Total Shareholder Return Paints

an Incomplete Picture

Eric Schwarte, SVP of Corporate Consulting Services, EVA Dimensions LLC

Total shareholder return (TSR)—the sum of dividend yield and share price
appreciation—is widely used by boards and governance committees because
of rising pressure in the investment community, increased investor activism,
watchdogs such as ISS, and say-on-pay practices. Many boards are tying pay to
TSR without realizing that it can be misleading and opaque.

TSR has four key flaws:

1.  It exaggerates the accomplishments or financial posture of companies that

have recovered from depressed valuations and wrongly assigns high scores.
At the same time, it penalizes elite firms that have slipped, even slightly,
in recent periods or that have not lived up to inflated expectations without
taking into account their superior long-term track records.

2.  TSR is distorted by differences in leverage ratios, because leverage magnifies

returns, for good or ill.

3.  It is an opaque and impractical metric for motivating managers and

equipping them with tools and decision techniques for creating more value.
According to a study by Pearl Meyer and Cornell University, TSR does not
appear to lead to better performance when incentive pay is tied to it.

4.  Since TSR measures the return for a shareholder who held the company’s
shares over the whole period, it ignores what happened to shareholders who
sold stock to the company during that time. They may have realized a far
higher or lower price.

Despite these flaws, TSR is widely used as the definitive measure of corporate
performance and benchmark for judging executive pay. Today, half the firms in the
S&P 500 use this measure to determine incentive pay, up from fewer than one in
five a decade ago. Many firms and boards are seeking an alternative.

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 Introducing the Corporate Performance Index

A new measure called the Corporate Performance Index (CPI) complements TSR by
greatly improving its reliability and effectiveness and providing executives with
a roadmap to drive performance and shareholder returns. CPI, developed by EVA
Dimensions, ranks companies in terms of their growth trend in generating economic
profits, the profitability and market value of their business franchises, and how
well positioned investors believe they are for future profit growth. It sums up each
company’s financial health as a percentile score compared with its industry group or
a broad market index.

When TSR and CPI agree, which is about 60% of the time, CPI lends weight and
credibility to the traditional shareholder-return measure and serves to demystify
TSR by providing a window into its underlying financial factors. When the measures
differ, it is usually because TSR is giving
CPI sums up each company’s a misleading verdict on performance.

financial health as a percen- The CPI score provides boards and

tile score compared with its senior management with a check on
TSR, confirming when TSR is right
industry group or a broad and showing when it is wrong—and
market index why. It arms them with a legitimate
way to counter TSR and rebuff criticism
or oppose an activist agenda when TSR misses the mark. And it gives the benefit of
the doubt to firms that are maintaining an edge over peers despite a recent return
shortfall.

Governance watchdogs are apt to find value in it. They will want to consult CPI to
be sure they are not hounding the wrong companies and to spotlight others that
need attention despite a seemingly favorable TSR record. They will also want to
cite the economic value added statistics when confronting an underperforming
company. They’re far less subject to the vagaries of the market and much more
reflective of management’s ability to allocate, manage, and redeploy capital resources
effectively—the real aim of the corporate governance game.

Copyright © 2016 MAPI. All rights reserved.

 How CPI Works

CPI uses a set of four measures to develop a comprehensive score of financial health
from a shareholder point of view:

1.  Wealth Creation and Franchise Value: The firm’s total market value premium
or discount to its book capital, stated per unit of sales (we call the valuation
premium “MVA,” for market value added).

2.  Profitability: The firm’s true economic profit, expressed as a profit margin ratio
of sales (the term we use for economic profit is “EVA,” standing for economic
value added; it is profit net of a full cost-of-capital interest charge on the
firm’s debt and equity capital).

3.  Profitable Growth: The trend growth rate in the firm’s EVA profit over the most
recent three years.

4.  Strategic Position: The long-run growth in EVA profit that investors have
factored into the firm’s share price.

The first two metrics are snapshot statistics, reflecting the firm’s profitability and
market valuation, while the latter two are moving pictures, gauging actual and

Market
Snapshots

th
(1) ow
Gr
Wealth Creation VA
te dE
MVA Margin
o jec
(MVA/Sales) Pr
(4)
Strategic Position
(3) EVA (2)

Profitable Growth Profitability

EVA Margin
(EVA/Sales)
h
o wt
Gr
EVA -2
A
EV
e nd
Tr
EVA -1

Corporate
EVA -3

Where we’ve been Where we are Where we’re going

Copyright © 2016 MAPI. All rights reserved.
expected profit trends. Two are market-based, incorporating investor perceptions
and expectations, and two reflect actual performance in terms of earning and
increasing economic profits.

Since the measures are calculated in

CPI arms boards with a
legitimate way to counter
TSR and rebuff criticism or
oppose an activist agenda
when TSR misses the mark
value creation. All four of the ratio statistics in CPI are variations of those two
measures.
relation to the firm’s total capital—its debt
plus equity—they capture the performance
of the business and aren’t affected by
financing ratios.
EVA (economic profit) and MVA (owner
wealth) are the two most essential
measures of corporate performance and

To reach CPI’s upper ranks, a firm has to score well on all four measures:

1.  It must preside over a valuable and profitable business franchise, one capable of
generating high-quality profits.

2.  Its stock must trade for a lofty premium to invested capital.

3.  The firm has to have generated an exceptional growth trend in profits over the
past three years.

4.  It must be so strategically well positioned that investors believe its future
profits will grow faster than those of its peers.

CPI reports are updated daily for 20,000 global tickers and 75 business sectors
via CPI Express, available at http://pub.evadimensions.com/cpiexpress.

Copyright © 2016 MAPI. All rights reserved.