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Published: March 21, 2011

 
Finance: The Essentials from Booz & Company
 

Total Shareholder Returns

This measure of business performance is the best indicator of corporate success.

For the past 20 years we have been working with the CEOs and CFOs of large, global public companies, helping them implement management approaches and capabilities, with the explicit objective of generating superior total shareholder returns (TSR). Total shareholder return is a measure of corporate performance. But as we shall see, it is also a system of management, grounded in a set of metrics and practices for running a company to maximize its value creation, over both the short term and the long haul. 

There are many ways to start working with this system. You could simply change your top-tier metrics and incentive compensation (for example, adding TSR to the scorecard and linking the pay rates for your top 50 executives to TSR). Or you could adopt a better way to run the company, incorporating new performance goals, strategies, management processes, and organizational behaviors. You might choose this type of action for a variety of reasons — for example, to return to industry-leading performance and valuation, to get the most out of a new organizational structure, to strive for strategic distinction, to improve the company’s resource allocation, or to make the company more than just the sum of its parts.

When starting down the TSR path, it is helpful to begin with two questions: How broad or narrow should we make our focus on TSR? What issues and opportunities are we seeking to address by adopting a sharper focus on managing for TSR?

Primary TSR Metrics

These are the four primary metrics to use when managing for top-tier TSR.

1. Total shareholder return. This is the change in a company’s stock price for a given period, plus its free cash flow over the same period, as a percentage of the beginning stock price. For example, if a company has a stock price of US$100 at the beginning of a year, free cash flow of $3 during the year, and a stock price of $110 at the end of the year, its TSR for that year is 13 percent. TSR can be measured only for publicly traded companies because it requires observable stock prices.

In any given year, a company’s TSR doesn’t mean all that much. But when measured over time, it is the single best indicator of success. This is because it reflects how well a company has created long-term value in highly competitive capital, labor, and product markets — markets that are often very short-term-oriented (or that at least feel that way).

2. Free cash flow (from a shareholder perspective). This is the difference between earnings and retained earnings (sometimes called equity cash flow). At the company level, it is the portion of earnings paid out to investors. In a year when a company neither issues nor repurchases equity, free cash flow is simply the dividends paid to shareholders. At the operating level, it is the portion of an operating unit’s earnings that are available to be paid to investors after it takes care of all its other investment needs. In any year when an operating unit’s investment needs exceed its earnings, its free cash flow is negative.

3. Economic profit. This is the difference between earnings and the cost of invested capital for a given period of time. A business that is earning at least its cost of capital is generating positive economic profit; a business that is earning less than its cost of capital has negative economic profit, even if its earnings are positive. For example, if a company has $15 of earnings, a 10 percent cost of capital, and $100 of invested capital, its economic profit is $5 (15 minus 10 percent of 100). But if its earnings are only $8, it has $2 of economic loss (8 minus 10 percent of 100).

 
 
 
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