VALUE. Creating and sustaining it is what CEOs are supposed to do. Creating a lot of value makes shareholders happy and justifies fat paychecks and big bonuses. Losing it angers shareholders, creates tension with the board and generates skepticism about CEOs' strategies, their team's effectiveness or both. When value creation eludes a CEO, his or her days are numbered.
To get a sense of how the S&P 500 CEOs were faring at wealth creation, Chief Executive partnered with the Applied Finance Group, creators of the Economic Margin (EM) value metric, and with Drew Morris, CEO of Great Numbers!, a results-improvement consulting firm. His framework for maximizing results, which includes EM, appeared in our January/February and March 2008 issues.
As we have seen with the recent meltdown in financial markets, value isn't always what it appears to be. And traditional accounting measures do not count what really counts. Earnings per share (EPS) and price/earnings (P/E) ratios are based on accounting profit, which is prone to distortion and has no real relationship to wealth creation. Trying to grow earnings or EPS in the belief that the stock market will reward you with a higher share price no longer works, as investors really seek to understand the company's underlying economic performance.
To state the obvious, navigating with instruments that mislead is dangerous. CEOs need to look at their businesses with the same wealth-creation measures that, for example, private equity and institutional investors use. Investors want to know how good a company and its leaders are at preserving and growing their capital.
Many companies have moved from accounting to economic approaches to measuring this. A few, such as EVA, are good because they reckon with the true cost of capital, but none are perfect. Our rankings rely on Economic Margin, a measure with which executives can readily manage wealth creation, and which is applicable at all levels of a company. EM is calculated as the difference between operating cash flow and an appropriate capital charge, all divided by invested capital. EM is suitable for both private and public companies and useful for making comparisons with competitors, as it's an economic-profitability percentage, not a monetary amount.
The ranking method we used (see sidebar, opposite) also considers management's demonstrated ability to protect shareholder wealth and create truly valuable assets. Our intent is to advance the art, science and practice of creating wealth for a company's owners and the associated results-creation skills of its executive team.
Ranking CEO Wealth Creation
The ranking focuses on the performance of companies (and their CEOs) in the S&P 500 index for three years ending on Sept. 1, 2008. It's based on reported results during that period and estimates for the next 12 months.
CEOs whose tenure did not coincide for the full three years were not ranked. Also not ranked are the 14 REITs in the S&P 500 and companies that have been acquired or no longer exist.
The four components of the ranking, explained below, were developed and calculated by the Applied Finance Group (AFG), an independent equity-research advisory firm, using proprietary metrics and data. A weighted combination of each company's component rankings is used to produce an overall score: 100 is awarded to the best wealth creator; 1 to the worst. The component rankings are shown as letter grades with companies in the top 20 percent of each component metric receiving an A grade; the bottom 20 percent receiving an F.
Market (or Enterprise) Value/Invested Capital (MV/IC)
This measure shows the degree to which investors consider the company's assets valuable, relative to their cost. Market value is what a buyer would have to pay to buy the company outright, that is, to purchase all of the stock and pay off all of the loans, leases and other obligations. Note that market value depends on the stock price. Invested capital is the inflation-adjusted total of all of the investments in the business. It does not depend on the stock price. So by its nature, MV/IC reflects the market's take on the value of the investments made in the business.
The Average of the Past Three Years' Economic Margins
Economic Margin (EM) measures the degree to which the company is making money in excess of its risk-adjusted capital cost. It's expressed as a percentage of invested capital.
EM is calculated as (Operating Cash Flow - Capital Charge) /Invested Capital. Companies with positive EM (greater than 0 percent) are creating wealth; those with negative EM (F grades) arc destroying it.
This is a 12-month forecasted EM, based on the ratio of the most recent EM to the 3-year average.
This AFG-proprietary measure rewards a company with positive EM for growing its asset base, and one with negative EM for shrinking their asset base. In other words, if a company is making money and it adds assets in such a way that it can make even more, that's good. So is selling off a money-losing division. That said, it's also valid that adding scale can help a business get past its fixed costs.
The top 50 companies in the ranking delivered an average Total Shareholder Return of 135.6% between January 2005 and August 2008. The bottom 50 companies' TSR averaged -6,1%, while the S&P 500's was 13.6%. Total Shareholder Return = share-price return plus reinvested dividends.
For more on Economic Margin and how companies scored, sec http://www.economicmargm.com/moreinfo.htn.
Three Top Wealth Creators--
Jeff Bezos, Amazon.com
The market values Amazon's assets (brand, customer base, warehouse and distribution capabilities and IT infrastructure). The company generates healthy cash flow exceeding its cost of capital (and it's expected to improve). Bezos has grown Amazon's asset base while continuing to produce returns above its cost of capital. That's just the numbers side of the story. Amazon's fanatical attention to the design of its customer experience, and passion for improving it, serves them well. Their customer-value proposition (including the thin margins that made analysts apoplectic in the past) continues to drive revenue growth. Amazon sees few limits to what it can offer customers. It's true that much of the cost of creating its IT and warehouse infrastructure is behind them, so it's easier to make money. But Amazonians still have their foot on the gas, continuing to bring on third parties, which drives sales and margins with low-to-modest impacts on its infrastructure. None of this seems like an accident. There's a lot to admire...