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Who’s Really Winning?
The criticism is that by providing undifferentiated praise, this generation is not being prepared for the real world where there are winners and losers. In the same way, there seem to be a lot of corporate rankings that hail all companies regardless of performance. Unfortunately, in the real world, the market does separate the winners and losers on a daily basis.
Given that a CEO’s primary duty is to allocate capital to its highest and best use, we ranked CEO performance of 125 of Northern California’s largest companies according to their ability to earn returns above their investors’ required return. For example, if a CEO’s company had $1 billion of capital tied up in working capital and fixed assets and investors require a 10 percent return, then the company would need to generate $100 million of profit (e.g., $1 billion x 10% required return) to fairly compensate its investors. The market bears out this approach by valuing companies that earn returns above their required return 2.5x higher than those that do not.
Figure 1 below highlights the Top and Bottom 5 companies in the SCCO International CEO Performance 125 according to the highest return above their required return:
Figure 1: Top and Bottom 5 Value Spread
To further examine the role of returns, we segmented the 125 companies into two groups and compared their respective performance. Group I consisted of the 85 companies (68 percent) with returns above their required return, while Group II consisted of the 40 companies (32 percent) with returns below their required return. Group I was the hands-down winner in all categories, outperforming Group II according to market value, return and growth measures.
Figure 2 below highlights how companies earning returns above required returns significantly outperformed companies earning returns below required returns in 2011:
Figure 2: 85 Companies Earning Returns Above Investor Requirements
Please click here for access to the SCCO International CEO Performance 125.
First, at year-end 2011, the market valued Group I companies demonstrably higher than Group II companies. Group I’s average market to book multiple of 5.2x is approximately 2.5x Group II’s average market to book multiple of 2.1x. In other words, the market is valuing every $1 invested in Group I at $2.50 versus only $1 for Group II. Clearly, the market does not believe in the “everyone deserves a medal” philosophy.
Next, we compared the performance of Group I and Group II over the last five years. During this period, Group I delivered higher returns and grew faster than Group II. The average return on capital for Group I was 26 percent versus 1 percent for Group II. Group I grew sales at 10 percent annually and delivered an average profit margin of 10 percent, while Group II grew at 16 percent annually with an average profit margin of 0 percent.
Going forward, Group I should emphasize growth since growth combined with high returns builds value. Conversely, Group II companies would generate relatively more value by focusing on margin improvement. Many CEOs fall into the trap of thinking that high growth will cure all; however, if margins remain low, then additional growth will only drive profits, free cash flow and value down.
In summary, returns do matter. Companies that exceed their investors’ required returns are valued significantly higher than companies that do not. The CEOs of these companies have strategies in place that deliver higher returns and more profitable growth, which is why they really are winners.
To read the Southern California “CEO Performance of 100 of Southern California’s Largest Companies” report published in the last issue click here.