What is the goal of a company chief executive officer?

It is widely accepted in finance theory that the prime goal of management is to maximise shareholder value.  But the path to delivering superior returns is not always clear, for a few reasons.

To start, there is the issue of metrics.  Corporate managers often perceive that managing to achieve competitive advantage is hard to balance with the demands of the share market.  They have to make the decision as to the most appropriate financial metrics, do they concern themselves about operational issues, or the capital markets?  How are those metrics linked to executive compensation?

Next, there is the topic of method.  Assuming that financial value drivers are properly identified, it is still critical to figure out how to proposition the business to gain a competitive advantage.  Which market segments should be addressed?  What customer characteristics are required to generate profitable sales? How are products or services delivered optimally?  Addressing these questions is the essence of strategy.

Finally, there is the issue of the market.  Managers and investors are not always clear how prices are set in the stock market.  Is value determined by earnings growth?  Sales gains?  Cash flow improvement?  Earnings per share (EPS) or price/earnings ratio (P/E)?  These questions require a clear understanding of how capital markets work.

Ask most chief executives what they are required to focus on, if they are to satisfy the stock market and maximise the stock price of the company they run, and almost invariably the reply is: “I need to maximise earnings and to show a steady earnings growth, quarter by quarter:  Most of what one hears from finance professionals seems to confirm this perspective.  Chief executives are taught to fear that a drop in reported earnings – or an equity analyst’s ‘adverse earnings report’ – will lead to an immediate (and often substantial) fall in the stock price.  Many chief executives consequently bemoan the “short-sightedness” of the market and the fact that, apparently, a long-term perspective is not rewarded by the market or its commentators.

The view that “earnings are everything” influences the vocabulary of stock market discussions.  In particular, two measures have come to dominate discussions of stock prices: earnings per share (EPS) and price/earnings ratios (P/Es).  There is a strong consensus about the ways these measures are correlated with stock price:  commentary such as, “EPS should rise by 10% over the coming period, with a corresponding increase in stock price” or “the P/E ratio is at an all-time high – can this be sustained?” is commonplace.

The Capital Asset Pricing Model (CAPM)

CAPM is a theory that shows how all capital assets, including shares, should be priced on a discounted cash flow/net present value basis.  From this perspective, the value of a stock equals the present value of its future free cash streams, discounted at a rate appropriate to the risk of the stock.

Understanding how CAPM works introduces four important variables, over and above earnings, that need to be managed well if the share price is to be maximised:

•         Cash flow is more important than earnings.  Focus on maximising free cash rather than massaging the earnings figure

•        The amount of capital invested, both now and each new year, in the form of retained earnings.  Free cash flow is what is important – cash used as capital invested in the business cannot be returned to shareholders

•         The rate of return on capital:  The lower this is, the greater is the percentage of earnings, all else being equal, that will be needed for growth and maintenance of the capital base

•        The rate of return on reinvested capital: the majority of companies are growing their capital base by 5% to 10% or more a year, and share price is significantly affected by whether the rate of return on the newly invested capital is greater or less than the discount rate (the ‘required return’) on that capital.

Why do managers focus on EPS?

Two assumptions underlie this frame of reference:

•        Each stock, each sector and the market overall have a ‘natural’ P/E that stock prices will settle at in a given market environment

•        The ‘natural’ P/E will cause the company’s stock price to increase if earnings increase and, conversely, to fall if earnings fall.  If P/Es go up, it’s because the market has become ‘over-enthusiastic’ and, if they fall, it is due to market pessimism.

These assumptions seem reasonable.  They are very widely held.  But are they true?

In the academic world, the Capital Asset Pricing Model (CAPM) is the most widely accepted theory, its exponents have won Nobel prizes for their work, and many thousands of studies have shown that CAPM and related theories are by far the best predictors of what happens to stock prices.  According to CAPM, the EPS-P/E perspective on stock prices is flawed, misleading and incorrect.

In contrast with the earnings-focused argument, CAPM recognises that there is no natural P/E for a company or market:  P/E can be expected to change rapidly with changes in actual, and/or required, return on equity (ROE).

Since P/E changes when ROE changes, we can, for example, find situations where EPS grows but ROE declines (for example, when newly retained earnings are invested at, say, a 1% return, which grows EPS but lowers overall ROE).  In such cases, stock price can decline significantly even though EPS has risen.

Therefore if you wish to maximise share price for the long term CAPM must be used

The plausible EPS-P/E view is widely held among analysts and market players – and therefore by most chief executives of companies (although this is not true in the US).  CAPM holds sway in academia, and among a relatively smaller group of market analysts.  Which should you believe in?

The question presents top mangers with a dilemma, since the effects of pursuing one or other theory will have enormous repercussions, both for their companies and for themselves:

•         Approaches to investment will be different

•        The strategic choice between short-term earnings and long-term return on capital will be affected

•        Depending upon how the market works in reality, future stock price performance will be heavily affected.

So, should top management seek to maximise earnings?  Or, as CAPM suggests, seek to invest only where an acceptable return on capital is to be achieved – and to invest in all such opportunities?  The question surely needs to be answered by knowing which of the methods more closely corresponds to reality – earnings multiples or discounted cash flow?

Most of the evidence – and it has been analysed for some thirty years, in thousands of published studies – shows that it is CAPM that best describes how the market works.  Every MBA who takes a finance course knows this.  And yet, analysis and action still revolve around EPS and P/E.

Chief executives need to focus on cash flow and return on invested capital, and make some key decisions

For top management who wish to embrace the CAPM approach to maximising their stock price, some key decisions may need to be made.  CSFB and other value based analysts say there are two differentiated sets of companies at this time:

•         Those whose returns are below the cost of capital.  For these companies, the crucial issue is not how to improve earnings but how to reorient where and how their capital is invested so that higher returns can be achieved.  This will involve, for them, a return to the themes such as: restructuring, taking tough decisions, exiting some businesses.  (Approx 50% of the top companies produce returns below their cost of capital).

•        Companies that are earning above the cost of capital.  For these companies, major new opportunities have emerged.  Because the required return on equity for the average company has dropped dramatically – from around 15% to around 10%.  This has opened up for these companies a vast array of new value-crediting business opportunities, those where expected returns lie between 10% and 15%.  These opportunities were there in the past, but to invest in them would have destroyed Shareholder Value.  If companies pursue them now, their stock prices will, instead, increase. With the cost of capital lowered, competition will increase and those who come late to the party will find that the competition has already taken the best opportunities.

But if managers don’t have a clearly articulated, and communicable, vision about what drives their stock price, then agreeing a coherent business strategy becomes far more difficult.  Investment decisions; internal performance measurement; the basis for managers’ rewards:  all of these, and more, become distorted.

It is essential that companies move away from the EPS-P/E bind and start focusing – in this capital economy of ours – on the real issue:  return on equity capital.

CFSB survey on what the market really cares about

CSFB has surveyed "excess return" or Economic Profits (Return on Invested Capital (ROIC) – Cost of Capital (WACC) spreads) to see if these spreads are reflected in stock price valuation. 

They determined for 1997, the S&P Industrials had a correlation of 79%.  The key point is that the market recognises and rewards positive economic returns, and the link between the stock market, competitive advantage and the strategy is therefore established. 

Strategy is the process that allows a company to achieve a competitive advantage.  Competitive advantage is the ability to generate returns on capital in excess of the cost of capital.  The stock market efficiently reflects excess returns. 

This means there are a few central messages for corporate managers and the investors that evaluate them:

•        Economic value creation should always be the guiding light for management decisions.  In free markets, above-average gains in shareholder value are generally a sign that collective corporate resources both financial and non-financial are being allocated effectively.  The further fact that the stock market efficiently capitalises value creation lends further credence to the importance of managing for value.

•        Growth should always be a second order consideration behind value creation.  Managers often assume that earnings growth is synonymous with the value growth.  However, this perspective is not supported by the empirical data there are projects that add to accounting earnings while detracting from shareholder value.  Correct prioritisation of value creation/growth objectives allows managers to avoid capital allocation mistakes.  This task is further complicated by the reality that many compensation schemes disproportionately reward growth versus value creation.

•         A company can create shareholder value if it invests below the average ROIC but above WACC as long as such investments meet or exceed market expectations.  But managers must be aware that the stock market is forward-looking.  As a result, some projects may be value creating (net present value positive) but many disappoint the market, leading to a lower stock price.

•        Single period ROIC - WACC spreads should be used with some caution.  This metric does offer a reasonable snapshot of the past performance and can serve as a good proxy for expectations.  However, the calculation is based on accumulated sunk costs (invested capital) and can be affected by the timing of capital expenditures and selection of depreciation method.  For this reason, it is critical to use Net Present Value (NPV) of Cash flows (which is equivalent to NPV of the Economic Profits or EVA) to just a positive ROIC - WACC spread.

•        In stock market valuation, both excess returns and duration of excess returns are important.  The latter notion is often called “sustainable competitive advantage.”  The competitive advantage period can be pinpointed by considering a company’s current returns, the rate of industry change and barriers to entry.  Consistently generating excess returns is management’s greatest challenge.

•         Strategy is key.  The data shows that excess returns can be earned even in the worst industry groups.  What separates the winners from the losers is how they organise their activities.  Managers of businesses that generate sub-par returns should constantly rethink the activities they pursue.