Ranking CEO Wealth Creation

The top 50 companies’ 3-year average TSR was 539 percent higher than the bottom 50’s

October 14 2009 by Drew Morris And Michael Burdi


The wealth creation ranking focuses on the performance of companies (and their CEOs) in the S&P 500 index for the three years ending on June 30, 2009. It’s based on reported results during that period and estimates for the next 12 months. CEOs whose tenure did not coincide for the full three years were not ranked. Also not ranked are the 16 REITs in the 2009 S&P 500 and the companies for which a full three years of financial results were not available.

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 proprietary metrics and data. A weighted combination of each company’s component rankings is used to produce an overall score: 100 is awarded to the best wealth creator, 1 to the worst. These rankings are shown as letter grades; companies in the top 20 percent of each component metric receive an A, the bottom 20 percent receive an F.

Market Value/Invested Capital (MV/IC)

This measure shows the degree to which investors consider the company’s assets valuable, relative to their cost. Market (or enterprise) 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’ EM

Economic Margin (EM) measures the degree to which the company is making money in excess of its risk-adjusted capital cost. It’s expressed as a percentage of invested capital. EM is calculated as (Operating Cash Flow – Capital Charge)/Invested Capital. Companies with positive EM (greater than 0 percent) are creating wealth; those with negative EM are destroying it.

 As the table below shows, the top 50 companies in the wealth
creation ranking outperformed the bottom 50 companies as well
as the S&P 500 between July 2006 and June 2009.

 
 Note: Total Shareholder Return = share-price return percent plus reinvested dividends.

Disclaimer: AFG, its owners, employees and/or customers may have positions in the
securities listed in this article. The information provided is based on material AFG
believes to be accurate and reliable, however, its accuracy and completeness, and
conclusions derived therefrom, are not guaranteed.

EM Change

This is a 12-month forecasted EM, based on the ratio of the most recent EM to the three-year average.

Management Quality

This AFG-proprietary measure rewards a company with positive EM for growing its asset base, and penalizes one with negative EM for shrinking its asset base. 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 48.3 percent between July 2006 and June 2009. The bottom 50 companies’ TSR averaged -11%, while the S&P 500’s average (without its 16 REITs) was -5.8%. The top 50’s average TSR was 539 percent higher than the bottom 50’s, a striking difference.

 Three Top Wealth Creators and Destroyers

John Martin, Gilead Sciences

Score: 95

This $5.3 billion pharmaceutical company develops and markets treatments for life-threatening infectious diseases (HIV and Hepatitis B), pulmonary and cardiovascular diseases.

Proprietary pharmaceuticals is a “hit-record” business, one in which your product or service is either very successful (and life is good) or it’s not (and you’re trying to survive while developing for your next, hoped-for hit).

Once you put all the brains, skills, capital and hard work into creating an industry-leading product, and if Dame Fortune is smiling (that is, your competitors don’t beat you to the punch with an even better product), you’ll do well—in Gilead’s case, 50 percent operating margins and global scalability. 

John Wiehoff, C.H. Robinson Worldwide

Score: 92

You can still make money as a matchmaker. C.H. Robinson is an $8.6 billion third-party logistics provider, a trucking broker. It sports an asset-light business model— doesn’t own any trucks, etc. Instead, it uses its solid relationships with 32,000 shippers and 50,000 trucking companies and its proprietary information system to keep trucks as full as possible and shipments moving economically.

 

It’s not as volume-sensitive as a shipper and no one shipper represents more than 3 percent of revenue. It can use its matchmaking information system as a vehicle to expand outside the U.S.

Douglas Baker, Ecolab

Score: 92

Six billion dollar Ecolab manufactures and sells cleaning, infection prevention and pest-elimination products, and textile and ware-washing systems to institutional, hospitality and industrial customers. The largest company in a highly fragmented industry, it has created a two-pronged approach to customer loyalty: high-touch service and proprietary product-dispensing equipment that both saves customers money and creates switching costs. (After all, why put a business based on relationships at the mercy of the purchasing department?)

With an international presence, its results have lately been impacted by the decline in the hospitality industry, but its infection-prevention (H1N1, etc.) presence bodes well going forward.

 

 

 —and Destroyers

 

 

 

 

 

Jeffrey Peek, CIT Group

Score: 8

$2.9 billion CIT has long been a lender to the now-troubled small and mid-size business (SMB) market, offering asset and cash-flow-based funding. And it’s the largest SBA lender.

CIT’s problems lie not only with the now-stressed SMB market, but are rooted in its management’s judgment calls—the heart of what a CEO is paid to do—and a healthy dollop of bad luck.

Its forays away from SMB financing into student loans and subprime mortgage lending did not pan out. And management seems to have ignored the risk that its source of money to lend (the capital markets) would freeze up, leaving it unable to lend and make money. Perhaps they thought they too were too big to fail. Lee Iacocca’s wisdom applies, paraphrased, “If we’re wrong about this, will we be able to absorb the consequences?”

 

 

John Faraci, International Paper

Score: 15

International Paper, with $24.8 billion in 2008 revenue, has changed its business model dramatically in recent years (selling much of its timberland, its coated paper and other businesses).  It’s now focused on making uncoated paper and containerboard. But it hasn’t freed itself from a challenged business model: Pricing and demand can change dramatically, industry overcapacity is a common problem, there’s domestic competition from low-cost locales and it has limited control over pricing (powerful buyers). Plus, it faces volatile raw-material and energy costs. If the CEO’s job is to create wealth for shareholders, we wonder why this business model seemed like it would do so. We believe that the core of the CEO’s responsibility to shareowners is to keep the company competitive in, or to move the company into, one or more great businesses—those with the power to truly create economic wealth.

 

Lewis Campbell, Textron

Score: 15

 

Textron is a $3.6 billion conglomerate, consisting of a financial services unit, Bell Helicopter, Cessna, an industrial (automotive) business and Textron Systems (defense, imaging and others). Although it has some now-solid franchises—Bell, and some Systems elements—its financial and industrial business units are challenged.

The “something’s always going to be in the tank” nature of a conglomerate prevents it from regularly outperforming the market. As we’ve seen with GE, a financial services division can facilitate sales in the other divisions. It can also create a perfectly legal “cookie jar” to smooth out earnings with well-timed asset sales. But at 5 percent of revenue, Textron’s financial-services unit seems to now be traumatizing the whole company.

It is reasonable to wonder about management’s belief that the company’s whole is worth more than its parts. On the other hand, when things go seriously south in one business, being able to rely on the cash flows of others that are doing well can be a lifesaver. —D.M.

 

Click here to view complete list of companies and their respective rankings
 

How to Move Up in the Rankings

In publishing this list, Chief Executive aims to show CEOs both where they stand with respect to their peers (awareness being the mother of improvement) and to make clear how to go about improving one’s standing. Improving will require several actions that the company’s CEO, division heads and general managers can take:

At the corporate level:

  • Use EM to measure wealth-creation throughout the company.
  • Manage your portfolio of businesses from a wealth-creation perspective. This includes sensing opportunities—entering lucrative or fast-growing businesses as well as putting businesses making subpar contributions into other hands or shuttering them. Set the contribution hurdle rate to maximize economic value creation.
  • Ensure that the company’s capital structure is right. This affects the capital charge and invested capital. Equity is more expensive than debt, but too much debt can kill a company (witness recent debacles).
  • Avoid overpaying for acquisitions or buying back stock at its peaks.

At the business-unit level:

The general managers of businesses need to find the best things they can do to boost operating results. (See “Leading Your Business to Maximum Results” )

At all levels:


Drew Morris (drew.morris@greatnumbers. com) is the founder and CEO of Great Numbers!, which helps executives figure out how to create them, and to master the skills needed to do so repeatedly. He has no stake in any of the companies mentioned.

Michael Burdi (www.economicmargin. com/moreinfo.htm) is senior analyst for Applied Finance Group, Ltd. (AFG), a Chicago-based independent equity research advisory firm specializing in performance and valuation measurement using Economic Margin.