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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

the market will price stock at the present value of the company’s future earnings stream, as best it can figure that out.

Step by Step

The next step is to translate the generic elements the market uses—earnings, growth, risk—into more specific tools that management can employ in improving that present value. Given any particular earnings stream, the generic aim is to increase expected growth or to reduce risk or to do both, but that generic aim needs to be decomposed to become actionable.

For this purpose, the concept of economic value is useful. Economic value, of course, is simply the value created by an activity over and above the capital cost employed by that activity. This is the metric that is invoked in the application of economic value added (EVA) techniques and the like. 1 The analytic steps are straightforward.

• Decompose the overall enterprise into natural P&L portfolio elements. These are likely to be differentiated on the basis of core business activity, risk profile (and therefore cost of capital), and perhaps financial structure. Treat corporate or shared overhead functions as a separate unallocated cost center so as to strip out any distortions that might arise from allocation.

• On the basis of current plans, project cash flow out for five years for each entity.

• Determine the weighted average cost of capital (WACC) appropriate to that particular differentiated cash flow. Most corporate finance or planning departments have their favored methods for determining this number, most such methods are defensible, and your company’s financial assumptions ought to be internally consistent, so just do what the Finance Department says on this one.

• Discount future cash flows at the relevant WACC to determine present value, using some reasonable method (back to the Finance department) for calculating a terminal value at the end of the 5-year forecast period. This is the value of the portfolio element. If capital assets are associated with that element, you can subtract the book equity value of those assets to determine how much economic value is being created (or wasted). Add the individual values to determine enterprise value.

• Divide enterprise value by the number of outstanding shares of common stock.

These steps provide a simple but illuminating profile of the company’s value position, the kind of profile every board of directors and every management team should have at its fingertips. The illumination comes from distinguishing the capital cost and growth plans of constituent element, understanding where value is being created and lost (in most companies value is being lost somewhere), and how the pieces fit together to create overall enterprise value.

Bear in mind that this display offers a picture of the value of the enterprise today given the plan you have developed for future performance. Some of these plans will doubtless unfold in future years, and today the market may know nothing of them, or may have only a general directional impression of them.

One of the interesting inquiries spawned by this kind of picture is to try reconciling the value implied in your plan to the