Advance Look

Ken Favaro Greg Rotz

Total Shareholder Returns and Managing for Value

Introduction This note introduces some basic building blocks for a discussion of Total Shareholder Return and Managing for Value. It is based on over 20 years of experience working with the CEOs and CFOs of large, global public companies to implement TSR-based measurement and management capabilities, often referred to as “Value Based Management” or “Managing for Value.” This note starts with a definition of the top tier metrics used in Managing for Value, and how those metrics relate to each other and other commonly used metrics. This is followed by a brief description of how these measures are typically used by companies that have implemented Managing for Value and what “Managing for Value” means for these companies. The note continues with an accounting of the pitfalls to avoid and what to get right, and concludes with a few words on “Company Purpose” because Managing for Value often raises questions about this. There are many ways to “pick up” a change in focus from quarterly EPS to TSR. This could range from changing metrics and incentive compensation (e.g. “we will add TSR to the scorecard and tie pay for our top 50 execs to TSR”), to adopting a more valuebased way of running the company (e.g. value-based performance goals, value-based strategies, value-based management processes and value-based organizational behaviors), to everything in between. In addition, there are any number of potential reasons for any particular company to pick this up as well, such as: returning to industry-leading TSR and multiples; getting the most out of a new organizational structure; driving strategic distinctiveness into the company; answering the question “what makes us more than our individual parts?”; and/or improving the allocation of resources to the most value-creating innovation, products, business models and corporate strategies. Thus, when starting down this path, it is useful to begin with two questions: 1. how broadly or narrowly should we pick up the change to having a sharper focus on TSR and managing for value? 2. what issues and opportunities will we be able to address by having a sharper focus on TSR and managing for value? Top Tier Metrics There are four primary metrics used when managing for value: free cash flow, economic profit, warranted value and total shareholder return. Free cash flow from a shareholder perspective (sometimes called “equity cash flow”) is the difference between earnings and retained earnings. 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, it is simply the dividends paid to shareholders. At the operating level, free cash flow is the portion of an operating unit’s earnings that are available to be paid out to investors after taking care of all its investment needs. In a year when an operating unit’s investment needs exceed its earnings, its free cash flow is negative. Economic profit is the difference between earnings and the dollar cost of invested capital – where the dollar cost is obtained by multiplying the percentage cost of capital by the amount of capital invested. 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

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capital has negative economic profit even if its earnings are positive. For example: if a company has $15 dollars of earnings, a 10% cost of capital and a $100 of invested capital, its economic profit is $5. But if its earnings were only $8, its economic profit would be a negative $2. Warranted value is the value today of a company or an operating unit based on management’s best estimate of its expected free cash flow (or economic profits) under a particular strategy. This is sometimes called “intrinsic value”, which Warren Buffet defines as “the present value of the earnings power a business has over its remaining life.” A company or operating unit’s warranted value depends on its particular strategy. The same company (or operating unit) will have as many warranted values as there are valid alternative strategies for it to pursue. Warranted value is not the same thing as market value, nor is warranted value per share the same things as stock price (see below on “The Relationship Between Metrics”). Total shareholder return 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 $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%. TSR can only be measured for a publicly traded company, because it requires observable stock prices to be able to measure it. The Relationship Between Metrics While they frequently diverge from each other at any point in time, a company’s stock price tends to track its warranted value per share over time. Hence, the impact of management’s strategies and decisions on a company’s warranted value per share will ultimately have an equivalent impact on its stock price. This is true at the operating level as well. The operational consequence of this is the imperative to choose strategies and make investment decisions based on warranted value, not on stock price or, for that matter, any other single financial metric such as ROC or EPS. If TSR is driven largely by change in stock price (see “Metrics” above) and if stock price is ultimately determined by warranted value per share, it follows that a company’s TSR is driven largely by the change in its warranted value per share. Hence, if a company operates so as to maximize long-term warranted value per share over time, it is also managing to maximize long-term TSR over time. When added to invested capital, the present value of future economic profits will yield the exact same estimate of warranted value as the present value of free cash flow. Hence, when a company or operating unit operates so as to maximize economic profit growth over time, it is also operating so as to maximize long-term warranted value and TSR over time. A company’s Price-Earnings Ratio (“PE”) is obtained by dividing its stock price by some measure of its earnings (e.g. last year, current year, next year). Over time, a company’s PE and stock price are determined by the same thing: its warranted value per share. PE does not determine stock price; it’s the other way around.

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Using the Metrics While no single measure is entirely free of problems, the best external measure of company and management performance is: relative shareholder returns over time. This is the total return (in the form of both free cash flow and share price appreciation) in relation to the returns of similar companies over a relevant time period. Total shareholder return relative to peers is an extremely important indicator of strategic success, particularly over a period of several years or more. In practice, no single measure or criterion should be used to make strategy choices and investment decisions. But the best single measure and criterion for such purposes is warranted value. No other measure can capture the trade-offs between growth and profitability, short term and long term, and risk and reward On the other hand, warranted value (or metrics derived from it, such as Total Business Return) should not be used for performance management or incentive compensation purposes. This is because it is based on a forecast of expected future results, not on actual delivered results. Instead, a combination of three measures should be used to set business targets, track strategy execution and evaluate management performance: revenue growth, economic profit and free cash flow. These three measures capture virtually all the high-level financial information that is important for an operating unit, and, in combination, it is very difficult to manipulate or “game” them. 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 Value “Maximizing shareholder value” means always choosing the course of action that has more warranted value (per share) than any other alternative course of action; it does not mean putting shareholders first. “Managing for value” is a continuous search for strategies, ideas, solutions and opportunities to increase the warranted value of the company; it is not managing for shareholders’ expectations or short-term stock price. When understood and lived well, value-based management will produce high-quality, sustained earnings per share growth and a premium multiple. In large part, this is because a greater portion of investment (financial resources, management time) is going into value creating activity, and this gives the company more competitive and financial strength. It also creates a mutual reinforcement that enables a company to invest in its future and in building its capabilities as its markets inevitably evolve. So, while managing for value is not about maximizing earnings per share, short-term or otherwise, it will produce consistently superior earnings per share growth. Chasing quarterly EPS will not. Many CFOs and their CEOs have used the framework and process of Managing for Value – in whole or in part - to transform their companies’ strategic direction, organizational capabilities and financial results, including:  Coca-Cola under Roberto Goizueta  Alcan under Travis Engen  Barclays plc under Matt Barrett

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Gillette under Jim Kilts Roche under Franz Humer

These companies used value-based metrics, tools and processes to increase the capacity of their people to create value and generate sustainably superior financial performance. For them, changing the operating model was as important as changing the metrics – meaning, how they set goals, communicate with investors, drive financial planning, develop strategies, prioritize and use top team time, allocate financial resources, determine the “role of the corporate center”, manage performance and reward operating staff. While the old adage “you manage what you measure” is timetested, changing what one measures will not automatically change how one manages, or how well one manages. Common Pitfalls There are many more companies that seek to maximize their long-term value creation than there are companies that succeed in doing it. There are many reasons for this. For example, one is the all-too common practice of managing to “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, warranted value per share drives stock price over time, and fundamentals drive warranted value per share, not shareholders’ expectations. Put another way, managing to shareholder expectations will almost always lead a company into pursuing performance targets that depress future multiples, thus undermining total shareholder returns. Incentive compensation that ties annual bonuses to performance against a predetermined plan or budget is another very common pitfall. This inevitably creates an unhelpful motivation to put forward “conservative” aspirations which are inevitably interpreted by the other side as “sand bagging”, thus setting off a time-consuming, souldestroying and ultimately unproductive gaming of the planning and budgeting process. Plans are meant to drive resources and actions to realize the full potential of the value-maximizing strategy. Budgets are meant to be a tool for controlling costs relative to revenue. Neither should be used to for annual bonusing. Nor should “annual value growth” or its closest cousin - “total business return” (TBR) - be used to determine annual bonuses. As mentioned earlier, these are based on a forecast of the long-term future, not on delivered results. Annual value growth and TBR are just measures of how the forecast performance for a business has changed over the course of a year. It is highly sensitive to small changes in assumptions about the future performance of the business over an infinite horizon. Annual bonuses should be based on delivered results, not on someone’s forecast of future results. Perhaps the most insidious pitfall, though, is introducing new measures in ways that don’t change old ways. There are many factors that determine a company’s ability to maximize long-term value creation. The processes that govern strategic planning, resource allocation, performance management and incentive compensation may be one of the most important factors. Companies that changed the metrics they use in these processes without changing anything else about how these processes work have had very little impact on their capacity to deliver superior shareholder returns.

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Introducing new measures – such as free cash flow, economic profit, warranted value and TSR – are powerful catalysts for change. But, as noted above, they do not in and of themselves change the way a company, management team, planning process or corporate center operate. What to Get Right Only two factors explain the value creation path of any company: the distinctiveness of its strategies and of the execution of those strategies. We often hear statements such as “a great strategy is worth nothing without great execution” and “I’d rather have great execution with a mediocre strategy than the other way around.” The reality is that “strategy” and “execution” are two sides of one coin. A company cannot have “great” execution without “great” strategies; nor can it have great execution without great strategies. Is Southwest or Tesco’s or Wells Fargo the product of great execution or of great strategies? Yes. Both are needed to produce consistently superior shareholder returns. What, then, enables a company to have and sustain distinctive strategies and execution? In our experience this requires getting right both the formal and informal aspects of how a company operates. On the formal side are corporate strategy, business strategies, strategic planning, resource allocation, performance management, incentive compensation, organizational design and role of the “corporate center.” On the informal side are leadership behaviors, peer-to-peer networks, teaming norms and skills, non-financial motivators, pride, and sense of purpose (see below). Where do people and “talent” fit in? Certainly, all the above is worth little without the people who have the talent to produce superior results. But leaders overestimate at their peril how far a company can get with people and talent alone. A company’s formal and informal operating model determines how well an organization with thousands or even hundreds of people can produce, no matter how talented they may be. (We will put aside for now the question of whether any large company can ever escape the law of large numbers when it comes to the average skill of its workforce compared to its competitors). Company Purpose Many business leaders and their organizations struggle with defining their company’s purpose as “maximizing shareholder value.” This is understandable. Business is a multi-purpose human activity. Through the customer’s eyes, the purpose of business is to provide products and services that make our lives better; from an employee’s perspective, it is to provide meaningful work and opportunities. A capitalist would say that the purpose of business is to create wealth; a European capitalist might say it is to create employment. For every Peter Drucker who says that the primary purpose of business is “to acquire and keep customers”, there is an Alfred P. Sloan – whom Drucker studied and greatly admired - who says it is “to make money.” Business leaders do need to give purpose to their people and most employees do not find purpose in maximizing shareholder value. Finding meaning and purpose is a personal quest rooted in one’s daily work and experience, not in “Our Purpose” statements from corporate headquarters. On the other hand, managing for value is a powerful approach to create and sustain a high-performance, agile company with

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high-quality growth. Most employees (and other stakeholders) are highly motivated to be associated with such a company.

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Booz & Company is a leading global management consulting firm, helping the world’s top businesses, governments, and organizations. Our founder, Edwin Booz, defined the profession when he established the first management consulting firm in 1914. Today, with more than 3,300 people in 61 offices around the world, we bring foresight and knowledge, deep functional expertise, and a practical approach to building capabilities and delivering real impact. We work closely with our clients to create and deliver essential advantage. For our management magazine strategy+business, visit www.strategy-business.com. Visit www.booz.com to learn more about Booz & Company.

Contact Information

About the Authors

New York Ken Favaro Senior Vice President +1-212-551-6826 [email protected]

Ken Favaro is a Booz & Company Senior Partner responsible for enhancing the firm’s capabilities and reputation in value based management, strategic management, and organic growth. His industry focus is in consumer, healthcare, and financial services. He currently leads the firm’s global area of expertise in Enterprise Strategy and Finance.

McLean, VA Greg Rotz Vice President +1-703-905-4140 [email protected]

Greg Rotz is a Partner in Booz & Company’s global health practice, focused on serving life science clients. Based in the Washington D.C. office, he works with senior business leaders in life sciences to help them grow the value of their companies in addressing their major strategy, organization and execution issues.

Rick Edmunds, Justin Pettit and Art Kleiner also contributed to this article.

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