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Managing for Superior Total Shareholder Returns

In his revised edition of Creating
Shareholder Value:A Guide for Managers
and Investors (Free Press 1998),Dr.
Alfred Rappaport provides practical
guidelines for generating superior total
shareholder returns.This is defined as
stock price appreciation plus dividends
greater than an index of peers.Building
on this pioneering work,Dr.Rappaport’s
Harvard Business Review article,New
Thinking on How to Link Executive Pay
with Performance (March/April 1999),
describes how to measure and reward
performance at all levels of an organization
in order to facilitate the quest for
superior shareholder value.The following
summarizes his ideas on how to
better align compensation to superior
total shareholder returns:
Senior management rewards
should focus on outperforming
In the early 1990s,company boards
concluded that stock options represented
the best way to link management and
shareholder interests.Based on this
view and bolstered by the strongest
stock market in history,stock options
have become the fastest growing
component of pay and now represent
more than 50% of total pay for CEOs
of the largest U.S.companies.
Although stock price represents
the right measure of performance,
traditional stock options (with an exercise
price equal to stock price at grant)
rewards both superior and sub-par levels
Our objective in producing this newsletter
series is to present topics that
you have expressed an interest in and
that illustrate the benefits of applying
Shareholder Value to your strategic and
operating functions.If there is a Shareholder
Value topic that you would like
to see discussed, please contact Leon
Schor at 1-800-929-4535 ext.9565 or
by e-mail at l_schor@lek.com.If you
would like to receive a complete set of
our SVA Newsletter series or if others
in your organization would like to
receive our publication, please feel
free to contact Leon.
Managing for Superior Total
Shareholder Returns was written by
David Rhoads, Vice President in
L.E.K.’s Chicago Office and Robert
Roath, retired Chief Financial Officer
of RJR Nabisco, and Chairman,
L.E.K. Advisory Board.
continue on page 2
L.E.K. Consulting llc
of performance because any increase
in share price rewards executives.In
contrast,indexed stock options with
an exercise price that varies up or down
based on the performance of a peer
group or market index provides rewards
for superior performers.In exchange
for this increased performance risk,top
executives should receive an increased
number of options.
Indexed options offer several
important advantages.First,they are fair,
as they reduce rewards for underperformers
in rising markets and they do
not penalize superior performers in
declining markets.Second,they align
the interests of managers and shareholders.
Peer indexing is applied in
Securities and Exchange Commission
disclosure requirements. AlsoThe Wall
Street Journal and L.E.K.Consulting
have selected this as the measure for
the annual Shareholder Scoreboard.
Determine the contribution of
each business unit to the overall
performance of the company.
Today,stock options constitute over
25% of total compensation for group
heads managing businesses with annual
revenues of less than $1 billion,while
annual and longer-term incentives
constitute another 40%. Stock options
will not give managers of independent
operating units the rewards they deserve
because their activities usually have a
limited impact on the company’s stock
price.On the other hand,the various
accounting measures typically used to
assess business unit financial performance
are not reliably linked to superior
shareholder returns.
Since shareholder value is
ultimately created at the unit level,
Dr.Rappaport argues for rewarding
business unit management for Superior
ShareholderValue Added (SSVA™).
SSVA™ determines changes in the future
cash flow of a business unit.It is calculated
by applying standard discounting techniques
to forecasts of operating cash
flows for a specified period,minus
the incremental future investments
anticipated for that period. If a
company is to deliver superior returns
to shareholders,then its business units
must create better than expected SVA
that is,superior SVA.This standard
rewards managers for meeting or beating
investor expectations rather than
their beating a budget disconnected
from expectations.
Involve all front line managers and
workers in the quest for value.
Finding measures that guide hands-on
decision making by front-line workers
and are correlated with the long-term
value of the business is the final set
required to drive superior total shareholder
returns.Middle managers and
front-line workers need to understand
what actions they can take to ensure
that investor expectations are met or
exceeded.Dr.Rappaport refers to these
measures as “leading indicators of
value,”or key value drivers,and views
them as an essential basis for calculating
incentives for front-line employees.
Schwab Inc.
• Leveraged brand name by selling
third party mutual funds
• Achieved technology edge in
Internet Trading
• Gained “first mover advantage”
— Direct Internet sales
— “Build to order” sales
• Revolutionized home
improvement market with
— Strong customer service
— Big cost advantage
• Changed the rules of competition
by aligning entire organization
around low cost, efficient service
• Avoided head-to-head competition
with majors
• Concentrated on businesses with
proven earnings performance and
strong management
• Favored businesses and industries
unlikely to experience major change
Industry Winning Strategy
1999 Wall Street Journal Shareholder Scoreboard
Total Shareholder Returns
Value of $100 Invested on January 1, 1989
How have top value creators rewarded shareholders?
L.E.K. Consulting llc
Question 1: Is your corporate
success defined as superior total
shareholder returns?
The way an organization defines
success has a profound impact on the
business. It provides a benchmark for
setting performance goals,evaluating
strategies,making investment decisions,
and rewarding management.
However,defining success and
communicating it effectively can be a
double-edged sword.The right definition
of success stimulates organizational
improvement,profitable growth,and
value creation.The wrong definition
diffuses focus, reduces motivation,
and works against goal achievement.
Incorrect measures can lead to inappropriate
actions and counterproductive
The single best measure of
overall company and management
performance is relative total shareholder
returns, or a company’s total return
compared to a group of comparable
peers.This measure offers a number of
important advantages over the others.
It is the most direct measure of a
company’s performance for shareholders,
free from distortions related to
alternative accounting practices.Since
it is indexed to eliminate the effect
of market and industry specific price
movements,it minimizes the influence
of events outside management’s control.
It therefore provides an unbiased
yardstick for gauging management’s
ability to execute strategies that
beat competitors in both the product
markets and the capital markets.
However,for the total shareholder
returns measurement to be effective,
several conditions must be met.
Management must accept the fairness
of the peer group or index used to
judge relative performance and there
needs to be an understanding of the
link between management’s actions
and the company share price.
Question 2:Are your business unit
strategies based on an externally
validated understanding of industry
attractiveness and competitive position?
The two primary strategic determinants
of value creation are industry
attractiveness and competitive position.
Factors driving industry attractiveness
include expected market growth,
supply and demand fundamentals for
customers and suppliers,technological
change,the distribution of relative
market share and power (between
buyers and sellers as well as among
competitors), entry and exit barriers,
vertical integration potential, threat of
substitutes,and competitive intensity.
Industry attractiveness reflects
factors which an individual ordinarily
has minimal influence.In contrast,key
aspects of a firm’s competitive position
are relative product differentiation,
economic cost (including capital costs),
and relative market share in strategic
segments.By its choice of strategy,a
business can change its relative position
within its industry,thereby making
the industry more or less attractive
for the business.
Six Questions to Consider
Generating superior total shareholder
returns over time is an enormously
demanding objective.Since a company’s
share price reflects current market
expectations for future performance,
beating peers requires exceeding
investors’expectations more than peers
do on a regular basis.
But potential rewards are
staggering.Based on the L.E.K.analysis
published inThe Wall Street Journal
Shareholder Scoreboard, the figure on
the opposite page shows how top value
creators beat the odds and exceeded
their peer group’s total shareholder
returns over the past ten years.While
their strategies and operating styles differ,
each management team is passionate
about understanding the evolution of
their industry structure,enhancing
sources of competitive advantage,and
creating shareholder value.
Despite the increasing emphasis
on stock options and stock ownership
for senior management,few companies
have fully realized the potential benefits
of aligning and managing for superior
total shareholder returns.The objective
of this edition of L.E.K.’s Shareholder
Value Added newsletter is to help you
diagnose your company’s capabilities
across six areas essential to managing
for superior returns.
Senior executives frequently
overestimate the extent to which their
company is aligned with superior
shareholder value performance.
Consider the following six questions.
Your answers and those of your management
team will help you identify
where your strengths and potential
weaknesses may be.
L.E.K. Consulting llc
Industry attractiveness and
competitive position drive future prices,
volume, cost, required investment,
and business risk.These factors in turn
determine value creation potential.
Consequently,business strategies must
be supported by an externally validated,
fact-based understanding of the
potential impact of future industry
trends on the competitive position
of the business.
Many companies do not allocate
the resources necessary to properly
assess industry attractiveness and competitive
position in this manner.Typical
reasons are that many managers rely on
intuition and limited internal data to
make strategic investment decisions,
although it is widely accepted that both
are frequently unduly optimistic.To be
fair,business unit managers are rarely
held accountable or rewarded for delivering
long-term value and few companies
even bother to compare past forecasts
with actual results.In addition, few
business units have the internal capabilities
and resources required to collect
and analyze external market data,and
to develop realistic financial forecasts.
To validate business unit strategies,
a process must be created that explores
industry attractiveness and competitive
position to discover where value is
created today and in the future.This
entails the development of an externally
validated cash-flow forecast supported
by a realistic assessment of industry
attractiveness and competitive position
as well as the current strategy for
calculating the value and SVA of each
business unit.Evaluating the alternative
strategies ensures the ones selected are
those which create the most value.
Question 3:Will your corporate business
plan exceed investor expectations?
Companies and the stock market are
engaged in an on-going signaling and
monitoring process.Companies
provide information via published
reports,news releases and other communications.
Investors incorporate this
information into their expectations
and collectively express their view
of a company’s prospects in the stock
price. Stock price, in turn, signals what

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