Issues with TRS

A performance measure must do more than simply record how much a stock goes up or down. It must cut through the noise of the market and provide an accurate picture of exactly how and why managers are creating value. Seen from this perspective, TRS has limitations.

Many factors other than management performance drive share prices. During the one to three years that TRS is usually measured for the purpose of evaluating performance, the market as a whole or the industry sector in

2 This section is based on the following article: R. Dobbs and T. Koller, ''The Expectations Treadmill," McKinsey Quarterly, no. 3 (1998), pp. 32-43.

which a company operates will drive the share-price movements. Analysis of total shareholder returns for a sample of nearly 400 companies showed that market and sector movements explained on average more than 40 percent of the returns during any one- or three-year period.

It follows that if performance is measured on the basis of TRS alone, managers are in effect being partially rewarded or penalized for events outside their control (this can be alleviated by using TRS relative to a market or sector index). Yet traditional share option schemes do just that, and the bull market of the 1990s rewarded option-holding employees in all but the most woefully underperforming companies. The other side of the coin is a growing problem for the volatile high-technology industry. When a sector re-rating made share prices plummet, companies found they had to reprice employee share-option packages to retain important staff.

In fact, in the short term, differences between actual performance and market expectations and changes in these expectations drive share prices more than the level of performance per se. It is the delivery of surprises that produces higher or lower total shareholder returns compared to the market. As a result, companies that consistently meet high performance expectations can find it hard to deliver high TRS. The market may believe that management is doing an outstanding job, but its approval has already been factored into the share price.

One way to understand the problem is by analogy to a treadmill. The speed of the treadmill represents the expectations for future financial performance implicit in the share price. If managers are able to beat these expectations, they accelerate the treadmill and so deliver above-average shareholder returns. As performance improves, the expectations treadmill turns more quickly. The better managers perform, the more the market expects from them; they have to pound the treadmill ever faster just to keep up.

For outstanding companies, the treadmill is moving faster than for anyone else. It is difficult for management to deliver at the expected level without faltering. Accelerating the treadmill will be hard. Continuing to accelerate the treadmill will eventually become impossible.

This explains why extraordinary managers may deliver only ordinary share price increases in the short run. If their compensation is based significantly on TRS through stock options, they are likely to be insufficiently rewarded. This predicament illustrates the old saw about the difference between a good company and a good investment: In the short term, good companies may not be good investments, and vice versa.

In the case of companies of which less is expected, TRS-driven measures may overcompensate managers. During the early years of a turnaround, for example, beating expectations may be relatively easy because the expectations treadmill is not moving fast. Since the market reflects changes in the performance expected in all future years, the net effect is that managers can deliver high TRS even when they have improved performance only marginally.

There is a considerable multiplier effect when the market re-rates a company to reflect higher expectations. The movement in share price reflects the present value of all the changes in expectations for all future years' cash flows. As a result, TRS could be well over 50 percent. Merely to announce a new chief executive officer can be enough to shift a share price by more than 10 percent before the new manager has even arrived, and certainly long before there has been any improvement in performance. On the day in 1996 that Credit Suisse announced the appointment of Lukas Muehlemann as CEO, the bank's share price rose by about 20 percent, causing shareholder value to soar by $3 billion.

Market Value Added: A Complementary Measure

An alternative market-based performance measure, market value added (MVA), has gained popularity, especially with the publication of the financial consultant Stern Stewart's MVA rankings in Fortune magazine in the United States and in other financial publications around the world. MVA is calculated as the difference between the market value of a company's debt and equity and the amount of capital invested. The market-to-capital ratio, a variation on MVA expressed as a ratio rather than a dollar amount, is the market capitalization of a company's debt and equity divided by the amount of capital invested.

MVA and market-to-capital ratio pose definition and measurement problems because they use accounting data. They are also subject to some of the same criticisms as TRS, namely that important elements of the valuation are outside of management's control. But they provide a worthy complement to TRS by measuring different aspects of a company's performance.

TRS can be likened to the speeding up or slowing down of the treadmill. It measures performance against the expectations of financial markets and changes in these expectations. TRS is a measure of how well a company beats the target set by market expectations—a measure of improvement, in other words. MVA and market-to-capital, on the other hand, can be likened to the current speed of the treadmill. They measure the financial market's view of future performance relative to the capital invested in the business. In this way, they assess a company's absolute level of performance.

To understand the difference between MVA and TRS, consider the example of the U.S. retailers Sears and Wal-Mart. In the five years ending December 31, 1997, Sears achieved an average TRS of 22 percent a year, while Wal-Mart managed 5 percent a year. Is Sears creating more value? Is it performing better?

The MVAs and market-to-capital for Sears and Wal-Mart are shown in Exhibit 4.2. On December 31, 1997, Wal-Mart's market capitalization (debt and equity) was $101.3 billion and its invested capital $32.1 billion. This resulted

Exhibit 4.2 MVA for Sears and Wal-Mart

Exhibit 4.2 MVA for Sears and Wal-Mart

in an MVA of $69.2 billion, one of the highest in the world. Sears' MVA was $11.8 billion, based on a market value of $42.5 billion and invested capital of $30.7 billion. If we then look at the market-to-capital ratios, Wal-Mart scored 3.2, Sears 1.4. In other words, every dollar that Wal-Mart had invested was valued by the market at $3.20, while every dollar Sears had invested was valued at $1.40.

Wal-Mart creates more value, so it has a high market-to-capital. It was not able, however, to exceed the market's performance expectations because its treadmill was already moving fast. Sears does not create as much value, so it has a lower market-to-capital. But during its restructuring, it has beaten market expectations. Its treadmill was moving slowly, and has speeded up. It could be argued that both companies have performed well over the five years, given their different starting points.

Combining TRS and market-to-capital can provide interesting insights into the dynamics of a company's performance, especially when the period examined is less than 10 years. To illustrate, Exhibit 4.3 plots a number of leading retailers in terms of market-to-capital ratio and TRS. The companies fall into four quadrants.

Quadrant 1 companies are the corporate elite. They include the U.S. clothing retailer The Gap, the U.S. supermarket chain Kroger, and the French supermarket chain Carrefour. These companies have earned exceptionally high TRS in the five years to December 1997 and have high market values in relation to the amount of capital invested in them. Quadrant 3 companies are the opposite; they face a considerable performance challenge. They include the U.S. supermarket Great Atlantic and Pacific, the U.S. discount retailer Kmart, and the German retailer Karstadt. In each case, TRS is low or negative, and market-to-capital is lower than for most retailers. Companies in this quadrant (and in quadrant 1) are easy to evaluate because both measures are low (or high).

Evaluating companies in quadrants 2 and 4 is more difficult. Quadrant 2 companies are recovering underperformers. This group includes Sears, the

Exhibit 4.3 Market Capitalization and TRS for Leading Retailers

Exhibit 4.3 Market Capitalization and TRS for Leading Retailers

U.S. drugstore chain Rite Aid, and the U.K. brewer, pub, and restaurant chain Whitbread. These companies have high TRS but low relative market-to-capital. Five years ago, when expectations of their performance were low, their market-to-capital was even poorer. They have since performed better than expected, accelerating the treadmill, but their market-to-capital ratios are still nowhere near those of excellent competitors.

Companies in quadrant 4 may have suffered from unrealistic market expectations, or they may be underachievers. They include Wal-Mart and Nordstrom. These companies have high relative market-to-capital but low TRS. You might think of them as emerging underperformers. Although highly valued, they have not exceeded—indeed, in some cases have not met—market expectations. Without detailed analysis, it is impossible to say whether this is the result of unrealistic performance expectations by the market at the beginning of the period, or of managers' inability to realize their companies' potential. The treadmills were simply moving too fast, and the companies have been unable to keep running at the required pace.

In these assessments, we used the relative measure of market-to-capital, but we can also use the absolute measure of MVA. Exhibit 4.4 shows the performance of the same retail companies using both absolute and size-adjusted measures. Relative to the amount of capital invested, the top retailer in our sample is The Gap. On an absolute basis, the winner is Wal-Mart. The

Exhibit 4.4 MVA and Market-to-Capital: Absolute and Relative Measures

Exhibit 4.4 MVA and Market-to-Capital: Absolute and Relative Measures

Gap creates more value for each dollar invested, but Wal-Mart creates more absolute wealth. Which is better? It is impossible to say, and probably irrelevant. Both are star performers.

Market Value Driven by Intrinsic DCF

The second issue to address in detailing our metrics framework is what drives the market value of companies. To make the problem tractable, we will compare the DCF approach to the earnings-multiple approach. The DCF approach provides a more sophisticated and reliable picture of a company's value than an earnings-multiple approach. In the next chapter, Cash Is King, we provide evidence that market behavior is consistent with the theory.

We begin by defining the two competing approaches:

1. In the earnings-multiple approach, companies are valued based on a multiple of accounting earnings. In its extreme form, the earnings-multiple approach says that only this year's or next year's earnings matter. A more complex form might discount the future stream of earnings at some rate or some form of ''normalized" earnings.3

3 A variation on earnings multiples is the use of multiples of operating parameters as a shorthand when comparing companies. For example, asset managers are often valued as a percentage of

(footnote continued on next page)

Exhibit 4.5 Projected Income of Long Life and Short Life Companies

Income statements

$

Year 1

Year Z

Vear 3

Year 4

Year 5

Year 6

Long Life Company

0 0

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