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(originally published by Booz & Company)

Finance: The Essentials from Booz & Company

Total Shareholder Returns

When understood and used appropriately, managing for top-tier TSR will produce high-quality, sustained EPS growth and a premium multiple. In large part, this is because a greater portion of your investment (financial resources, management time) goes into value-creating activity, and this gives your company more competitive and financial strength. It also enables you to invest in your future and in building the right capabilities as your markets inevitably evolve.

Although managing for top-tier TSR is not about maximizing earnings per share — short term or otherwise — it will produce consistently superior EPS growth. Chasing quarterly EPS will not. As Yale University executive-in-residence Peter Kontes shows in his book The CEO, Strategy, and Shareholder Value: Making the Choices That Maximize Company Performance (Wiley, 2010), companies that consistently manage for economic profit growth not only produce twice the TSR, but also one-third higher earnings growth than companies that are dominated by an earnings culture.

Many CFOs and their CEOs have used the framework and process of managing for top-tier TSR — in whole or in part — in order to transform their companies’ strategic direction, organizational capabilities, and performance. This includes Coca-Cola under Roberto Goizueta, Alcan under Travis Engen, Barclays under Matthew Barrett, Gillette under James Kilts, and Roche under Franz Humer.

These companies used a variety of “value-based” metrics, tools, processes, and strategies to increase the capacity of their people to create long-term value and generate sustainably superior capital and product market performance. For these executives, changing the operating model and strategies was as important as changing the metrics. They were concerned with all parts of their operating model and strategies, including setting goals, communicating with investors, setting priorities for their top team, allocating financial and nonfinancial resources, and managing performance, as well as strategy development, financial planning, the role of the corporate center, and rewards for operating staff.

Common Pitfalls

Many companies set out to maximize their long-term value creation without success. There are a few important reasons for this. One is the all-too-common practice of managing for shareholder expectations. This is the tail wagging the dog, and often leads to pursuing overly aggressive short-term EPS targets at the expense of profitable investment in the future. Recall that warranted value per share drives stock price over time, and fundamentals, not shareholders’ expectations, drive warranted value per share. Put another way, managing for shareholder expectations will almost always lead a company into a course of action that depresses its future multiples, thus undermining its TSR.

Another common pitfall is tying incentive compensation, such as annual bonuses, to performance against a predetermined plan or budget. This inevitably leads people to restrain their aspirations for the business in order to make it easier to “beat plan.” In turn, this is interpreted as sandbagging by corporate headquarters or investors. The end result is a time-consuming, soul-destroying, and ultimately unproductive gaming of the planning and budgeting process. Instead, your plan should drive resources and actions that help you realize the full potential of your best strategy. Your budget should be a tool for controlling costs relative to revenue. Neither should be used for determining annual bonuses.

Nor should annual value growth or its closest cousin — total business return (TBR) — be used to determine annual bonuses. These are based on forecasted results, not on delivered results. Annual value growth and TBR are just measures of how the performance forecast for a business has changed over the course of a year. This forecast is highly sensitive to small changes in assumptions about the future performance of the business over an infinite horizon. As we mentioned earlier, annual bonuses should be based on delivered results, not on a forecast of results.

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