MEASURING CORPORATE EXCELLENCE
A Comprehensive Ranking of Management's Contribution to Share Value
Objectives of the Survey:
- Differentiate the shareholder value created or destroyed by management from changes attributable to general industry health and the economy.
- Track recent corporate performance rather than historical or embedded performance.
- In traditional surveys, a companys ranking almost always is predetermined by its industry. Its industry performs well or poorly, and the company clusters at the top or bottom of the survey near its peers. The surveys are thus misleading. They perpetuate the impression, for example, that all domestic railways are poorly managed, and that all pharmaceutical companies are well-managed.
We know of no survey which measures managements distinctive contribution to share value by filtering out peer performance, and which then standardizes that measure for meaningful comparison across industries.
- We know of few surveys which focus on recent management performance rather than the companys or industrys inherited position in the corporate pecking order. Thus, while there have been sweeping upheavals in the markets, environment, structure and we believe performance of companies like RJR Nabisco, Phillip Morris, McDonalds and PepsiCo, it is unlikely that these upheavals will be reflected in conventional rankings.
Example: Chrysler vs. GM
- Size places GM at the top, despite lackluster profits, eroding market share, and shrinkage relative to Ford and Chrysler.
- By contrast, profitability and MVA relegate GM and Chrysler forever to the bottom, because of impossibly high embedded levels of old, under-productive capital.
- A true indexed ranking would place Chryslers management near the top of the list, and GMs near the bottom, because of each companys relative, recent effectiveness in deploying like amounts of capital.
- Executive pay scales have been so inflated by large option grants that everyone is asking whether boards are rewarding good luck, not good management.
- Focusing attention on managements distinctive contribution to share value is, we believe, the only way to sustain competitiveness in a bear market.
- The capital markets have shown increased appetite for indexed and equity-linked debt, suggesting the time has come to strip out industry risk from equity investment.
- Indexed performance is the only scorecard for determining whether the recent wave of management transitions has added value.
- Indexed rankings ask the question: If you or management had gone long on a stock while shorting the competition, how well would you or management have performed? Stated differently, indexed rankings provide a measure of managements distinctive contribution to share value which can be compared fairly within and across industries, without regard to industry cycles, capital intensity, or embedded levels of profitability.
- Indexed rankings inform readers which companies are great management plays, not merely industry plays.
The True Measures of Corporate Excellence
||Dollar amount of MVA created during a prescribed number of years, over and above the MVA created by competitors after indexing competitors beginning capital to the companys.
XVA is an external measure of share value creation. It differs from relative stock price performance in that it is capital-weighted. Thus, XVA permits superior gauging of CEO pay-for-performance.
Pay-versus-XVA comparisons will not (as TSR-based surveys do) intimate that the CEO of a $100 million company deserves more pay than the CEO of a $1 billion company, just because their TSRs were 35 percent and 34 percent, respectively.
||Dollar increase in economic profit (or EVA ®) during a prescribed number of years that cannot be explained by changes in the economic profit of competitors again adjusted to reflect differences in beginning capital.
XEP is an internal measure of corporate performance and, we believe, share value creation. Over time, XEP and XVA are highly correlated. The correlation improves with how tightly industry peers are defined.
XEP differs from ROE in that, again, XEP is capital-weighted providing a much better benchmark for comparing executive pay.
Scope of the Study:
- S&P 500 and all equivalently capitalized companies on a U.S. exchange.
- Sample includes the top 1,700 publicly traded companies, ranked by market capitalization as of December 31, 1996, inclusive of all major IPOs.
- Industry groups were based initially on those employed by Dow Jones to create securities indexes, and then modified where categories seemed too broad or narrow.
Mechanics of the Survey:
While intuitively straightforward, calculating XVA and XEP is complicated by two factors:
- Both measures require a record of capital invested. Consequently, we are at the mercy of SEC filing schedules and the
turnaround for Standard & Poors Compustat®. It was only this month that 1996 data was available for all the companies in our sample.
- Competing rankings have raised the bar on economic consistency. Quite simply, it is no longer sufficient to define capital as reported debt plus equity, or net operating profit as net income before financing charges. The world is aware that a variety of accounting rules and elections materially distort the presentation of economic performance, and thus distort fair comparison of different companies.
Whenever we work with a company, we attempt to translate its reported financials into figures that are meaningful on an economic cash-flow basis. Some of the basics include capitalizing R&D expenditures, using cash-basis accounting for taxes and operations, separating operating cash flows from financing decisions, and adding the change in balance sheet reserves back to operating profits. Other adjustments include:
- Purchase vs. Pooling-of-Interest Accounting
Acquiring companies in a stock-for-stock transaction can sometimes circumvent the
recording of goodwill by making a pooling-of-interest election. Under
pooling-of-interest accounting, the earnings, assets, liabilities and equity of the two
companies are simply added, as if they had always been one company. The acquisition premium is never recorded, inflating combined ROE. Similarly, the acquisition premium is never amortized (as in the case of goodwill), so reported earnings are higher. Our survey, as the FASB presently proposes, restates all pooling-of-interest transactions as purchases, thus recognizing goodwill.
- FASB 109 Restatement of Deferred Taxes
FASB 109 requires companies to restate deferred taxes to reflect tax rates at the time
deferred taxes become due, rather than the time they are incurred. Since corporate tax rates fell during the late 1980s, there were massive one-time adjustments to income for many companies in the year of adoption. We amortized the adjustment back against prior years, and thus mitigate the one-time adoption-year effect.
- FASB 106 and 112 (Post-Employment and Post-Retirement Benefits)
FASB 106 and 112 requires companies to record the cost of anticipated post-employment costs in the year accrued, rather than paid. This had a cumulative negative impact on companies earnings in the year of adoption, because it accelerated by many years the timing of eventual charges to income. Once again, we amortized the charge back against prior years, to better measure performance in the year of adoption.
- FASB 107 and 115 (Marking Debt and Investments to Market)
Widely interpreted and inconsistently applied, there are a complex set of rules for
marking debt instrument and financial investments (including derivatives) to market, and for recording that information in the footnotes. We have elected to forego these adjustments, at least until compliance becomes more uniform and less haphazard.
- FASB 123 (Value of Employee Stock Options)
FASB 123 allows companies to elect between, essentially, not recording the cost of stock options until exercise or recording their imputed fair market value upon the date of grant. We know of no company that has elected the latter, although the imputed fair market value must now be reported in the footnotes. Since similar data was not available for the last three years, we felt adjustments based on FASB 123 were premature.
- Extraordinary Charges and Write-Offs
Companies frequently put poor investments behind them by taking one-time charges. Since our survey spans several years, we restate extraordinary charges by adding the non-cash, after-tax portion back to capital.
- Capitalization of Operating Leases
Relative performance can be distorted by a companys decision to lease versus buy equipment, despite equivalent economic commitments. Following the practice of all the major credit rating agencies, we restated operating leases as capital leases.
- Despite our best precautions, the ranking process will always be obscured by corporate spinoffs and split-offs. While unquestionably value-adding for most companies, the value will not be obvious because we have not tracked combined performance. This is not, of course, a problem unique to our survey, but every survey we have seen.
- The ability to draw conclusions from the survey depends partially on how well weve specified industry groupings. In some industries, were overbroad, and will reward or penalize companies the same way other surveys do by clustering industry players together at the top or bottom of the survey.
In the end, choosing industries boils down to balancing economic accuracy against
proliferating unfamiliar categories. We believe weve conducted as painstaking and fair a division as possible.
- A list of all 1,703 companies, ranked by XVA, with comparative statistics relating to operating performance, executive pay, and total stockholder returns.
Microsoft Excel Document [589 KB zipped]
- A comparison of the industries themselves.
Microsoft Excel Document [79.3 KB zipped]
Not shown but available for download are
individual corporate comparisons within each industry group, plus a host of supporting
statistics. Stay tuned, in the coming weeks, as we present our insights into
interpreting the surveys results, and feature certain industries.