CORPORATE VALUATION
MSC FINANCE 2022/2023 – RIJKSUNIVERSITEIT GRONINGEN
1) WHY VALUE VALUE?
Principle of business value creation: companies that grow and earn a return on capital that exceeds their cost
of capital create value.
There is an important distinction between creating shareholder value and maximizing short-term profits.
Companies that conflate the two often put both shareholder value and shareholder interests at risk.
Value creation: maximizing a company’s collective value to its shareholders, now and in the future. Thus, it
cannot be thought of as simply maximizing today’s share price.
Since investors don’t have complete information (information asymmetry), companies can easily pump up their
share price in the short term or even longer. Eventually, the company has to come clean and it can take years
for the stock price to recover.
Companies with a long strategic horizon create more value than those run with a short-term mindset. Managers
who create value for the long term do not take actions to increase today’s share price if those actions will
damage the company down the road.
Activist investors strengthen the long-term health of the companies they pursue, for example by challenging
existing compensation structures that encourage short-termism. Executives and board members are the
greatest sources of pressure for short-term performance.
Other challenges: externalities can be extremely challenging for corporate decision making, because there is no
objective basis for making trade-offs among parties.
Pursuing the creation of long-term shareholder value requires satisfying other stakeholders as well (i.e., cannot
ignore customers, suppliers, and employees). Investing for sustainable growth should and often does result in
stronger economies, higher living standards, and more opportunities for individuals.
The combination of growth and return on invested capital (ROIC), relative to its cost, is what drives cash flow
and value. Anything that does not increase ROIC or growth at an attractive ROIC does not create value.
Only if companies have a well-defined competitive advantage can they sustain strong growth and high returns
on invested capital. Creating sustainable value is a long-term endeavour, one that needs to take into account
social, environmental, technological, and regulatory trends.
2) FINANCE IN A NUTSHELL
Companies create value when they earn a return on invested capital (ROIC) greater than their opportunity cost
of capital. If the ROIC is at or below the cost of capital, growth may not create value.
• A simple definition of return on invested capital is after-tax operating profit divided by invested capital
(working capital plus fixed assets). ROIC is a calculation from a company’s financial statements.
Companies should aim to find the combination of growth and ROIC that drives the highest discounted value of
their cash flows. In so doing, they should consider that performance in the stock market may differ from intrinsic
value creation, generally as a result of changes in investor’s expectations.
Comparing ROIC to the opportunity cost of capital shows whether companies could earn more money by
investing elsewhere than in their current working capital and property, plant, and equipment.
The discounted cash flow (DCF) is a measure that is also known as the present value. DCF is a way of collapsing
the future performance of the company into a single number. Can
be achieved by forecasting the future cash flow of the company
and discounting it back to the present at the same opportunity
cost of capital. If the DCF with the new concept is greater than
without, the concept is valuable.
Economic profit is defined as the spread between ROIC and cost
of capital multiplied by the amount of invested capital.
Companies should seek to maximize economic profit (not just
ROIC) over the long-term. Economic profit and DCF are the same.
,In the real market, the decision rule is simple: choose strategies or make operational decisions that maximize
the present value of future cash flow or future economic profit.
When a company enters the capital market, the decision rules for the real market remain essentially unchanged.
But it gets more complicated, because management must simultaneously deal with the financial market.
• When a public company goes public and sells shares to a wide range of investors who can trade those shares
in an organized market, the interaction (or trading activity) between investors and even market speculators
sets a price for those shares.
• The price of the shares is based on what investors think those shares are worth. Each investor decides what
he or she thinks the value of the shares should be and make trades based on whether the current price is
above or below that estimate of the intrinsic value.
• The intrinsic value is based on the future cash flows or earnings power of the company.
• Thus, investors are paying for the performance they expect the company to achieve in the future, not what
the company has done in the past (and certainly not the cost of the company’s assets).
The difference between share price and intrinsic value means that the market should be willing to pay a
premium over the invested capital for the future economic profit the company is expected to earn. Hence, the
return investors earn is driven by performance relative to its expectations (and not performance itself).
• As long as a company performs as expected, the return for shareholders will just be their opportunity cost
(so no profit or loss).
• Performing better than expected, leads to a profit for shareholders; and performing worse than expected,
leads to a loss for shareholders.
Managers have a dual task: to maximize the intrinsic value of the company and to properly manage the
expectations of the financial market. Expectations should not be too high or too low.
• Companies that convince the market that they will deliver great performance and then do not deliver on
those promises, often results in a share price drop and regaining credibility may take years.
• If market’s expectations are too low and you have a low share price relative to the opportunities the
company faces, you may be subject to a hostile takeover.
The problem with any financial measure is that it cannot tell how managers are doing at building the business
for the future. It is important to make sure to build in measures related to customer satisfaction or brand
awareness – measures that let you know what the future will look like, not just what the current performance
is. For example, a company could need a planning and control system that incorporates forward-looking
measures besides looking backward at financial measures.
Some core ideas around value creation and its measurement:
1. In the real market, you create value by earning a return on your invested capital greater than the
opportunity cost of capital.
2. The more you can invest at returns above the cost of capital, the more value you create. That is, growth
creates more value as long as the ROIC exceeds the cost of capital.
3. You should select strategies that maximize the present value of future expected cash flows or economic
profit. The answer is the same regardless of which approach you choose.
4. The value of a company’s shares in the stock market equals the intrinsic value based on the market’s
expectations of future performance, but the market’s expectations of future performance may not be same
as the company’s.
5. The returns that shareholders earn depend on changes in expectations as much as on the actual
performance of the company.
3) FUNDAMENTAL PRINCIPLES OF VALUE CREATION
Companies create value for their owners by investing cash now to generate more cash in the future. The amount
of value they create is the difference between cash inflows and the cost of the investments made, adjusted to
reflect the fact that tomorrow’s cash flows are worth less than today’s because of the time value of money and
the riskiness of future cash flows.
The conversion of revenues into cash flows – and earnings – is a function of a company’s return on invested
capital (ROIC) and its revenue growth. That means that the amount of value a company creates is governed
ultimately by its ROIC, revenue growth, and ability to sustain both over time.
• Only if ROIC exceeds the cost of capital will growth increase a company’s value. Growth at lower returns
actually reduces a company’s value.
,• The cost of capital is an opportunity cost for the company’s investors, not a cash cost.
Value is the sum of the present values of future expected cash flows – a point-in-time measure. Value creation
is the change in value due to company performance (changes in growth and ROIC). Sometimes we refer to value
and value creation based on explicit projections of future growth, ROIC, and cash flows. At other times, we use
the market price of a company’s shares as a proxy for value, and total shareholder returns (share price
appreciation plus dividends) as a proxy for value creation.
The core principle of value creation:
Following these principles helps managers decide which strategies and investments will create the most value
for shareholders in the long term. The principles also help investors assess the potential value of companies they
might consider investing in.
High-ROIC companies typically create more value by focusing on growth, while lower-ROIC companies create
more value by increasing ROIC.
Many executives, boards and financial media still treat accounting earnings and value as one and the same and
focus almost obsessively on improving earnings. However, while earnings and cash flow are often correlated,
earnings do not tell the whole story of value creation. Focusing too much on earnings (growth) often leads
companies to stray from a value-creating path.
If all companies in an industry earned the same ROIC, then earnings growth would be the differentiating metric,
because then only growth and not ROIC would determine differences in companies’ cash flows. For reasons of
simplicity, analysts and academics have sometimes made this assumption. However, returns on invested capital
can vary considerably, not only across industries but also between companies within the same industry and
across time.
Growth, ROIC, and cash flow are mathematically linked. Almost all companies need to invest in plant, equipment,
or working capital to grow. Free cash flow is what’s left over for investors once investments have been
subtracted from earnings.
We can value companies by discounting their future free cash flows at a discount rate that reflects what investors
expect to earn from investing in the companies (i.e., their cost of capital).
Differences in ROIC – defined as the incremental net operating profit after taxes (NOPAT) earned each year
relative to the prior year’s investment – are what drives difference in investment rates.
Growth, ROIC, and cash flow (as represented by the investment rate) are tied together mathematically in the
following relationship:
• Growth = ROIC × Investment Rate
Another way to look at this comparison between growth rates is in terms of cash flow:
Growth
• Cash Flow = Earnings × (1 − Investment Rate) = Earnings × (1 − )
ROIC
Since these three variables are tied together mathematically, you can describe a company’s performance with
any two variables. Generally, a company’s performance is described in terms of growth or ROIC because you can
analyse growth and ROIC across time and versus peers.
If you simplify some assumptions – for example, that a company grows at a constant rate and maintains a
constant ROIC – you can reduce the discounted cash flow to a simple formula. We call this the value driver
formula. Here, NOPAT represents the net operating profit after taxes, 𝑔 is the growth rate of the company, and
WACC is the cost of capital.
𝑔
NOPATt=1 (1−ROIC)
• Value =
WACC−𝑔
• In practice, we rarely use this formula by itself, because of its assumption of constant growth and ROIC
forever. Still, it is a useful reminder of the elements that drive value: growth, ROIC, and cost of capital.
,• Improving ROIC, for any level of growth, always increases value because it reduces the investment required
for growth. The impact of growth, however, is ambiguous, as it appears in both the numerator and the
denominator. Faster growth increases value only when a company’s ROIC is greater than its cost of capital.
Matrix that shows how different combinations of growth and ROIC translate into value:
For any level of growth, value increases with improvements
in ROIC → when all else is equal, a higher ROIC is always good
because it means that the company does not have to invest as
much to achieve a given level of growth.
When ROIC is high (13% and 25%), faster growth increases
value. But when ROIC is lower than the company’s cost of
capital (7%), growing faster means investing more at a value-
destroying return.Where ROIC equals the cost of capital, value
is neither created nor destroyed, regardless of how fast the
company grows.
A company with a high ROIC and low growth may have a similar or higher valuation multiple than a company
with higher growth but low ROIC. We sometimes hear the argument that even low-ROIC companies should strive
for growth. The logic is that if a company grows, its ROIC will naturally increase. However, we find this is true
only for young, start-up businesses. Most often in mature companies, a low ROIC indicates a flawed business
model or unattractive industry structure. Don’t fall for the trap that growth will lead to scale economies that
automatically increase a company’s return on capital. It almost never happens for mature businesses.
The core valuation principle applies at both the company and sector level.
Several lessons managers should learn for strategic decision making:
• In general, companies already earning a high ROIC can generate more additional value by increasing their
rate of growth, rather than their ROIC.
• Low ROIC companies will generate relatively more value by focusing on increasing their ROIC.
The general lesson is that high-ROIC companies should focus on growth, while low-ROIC companies should focus
on improving returns before growing. Of course, this analysis assumes that achieving a one-percentage-point
increase in growth is as easy as achieving a one-percentage-point increase in ROIC, everything else being
constant. In reality, achieving either type of increase poses different degrees of difficulty for different companies
in different industries, and the impact of a change in growth and ROIC will also vary between companies.
However, every company needs to conduct the analysis to set its strategic priorities.
Different types of growth can earn different returns on capital, so not all growth is equally value-enhancing. Each
company must understand the pecking order of growth-related value creation that applies to its industry and
company type.
• New products typically create more value for shareholders, while acquisitions typically create the least. The
key to the difference between these extremes is differences in returns on capital for the different types of
growth.
• Growth strategies based on organic new-product development frequently have the highest returns because
they do not require much new capital; companies can add new products to their existing factory lines and
distribution systems. Furthermore, the investments to produce new products are not at all required at once.
If preliminary results are not promising, future investments can be scaled back or cancelled.
• Acquisitions require the entire investment be made up front. The amount of up-front payment reflects the
expected cash flows from the target plus a premium to stave off other bidders. So even if the buyer can
improve the target enough to generate an attractive ROIC, the rate of return is typically only a small amount
higher than its cost of capital.
• (Risk of failure is excluded from this pecking order of investments from a value-creation viewpoint).
The interaction between growth and ROIC is a key factor to consider when assessing the likely impact of a
particular investment on a company’s overall ROIC.
• Faster growth rarely fixes a company’s ROIC problem (except at small start-up companies). Low returns
usually indicate a poor industry structure, a flawed business model, or weak execution. If a company has a
problem with ROIC, the company shouldn’t grow until the problem is fixed.
One final factor for management to consider is the method by which it chooses to improve ROIC. A company
can increase ROIC by either improving profit margins or improving capital productivity.
,• With respect to future growth, it does not matter which of these paths a company emphasizes.
• However, for current operations, at moderate ROIC levels, a one-percentage-point increase in ROIC through
margin improvement will have a moderately higher impact on value relative to improving capital
productivity. At high levels of ROIC, though, improving ROIC by increasing margins will create much more
value than an equivalent ROIC increase by improving capital productivity.
We can also use a measure of company’s value creation using economic profit, a measure that combines ROIC
and size into a currency metric. Economic profit measures the value created by a company in a single period and
is defined as follows:
• Economic Profit = Invested Capital × (ROIC − Cost of Capital)
• Economic profit is the spread between the return on invested capital and the cost of capital times the
amount of invested capital.
We can also value a company by discounting its projected economic profit at the cost of capital and adding the
starting invested capital.
• Value = Starting Invested Capital + PV(Projected Economic Profit)
• This value will be exactly the same with the discounted-cash-flow (DCF) approach.
Economic profit is also useful for comparing the value creation of different companies or business units.
Measuring performance in terms of economic profit encourages a company to undertake investments that earn
more than their cost of capital, even if their return is lower than the current average return.
A corollary of the principle that discounted cash flow (DCF) drives value is the conservation of value: anything
that does not increase cash flows does not create value. That means value is conserved, or unchanged, when a
company changes the ownership of claims to its cash flows but does not change the total available cash flows.
• Changing the appearance of the cash flows without actually changing the cash flows – say, by changing
accounting techniques – does not change the value of a company.
• The value of a company should not be affected by changing the structure of the debt and equity ownership
unless the overall cash flows generated by the company also change (Modigliani and Miller).
o In most countries, however, borrowing money does change cash flows because interest payments
are tax deductible. The total taxes paid by the company are lower, thereby increasing the cash flow
available to pay both shareholders and creditors.
o In addition, having debt may induce managers to be more diligent because they must have cash
available to repay the debt on time and, therefore, increase the company’s cash flow.
o The point is that: it matters only if the substitution of debt for equity changes the company’s cash
flows through tax reductions or if associated changes in management decisions change cash flows.
• The market is not fooled by actions that do not affect cash flow.
The conservation of value principle is so useful because it tells us what to look for when analysing whether some
action will create value: the cash flow impact and nothing else.
• A common fallacy is that share repurchases create value simply because they increase earnings per share
(EPS). Unfortunately, this does not square with the conservation of value, because the total cash flow of the
business has not increased. While the EPS has increased, the company’s debt has increased as well. With
higher leverage, the company’s equity cash flows will be more volatile, and investors will demand a higher
return. This will bring down the company’s P/E, offsetting the increase in EPS.
o Moreover, you must consider where the company could have invested the cash rather than
returning it to shareholders. If the return on capital from the investment exceeded the company’s
cost of capital, it’s likely that the longer-term EPS would be higher from the investment than from
the share repurchases. Share repurchases increase EPS immediately, but possibly at the expense
of lower long-term earnings.
o When the likelihood of investing cash at low returns is high, share repurchases make sense as a
tactic for avoiding value destruction. But they do not in themselves create value.
• Acquisitions create value only when the combined cash flows of the two companies increase due to cost
reductions, accelerated revenue growth, or better use of fixed and working capital.
o Multi-expansion illusion (or rerating): the notion that the multiple of Company B’s earnings expand
to the level of Company A’s because the market does not recognize that perhaps the new earnings
added to A are not as valuable (in reality, the new P/E will lie somewhere between A and B).
• Financial engineering is defined as the use of financial instruments or structures other than straight debt
and equity to manage a company’s capital structure and risk profile. Financial engineering can include the
, use of derivatives, structured debt, securitization, and off-balance-sheet financing. While some of these
activities can create real value, most do not.
o Still, the motivation to engage in non-value-added financial engineering remains strong because of
its short-term illusory impact.
THE MATH OF VALUE CREATION
Terminology:
• Net operating profit after taxes (NOPAT) represents the profits generated from the company’s core
operations after subtracting the income taxes related to those core operations.
• Invested capital represents the cumulative amount the business has invested in its core operations –
primarily property, plant, and equipment and working capital.
• Net investment is the increase in invested capital from one year to the next:
o Net Investment = Invested Capital𝑡+1 − Invested Capital𝑡
• Free cash flow (FCF) is the cash flow generated by the core operations of the business after deducting
investments in new capital:
o FCF = NOPAT − Net Investment
• Return on invested capital (ROIC) is the return the company earns on each dollar invested in the business:
NOPAT
o ROIC =
Invested Capital
o ROIC can be defined in two ways: as the return on all capital or as the return on new, or
incremental, capital. For now, we assume that both returns are the same.
• Investment rate (IR) is the portion of NOPAT invested back into the business:
Net Investment
o IR =
NOPAT
• Weighted average cost of capital (WACC) is the rate of return that investors expect to earn from investing
in the company and therefore the appropriate discount rate for the free cash flow.
• Growth (𝑔) is the rate at which the company’s NOPAT and cash flow grow each year.
Assume that the company’s revenues and NOPAT grow at a constant rate and the company invests the same
proportion of its NOPAT in its business each year. Investing the same proportion of NOPAT each year also
means that the company’s free cash flow will grow at a constant rate.
Since the company’s cash flows are growing at a constant rate, we can begin by valuing a company using the
well-known cash-flow perpetuity formula:
FCF𝑡=1
• Value =
WACC−𝑔
Next, define free cash flow in terms of NOPAT and the investment rate:
• FCF = NOPAT − Net Investment = NOPAT − (NOPAT × IR) = NOPAT(1 − IR)
Earlier, we developed the relationship between the investment rate (IR), the company’s projected growth in
NOPAT (𝑔), and the return on investment (ROIC):
• 𝑔 = ROIC × IR
Solving for IR, rather than 𝑔, leads to:
𝑔
• IR =
ROIC
Now build this into the definition of free cash flow:
𝑔
• FCF = NOPAT (1 − )
ROIC
This formula underpins the discounted-cash-flow (DCF) approach to valuation, and a variant of the equation lies
behind the economic-profit approach. In most cases, we do not use this formula in practice, because the model
is overly restrictive: it assumes a constant ROIC and growth rate going forward. For companies whose key value
drivers are expected to change, we need a model that is more flexible in its forecasts.
It is also possible to use the key value driver formula to show that ROIC and growth determine the multiples
commonly used to analyse company valuation, such as price-to-earnings and market-to-book ratios. To see this,
divide both sides of the key value driver formula by NOPAT:
𝑔
Value (1− )
• = ROIC
NOPAT𝑡=1 WACC−𝑔
• As the formula shows, a company’s earnings multiple is driven by both its expected growth and its return
on invested capital.
,You can also turn the formula into a value-to-invested-capital formula.
• Start with the identity:
o NOPAT = Invested Capital × ROIC
• Substitute this definition of NOPAT into the key value driver formula:
𝑔
Invested Capital×ROIC×(1− )
ROIC
o Value =
WACC×𝑔
• Divide both sides by invested capital:
𝑔
Value 1−
ROIC
o = ROIC ( )
Invested Capital WACC−𝑔
The reason that analysts’ reports and investment-banking pitches often use earning multiples rather than
valuations based on DCF analysis is that earnings multiples are a useful shorthand for communicating values to
a wider public. In practice, we always compare a company’s implied multiple based on our valuation with those
of its peers to see if we can explain why its multiple is higher or lower in terms of its ROIC or growth rates.
4) RISK AND THE COST OF CAPITAL
In valuing companies or projects, the subjects of risk and the cost of capital are essential, inseparable, and
fraught with misconceptions. These misconceptions can lead to damaging strategic mistakes.
A company’s cost of capital is critical for determining value creation and for evaluating strategic decisions. It is
the rate at which you discount future cash flows for a company or project. It is also the rate you compare with
the return on invested capital to determine if the company is creating value. The cost of capital incorporates
both the time value of money and the risk of investment in a company, business unit, or project.
The cost of capital is not a cash cost, but an opportunity cost→ is based on what investors could earn by investing
their money elsewhere at the same level of risk. This is always an option for publicly listed companies.
• Example: when one company acquires another company, the alternative might have been to return that
cash to shareholders, who could then reinvest it in other companies. So, the cost of capital for the acquiring
company is the price investors charge for bearing risk – what they could have earned by reinvesting the
proceeds in other investments with similar risk.
• The core principle is that the cost of capital is driven by investors’ opportunity cost, because the executives
leading the company are the investors’ agents and have a fiduciary responsibility to the investors.
• Most practitioners use a weighted average cost of capital (WACC), meaning the weighted average of the
cost of equity and the cost of debt capital.
o A company’s cost of equity capital is what investors could earn by investing in a broad portfolio of
companies (say, the S&P 500), adjusted for the riskiness of the company relative to the average of
all companies.
Only certain types of risks – those that cannot be diversified – affect a company’s cost of capital. Other risks,
which can be diversified, should only be reflected in the cash flow forecast using multiple cash flow scenarios.
• The range of the WACC is small because investors purposely avoid putting all their eggs in one basket. The
ability of investors to diversify their portfolios means that only non-diversifiable risk affects the cost of
capital. Furthermore, because non-diversifiable risk also generally affects all companies in the same industry
in the same way, a company’s industry is what primarily drives its cost of capital. Companies in the same
industry will have similar costs of capital.
Stock market investors may hold hundreds of different stocks
in their portfolio. As a result, their exposure to any single
company is limited. It is possible to show how the total risk of
a portfolio of stocks declines as more shares are added to the
portfolio. The risk declines because companies’ cash flows are
not perfectly correlated.
If diversification reduces risk to investors and it is not costly to
diversify, then investors will not demand a higher return for any
risk that can be eliminated through diversification. They require
compensation only for risks they cannot diversify away.
The unique risks that any company faces – say, product obsolescence and new competition – are not priced into
the cost of capital. That does not mean a company’s value is immune to these risks; they do affect expected cash
flows and therefore expected value.
, It is not unusual for companies to bump up the assumed cost of capital to reflect the uncertainty of risky projects.
In doing so, however, they often unwittingly set these rates at levels that even substantial underlying risks would
not justify – and end up rejecting good investment opportunities as a result.
An approach to determine the expected value of a project is to develop multiple cash flow scenarios, value them
at the unadjusted cost of capital, and then apply probabilities for the value of each scenario to estimate the
expected value of the project or company. Using scenarios has several advantages:
• Provides decision makers with more information: rather than looking at a project with a single-point
estimate of expected value, decision makers know that there is a chance that the projects value is high
(success) and another probability that the projects value is low (failure). Making implicit risk assumptions
explicit encourages dialogue about the risk of the project.
• It encourages managers to develop strategies to mitigate specific risks, because it explicitly highlights the
impact of failure or less than complete success.
• It acknowledges the full range of possible outcomes. When project advocates submit a single scenario, they
need it to reflect enough upside to secure approval but also a realistic enough that they can commit to its
performance targets. These requirements often produce a poor compromise. If advocates present multiple
scenarios, they can show a project’s full upside potential and realistic project targets they can truly commit
to while also fully disclosing a project’s potential downside risk.
Companies should take on all investments that have a positive expected value (NPV), regardless of their risk
profile, unless the projects are so large that failure would threaten the viability of the entire company.
When we talk about total cash flow risk, we mean the uncertainty that a company faces about its future cash
flows, whether for the company as a whole, a business unit, or a single project. Finance theory provides guidance
on pricing the non-diversifiable part of cash flow risk in the cost of capital.
• In theory, a company should take on all projects or growth opportunities that have positive expected values
even if there is high likelihood of failure, as long as the project is small enough that failure will not put the
company in financial distress.
• In practice, we’ve found that companies overweight the impact of losses from smaller projects, thereby
missing value creation opportunities.
• The implication is that a company should not take on a risk that will put the rest of the company in danger.
In other words, don’t do anything that has large negative spill-over effects on the rest of the company.
To overcome loss aversion and make better investment decisions, individuals and organizations must learn to
frame choices in the context of the entire company’s success, not the individual project’s performance. In
practice, this means looking at projects as a portfolio by aggregating them, rather than focusing on the risk of
individual projects.
One technology companies successfully used a portfolio approach to assess its projects:
1. Executives estimated the expected return of each project proposal (measured as expected present value
divided by investment) and the risks associated with each (measured as the standard deviation of projected
returns).
2. Executives then built portfolios of projects and identified combinations that would deliver the best balance
between return and risk.
3. When they viewed portfolios of projects in the aggregate, executives could see that portfolios of projects
had higher returns than most of the individual projects and much lower risk compared with most of the
individual projects.
a. Even though a portfolio of projects has lower risk, the use of portfolios does not lower a company’s
cost of capital. That is because the portfolio, by definition, cannot reduce the non-diversifiable risk,
which is the risk embedded in the cost of capital.
5) THE ALCHEMY OF STOCK MARKET PERFORMANCE
A commonly used measure for evaluating the performance of a company and its management is total
shareholder returns (TSR): the percent increase in share price plus the dividend yield over a period of time.
If managers focus on improving TSR to win performance bonuses, then their interest and the interests of their
shareholders should be aligned (this is true over long periods – at a minimum, 10 to 15 years). But TSR measured
over shorter periods may not reflect the actual performance of a company, because TSR is heavily influenced by
changes in investors’ expectations, not just the company’s performance.
