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(originally published by Booz & Company)

Finance: The Essentials from Booz & Company

Total Shareholder Returns

4. Warranted value. This is the current value of a company or an operating unit based on the best estimate of its expected free cash flow (or economic profits) under a particular future strategy. This metric is sometimes called intrinsic value. Warren Buffett defines it as “the present value of the earnings power a business has over its remaining life.”

There are two important points to be understood about warranted value. First, a company (or operating unit) has as many warranted values as there are valid alternative strategies for it to pursue. Second, warranted value is not the same thing as market value, nor is warranted value per share the same thing as stock price.

The Relationship among Metrics

Although a company’s stock price can and often does diverge from its warranted value per share, the company’s market value still tends to track its warranted value over time. Hence, the impact of strategic and investment decisions on your company’s warranted value per share will ultimately have an equivalent impact on your stock price. Therefore, choose your strategies and make investment decisions based on your warranted value — not on your stock price or, for that matter, any other single financial metric such as revenue growth, return on capital (ROC), or earnings per share (EPS).

If your TSR is driven largely by a change in stock price, and if that price is ultimately determined by warranted value per share, it follows that your company’s TSR is driven largely by the change in its warranted value per share. Hence, if your company operates in a way that maximizes long-term warranted value per share over time, it is managing in a way that also maximizes long-term TSR over time.

Likewise, when added to invested capital, the present value of future economic profits will yield exactly the same estimate of warranted value as the present value of free cash flow. Working to maximize economic profit growth over time is thus the same thing as working to maximize long-term value creation and TSR.

A company’s P/E ratio is obtained by dividing its stock price by its annual earnings. Over time, your company’s P/E and stock price are determined by the same thing: its warranted value per share. A P/E does not determine stock price; it’s the other way around.

Using TSR Metrics

In practice, you should not rely on any one measure or criterion to make strategy choices and investment decisions. If you did, the single best measure for such purposes would be warranted value. No other measure can capture the trade-offs between growth and profitability, short term and long term, and risk and reward better than warranted value.

But in itself, this metric is inadequate. Do not use warranted value (or metrics derived from it, such as total business return) for performance management or incentive compensation. It is based on a forecast of expected future results, not on actual delivered results. Instead, use a combination of three measures — revenue growth, economic profit, and free cash flow — to set business targets, track strategy execution, and evaluate management performance. These three measures capture virtually all the high-level financial information that is important for an operating unit. As long as internal management reporting processes are designed to report these measures accurately, they provide excellent feedback on whether the value creation expectations of a particular strategy are being met. Moreover, they are good indicators of which questions to ask and where to look for answers when performance is off track.

Managing for Top-Tier TSR

Managing for top-tier TSR means always choosing the course of action that has more warranted value (per share) than any other alternative. This approach to management involves a continuous search for strategies, ideas, solutions, and opportunities that can increase the company’s warranted value per share. It does not mean “putting shareholders first,” nor does it focus on managing for shareholders’ expectations or short-term stock price.

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