Finding the Right Measure of Success
Excerpt from A Random Search of Excellence:
When looking for outperforming companies, the first question is always how do you measure performance?
A common, but hardly unanimous, practice is to look at total returns to shareholders (TSR): Blueprint to a billion used sales, Built to Last used a composite measure of general esteem, The Breakthrough Company used primarily sales growth. Some studies wanted to examine a specific phenomenon (how to get to a billion in sales), while others had to cope with constraints on data availability (if you’re looking at private companies, you can’t use TSR).
We took the view that at first principles, the object of all of these studies, ours included, is to identify noteworthy management practices. This has some important implications, of which perhaps the most surprising is that TSR is arguably the worst measure to use.
Shareholder returns are a function of the capital market’s estimate of future performance. A good fraction of TSR tells the story of changing hopes for the future rather than delivering on past promises. Consequently, strong returns over time are often largely the result of consistent upside surprises that serve to ratchet up expectations, which is then made manifest in a rising stock price.
This is perhaps most evident in companies that deliver great performance but lackluster TSR: a company can deliver fabulous profitability and eye-popping growth and have a share price that goes nowhere because at some point in the past the markets “figured them out” and priced that performance into the shares.
Now, if one is interested in what behaviors surprise investors, TSR might be just the ticket. But if great management is what you want to understand, operating measures of performance are much better. Of the operating measures available, we like return on assets as an overall measure of profitability.
The cult of shareholder value has its place. After all, shareholders are people, too. But a firm’s ability to generate shareholder value is as much a function of how shareholders view it as how well it is managed. If anything, shareholder returns either positive or negative reflect changes in expectations for the future.
So, shareholder value is certainly a valid measure, but it’s likely not the best measure of corporate performance if you want to understand the contribution of managers to that performance. And so we’re focused on ROA. It’s not perfect, either, though, and so we’re working hard to qualify our findings in keeping with the limitations of this measure.
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