What’s Wrong with TSR, and How to Fix It

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Total shareholder return (TSR) has become an incredibly important metric for boards to use to determine executive compensation, with over half the firms in the S&P 500 implementing the metric—a number up from fewer than one in five a decade ago. TSR as a metric is deeply flawed, though. It overrates weak companies that merely recovered from depressed valuations, and unfairly demotes elite firms that have slipped, even slightly, or that failed to live up to unrealistic expectations. It’s also distorted by leverage. Say two firms perform exactly the same. The one with more debt and less equity produces a higher TSR on the upside and a lower one on the downturn. TSR also is silent about how managers can actually make better decisions. It is a way to keep score, not a formula to win the game.

Enter the Corporate Performance Index (CPI). The CPI is a four-pronged test that accurately sums up the totality of corporate performance from a shareholder point of view in a composite percentile score. CPI is correlated to TSR rankings at a rate of 60 percent, so it adds weight and credibility to the TSR verdict for most companies while revealing what’s behind it. The other 40 percent of the time, CPI provides a different—and usually far more accurate—assessment of how well a company is performing.

The four ratios used in CPI are interesting in their own right. They are:

  1. Wealth creation: the firm’s total market value premium to its book capital, stated per unit of sales (we call the valuation premium MVA, for market value added);
  2. Profitability: the firm’s economic profit, expressed as a profit margin ratio to sales (the term we use for economic profit is EVA, standing for economic value added; it is the profit remaining after deducting a full cost-of-capital interest charge on the firm’s debt and equity capital and repairing accounting distortions that run counter to business logic);
  3. Profitable growth: the trend growth rate in the firm’s EVA profit over the most recent three years; and
  4. Strategic position: the long-run growth in EVA that investors have factored into the firm’s share price, effectively a “buy-side” consensus outlook.

There’s an important, consequential link among these metrics. MVA measures the wealth of the owner, and is the difference between the money put into a business and the value coming out of it. Boards should monitor MVA because shareholder returns come directly from this metric. TSR, in fact, is simply the rate of wealth creation, per unit of value. It comes from increasing the MVA premium over time. Market value added, in turn, comes from EVA. It is mathematically equal to the present value of the EVA profits the market forecasts a firm will earn. This means that increasing EVA is ultimately the real key to driving TSR, making it an ideal tool to manage a business and make better decisions.

CPI, then, is a distillation of EVA and MVA into an overall index of financial excellence. It assigns the highest scores to firms that have achieved the best records of profitable growth, that preside over the most valuable and profitable business franchises, and that are strategically best positioned to continue robust growth above the cost of capital for years to come, compared to peers. Firms like those are truly excellent, no matter what their recent TSR may be, and firms with low or declining CPI scores are really in trouble, even if TSR looks good.

Boards should turn to CPI and the underlying ratio metrics as a complement to TSR. Firms with high CPI scores can use it to repel undeserved say-on-pay criticism and activist overtures, while low scorers can stay on high alert. There’s also a case that TSR’s role in long term incentive plans should be diminished, and that managers should be rewarded instead for increasing the firm’s EVA profits over time. Turning instead to CPI could lead to better decisions, better incentives, better return to shareholders, and an even greater alignment between pay and performance.

Bennett Stewart is an expert in shareholder value and corporate performance management, and CEO of EVA Dimensions, a financial technology firm, and creator of the EVA and CPI frameworks used by Dow Chemicals and others.

Oversight in an Uncertain World: What Can Directors Do Post-Brexit?

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This is the first of a three-part series looking at the global economy and uncertainty in 2016. In our next post, we will focus on geopolitics and its implications for business strategy and decision making.

The United Kingdom’s vote on June 23 to leave the European Union highlights the uncertainty and volatility that companies face this year. (See my “Why Brexit Really Matters” article in Forbes.) Indeed, the sharp fall in global equities and currency markets on June 24 accentuates the rude awakening. But should the investment and business communities have been surprised? Most polling in the run-up to the vote suggested the leave campaign could prevail. Companies are now scrambling to implement their contingency plans…or to create them. Currency shifts will be the most immediate shock to manage.

According to NACD members, the greatest concern they foresee in 2016 is the global economic slowdown and how this will affect their company. This issue outranks other concerns, such as the changing industry landscape or cybersecurity. When looking at the board’s activities, NACD members say that the most important area for improvement is the board’s ability to test management assumptions underlying corporate strategy.

The Brexit vote highlights the strategic challenges directors face in today’s volatile world: How can directors make sense of increasingly uncertain economic conditions and what can they do to pressure test the validity of management’s assumptions about future growth?

A slow-growth world

Companies are facing strong headwinds in a slow-growth world. In April, the International Monetary Fund (IMF) downgraded its outlook for global growth this year to 3.2 percent—barring any system shocks. This is about the same rate as last year. The IMF downgraded the outlook for most major economies as well (see chart).

In June, the Organisation for Economic Co-operation and Development (OECD) fretted that the global economy is “stuck in a low-growth trap.” Shortly thereafter, the World Bank issued a more negative forecast, saying global growth would come in at only 2.4 percent this year, down substantially from the 2.9 percent pace it had projected just several months before.

Of significance, there are few positive country narratives. The United States is a relatively bright spot, with the IMF expecting 2.4 percent U.S. growth in 2016—the same as last year, but lower than the IMF had forecast in October 2015. The Business Roundtable recently downgraded their expectations for U.S. growth from 2.2 percent to 2.1 percent, based on concerns over impediments to trade and immigration. And, as most Americans feel, U.S. growth is neither robust nor equally enjoyed.

Europe looked like it might have been turning the corner: Business and consumer sentiment had improved, productivity had increased, and GDP growth strengthened significantly. But growth across the eurozone in 2016 is expected to come in at just 1.4–1.6 percent—barring a sustained Brexit shock.

Over the past decade or so, many companies have globalized and bet heavily on emerging markets (EMs)—sometimes dubbed “rapid growth markets.” This strategy could be easily justified by management when EM growth rates consistently outstripped those of the United States and Europe by five percentage points or more.

But these markets have been underperforming in recent years and their outlook has been consistently downgraded. This year, the World Bank expects emerging markets to grow by just 3.5 percent—about two percentage points below their average growth over the past decade.

Moreover, EM performance will continue to be uneven and uncertain thanks to poor governance—as exemplified by a massive corruption crisis that has gripped Brazil’s business and political communities. India continues to be a top performer at 7.5 percent growth, but the reform-oriented government there has made little headway tackling the myriad of bureaucratic impediments to investing and doing business there.

And while China is still doing relatively well—with its growth expected to be in the 6.5–7.0 percent range this year—this performance has come thanks to renewed stimulus and the expansion of debt, which raises more questions about the sustainability of China’s trajectory. At the same time, Western companies conducting business in China are facing increasing political and regulatory headwinds, not to mention a much more competitive business environment.

An uncertain outlook

Not only are we in a slow-growth world but we are also in an era of significant uncertainty about the future. The IMF in April described global economic activity as “increasingly fragile” and the World Bank warned in June that “the balance of risks to global growth forecasts has tilted further to the downside.”

Uncertainty is rooted in the fact that traditional cyclical drivers such as business capital investment and consumer spending seem to have lost their oomph. In short, in our chronically slow-growth world, businesses don’t want to invest and consumers don’t want to spend. Moreover, productivity, profits, wages, and trade growth are stagnant as well, and many economists believe that income inequality is exacerbating the slow-growth problem.

On top of this, the growing influence of geopolitical risks—the Brexit vote, the upcoming U.S. presidential election, refugee migration, and China—are adding new and hard-to-quantify variables to the outlook.

Given this context, the severe market volatility seen during the summer of 2015 and in January 2016 points to profound uncertainties about the future and to how easily perceptions and the markets can get shaken in our slow-growth world. A resurgence of sustained global market volatility triggered by the Brexit vote has the potential to derail global growth.

Pressure test management’s assumptions

In this uncertain and volatile world, directors should be testing management’s assumptions about growth—now and in the future.

Start by confirming the baseline: Does management’s view of macroeconomic growth for 2016 in the company’s key markets align with the market consensus?

Get your own perspective. As noted above, we rely on the views of multilateral organizations—such as the IMF, World Bank, and OECD—for a global perspective. Their economic outlooks are easily accessible and widely viewed as a reputable baseline around which to test assumptions.

The OECD has put together a handy one-page summary chart focused on advanced economies that a director can take to a board meeting as a reference. The World Bank has an easy-to-navigate website for exploring regional and country economic outlooks. Central banks also are a good source of country-level data.

Ask questions about management’s assumptions:

  • What data sources does management rely on?
  • Does management’s view differ materially from what others are saying?
  • What assumptions support a divergent outlook?
  • How does management account for political risks?

Next, test management’s view of the future. Economists have had to significantly downgrade their expectations of U.S. and global growth and the economic headwinds are not expected to diminish over the next several years.

  • Has management adjusted its growth projections downwards as well?
  • What is management’s two- to three-year view of China and other emerging markets?
  • Do the company’s plans reflect a slow-growth environment going forward?

Given widespread uncertainty and the risk of volatility, management should be able to present a range of alternative market scenarios.

  • Does management have an economic disruption scenario?
  • How has management sought to make the company more resilient to the uncertainty and volatility in the global market?

Many directors we have spoken with have highlighted the challenge of managing near-term foreign exchange risks.

  • What steps has the company taken to hedge against swings in key currencies?

If management says the company is going to significantly outperform its peers or the macro economy—especially in emerging markets—that is a yellow flag that should signal you to dig deeper and ask more questions.

NACD’s Global Board Leaders’ Summit in September, themed around the issue of convergence, will have dedicated sessions on global economic and political disruption, featuring subject-matter experts and seasoned directors.

The Brexit Vote: Scenarios for Business Leaders and Boards

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This Thursday, the United Kingdom (UK) will vote in a referendum on whether to leave the European Union (EU)—referred to as the “Brexit.” Opinion polls have shifted sharply over the past two weeks to indicate that the likelihood of Brexit has increased substantially, but Frontier Strategy Group continues to believe that the UK will vote to remain in the EU, albeit by a very small margin. Opinion polls have been extremely inaccurate in the past two UK elections and we believe some hesitant voters will choose to remain in the EU in a conservative bias that we saw in both the parliamentary elections last year and in the Scottish referendum. Markets are also interpreting the murder of pro-EU Labour MP Jo Cox as likely to damage the Leave campaign.

A narrow win for the Remain campaign—our baseline scenario—is unlikely to alleviate the grievances of those supporting Brexit and would cause deeper tensions within the UK’s Conservative Party, raising the likelihood of early elections and another referendum in the next couple of years. While the economic impact of these trends would be relatively modest, lingering uncertainty would cause investments to underperform.

Should Brexit happen, however, multinational businesses would be affected in several key ways. Besides the initial financial volatility and somewhat weaker growth in Europe, most of the broader effects of Brexit outside the UK would be slow-moving, although their long-term implications could be significant enough to reshape the European Union. Companies need to be prepared for short-term volatility—particularly of currencies—but should Brexit occur companies can expect to be gradually adapting to its effects for at least the next two to three years.

Financial-market volatility and currency depreciation

The possibility of Brexit has already rattled currency, bond, and equity markets and this volatility will increase in the immediate aftermath of the event should Brexit occur. The British pound could depreciate by as much as another 10–20% against the United States’ dollar (USD) in the aftermath of Brexit, and the euro would also likely lose value, possibly as much as 5–10% against the USD. The scale of the losses would likely be temporary, but neither currency would be likely to recover to pre-Brexit levels. Brexit would also dampen investment confidence, softening commodity prices and causing overall financial market uncertainty. Added to a backdrop of weak global growth and deep concerns about China’s slowdown, Brexit would prompt another bout of volatility that would cloud corporate expectations and complicate 2017 planning for emerging markets generally.

Growth in Europe

Brexit would cause a slowdown in UK investment and business activity. A similar, though smaller, effect would be likely in the EU as a whole. Markets strongly linked to demand from the EU—such as North Africa, Eastern Europe, and parts of Asia—would see a softening of demand for the next 12 months that would affect industrial performance but would not disrupt growth trajectories. The demand effect for other parts of the world would likely be negligible. As corporate leaders gear up for 2017 planning, they would have to dedicate more analytical energy to identifying sources of growth in Asia, the Middle East, Africa, and the Americas to compensate for weaker performance in Europe.

Policy predictability

Brexit would raise a host of trade issues from the future of the Schengen Area to the outlook for the Transatlantic Trade and Investment Partnership, all of which would increase uncertainty over the cost and structure of supply chains that involve the EU. Any tangible effect on supply chains, however, would likely materialize over a period of several years, giving companies ample time to respond. It would, however, raise fundamental organizational issues such as where companies’ European headquarters will be located, tax rates, distribution-chain structure, and other concerns that should be factored into 2017 and longer-range planning as well as profitability targets. Making changes earlier could yield valuable competitive differentiation for cost and talent.

Political risks

Brexit’s most dangerous effect could be to galvanize anti-EU sentiment and populist parties across the EU, setting into effect a series of policy disruptions in the region that could weaken the EU, slow down EU integration, or even lead to other EU members exiting the union. All of this would undermine the EU’s economic outlook, and force multinational corporations to manage political risk in this usually stable region much more closely. While that would be unlikely to have ripple effects globally, it could contribute to greater instability in the Middle East and Eastern Europe if it coincided with increasingly isolationist foreign policy from the United States.

Overall, Brexit would put greater pressure on regions outside of Europe to deliver strong results that can compensate for years of underperformance by the UK and the EU in corporate portfolios. This may be a big challenge in the current global growth environment, requiring an even greater focus on agile strategies that emphasize strong competitive positioning, careful risk management, and a reshaping of how companies plan to win in emerging markets.

In case the UK votes next week to leave the EU, boards and executive teams should ask themselves several urgent questions to effectively prepare their response:

  1. What is our company’s exposure to short-term currency volatility of both the British pound and the euro? How would significant depreciation against the dollar affect our overall revenue and profit targets for this year?
  1. Have we developed alternative international growth strategies that rely less on demand in Europe?
  1. What production and distribution disruptions are we likely to face in our European operations?
  1. How should we adjust our long-term outlook for doing business in Europe? What economic and political risks are now more likely and more significant to our company?

Joel Whitaker is Senior Vice President of Global Research at Frontier Strategy Group (FSG), an information and advisory services firm supporting senior executives in emerging markets.