The ranking focuses on the performance of companies (and their CEOs) in the S&P 500 index for the three years that ended on June 30, 2010. It’s based on reported results during that period and estimates for the next 12 months.
CEOs whose tenure did not cover the full three years were not ranked. Also not ranked are the 14 REITs in the 2010 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 equityresearch 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. (The list itself casts these scores as a sequential ranking.) The component rankings are shown as letter grades with companies in the top 20 percent of each sector receiving an A; the bottom 20 percent receiving an F.
Market (or Enterprise) Value/Invested Capital (MV/IC)
This measure shows the degree to which investors value the company’s assets, relative to their cost. Market value is what a buyer would have to pay to buy the company outright; that is, to purchase all the stock and pay off all 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. 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.
This is a 12-month forecast, based on the ratio of the most recent EM to the three-year average.
This AFG-proprietary measure rewards a company with positive EM for increasing its asset base, and penalizes one with negative EM for growing 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 73.3 percent between January 2007 and June 2010 (the period covered in the reported financials). The bottom 50 companies’ TSR averaged -3.4 percent, while the S&P 500’s average was 14.9 percent (without its 14 REITs). The top 50’s median TSR was 33 percent; the bottom 50’s was 9.5 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. Note: Total shareholder return equals share-price return plus reinvested dividends.
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. Improvement 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 opportunity sensing—entering lucrative or fast-growing businesses, as well as putting businesses making sub-par 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.
- 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” (CE Jan/Feb 2008).
At all levels:
Get all you can out of your assets. Example: large software companies (IBM, Oracle and others) have been acquiring other software firms so that their sales forces, which are major leverageable assets, have more offerings to sell to customers. Include all of your intangible assets, not just intellectual property, in your thinking. Work hard to create and improve customers’ feelings about your company and its offerings, the promises your brands represent, your value propositions, etc. (For more, see The Economic Stimulus Package Inside Every Business CE Online Jan/Feb 2009, and “Do Intangibles Matter?“, CE July/August 2008).
Finally, manage internal and external risks across the company and its aggregate risk-reward profile by taking a wide-angle lens to what could happen.—Drew Morris