June 23, 1997

HOW KILLERS COUNT

ou really know you're winning when you grab a bigger share of the new wealth in your industry.

It's really a no-brainer to raise short-term shareholder returns. Find a 59-year-old CEO, give that person a ton of share options, and set a mandatory retirement age of 62. Voila!--the share price will zoom. The CEO will get rid of underperforming businesses, repurchase shares, and slash away at corporate bloat.

And this is not just theory; senior executives, near retirement age or not, have been behaving in precisely this way for some time. That should be no surprise, given the increasing alignment between top management's compensation criteria and short-term gains in share price. Neither should it be surprising that in 1996, U.S. companies repurchased more than $170 billion of their own shares--a record. Nor that between 1980 and 1995, the top 100 companies in the U.S. got rid of more than 25% of their employees.

While such actions may succeed in raising the share price, they do not create new wealth. They do not yield new revenue streams, they do not take the company into new markets, and they do not create fundamentally new value for customers. In every company there are dozens of people who stand around tearing up $100 bills and flushing them down the toilet. But it is not enough to find these people and tell them to stop. One must also find a few people who know how to print new $100 bills.

Companies that don't do more than excise the things that destroy wealth will soon run out of room for improving share price. Many of the typical approaches to raising share price are not sustainable in the medium term. What do you do once you've trimmed away all the fat and given all the excess cash back to shareholders? Any savvy corporate turnaround artist will be on the beach when the day of reckoning arrives.

Hence, it's crucial to measure a company's success or failure in creating new wealth. Ask a manager in most companies, "What has been your company's share of wealth creation over the past decade?" and you'll get either a blank look or some mumbo jumbo about "economic value added." Yet EVA, which measures a company's ability to produce an economic profit, i.e., returns in excess of cost of capital, reveals little about a company's share of new wealth creation. Share of new wealth creation must be measured with respect to the total amount of new wealth that has been generated in an industry over time, not with respect to the company's ability to earn more than its cost of capital. Of course it's important to investors that a company earn more than its cost of capital--otherwise it would be destroying wealth. But EVA doesn't tell the whole story. It's like kindergarten, a good place to start. Maximizing one's share of new wealth creation, however, is graduate school.

Clearly, no one measure can fully capture all of the dynamics of corporate performance, and there are a variety of ways of calculating a company's share of new wealth creation. A rough indicator can be derived by comparing a company's current share of the total market capitalization of its relevant competitive "domain" with its share a decade ago. In 1988, the Gap's share of market capitalization within the broad retailing domain amounted to 1.2%. By early 1997 this had risen to 4.6%. As a new player in the retail domain, Home Depot's share rose from 0% to 12.5% over this same period. Conversely, the Limited's share dropped from 4.7% to 2.5%. Woolworth's share shrank from 3.5% to 1.4%. Put simply, over the past decade the Gap and Home Depot captured a lot more of the new wealth that was created within the retailing domain than did the Limited, Woolworth's, and many other retailers. In fact, of the 17 large retailers that dominated the industry in 1987, only six managed to increase their share of wealth over the ten years that followed.

In many cases a company can be losing "share of wealth" but still have a relatively healthy EVA or return on invested capital. Though Amoco's return on capital was better than the average in its domain last year, its share of wealth has been trimmed from 8.7% to 8.2% over the past ten years. At the same time, Shell's share of wealth zoomed from 13.8% to 18.0%. And while IBM's return on invested capital was more than 17% last year, its share of wealth in the computing domain has plummeted from 45.9% to just 14.2% over the past ten years (see chart). Surely in the medium term IBM will have to do something more than cut costs and pour billions into share buybacks if it hopes to reverse this slide. Whatever financial theory might suggest, it would be unwise for a company to be content with a 10% growth rate and a positive EVA while unconventional competitors are capturing the majority of the new wealth generated in a particular industry.

To begin to think about share of new wealth creation, one must have some view of just what opportunities are out there. For example, in the late 1980s, IBM sat on the sidelines as Toshiba and others created the laptop computer business. Even today, Toshiba is still the leader in the laptop business. IBM's tardy entry in the late 1980s led it to surrender hundreds of millions of dollars in potential new wealth to its Japanese rival and other computer upstarts. Yes, a company must learn to generate new wealth-creating strategies, but first it must understand how to measure its performance accurately.