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If, on the other hand, you did better then expected, your shareholders would earn more than 10 percent. If you did worse than expected, your shareholders would earn less than 10 percent.
Investing in the stock market is like betting on sports teams. When you bet on American football, you bet based on a market-determined point spread. If you bet on the favorite, they not only have to win the game for your bet to pay off, they have to win by more points than the spread. In other words, the favorite has to win by more points than expected for their supporters to win their bets.
So, Fred said, the return that investors earn is driven not by the performance of my company but by the performance relative to expectations. Exactly, we said. That means I have to manage my company's performance in the real markets and the financial markets at the same time? Exactly, we said. If you create lots of value in the real market (by earning more than your cost of capital and growing fast) but don't do as well as investors expect, they will be disappointed. Your task as manager is to maximize the intrinsic value of the company and to properly manage the expectations of the financial market.
Managing the expectations of the market is tricky. You don't want their expectations to be too high or too low. We have seen companies convince the market that they will deliver great performance and then not deliver on those promises. Not only does the share price drop when the market realizes that the company will not be able to deliver, but it may take years for the company to regain credibility with the market. On the other hand, if the market's expectations are too low and you have a low share price relative to
the opportunities the company faces, you may be subject to a hostile takeover.
Okay, said Fred, I'm ready to go public. Fred initiated an IPO and raised the capital he needed for the company.
Fred Expands into Related Formats
Fred's Hardware grew quickly and regularly beat the expectations of the market, so his share price was a top performer in the market. Fred was comfortable that his management team would be able to achieve high growth in the Superhardware stores so he decided to try some new concepts: Fred's Furniture and Fred's Garden Supplies. But he was a little concerned about how to manage the business as it became more and more complex. He had always had a good feel for the business. As the business grew and he had to delegate more decision making, he wasn't so confident that things would be managed well.
He told us that his financial people had put in place a planning and control system to closely monitor the economic profit of every store and each division overall. Economic profit targets were set annually for the next three years, progress monitored monthly and managers' compensation tied to economic profit against these targets. Yet, he wasn't sure that the company was on track for the long-term performance that he and the market were expecting.
You need a planning and control system that incorporates forward-looking financial measures, not just backward-looking ones, we told Fred. Tell me more, said Fred.
As you pointed out, Fred, the problem with financial measures is that they can't tell you how your managers are doing at building the business for the future. For example, in the short term, managers could improve their financial results by cutting back on customer service (the number of employees available in the store at any time to help customers, or employee training), or deferring maintenance or brand-building spending. You must also incorporate measures related to customer satisfaction or brand awareness that can give you an idea about the future, not just the current performance.
Finally, Fred was satisfied. He came back to see us, but only for social visits.
Summarizing Fred's Lessons
While Fred's story may be simplistic, it highlights the core ideas around value creation and its measurement. Here are five key lessons of value creation:
1. In the real market, you create value by earning a return on your invested capital greater than the opportunity cost of capital.
2. The more you can invest at returns above the cost of capital the more value you create (i.e., growth creates more value as long as the return on capital exceeds the cost of capital).
3. You should select strategies that maximize the present value of expected cash flows or economic profit (you get the same answer regardless of which you choose).
4. The value of a company's shares in the stock market equals the intrinsic value based on the market's expectations of future performance, but the market expectations of future performance may not be an unbiased estimate of performance.
5. The returns that shareholders earn depend primarily on changes in expectations more than actual performance of the company.
4— Metrics Mania: Surviving the Barrage of Value Metrics
We saw through Fred's story in Chapter 3 how companies create value and how it can be measured. In the real world, managers have been bombarded with advice about performance measures: TRS, DCF, economic profit,1 EVATM, CFROI, ROIC, EPS, profit margin, and many others. But we think that the debate over which metric to use has come unstuck from the real purpose of metrics: to help managers make value-creating decisions and to orient all company employees toward value creation.