Home > Value Creation > Performance Metrics and long term alignment (II)

Performance Metrics and long term alignment (II)

(continues from our previous post).

Using TSR to measure Long term Performance: other metrics.

 The authors identify (see graph below) a large percentage of firms in their sample that while having a positive 5-year relative TSR, achieved a negative cumulative 5-year Economic Profit (EP), and a return on invested capital lower that their respective Wacc. These firms seemed to have a value destroying business model; they also identify 17% of firms where the opposite happened. 65% of firms in the sample had aligned TSR and Economic Profit in a 5-year period. 42% of the sample consisted in firms that had cumulative negative EP in the period.

 TSR EP FOUR Q

What should managers conclude from this TSR-EP analysis?

  1.  Where EP is negative (but TSR positive), they should question whether EP trend remains negative in a 5-year period or if it signals improvement.
  2. Where EP is positive (but TSR negative), they should question if EP is starting to fade, if investors are perceiving clouds in the future value creation and why.
  3. Where both EP and TSR are positive, they should analyse if both present and future value are contributing, and how to give each of them the necessary emphasis.
  4. When both are negative, recommendations are clear.

In brief, the use of TSR to evaluate long-term performance can be misleading and does not necessarily align managers interests and long-term value creation sustainability. The authors suggest that managers should be evaluated against operational metrics, connected to the value creation process, that are also in the core of the TSR rationale, (Nopat, Sales growth, capital charge, EP and Roic relative to the cost of capital,…). Nevertheless, the authors grant TSR a relevant role, as they suggest considering it a proxy for “future value creation”, (as a market signal).

In particular the authors find thar sales growth does not necessarily entails value creation, so that this metric needs to be accompanied by EP and Roic minus wacc analysis).

The authors present evidence that NEquityPAT, EP, sales growth and Roic explain 48% of a 5-year variation in shareholder returns. So companies still need future value metrics. EV divided by Nopat, and a very similar measure, Price Earnings Ratio, (PER) are helpful for that.

Corporate life cycle and the value creation quadrants

 

When combining “EP or Roic versus wacc” with “Relative TSR as a proxy for future value change”, the authors arrive to a life cycle interpretation, as they show in the graphs below:

4 Q life cycle

TIME LIFE

In our next post we will cover the authors’ view and proposals about Executive Compensation and Value Creation alignment.

The graphs used in the post have been extracted by the study, that can be found below in link:

The Alignment Gap Between Creating Value, Performance Measurement, and Long-Term Incentive Design

  1. http://irrcinstitute.org/projects.php?project=75, by Organizational Capital Partners and commissioned by the Investor Responsibility Research Center Institute (IRRCi), (Mark Van Clieaf, Karel Leeflang, Partner and Stephen O’Byrne).
  2. See also interviews with Jon Lukomnik, Executive Director, Investor Responsibility Research Center Institute (IRRCi), at https://www.nyse.com/corporate-services/nysegs/videos/twib, (January 15th and previous).
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