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Total Shareholder Return: Planning a Future Perfect

Total shareholder return can not only be a measure of past performance, but it can be harnessed as the prime touchstone for planning future performance.

Fortnightly Magazine - January 2006

for most improved. A student who goes from D to B beats the student who goes from B+ to A-, or the student who consistently gets A’s. When a board gives management a target of being a first-quartile TSR performer each year, it is asking for something that is by definition extremely difficult, if not impossible, to deliver. It’s asking management year after year to rank among the most improved. As Table 1 indicates, no utility over the past five years has consistently accomplished that feat.

The reason is apparent. When a company’s good fortune and superior management has endowed it with strong growth prospects, that expectation of strong performance is reflected in its share price. To elevate that share price further, management must offer the market new expectations of even better performance. In time, any management runs out of opportunity or ideas for that next increment of improvement. Its rate of improvement subsides to the mean. It still may be a very well run company, rendering strong and reliable earnings, but its reputation for strong performance is now baked into its share price.

There’s a related problem with TSR as a planning tool. It reflects market dynamics, and management is perennially suspicious of market dynamics. Investor preferences seem to change with the seasons. Today’s favored strategy is tomorrow’s pariah. As far as TSR is concerned, it seems all that sensible executives can do is manage the fundamentals and then cross their fingers.

A good planning metric provides specific guidance in two ways: in making choices for future action and in evaluating current management performance. In light of the drawbacks just noted, how can TSR serve either to guide choices or to evaluate performance?

Planning for TSR

To use TSR as a guide to management choice, we need to recognize, or at least pretend to recognize, that the market’s seemingly fickle behavior is not irrational. To be sure, from day to day the stock market reacts to a varied assortment of events, rumors, enthusiasms, barely perceived trends, and the like. But the market is trying to sort out three fundamental assessments:

(1) How much is this company earning?

(2) What is the expected growth rate of those earnings? and

(3) What is the risk associated with that expectation?

If an investor accurately can appraise those three elements, she will know what a stock is worth. Current earnings are (usually) easy to determine. Growth and risk are tougher—indeed, they’re inherently speculative—and it’s primarily the elusiveness of these two elements that leads the market to bounce around in response to various signals as it tries to sort out the telling indicators from the static.

So let’s stipulate for now that the market is rational but inquisitive for new information, that over any short-term period it may under-react or over-react in unpredictable ways to new information, but that over the long run it will register a reasonably accurate appraisal of earnings, growth, and risk (see “Doing the Stock Market Math,” P. 47).

On this assumption, which, true or not, is axiomatic to any valuation discussion,