2011 Wealth Creation Index Methodology
November 16 2011 by Drew Morris And Michael Burdi
Click here to see a slideshow of the Top 10 Most Valuable CEOs
Click here to see a full list of companies and their respective rankings
Click here to read Editor-in-Chief JP Donlon’s editor’s note about this year’s top CEOs
Click here to see the Best and the Worst and How to Improve Your Ranking
The fourth annual ranking of the Chief Executive/Applied Finance Group wealth creators — and destroyers — finds that discipline is rewarded.
Ranking CEO Wealth Creation
Our ranking is based on the performance of companies in the S&P 500 index (and their CEOs) for the three years ending on June 30, 2011. It considers reported financial results during that period and estimates for the next 12 months. Only companies whose CEOs were in their roles for the entire July 2008 through June 2011 period were ranked. Not ranked are the 13 REITs in the 2011 S&P 500.
The four components of the ranking, explained below, were developed and calculated by the Applied Finance Group (AFG), an independent equity-research advisory firm, using their proprietary metrics and data. An again-proprietary weighted combination of each company’s component rankings, taking into account the industry the company is in, is used to produce an overall score: 100 is awarded to the best wealth creator; 1 to the worst. (The list itself shows these overall scores as a sequential ranking.) The component rankings are shown as letter grades with companies in the top 20 percent of each component metric receiving an A grade; the bottom 20 percent receiving an F.
Market (or Enterprise) Value/Invested Capital (MV/IC)
This measure shows the degree to which investors consider the company’s assets valuable, relative to their cost. Market value is what a buyer would have to pay to buy the company outright, that is, to purchase all of the stock and pay off all of the loans, leases and other obligations. Note that market value depends on the stock price. Invested capital is the inflation-adjusted total of all of the investments in the business. It does not depend on the stock price. So by its nature, MV/IC reflects the market’s take on the value of the investments made in the business.
The Average of the Past Three Years’ Economic Margins
Economic Margin (EM) measures the degree to which the company is making money in excess of its risk-adjusted capital cost—riskier businesses get relatively higher capital costs. EM is expressed as a percentage of invested capital. It’s calculated as (Operating Cash Flow -the Capital Charge)/Invested Capital. Companies with positive EM (greater than 0 percent) are creating wealth; those with negative EM are destroying it.
This is a 12-month forecasted EM, based on the ratio of the most recent EM to the 3-year average.
This AFG-proprietary measure rewards a company with positive EM for growing its asset base, and penalizes one with negative EM for doing the same thing. In other words, if a company is making money and it adds assets in such a way that it can make even more, that’s good. So is selling off a money-losing division. That said, it’s also valid that adding scale can dramatically increase profitability in a business with high fixed costs.
A Validity Check on the Ranking Method
The top 50 companies in the ranking delivered an average Total Shareholder Return (TSR) of 68.5 percent between January 2008 and June 2011 (the period covered in the reported financials). The bottom 50 companies’ TSR averaged -10.3 percent, while the S&P 500’s average was 14.9 percent (without its 14 REITs). The top 50’s median TSR was 40.7 percent; the bottom 50’s was -11.7 percent.
As the table above shows, the top 50 companies in the wealth creation ranking far outperformed the bottom 50 companies and the S&P 500 between July 2008 and June 2011. Note: Total Shareholder Return = Share-Price Return Percent + Reinvested Dividends.
For more on Economic Margin and how companies scored, see http://www.economicmargin.com/moreinfo.htm.