I c The Real Reasons Enron Failed [Stewart-2006] JACF

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VOLUME 18 | NUMBER 2 | SPRING 2006
APPLIED CORPORATE FINANCE
Journal of
A M O R G A N S T A N L E Y P U B L I C A T I O N
London Business School Roundtable on Shareholder Activism in the U.K. 8 Panelists: Victor Blank, GUS Plc and Trinity Mirror Plc; Alastair 
Ross Goobey, Morgan Stanley International; Julian Franks, 
London Business School; Marco Becht, Université Libre 
de Bruxelles; David Pitt-Watson, Hermes Focus Asset Man-
agement; Anita Skipper, Morley Fund Management; and 
Brian Magnus, Morgan Stanley. Moderated by Laura Tyson, 
London Business School, and Colin Mayer, Oxford University
The Role of Real Options in Capital Budgeting: Theory and Practice 28 Robert L. McDonald, Northwestern University 
How Kimberly-Clark Uses Real Options 40 Martha Amram, Growth Option Insights, and Fanfu Li and 
Cheryl A. Perkins, Kimberly-Clark Corporation 
Handling Valuation Models 48 Stephen H. Penman, Columbia University
FMA Roundtable on Stock Market Pricing and Value-Based Management 56 Panelists: Tom Copeland, MIT; Bennett Stewart, Stern Stewart; 
Trevor Harris, Morgan Stanley; Stephen O’Byrne, 
Shareholder Value Advisors; Justin Pettit, UBS; David Wessels, 
University of Pennsylvania; and Don Chew, Morgan Stanley. 
Moderated by John Martin, Baylor University, and Sheridan 
Titman, University of Texas at Austin 
Expectations-Based Management 82 Tom Copeland, MIT, and Aaron Dolgoff, CRAI 
Incentives and Investor Expectations 98 Stephen O’Byrne, Shareholder Value Advisors, 
and S. David Young, INSEAD 
The Effect of “Private” and “Public” Risks on Oilfield Asset Pricing: Empirical 
Insights into the Georgetown Real Option Debate
106 Gavin L. Kretzschmar and Peter Moles, 
University of Edinburgh 
The Real Reasons Enron Failed 116 Bennett Stewart, Stern Stewart & Co. 
Multinationals in the Middle Kingdom: Performance, 
Opportunity, and Risk
120 David Glassman, Prince Management Consulting 
In This Issue: Valuation, Capital Budgeting, and Value-Based Management 
by Bennett Stewart, Stern Stewart & Co.
W
hy did Enron tank? The conventional wisdom 
blames sloppy board oversight, imaginative 
accounting, off-balance sheet financing, and a 
criminal CFO. But I believe those explanations 
are better viewed as consequences than causes. Enron did 
not fail because of creative bookkeeping, for instance, but 
was creative in bookkeeping because it was failing. In my 
view, Enron collapsed chiefly because its managers were paid 
to aim at the wrong financial measures. The incentives were 
screwed up, and they were screwed up in ways that would 
escape detection by most directors even to this day.
When Jeff Skilling joined Enron directly from McKinsey 
in 1990, he pushed the pipeline company into becom-
ing an “energy bank,” a middleman hedging supply and 
demand risk in the gas market that had become suddenly 
volatile in the wake of deregulation, and pocketing a spread 
on the contracts established between buyers and sellers of 
the commodity. Enron was quickly transformed from a 
sleepy cash cow to a darling of Wall Street with a bounty of 
promising opportunities. And yet the firm failed because top 
management—and the board—made three cardinal errors.
Not content to book profit the old-fashioned way—that 
is, when earned and paid for—Skilling persuaded the SEC 
and Arthur Andersen to approve the firm’s use of mark-
to-market accounting (“M2M”), a technique whereby the 
entire future stream of profit to be derived from the spread 
between the long and short gas contracts would be taken into 
earnings up front, at the time a contract is signed. With a 
wave of the accountants’ magic wands, Enron was authorized 
to record in a single year all the profit that would normally 
be booked over 10 to 20-year contract lives. Beginning as 
far back as 1992, mark-to-market put Enron’s earnings on 
steroids, turbo-charging its already highly revving profit 
figures. Little did Skilling—or the accounting profession-
als—guess that merely changing the way profit was recorded 
would reverberate throughout Enron, molding strategy, 
manipulating decisions, and warping the culture.
I hasten to add that, in the right hands, and consistently 
and conservatively applied, M2M is a legitimate accounting 
method, one that can enhance the information flow between 
management and the market. M2M is clearly appropriate, 
for example, when measuring the performance of trading 
portfolios.1 But Enron abused mark-to-market accounting 
to a staggering degree, applying it in ways never intended, 
such as marking assets to the value of spreadsheet projections 
(“mark-to-model”) and to prices set by Enron itself in markets 
where Enron was effectively the market-maker (“mark-to-my-
value”). Even more egregious, however, was the firm’s decision 
to report as earnings the projected value of an unproven new 
venture with Blockbuster to deliver video on demand (as 
things turned out, the venture failed miserably after a much 
ballyhooed Enron technology could not be made to work). 
It should be the job of the stock market, not accountants, to 
value a new venture, or the 20-year output of a power plant. 
Yet SEC policy at the time gave Enron license to use this legit-
imate accounting technique in creative ways, the corporate 
equivalent of putting matches in the hands of a child.
The interesting question then is: why did Enron strike 
the match? Mark-to-market would likely have remained 
an innocuous anomaly—footnote material—had Enron’s 
leaders not made a second critical mistake. Throughout 
the 1990s, as the seeds of collapse were being sown, Enron 
funded management’s annual bonus as a percent of reported 
net income, subject to downward modification at board 
discretion if management failed to meet goals for earnings 
per share (EPS), among other measures. Whether inten-
tional or not, by establishing and administering a bonus plan 
such as this, the board of directors put out the word that 
growth in earnings and EPS was to be the firm’s paramount 
goal, the measure of its financial success, and that managers 
should concentrate on producing as much accounting profit 
as possible. Top management eagerly backed the earnings 
goal, in case anyone missed the message. “Enron is laser-
focused on EPS, and we expect to continue strong earnings 
* This article has been modified from the original article, previously published in the 
March 2006 issue of Directorship, and is reprinted here with permission. 
1. Even so, managers and investors should understand that volatile, non-recurring 
changes in “stock” values (i.e., of the value of capital assets) are fundamentally different 
from recurring profit “flows” from business operations, and deserve a fundamentally dif-
ferent valuation. To make them roughly equivalent, value gains and losses should not be 
dumped into earnings all in the year they occur, as M2M does. Rather, value gains and 
losses should be “annuitized” and smoothed in some way, say by multiplying the cumula-
tive value change by the company’s cost of capital. Under this rule, a company with a 10% 
cost of capital, and a cumulative value gain of $100 million, would add $10 million to its 
profits, which is the amount an investor would realize annually by reinvesting the value gain 
for that return. GAAP accounting does not follow this sensible economic adjustment, of 
course, and that is one reason why firms that book large mark-to-market trading profits 
tend to sell for low multiples of reported earnings.
116 Journal of Applied Corporate Finance • Volume 18 Number 2 A Morgan Stanley Publication • Spring 2006
The Real Reasons Enron Failed
performance,” trumpeted Ken Lay and Skilling in their year 
2000 letter to shareholders. Without a doubt, getting ahead 
at Enron would be a matter of producing book earnings, the 
more the better.
Here’s the rub. Even putting aside mark-to-market distor-
tions (which we’ll examine in more detail later), the most 
basic accounting rules dictatethat earnings be computed 
in a number of ways that are inconsistent with measuring 
true economic profit. As a result, managers are invariably 
tempted to do things that fundamentally make no sense and 
can reduce shareholder value. Chief among the distortions 
is the failure to deduct a cost for using shareholders’ capital. 
While interest on borrowed funds is accounted as a legiti-
mate financing expense, shareholders’ equity is deemed free. 
In truth, shareholders no less than lenders expect a return on 
their investment to compensate them for bearing risk. Until a 
firm covers that “cost”—in other words, until it earns at least 
the return shareholders could earn on their own by invest-
ing in a comparably risky stock portfolio—the firm is really 
losing money even though its accountants book profit.
The bookkeepers’ oversight gives managers the oppor-
tunity to stoke up reported earnings growth and increase 
their bonuses while destroying value. To do that, a manager 
simply pours an excessive amount of new capital into 
a business, taking on ever less attractive, lower-return-
ing projects, investing all the way to the point where the 
expected return just covers after-tax interest. Such a strat-
egy maximizes bottom line earnings and earnings-per-share, 
but sticks shareholders with a wholly unacceptable return 
on their equity. Once investors realize management is inflat-
ing earnings growth with low-return investments, they will 
bail out, leaving a heavily marked down stock price and a 
discounted price-earnings ratio in the wake.
Enron offers a classic example of this. After riding an 
impressive earnings trajectory for a time (perhaps longer 
than should have been the case, but Enron was ruthless in 
stifling critics and hiding problems), the company came 
under attack by skeptics who doubted the firm’s ability to 
generate a decent shareholder return. James Chanos was 
the first to declare the emperor had no clothes. He made 
a fortune shorting the stock a year before its bankruptcy, 
declaring his decision was based on noting that Enron’s 7% 
pre-tax return on assets was wholly inadequate compared to 
its overall cost of capital, and was a sign of poor investment 
decisions. With that announcement, other investors jumped 
ship and the stock tumbled, triggering loan covenants and a 
death spiral that could not be reversed.
Although many directors and CEOs may not believe 
it, given the incessant drum beat they hear from sell-side 
analysts seeking earnings guidance, the smart money inves-
tors who set stock prices do attempt to see through accounting 
appearances and to pay for genuine economic value. In the 
real world, P/E multiples regularly shift to counter EPS 
and to reflect a change in earnings quality, as indicated by 
the progression in a firm’s return on capital. And thus it is 
extremely dangerous to base bonuses on earnings and EPS.
But as noted, that’s just what Enron had done. And once 
the book earnings focus set in, it spread like a cancer. Consis-
tent with the firm’s growth orientation, it was agreed that 
project developers would be rewarded just for signing up 
new deals and not according to the value of the deals. With 
hindsight, the initiation of this policy in the early 1990s was 
clearly a precipitating factor in the firm’s eventual demise, 
the corporate equivalent of commanding “full speed ahead” 
as the Titanic cruised through ice cold waters.
The outcome was as predictable as it was unfortunate. In 
a memorable scene depicted in Kurt Eichenwald’s Conspiracy 
of Fools, a wonderfully illuminating chronicle of the Enron 
debacle, newly hired public relations executive Mark Palmer 
is unable to grasp why a new power plant proposal, which 
everyone acknowledges is a poor project (a golfer in the room 
referred to it as a “long putt”), is going to get done anyway: 
“So why don’t we just not do the deal if it’s lousy?”
One of his new colleagues looked at Palmer knowingly. 
He explained the compensation system for the international 
division, detailing how developers gained huge bonuses if 
the financing and other paperwork on a project was signed.
“So you’re telling me,” Palmer said, “it doesn’t matter if 
it’s a good deal, so long as it gets done?”
There were nods around the room. 
That was in 1996 and, after three more years of bad deals, 
Skilling sat down in late 1999 to review plans for the year 
ahead. He was stunned to learn that managers in the interna-
tional division expected to earn just $100 million in operating 
profit on a $7 billion investment in the division’s assets.
Skilling worked his jaw. Seven billion dollars. Seven 
billion dollars to earn $100 million in profits. Hell, if they 
had stuck the money in a bank account earning 3 percent, 
the earnings would have been higher.
But Skilling should not have been surprised. The paltry 
return was a predictable consequence of the measures and 
incentives that he and the board had put in place. 
By turbo-charging the earnings, mark-to-market 
accounting compounded the pressure to grow earnings 
and commit capital before fully thinking through the 
ramifications. Let’s listen in on a year-end 1998 exchange 
between Ken Rice and Kevin Hannon, co-heads of Enron’s 
wholesale-trading division. 
Rice sighed: “Man, this is gonna be hard. How the hell 
are we gonna make earnings next year?”
Both Rice and Hannon were already familiar with the 
Journal of Applied Corporate Finance • Volume 18 Number 2 A Morgan Stanley Publication • Spring 2006 117
tyranny of Enron’s mark-to-market accounting. They called 
it “the treadmill,” and each year it just got steeper and steeper. 
No matter the division’s performance, once January rolled 
around, the earnings cupboard would be empty. All the cash 
coming in for the next several decades on energy contracts 
had already been eaten up, reported as current profits. 
Maybe it was time to break out the idea they had been 
tooling with for months: using the fledgling Portand telecom 
business—now called Enron Communications—to trade 
Internet bandwidth like a commodity… New markets meant 
big profits. And no potential market was bigger than the one 
for the Internet. Rice looked up from his paperwork.
“Kevin, it’s time to get serious with what we’re going to 
do next.”
Hannon looked at Rice evenly. “Bandwidth trading?”
“Yup. Gotta get serious.” 
As it happened, bandwidth trading was folded into 
Enron Communications, a unit that invested billions for a 
grab bag of ill-conceived “new economy” opportunities for 
negligible returns, the last in a long line of losers that eventu-
ally sunk the ship. 
Were Enron’s managers so unschooled in business basics 
they were unaware capital requires a return? Not at all. Skill-
ing in fact long portrayed the firm’s “asset light” trading, 
hedging, and market-making strategy as a way to boost the 
firm’s return on capital, and considered that an essential part 
of its appeal. But with incentives so entwined with complet-
ing deals and growing book earnings, clever managers found 
ways to circumvent return hurdles while paying lip service 
to clearing them. 
Rebecca Mark, an Enron executive the business media 
lionized through the 1990s, offers a prime example. For 
most of the decade she ran the firm’s international energy 
division—a division where developers were paid to close 
deals and significant value was squandered. Yet, through it 
all she insisted her projects were producing stellar returns. 
Mark maintained the façade by incorrectly treating fee 
income as a reduction in initial capital investments (rather 
than as a component of ongoing earnings), and treating loan 
proceeds as cash inflow (while ignoring the obligation the firm 
held to pay back the loans). She radically altered the return 
formula in order to justify the decisions that would maximize 
the incentive pay that she and her team would earn. 
This is beyond ridiculous, Skilling thought. Here they 
were [Skilling and Mark], the chief operatingofficer and 
vice chairman of Enron, and they didn’t have anything like 
the same idea about how to calculate investment returns. 
Mark subsequently ran Enron’s water business, Azurix, 
which had been slated for rapid investment to produce, 
naturally, a rapid growth in reported earnings. But finding 
it difficult to earn even trivial returns in a field where Enron 
enjoyed no competitive advantage, Mark abandoned all 
pretense of defending returns and insisted her performance 
now be judged by growth in EBITDA. “This is what our 
banker tells me is the way things are in this industry,” she 
told Jeff Skilling and Ken Lay. “We have to grow EBITDA. 
That’s all that matters.” 
EBITDA—earnings before interest, taxes, deprecia-
tion and amortization—deducts no charge at all for using 
capital—neither principal or interest—and ignores taxes. In 
so doing, it ranks as the least accountable, most misleading 
indicator of corporate performance ever devised. It is the 
measure of choice for those who would grow at all costs, and 
those who benefit from earning transaction fees. 
Skilling saw right through the smoke screen: “Rebecca, 
that doesn’t make any sense. Surely you understand that if you 
put capital into projects with returns below the cost of capital, 
ultimately you’re going bankrupt.” Yet, Mark got her way, the 
capital was spent, the acquisitions made, and the water business 
Azurix turned into a financial Black Hole of Calcutta—money 
went in, but no value ever came out. The earnings magnet was 
simply a lot stronger than the return one at Enron because, 
even when a decision is counter to common sense and finan-
cial logic, you do tend to get what you pay for. 
Many corporate strategists who have studied Enron 
suggest management’s inability to grasp the economics of 
their business model caused them to range far outside its 
natural boundaries—into broadband telecom and water, 
for instance. Perhaps there is some truth to that, but the 
record more strongly suggests that Enron’s managers were 
not inherently less capable of strategic analysis than other 
managers. They made strategic blunders because they were 
pursuing to their most illogical conclusions the wrong 
measures measured in the wrong way. 
In most firms, the chief financial officer is counted 
upon to play the gatekeeper, restraining widespread capital 
misallocation and ill-conceived corporate strategies by 
establishing a consistent system of financial measurement 
and control. But not at Enron, because a third crucial 
mistake was made in mid-1996, and thus more than four 
years before Enron filed for bankruptcy. Skilling acqui-
esced to CFO Andrew Fastow’s absurd request that the 
finance department be turned into a profit center. Fastow 
reasoned that commercial people made big bucks because 
they got a share of the profit they produced, and he wanted 
the same opportunity, and got it. Now instead of worrying 
about such perfunctory matters as managing cash, strategic 
planning, capital budgeting and financial control, Fastow 
and his hirelings would concentrate on doing deals, financ-
ing growth, bullying naysayers, and papering over problems 
that stood in the way of earning massive incentive awards. 
Even this colossal error in judgment would not have 
been fatal had Enron not made the first two. By paying 
118 Journal of Applied Corporate Finance • Volume 18 Number 2 A Morgan Stanley Publication • Spring 2006
incentives on hyped up earnings, and giving developers up-
front bonuses to close deals, Enron’s appetite for capital was 
so voracious, and its ability to destroy shareholder value so 
massive that Fastow was effectively forced into finding excep-
tionally creative finance techniques and masking troubles 
with creative accounting. 
No one can condone Fastow’s machinations and miscon-
duct. But the more interesting question is why apparently 
intelligent people gave him the opportunity to do what 
he did. Why, for example, did the board consider Fastow 
a hero for his convoluted, off-balance-sheet financings and 
accounting manipulations, and why was he given so much 
latitude and trust? Because, as with a real drug, once a 
book-earnings addiction takes hold and an entire organiza-
tion is geared to running faster and faster on that treadmill, 
it is virtually impossible to shake the earnings monkey off 
the back. Even a board consisting of experienced, talented, 
and dedicated people cannot do it, as Chairman Ken Lay 
plainly admitted (in a meeting with a board counselor in 
January 2002). 
“So we had a choice,” he said. “We could either signifi-
cantly decrease the growth rate or continue to grow rapidly 
through utilizing off-balance-sheet transactions.”
He glanced around the room. “We opted to continue 
focusing on rapid growth.” 
Lacking an ethical compass, Fastow was only too happy 
to join the earnings parade rather than insisting on hard and 
fast, and clearly defined, return barriers. Quite the contrary, 
Fastow and his henchmen only added fuel to the fire when 
they established the firm’s risk manual, which included this 
astounding policy declaration: 
“Reported earnings follow the rules and principles 
of accounting. The results do not always create measures 
consistent with underlying economics. However, corpo-
rate management’s performance is generally measured 
by accounting income, not underlying economics. Risk 
management strategies are therefore directed at accounting 
rather than economic performance.” 
Here then, in bald, black and white text, is the real reason 
Enron failed. Everything, and not just risk management, was 
directed to managing and manipulating accounting earnings 
rather than creating and sustaining real economic value. The 
wrong measures and the wrong incentives overrode human 
judgment, overran normal business ethics, and precipitated 
the largest bankruptcy in U.S. history. 
What then are the key takeaways from the Enron story? 
• Managers at Enron knowingly, and in many cases 
openly, made decisions that wrecked the company because 
they were paid to do so, and because they went along with 
top management’s and the board’s decision to “laser-focus” 
on growth in earnings-per-share. 
• What gets measured gets managed, and you do tend 
to get what you pay for. Those are every board’s most power-
ful levers to shape behavior, mold culture, and influence 
strategy, the first lines of defense and offense in the corporate 
governance game. 
• The impact of measurement and incentive levers ought 
to be traced all the way down the line and not just scrutinized 
for the five top reporting executives. The incentives created 
at lower levels, for project developers, or sales and marketing 
people in other organizations, even shop floor workers, can 
have a tremendous impact on performance and value. 
• Reporting is not reality. The stock market values high 
returns far more highly than rapid book income growth. 
Directors that endorse bonus plans based on reported 
earnings should know they are following the path trod by 
Enron. They are sending corporate managers into a make-
believe world where they have to jump a three-foot hurdle 
to win—to cover just the cost of debt on new capital invest-
ments—when shareholders require a much higher return 
standard to ensure that they are adequately compensated for 
their investment in the firm. 
• Mark-to-market, although useful in valuing finan-
cial assets and liabilities, is an easily-abused accounting 
method that readily morphs into two deviant versions: 
“mark-to-model” and “mark-to-my-value.” It is the market’s 
job to make forecasts and determine the value of operating 
assets, not the accountants’. Given the Enron experience, 
managers and regulators should tread carefully when they 
consider applying M2M outside the realm of the valuation 
of financial assets and liabilities with readily determinable 
“market values.” 
• Directors should pay managers only for producing 
high quality earnings, or EVA—thatis, earnings over and 
above the full cost of capital. EVA ensures that managers will 
win only when the shareholders do too—only if the return 
on existing capital is improved, new capital is invested for 
returns over the shareholder-set threshold, or capital is 
withdrawn from uneconomic assets and activities. 
• If directors do not insist upon establishing and clearly 
defining a value-linked metric to override the others, manag-
ers will shop for the metrics and manipulate the dialogue to 
permit them to do the things that will maximize how they 
are rewarded. 
As economist Steven Levitt has written in the introduc-
tion to his fascinating book Freakonomics, “dramatic effects 
often have distant, subtle causes,” “the conventional wisdom is 
often wrong,” and “incentives are the cornerstone of modern 
life.” The real Enron story is a perfect case in point. 
bennett stewart is a co-founder of Stern Stewart & Company, CEO 
of EVA Dimensions and author of The Quest for Value.
Journal of Applied Corporate Finance • Volume 18 Number 2 A Morgan Stanley Publication • Spring 2006 119
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