Total Shareholder Return How does it really add value?

Transcription

1 Total Shareholder Return How does it really add value?

2 Total Shareholder Return: How does it really add value? BY BRIAN HOLMEN & JELENA JOVIC An increasing number of companies are incorporating total shareholder return (TSR) metrics into their long-term incentive (LTI) plans for executives, but opinion is still divided on whether TSR accurately measures what it s intended to the ultimate success of a company. Should boards give up on TSR? The short answer: It depends on your industry and your benchmarks. We set out to better quantify results and recommendations by asking: Is there a correlation between certain financial metrics and TSR within specific industries? In choosing a peer group for a relative TSR metric, should you compare your company with others outside your industry? 47 KEEP READING

3 Is there a correlation between certain financial metrics and TSR within specific industries? To find out, we assessed the correlation between TSR and a set of financials over a three-year, four-year and five-year period. We started from a general set of companies (Russell 3000), or so-called General Industry, then narrowed the scope of companies to a specific GICS Sector, Industry and eventually Sub-Industry. Our hypothesis was that TSR would more closely correlate with specified financial metrics as we moved into narrower groups of companies (i.e., Sub-Industries) and that we would observe statistically significant TSR correlations at this level. For our analysis, we focused on the Consumer Discretionary and Information Technology Sectors and looked at specified Industries/ Sub-Industries within those Sectors. The Findings Observation #1 We generally observed the following; further details can be found in Table 1: > Low TSR correlation with financial metrics at the General Industry level and Sector level, as expected. > Higher TSR correlation with financial metrics at the Industry level (with two observed statistically significant correlations for Specialty Retail TSR and Revenue). We further observed that even if the correlation between TSR and a financial metric is relatively high at the Industry level (e.g., TSR and Revenue at the Specialty Retail level), the correlation may not necessarily hold up for each of the Sub-Industries within that Industry. For example, Apparel Retail has a much lower correlation between TSR and Revenue than does the Specialty Retail Sub-Industry. > Relatively high TSR correlation with certain financial metrics at the Sub-Industry level (with EBITDA and Revenue showing a statistically significant correlation for the observed Retail companies and Assets showing a statistically significant correlation for the observed Information Technology companies). 48

4 Table 1. Variance in TSR Correlation TSR Correlation: 3 YEAR General Industry Consumer Discretionary Specialty Retail Apparel Retail Specialty Stores Information Technology Internet Software & Services TSR Correlation: 4 YEAR General Industry Consumer Discretionary Specialty Retail Apparel Retail Specialty Stores Information Technology Internet Software & Services TSR Correlation: 5 YEAR General Industry Consumer Discretionary Specialty Retail Apparel Retail Specialty Stores Information Technology Internet Software & Services DOWNLOAD CHART Revenue Op. Income Op. Margin EBITDA Net Income EPS Assets Op. CF ROIC 0.3% 1.7% 2.5% 2.9% 1.8% 1.5% 3.7% -6.6% 0.5% 13.4% 13.8% 13.0% 10.1% 5.5% 9.5% 12.9% 12.4% 13.8% 9.2% 6.4% 6.3% 22.1% -14.6% 5.8% 15.1% 3.3% 5.7% 7.3% 29.5% 30.7% 60.6% -23.2% 33.1% 23.4% 54.5% 29.9% 11.4% -33.4% -34.7% -6.8% -51.7% -53.2% 2.8% -4.2% -37.8% -11.3% 3.6% 3.3% 6.5% 4.6% 8.6% 4.2% 6.9% 5.3% 26.9% 14.4% 7.6% 29.8% -18.3% -16.0% 32.2% 38.5% 12.0% Revenue Op. Income Op. Margin EBITDA Net Income EPS Assets Op. CF ROIC 4.3% 22.9% 20.2% 19.2% 13.2% 23.1% 13.6% 15.9% 19.4% 24.6% 36.5% 29.1% 28.5% 25.1% 28.9% 31.6% 25.3% 24.3% 53.7% 47.7% 31.9% 68.5% 31.8% 37.9% 53.1% 30.0% 23.5% 29.1% 33.8% 24.3% 58.0% 8.9% 12.9% 45.0% 41.0% 7.4% 50.0% 47.5% 32.2% 69.3% 39.3% 45.2% 47.8% 25.5% 30.8% 28.5% 43.4% 30.9% 45.5% 26.1% 28.4% 44.5% 41.5% 18.5% 37.7% 31.7% 13.3% 47.4% 0.6% -2.6% 61.8% 58.8% 10.8% Revenue Op. Income Op. Margin EBITDA Net Income EPS Assets Op. CF ROIC 4.2% 8.3% 9.5% 7.1% -0.8% 2.4% 7.7% 6.1% 6.4% 8.7% 13.8% 13.8% 8.0% -5.3% 2.8% 8.4% 12.6% 6.1% 54.8% 41.7% 39.5% 40.9% 22.6% 39.6% 48.5% 29.7% 36.5% 27.2% 56.1% 56.0% 57.7% -0.1% 27.5% 42.3% 50.3% 54.8% 68.3% 24.4% 19.5% 27.7% 15.9% 19.4% 53.2% 50.3% 17.9% 32.2% 8.8% 7.4% 13.8% 5.0% 4.1% 45.3% 10.1% 6.1% 41.3% 17.4% 12.6% 51.1% 9.2% 11.5% 53.2% -17.0% 8.9% Observation #2 In general, the correlation significantly increased, and some financial metrics became statistically significant, when we moved from a threeyear to a four- or five-year performance period. (See TSR and Revenue correlation for Specialty Retail.) This suggests that while TSR may not have a significant correlation with certain financial metrics over shorter time periods, it may work as a reasonable proxy for certain financial metrics over a longer time horizon, as we see in EBITDA or Revenue metrics for specialty retailers. Observation #3 Correlations were industry specific: For each industry, a specific set of metrics showed high correlation. For example, while Apparel Retail and Specialty Stores are in the same Industry (Specialty Retail), the latter Sub-Industry shows a much higher correlation between TSR and Revenue than Apparel Retail does. A company in the Specialty Store Sub- Industry that is focused on Revenue might anticipate that its relative TSR metrics will be influenced by long-term EBITDA performance if it incorporates Apparel Retail companies into its comparator peer group. 49 KEEP READING

5 TSR In choosing a peer group for a relative TSR metric, should you compare your company with others outside your industry? Here are the key implications: Implication #1 Using peers outside the Industry (or even Sub-Industry) for design benchmarking purposes might actually skew the results of industryrelevant metrics, or allow less important metrics to become more prominent if a significant number of peer companies are outside your Industry. A simple test of correlation between TSR and the peer group s financials would surface any significant anomalies. If the group correlation is very low compared to that Industry s detected TSR/ Financials correlation, this might warrant peer group revisions for incentive design, although this wouldn t be relevant for pay levels, as this is typically driven by company size and market cap. Implication #2 TSR can be useful in detecting what shareholders value when it comes to a company s specific financial performance within the specific Sub- Industry. By testing for correlations between certain financial metrics and TSR over specified time horizons, companies can ascertain whether certain financial metrics have a high degree of correlation with TSR that is, if market success correlated with specific metrics that might be incorporated into an LTI plan. 50

6 Conclusions Our study suggests that, while the correlation between financial metrics and TSR may not be strong for Industry classifications that include a number of varied Sub-Industries (e.g., Specialty Retail), there may be a strong correlation between certain financial metrics and TSR within specific Sub-Industries. In choosing a TSR peer group, looking to other companies within a broader Industry could result in misalignment between desired financial outcomes and TSR; e.g., an Apparel Retail company that is focused on EBITDA may have lower alignment with those goals if it includes Specialty Stores in the peer group as the latter group has a much stronger correlation with Revenue and TSR than EBITDA and TSR over longer time horizons. 51 NEXT ARTICLE