Eric Schwarte, SVP of Corporate Consulting Services, EVA Dimensions LLC

Total shareholder return (TSR)—the sum of dividend yield and share price appreciation—is widely used by boards and governance committees because of rising pressure in the investment community, increased investor activism, watchdogs such as ISS, and say-on-pay practices. Many boards are tying pay to TSR without realizing that it can be misleading and opaque.

TSR has four key flaws:

1. It exaggerates the accomplishments or financial posture of companies that have recovered from depressed valuations and wrongly assigns high scores. At the same time, it penalizes elite firms that have slipped, even slightly, in recent periods or that have not lived up to inflated expectations without taking into account their superior long-term track records.
2. TSR is distorted by differences in leverage ratios, because leverage magnifies returns, for good or ill.
3. It is an opaque and impractical metric for motivating managers and equipping them with tools and decision techniques for creating more value. According to a study by Pearl Meyer and Cornell University, TSR does not appear to lead to better performance when incentive pay is tied to it.
4. Since TSR measures the return for a shareholder who held the company’s shares over the whole period, it ignores what happened to shareholders who sold stock to the company during that time. They may have realized a far higher or lower price.

Despite these flaws, TSR is widely used as the definitive measure of corporate performance and benchmark for judging executive pay. Today, half the firms in the S&P 500 use this measure to determine incentive pay, up from fewer than one in five a decade ago. Many firms and boards are seeking an alternative.

Introducing the Corporate Performance Index

A new measure called the Corporate Performance Index (CPI) complements TSR by greatly improving its reliability and effectiveness and providing executives with a roadmap to drive performance and shareholder returns. CPI, developed by EVA Dimensions, ranks companies in terms of their growth trend in generating economic profits, the profitability and market value of their business franchises, and how well positioned investors believe they are for future profit growth. It sums up each company’s financial health as a percentile score compared with its industry group or a broad market index.

When TSR and CPI agree, which is about 60% of the time, CPI lends weight and credibility to the traditional shareholder-return measure and serves to demystify TSR by providing a window into its underlying financial factors. When the measures differ, it is usually because TSR is giving a misleading verdict on performance.

The CPI score provides boards and senior management with a check on TSR, confirming when TSR is right and showing when it is wrong—and why. It arms them with a legitimate way to counter TSR and rebuff criticism or oppose an activist agenda when TSR misses the mark. And it gives the benefit of the doubt to firms that are maintaining an edge over peers despite a recent return shortfall.

Governance watchdogs are apt to find value in it. They will want to consult CPI to be sure they are not hounding the wrong companies and to spotlight others that need attention despite a seemingly favorable TSR record. They will also want to cite the economic value added statistics when confronting an underperforming company. They’re far less subject to the vagaries of the market and much more reflective of management’s ability to allocate, manage, and redeploy capital resources effectively—the real aim of the corporate governance game.

How CPI Works

CPI uses a set of four measures to develop a comprehensive score of financial health from a shareholder point of view:

1. Wealth Creation and Franchise Value: The firm’s total market value premium or discount to its book capital, stated per unit of sales (we call the valuation premium “MVA,” for market value added).
2. Profitability: The firm’s true economic profit, expressed as a profit margin ratio of sales (the term we use for economic profit is “EVA,” standing for economic value added; it is profit net of a full cost-of-capital interest charge on the firm’s debt and equity capital).
3. Profitable Growth: The trend growth rate in the firm’s EVA profit over the most recent three years.
4. Strategic Position: The long-run growth in EVA profit that investors have factored into the firm’s share price.

The first two metrics are snapshot statistics, reflecting the firm’s profitability and market valuation, while the latter two are moving pictures, gauging actual and expected profit trends. Two are market-based, incorporating investor perceptions and expectations, and two reflect actual performance in terms of earning and increasing economic profits.

Since the measures are calculated in relation to the firm’s total capital—its debt plus equity—they capture the performance of the business and aren’t affected by financing ratios.

EVA (economic profit) and MVA (owner wealth) are the two most essential measures of corporate performance and value creation. All four of the ratio statistics in CPI are variations of those two measures.

To reach CPI’s upper ranks, a firm has to score well on all four measures:

1. It must preside over a valuable and profitable business franchise, one capable of generating high-quality profits.
2. Its stock must trade for a lofty premium to invested capital.
3. The firm has to have generated an exceptional growth trend in profits over the past three years.
4. It must be so strategically well positioned that investors believe its future profits will grow faster than those of its peers.

CPI reports are updated daily for 20,000 global tickers and 75 business sectors via CPI Express, available at http://pub.evadimensions.com/cpiexpress.