the "contract" between employer and employee. In effect, business has moved from the paternalistic '70s to the costcontaining '80s and through the partnerships/alliances of the '90s. The companies that have track records of sustained returns to shareholders have long recognized (intuitively, we suspect) the important contribution of superior and easily adaptable human capital practices. By connecting the people practices discussed in this article with evolving business strategies and key organizational performance indicators, those firms will continue to distinguish themselves in the market.

The first decades of the new millennium will surely be focused on leveraging people for competitive advantage. To do so effectively requires approaches that attract, retain, communicate, recognize and reward (in both the short and long term) the value of seasoned, knowledgeable workers with fresh talent and ideas. All of this must happen in an environment that makes it attractive and worthwhile for people to come to work every day.

Linking human capital practices with shareholder value is the first step to achieving future corporate success. It also raises this very important question: What is your management team doing about fostering this link?