2. A New Understanding
In September 2017, Palgrave Macmillan published Customer Value, Shareholder Wealth, Community Wellbeing, which included a foreword written by Westpac CEO Brian Hartzer.
The purpose of this book was to provide a roadmap for those leaders of listed companies that were seeking to build truly enduring institutions capable of creating value for their customers and wealth for their shareholders on an ongoing basis – and so prosper well beyond the tenure of any one executive leadership team.
The path laid out for business leaders also included the option to pursue this goal in a way that deliberately sets out to enhance the wellbeing of all legitimate stakeholders, including the wider community and the environment.
Central to the thinking presented in the book was a breakthrough in applied corporate finance. This breakthrough had two mutually supportive aspects. One was conceptual. The other was research-based.
The conceptual aspect centred on the realisation that there exists a Bow Wave of Expected Economic Profits embedded in the share price and market capitalisation of every listed company at every point in time. This EP Bow Wave construct provided a clear and actionable bridge linking the product and services market performance produced by management with the capital market outcomes experienced by shareholders.
The research aspect of the breakthrough made use of the EP Bow Wave construct to firstly explore and then establish the mechanism by which wealth was being created on an ongoing basis by truly successful companies listed on the Australian Securities Exchange (ASX), the New York Stock Exchange (NYSE) and the London Stock Exchange (LSE). The conclusions were clear and consistent across the three markets.
The remainder of this section outlines the conceptual breakthrough that has been achieved, before presenting the principal research findings that arise from its application. Fundamental to the thinking presented and to a successful path forward, is the adoption of economic performance measures.
An Economic Approach to Performance Measurement
True commercial success for a listed company means succeeding in two markets — the market for the company’s products and services and the market for shareholder capital. Good performance in the first ultimately leads to success in the second.
Success in the Products and Services Market
Success in the market for a company’s products and services initially means being economically profitable — by producing a return on equity (ROE) greater than the cost of equity capital (Ke).
As illustrated in Figure 1, once a business becomes economically profitable, the criterion for success transitions to delivering a growing stream of economic profit (EP).
True success in the product and service market cannot be assessed in terms of meeting specific Earnings, Earnings per Share (EPS) or EPS growth outcomes. Such measures don’t take account of the amount or the cost of the capital required to deliver a given level of Earnings or EPS. As a result, Earnings or EPS outcomes can quite literally be bought at any price – and they often are, as we discovered when completing research for Customer Value, Shareholder Wealth, Community Wellbeing. [ii]
Figure 1. Defining Success in the Market for Products and Services
Success in the Capital Market
Success in the capital market means producing a total shareholder return (TSR), in the form of dividends and share price appreciation, that exceeds Ke.
Ke is the long-term return on market value that shareholders require to preserve wealth from an investment in a specific company. When TSR exceeds Ke, shareholder wealth is created. When TSR is less than Ke, shareholder wealth is destroyed. When TSR equals Ke, shareholder wealth is preserved. [iii]
Linking Product and Capital Market Performance Using the EP Bow Wave
It is a fundamental tenet of business economics that market forces erode EP to zero over time, as returns are driven back to the cost of capital and growth recedes to average economic growth. This gives rise to the notion of a Bow Wave of Expected Economic Profit, as illustrated in Figure 2.
Figure 2. EP Bow Wave Construct
Shaped like a child’s ‘slippery dip’ or ‘slippery slide’, the EP Bow Wave is analogous to the bow wave of a ship moving through the ocean. A bigger bow wave denotes a ship that has built up greater momentum. The height of the EP Bow Wave is economic profitability (ROE-Ke). The width is the level of investment, or the equity capital base on which the economically profitable return is being earned. Growth or further investment makes the EP Bow Wave wider. The length of the EP Bow Wave is the sustainability of a positive EP stream.
The left-hand side of Figure 2 presents the same EP outcome shown in Figure 1. The vertical axis is ROE. The horizontal axis is equity capital employed – and in this example, that figure is $100 million.
The area of the large rectangle is Profit After Tax (PAT). The charge for equity capital at a Ke of 10 per cent is $10 million, and the residual EP is $20 million.
The right-hand side of Figure 2 shows the dynamics of the EP stream over time. The three dimensions of returns (or economic profitability), growth and sustainability illustrated in Figure 2 constitute the metrics that define the EP Bow Wave for any company at any point in time.
When we put all three dimensions together, the ‘volume under the slippery slide’ represents the expected EP stream. We can value this EP stream by discounting at the cost of equity.
Shareholder wealth will be preserved in the capital market, and TSR will equal Ke over the long term, when a company begins to deliver, and investors believe it will continue to deliver, an EP stream consistent with the EP Bow Wave that was embedded in its share price at the beginning of a given measurement period. Wealth will be created (TSR > Ke) when management finds a way to enhance the shape of their EP Bow Wave – making it higher with enhanced return expectations, wider through greater growth expectations, or longer through actions that make the business more sustainable, as illustrated in moving from the blue to the green bow wave in Figure 3.
Figure 3. Enhancing the Shape of the EP Bow Wave
One of the important realisations that emerges from the EP Bow Wave construct is that wealth is not created in the capital market simply by making returns higher in the product and services market. In a mechanistic sense, the objective is to increase the ‘volume under the slippery slide’ in Figure 3. This is not the same as simply making the EP Bow Wave higher with higher returns. Making it wider and especially longer can sometimes be more important – particularly for companies that are already economically profitable. Focusing solely on increasing ROE, or ROE-Ke, can sometimes result in a narrower and/or shorter EP Bow Wave, and lead to the destruction of shareholder wealth.
The Pair of EP Bow Waves
A key analytical step in linking product and capital market performance using the EP Bow Wave construct, is to introduce the notion of a Pair of EP Bow Waves. Figure 4 shows a Pair of EP Bow Waves, with one representing EP expectations at the beginning of a five-year measurement period and the other showing EP expectations at the end.
The Pair of EP Bow Waves in Figure 4 is constructed in two dimensions rather than three, so that we can overlay them. The y-axis is EP in dollars. It corresponds to the shaded planes in Figures 2 and 3.
The amber line in Figure 4 represents the EP expectations embedded in the share price at the beginning of the measurement period (which in the case illustrated covers five years beginning in 2011). The blue line represents current expectations from 2016 onwards, plus the EP outcomes that were delivered over the measurement period from 2011 to 2016.
Figure 4. A Pair of EP Bow Waves
The red area on the left-hand side and the green area on the right in Figure 4, represent the two potential sources of wealth creation that exist for every listed company over any measurement period. They are:
- The wealth created from the delivery of an EP stream that exceeded the expectations in place at the beginning of a given measurement period, and
- The wealth created from any increase in expectations during that measurement period, in relation to the EP to be delivered beyond the measurement period.
The hypothetical company portrayed in Figure 4 failed to meet expectations over the five-year measurement period. But the resultant wealth destruction was more than offset by wealth created from an increase in expectations in relation to the EP to be delivered beyond the measurement period.
Measuring Wealth Creation Using the Pair of EP Bow Waves
Figure 5 illustrates a Pair of EP Bow Waves for London Stock Exchange listed Unilever Plc over the five years to 31 December 2016. The bottom half of the figure details the EP expectations that needed to be delivered to preserve wealth as at 31 December 2016.
Unilever created £18.8b in shareholder wealth over the five years to 31 December 2016. This was made up of wealth destruction of £2.2b from failing to meet existing EP expectations over the measurement period, and wealth creation of £21.0b from establishing new EP expectations to be delivered in future. Of the £21.0b arising from new expectations, £14.4b came from extending the length of the EP Bow Wave from 40 to 50 years.
It is important to note that Unilever’s wealth creation profile is typical of that which we see in more successful listed companies, as will be evident when we cover research outcomes under the heading ‘Understanding How Wealth is Really Created’.
To preserve wealth and justify the share price in December 2016, Unilever would need to deliver the EP expectations shown in the lower half of Figure 5. This would mean sustaining a level of economic profitability (ROE-Ke) between 21 and 22 per cent until 2026, having a capital base almost doubling in size over the same period, and generating an underlying EP outcome that would increase from £3.7 billion in 2017 to £6.9 billion by 2026, and remain positive until 2066.
Figure 5. The Pair of EP Bow Waves for Unilever over the Five Years to December 2016
A Bridge between the Product and Capital Markets
The Pair of EP Bow Waves provides both a conceptual and an analytical bridge between the product and service market performance produced by management, and the capital market outcomes experienced by shareholders.
To build such a bridge we must use economic measures. This is because with economic measures, the ultimate performance benchmark in both markets is the same – the cost of equity capital (Ke).
Book value is preserved in the product and services market when ROE matches Ke. Market value is preserved in the capital market when TSR matches Ke. In both cases, market forces drive returns back to Ke over time.
For many years, business commentators have focused largely on Earnings or EPS, or sometimes ROE, as the primary measures of the financial performance achieved by management in the market for a company’s products and services. They then applied an ‘earnings multiple’ or ‘PE Ratio’ to bridge to a capital market outcome. In this way, an incremental value or share price outcome was inferred from an incremental Earnings or EPS outcome.
However, this thinking is flawed, as is explained later as part of a discussion of research outcomes in a section entitled The EPS Myth. It is addressed in more detail in an address to the annual conference of the Governance Institute of Australia in 2015, and in Section 2 of Customer Value, Shareholder Wealth, Community Wellbeing. [iv]
The Pair of EP Bow Waves reveals quite a different relationship between product and capital market performance to that which most business leaders, investors and commentators assume exists. Its strength lies in its accuracy and in the amount of information that it reveals.
The full power of the Pair of EP Bow Waves as both an analytical tool, and as a platform upon which to construct a comprehensive economic performance measurement framework that can support a Board and its executive team in building an enduring institution, is brought to life in the Wesfarmers case study in Section 5.
Measuring Wealth Creation in Terms of TSR-Ke and TSR Alpha
The Pair of EP Bow Waves provides a means with which to measure the wealth created for shareholders over a given measurement period from both a product and service market perspective and from a capital market perspective. It also enables the performance achieved in both markets to be reconciled.
From a product and service market perspective, the wealth created over a given measurement period is the sum of the wealth created by delivering an EP stream that exceeded the expectations in place at the beginning of the period (i.e. the left-hand side of the Pair of Bow Waves); and the wealth created from any increase in expectations during the measurement period, in relation to the EP to be delivered beyond the measurement period (i.e. the right-hand side of the Pair of Bow Waves).
To use the Pair of EP Bow Waves to understand wealth creation from a capital market perspective, we need to introduce the concept of TSR Alpha. TSR Alpha is the economic return on market value over the short-to-medium term, in the same way that TSR-Ke is the economic return on market value over the long term.
We know that when TSR exceeds Ke, shareholder wealth is created. When TSR is less than Ke, shareholder wealth is destroyed. When TSR equals Ke, shareholder wealth is preserved. However, the challenge with TSR-Ke as a performance metric is that it is a long-term measure. This is because the shareholders’ required rate of return Ke is essentially constant over the long term. Over the short term, if equities markets are rising across the board, it is relatively easy to produce a TSR greater than Ke. But when equities markets are falling, it can be very difficult.
Underlying movements in the equities market have nothing to do with the efforts or the performance of management. So, when measuring performance from a capital market perspective, we need to be able to strip out the impact of underlying market movements to reveal management’s contribution to wealth creation. When we do, what remains is TSR Alpha. Over any given measurement period, TSR-Ke and TSR Alpha are linked by the following relationship:
TSR-Ke = ‘Risk-Adjusted Impact of Short-Term Market Movements’ + TSR Alpha
Shareholders always experience TSR-Ke – with a positive outcome signifying wealth creation and a negative one indicating wealth destruction. The TSR-Ke outcome will always be the sum of the ‘Risk Adjusted Impact of Short-Term Market Movements’ which have nothing to do with the performance of management; and TSR Alpha, which is driven largely by the capital market’s reaction to the decisions made and the actions taken by management during the measurement period.
These two elements comprise the capital market perspective on wealth creation, which is illustrated in the case of Unilever on the right-hand side of Figure 6. The product and services market perspective on the left-hand side contains the same information that was in the top half of Figure 5.
The numerical outcomes in the right-hand panel in Figure 6, and particularly the TSR Alpha outcome, can be derived either directly from observable capital market data, or from an analysis of the Pair of EP Bow Waves. The direct approach, where TSR Alpha is calculated from observable capital market data, can only be done at a Group level. But the calculation based on the Pair of EP Bow Waves can be done at a Group, Divisional or Business Unit level. Being able to calculate TSR Alpha at a Divisional, Business Unit and potentially even at a customer segment level, is particularly helpful in performance measurement and executive reward applications.
Figure 6. Two Perspectives on Wealth Creation for Unilever Plc
When working with TSR-Ke and TSR Alpha, it is important to remember that the benchmark performance for both metrics is always zero, indicating a level of performance commensurate with wealth preservation. A TSR-Ke of zero means wealth was preserved for shareholders, but it incorporates the impact of short-term market movements. A TSR Alpha of zero means that management’s contribution tended to preserve shareholder wealth, irrespective of the impact of market movements.
The Progression of Annual EP Bow Waves
Businesses that succeed in creating wealth for shareholders on an ongoing basis tend to systematically enhance the shape of their EP Bow Wave over time – by making it higher, wider and especially longer. They do this by meeting (or going close to meeting) EP expectations in the short term, while at the same time creating new and higher EP expectations to be delivered in the future. They then deliver the new expectations, while creating a further series of new and even higher EP expectations to again be delivered in the future. And then they do this again, and again, and again.
This behaviour is evident in the Progression of Annual EP Bow Waves for Unilever Plc illustrated in Figure 7. It is even more apparent in the research outcomes that will be summarised later.
Figure 7. Progression of EP Bow Waves for Unilever over the Five Years to 31 Dec 2016
The change or progression in the shape of a company’s EP Bow Wave each year provides a unique perspective on how the market is reacting to the actions and the performance of the company and its management team. An EP Bow Wave that improves steadily over a long period of time is a good indicator of the extent to which a company is succeeding in institutionalising the ability to innovate – to create value for its customers and wealth for its shareholders on an ongoing basis.
The Progression of EP Bow Waves for Unilever over the five years to 31 December 2016 as illustrated in Figure 7, shows that in general, Unilever tended to either meet, slightly exceed, or slightly underperform EP expectations each year. More importantly though, it was continually taking action that led to the establishment of new EP expectations to be delivered in the future.
It is important to appreciate that the EP Bow Wave tends to have a natural maximum length of around 60 years (or 50 years beyond an explicit 10-year forecast period). Beyond that, the value of incremental EP is negligible due to the compounding effect of discounting at Ke.
The EP Bow Wave also tends to erode naturally over time – unless management acts to maintain it. For better-performing companies, maintaining a strong existing EP Bow Wave is a wealth-creating endeavour in its own right. Unilever’s EP Bow Wave was 50 years in December 2016 – well above its sector peers. The ability to maintain this, rather than to just deliver embedded EP expectations and allow the EP Bow Wave to erode by one year with each passing year, would be worth an additional £5.0b in wealth to the shareholders of Unilever over the three years from 31 December 2016 to 31 December 2019.
In a general sense, the goal is to either maintain or enhance the shape of the EP Bow Wave – depending upon the shape of the existing EP Bow Wave and where a company’s EP Bow Wave profile sits relative to others in its sector.
Linking the Progression of Annual EP Bow Waves to Wealth Creation and TSR Alpha
There is a direct relationship between the progression in a company’s EP Bow Wave, the level of wealth created (TSR-Ke) and the extent to which a company delivers a positive TSR Alpha outcome over a given measurement period.
Initiatives pursued by management in the product and services market that result in the shape of their company’s EP Bow Wave improving, and its intrinsic value increasing over time, manifest in the capital market as positive TSR-Ke outcomes over the longer term, and as positive TSR Alpha outcomes over the short-to-medium term.
As is evident in Figure 7, the capital market reacted favourably to the actions of Unilever’s management over the period from December 2011 to December 2016, resulting in a steadily improving EP Bow Wave profile. As a result, Unilever created a significant amount of wealth over each of the rolling three-year measurement periods ended December 2014, 2015 and 2016, as well as the five-year measurement period ended December 2016. This is apparent from the TSR-Ke outcomes in Figure 8.
Figure 8. Wealth Creation and EP Bow Wave Progression for Unilever
Looking back over the measurement period, the change in the shape of Unilever’s EP Bow Waves follow the movements in TSR-Ke, the long-run economic return on market value. This is the ultimate indicator of shareholder wealth creation or destruction. But once again, TSR-Ke is made up of two components, the risk adjusted impact of movements in the market as a whole across the measurement period (which created a ‘headwind’ for the company) and TSR Alpha.
The impact of management’s efforts is captured in TSR Alpha, whereas the return shareholders experience is captured in TSR-Ke.
Looking forward, management should be seeking to enhance the profile of the EP Bow Wave through the actions they take in the product and services market. Succeeding in this will create wealth and produce a positive TSR-Ke outcome over the long term. However, market ‘headwinds’ or ‘tailwinds’ can distort this over the short term. So, looking backwards for performance measurement purposes, it is always necessary to strip out the impact of short-term market movements, to isolate that component of wealth creation that arose largely from the market’s reaction the actions of management. This is captured in TSR Alpha.
Insights Derived from Research
There is an extensive body of research that underpins the understanding we have just outlined.
Understanding How Wealth is Really Created
When we examine performance over time using the Pair of EP Bow Waves, we find that for more successful companies, the wealth created from establishing new and higher EP expectations to be delivered in the future, is far more important than that arising from exceeding existing expectations.
Successful companies create wealth by establishing capabilities and harnessing innovation to devise better customer value propositions and to develop higher value strategies. These lead to a series of new and higher EP expectations to be delivered in the future. Successful companies then deliver, or go close to delivering, these new and higher expectations. But our research suggests that they tend not to exceed existing EP expectations over the short-to-medium term – and certainly not to any great degree.
We have observed this in each of the studies we have conducted in the ASX, the NYSE and the LSE. They all showed that in general:
- The more successful a company was in continually creating shareholder wealth, the higher the proportion of the wealth they created that came from establishing new and higher EP expectations to be delivered in the future; and
- The greater the proportion of the wealth created in this way that came from making their business more sustainable, with a longer EP Bow Wave.
This is evident in Figure 9, which summarises the results of a research effort involving the construction of Pairs of EP Bow Waves for the 100 largest companies by market capitalisation in the ASX, the NYSE and the LSE. This research was completed while writing Customer Value, Shareholder Wealth, Community Wellbeing.
Figure 9. Wealth Creation in Successful ASX, NYSE and LSE Companies – Five Years to 31 Dec 2015
In the case of the ASX, just over 60 per cent of the wealth created by the 63 companies that managed to create wealth for their shareholders over the five-year measurement period, arose from actions that led to an increase in the sustainability of their businesses and the associated economic profit streams. Roughly 35 per cent of the wealth these companies created arose from improvements in the underlying economics of their businesses, which were evident in the form of increased expectations in relation to future economic profitability and/or future growth. Just 5 per cent of the wealth created by these top-performing companies, came from outperforming market expectations over the five-year measurement period.
For companies listed on the NYSE and the LSE that created wealth for their shareholders over the five years to 31 December 2015, the picture was even more skewed towards wealth being created from enhanced expectations in relation to longer-term performance, together with an increase in the sustainability of the associated economic profit streams.
Figure 10 summarises the results of a more recent and quite detailed study of the largest 120 ASX-listed companies by market capitalisation (excluding resources companies and real estate investment trusts). In this case, we looked at the aggregate wealth creation for five rolling three-year periods over the seven years to 31 December 2016. The table shows each of the components of the aggregate wealth creation outcome in percentage terms. There were three groups of companies clearly identifiable based on their management’s contribution to wealth creation (TSR Alpha):
- Top performers that achieved an annualised TSR Alpha greater than 10 per cent;
- Good performers whose annualised TSR Alpha was positive but less than 10 per cent; and
- Other companies whose annualised TSR Alpha was zero or below.
The first column is 100 per cent in every case. Green shading in this column means 100 per cent of a positive number (meaning wealth was created). Red shading means 100 per cent of a negative number (meaning wealth was destroyed).
Figure 10. Sources of Wealth Creation in 120 ASX Listed Companies – Seven Years to 31 Dec 2016
For the 49 ‘top performing’ companies, all the wealth created came from establishing new EP expectations to be delivered in the future – or from the right-hand side of the Pair of EP Bow Waves. More than half of this came from enhancing the sustainability of the business, or from increasing the length of the EP Bow Wave.
For the 26 ‘good performers’, 93 per cent of the aggregate wealth creation came from the establishment of new EP expectations. Again, more than half of this came from an increase in the length of the EP Bow Wave.
The Problem with Stretch Targets
The understanding which flows from this research calls into question the focus on ‘stretch targets’ that underpins budgeting, performance management and executive reward in many listed companies. In most cases, stretch targets challenge management to extract more performance from a business (and particularly more short-term performance) than its strategy was intended to deliver. In imposing stretch targets, and then asking management to pursue them, a Board runs the risk of inadvertently encouraging the destruction of shareholder wealth by encouraging short-termism. This often involves either under-investing in the business or taking action that supports the pursuit of stretch financial performance targets in the short term; but erodes the value of the company’s franchise with its customers and at the same time harms other non-shareholder stakeholders. Such actions run the risk of eroding the shape of the EP Bow Wave, and so can destroy shareholder wealth over the longer term.
In companies that are working towards becoming enduring institutions that create value for customers and wealth for shareholders on an ongoing basis, non-shareholder stakeholders need to be seen as allies in creating customer value and shareholder wealth over the long term, not as adversaries in the pursuit of stretch target outcomes over the short term.
The problem with stretch targets is exacerbated by the fact they are usually expressed in terms of accounting measures. Earnings, EPS and EPS growth are the most common measures used. Their use further increases the risk of short-termism, due to the existence of the EPS Myth.
The EPS Myth – A Driver of Short-termism and an Impediment to Ongoing Wealth Creation
There is a widely-held belief throughout the business and investment communities (and particularly within the financial press), that enhancing short-to-medium term Earnings and EPS will enhance shareholder wealth. Many have researched this question over the years and the evidence is clear. It is simply not true. [v]
Worse than that, widespread adherence to this belief has been a major driver of short-termism. It has also been a significant impediment to the building of enduring institutions that can create value for customers and wealth for shareholders on an ongoing basis.
Over the years, there have been many studies also demonstrating that Earnings and EPS are poor indicators of management performance because they can be ‘bought at any price’. Their use in justifying acquisitions because they are ‘earnings accretive’ or ‘EPS accretive’ can be particularly problematic. Being Earnings or EPS accretive says nothing about the impact of an acquisition on shareholder wealth.
The fundamental problem with Earnings and EPS is that the amount and the cost of the capital required to underpin an Earnings or EPS outcome is not captured in Earnings, Earnings growth, EPS or EPS growth. Similarly, the widely held view that expressing Earnings on a per share basis as EPS will normalise it for the additional capital required, is also not true. New shares required to fund growth are issued at market value, not book value. Consequently, Earnings and EPS will generally move in lock step – as is demonstrated in Appendix 1 of Customer Value, Shareholder Wealth, Community Wellbeing. To the extent that there is any divergence at all between Earnings growth and EPS growth, it arises because new shares might at times be issued at a slight discount to market value in a placement. But the impact of this is not significant.
There have also been many studies demonstrating that the relationship between EP growth and TSR is much stronger than the relationship between EPS growth and TSR. Our research shows that the relationship between EP growth and TSR Alpha is much stronger again – as shown in Figure 11 below.
Figure 11 captures the results of two studies. One was completed by former Marakon Associates CEO Peter Kontes (dec.) and a team from the Yale School of Management. It covered S&P 500 companies over the ten years to 31 December 2007. The second was done by KBA and covered ASX 300 companies over the five years to 30 June 2013.
Figure 11. The Strong Relationship Linking EP per share with TSR and TSR Alpha
In both cases, the difference in annualised TSR between companies whose EP per share growth was significantly greater than their EPS growth, and those companies whose EPS growth was significantly greater than their EP per share growth, was more than six percentage points. The difference expands to nearly 11 percentage points when we use TSR Alpha, which is a much more appropriate indicator of relative performance over the five-year timeframe of the ASX study. [vi]
TSR Alpha – The Metric that Captures Management’s Contribution to Wealth Creation
Figure 12 illustrates the distribution of annualised TSR Alpha outcomes on the NYSE for the S&P 500 over the five years to 31 December 2015. The distribution is centred around zero as we would expect.
Figure 12. Distribution of 5-Year TSR Alpha Outcomes for S&P 500 – Five Years to Dec 2015
We have already established that TSR Alpha constitutes management’s contribution to TSR-Ke – the capital market outcome experienced by shareholders over any given measurement period.
Benchmark capital market performance is zero for both TSR-Ke over the long term (when short-term market movements are no longer a factor), and for TSR Alpha over the short-to-medium term. These benchmarks correspond to wealth preservation.
It is important to appreciate that it is difficult to continually deliver a positive TSR Alpha outcome.
If a company puts in place a performance improvement initiative, or a new and higher value strategy is adopted that is well received by the market, a positive TSR Alpha outcome will ensue. If over the next measurement period, the company delivers the enhanced expectations associated with that strategy but does nothing new beyond that, TSR Alpha should revert to zero. In order to once again produce a positive TSR Alpha, the company must do something further that is both new and wealth creating. It must do this again and again if it wants to produce a positive TSR Alpha on an ongoing basis.
Figure 12 suggests that it is relatively difficult to produce a TSR Alpha outcome of 10 per cent or more over one five-year period, let alone do it on an ongoing basis. This performance threshold is also supported by other research outcomes. But a small number of companies are able to do it – and those that do tend to have a quite a disciplined approach to innovation. In our experience, this is best done by focusing the strategy development and strategic planning process at a disaggregated level – the most productive generally being a customer segment level.
The breakthrough in understanding we have documented tells us many things that both individually and collectively, offer a new way of thinking in relation to the way wealth is created in listed companies. Seven are particularly important from the perspective of performance measurement frameworks and executive reward plan design.
- The goal is not to maximise shareholder value or even to create shareholder wealth per se. It is to build an enduring institution that can create value for customers and wealth for shareholders on an ongoing basis. In an economic sense, success in this endeavour stems from continually finding ways to make the company’s EP Bow Wave higher, wider and/or longer over time.
- Most of the improvement in the shape of the EP Bow Wave we observe in successful listed companies (and therefore the wealth they create) comes from establishing new and higher EP expectations to be delivered in the future, and then meeting those expectations over time.
- Successful listed companies tend not to exceed existing expectations over the short-to-medium term – and certainly not to any great degree. They understand (at least intuitively) that to improve short-term capital market outcomes, they need to focus on developing the ability to deliver better long-term product and service market outcomes. This understanding calls into question the strong emphasis on short-term ‘stretch targets’ that underpin the budgeting, performance management and executive reward processes in many listed companies.
- The EPS Myth means the focus on ‘stretch targets’ is even more problematic when the target is expressed in terms of Earnings growth or EPS growth outcomes.
- For companies that are already economically profitable, increasing the width of the EP Bow Wave (through growth) and increasing its length (by taking action that makes individual businesses and their EP streams more sustainable) can be much more important than improving returns.
- We can split the wealth created for shareholders over any measurement period (the TSR-Ke outcome) into that attributable to movements in the market as a whole, and that attributable largely to the efforts of management. The latter is captured in TSR Alpha.
- TSR Alpha is a particularly important capital market performance metric that can be used to encourage systematic enhancement in the shape of the EP Bow Wave over time. Once its dynamics are understood by a management team, it will help focus their attention on creating wealth by enhancing the right-hand side of the Pair of EP Bow Waves. This means pursuing initiatives that lead to the establishment of new and higher EP expectations to be delivered in the future, and then meeting those expectations over time.