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A new look at measuring shareholder value shows which management teams in Asia are truly delivering excess returns.
Justin Wood, CFO Asia
November 9, 2005
As CFO of Taiwan Semiconductor Manufacturing Corporation (TSMC), Lora Ho is no stranger to business cycles. Every few years, her industry is tossed violently from peaks of stretched production lines and handsome profits to troughs of bleak inactivity and desperate losses.
But just because the semiconductor industry as a whole is caught up in bruising rounds of boom and bust, Ho sees no reason why her company — a NT$256 billion-a-year (US$7.7 billion) contract chip manufacturer — should suffer the same fate. "While much of our performance is driven by factors in the economy beyond our control, we still believe we can shape our destiny," states Ho. "If you look at our track record we've been consistently better than our competitors at managing the cycle. As managers we believe we can outperform."
Ho's claim is no hollow boast. A new study from CFO Asia shows that TSMC is indeed being managed by a team of superior executives who have outdone their peers time and again. The study was produced in partnership with the Singapore office of Marakon Associates, a strategy and management consultancy, and aims to identify the top management teams in Asia. Our yardstick was simple: Which managers are creating the most value for their shareholders?
Numerous other studies have attempted similarly lofty goals. As their benchmark, these surveys have tended to use total shareholder return (TSR) — share-price gains plus dividends paid — to show how much value a company has generated. But for our money, such an approach isn't the most suitable when it comes to revealing what sort of role managers have played in creating value. As the stock-market bubble of the late 1990s showed, a rising tide lifts all boats, while an ebbing tide brings them all back down again. Share prices are constantly buffeted by factors that managers have no control over: the likes of interest rate changes, shifts in investor optimism, and the impact of natural catastrophes.
To truly see which management teams are adding the most value to their companies, a different approach is needed. To this end, CFO Asia and Marakon Associates have used a metric we call "company edge." Put simply, this measure tots up a company's TSR over a set period of time, and then strips out all background influences that are beyond the control of the company's managers.
For our study, we calculated the five-year annual average TSR for the 462 biggest companies in Asia, except those in Japan. We then modified each company's result to remove the average TSR of the country in which it's based. Finally, we further modified the results to remove the average regional TSR of the industry sector for each company. What's left is a measure of shareholder value that a company's managers can reasonably take credit for creating — or destroying.
A "company edge" score of zero shows that a company has performed exactly in line with the broader market in its home country as well as in line with the rest of its industry across the region — and therefore created no excess value at all. A negative score shows that managers have destroyed value.
Take Samsung Electronics, which came top in our survey. The company has a five-year annual average TSR of 13 percent. However, the five-year annual average TSR for the wider market in South Korea is -5 percent. As a result, Samsung's country-adjusted TSR rises to 18 percent. Next, we look at the Asian regional five-year average TSR for the electronics sector — adjusted to take out country differences — which comes to -3 percent. Hence, Samsung's "company edge" is 21 percent.
Put in dollar terms, by multiplying "company edge" by Samsung's market capitalization on the start date of the study, Samsung's managers can personally claim to have created a staggering US$7.3 billion of shareholder value every year for the past five years. (For more on the methodology, see "Behind the Numbers," at the end of this story.)
At TSMC, which finished eighth in our survey, the results are also impressive. Even though TSMC recorded a negative annual average TSR over the past five years of -6 percent, it still scores a positive "company edge" of 3 percent. In effect, TSMC created value for its shareholders by shedding less value than its competitors.
Indeed, that's one of the benefits of the "company edge" metric. Pure TSR figures depend very much on the start and finish date of the period in question. Our survey starts on December 31, 1999, and ends on December 31, 2004, a period when most stock markets around the world fell in value. However, with "company edge," such background factors are taken out of the equation and all that's left is a measure of a company's outperformance (or underperformance).
Looking at the results you'll see we've chosen to rank our companies by the annual average dollar amount of excess shareholder value created. By its nature, such a ranking tends to favor large-capitalization companies. However, the ranking can also be cut another way, by looking at those companies with the highest "company edge." Viewed through this lens, the likes of Precious Shipping in Thailand, Techtronic Industries of Hong Kong, and Amore Pacific of South Korea top the list, with scores of 100 percent, 96 percent, and 72 percent respectively.
The results can also be used to compare the quality of management in different countries. Of particular note, while the likes of India, Malaysia, and Thailand scored the highest absolute TSRs over the five years of our study, they also posted some of the worst "company edge" results. The inevitable conclusion is that many companies in these countries are recording decent shareholder returns by dint of being in the right place at the right time, not through any kind of management excellence.
Value for Money
So what is it that pushes some companies to the top of the outperformance rankings, while others languish far below? What is it that separates the leaders who consistently create excess value for their shareholders from those who seem able only to destroy it?
Of course, it's difficult to generalize, and there are no easy answers or quick fixes. But as Sandeep Malik, the partner managing Marakon's Asia practice, sees it, the first step is for companies to have a clear philosophy and framework with regard to how they think about shareholder value. And once that philosophy is in place, they need to be highly disciplined in applying it across their companies.
In particular, Malik notes, that means having a rigorous decision-making process that encourages managers to make the right choices. "A lot of companies in Asia are still making decisions using only traditional metrics like sales, margin, and net income," he observes. "What they should also be doing is thinking about economic profit. They need tools that analyze future cash flows and discount them at the appropriate cost of capital. And they need clearer ideas of how to allocate costs and capital to different parts of the business."
Frequently, adds Malik, companies in Asia profess to be converts of economic profit and to use techniques based on the principles of Economic Value Added (EVA). But in practice, he says, "EVA is often used just as a measurement tool for recording past performance and not as a key input to ongoing decisions about the future."
Amar Gill, head of research in Hong Kong for investment bank CLSA, agrees with Malik's analysis. "Most companies in Asia are still focused on revenue growth and earnings per share (EPS)," he says. "They talk about the benefits of acquisitions in terms of EPS impact rather than generating returns above their cost of capital."
What's more, Gill says, "many companies have their accountants and advisors prepare cash-flow analysis for new projects in order to calculate internal rates of return, but then they tend to prefer simple payback calculations when it comes time to make decisions."
Nothing could be further from the truth at TSMC. As Ho explains: "Our business is both cyclical and capital intensive, so making the right capex decisions is crucial." Every new investment at TSMC is subjected to rigorous analysis using a return on invested capital (ROIC) model that factors in the company's weighted average cost of capital.
With capital expenditure at TSMC now exceeding US$2 billion a year, it's little surprise that Ho takes "great care to ensure that only the correct investment decisions are made from a value perspective." Many other factors lie behind TSMC's success too: legendary cost control, industry-leading technology, excellent manufacturing capabilities, the quality of partnerships built up with the company's customers, to name a few. But by getting the company's decision-making processes right, and by making the creation of economic profit the company's guiding principle, TSMC's managers go a long way towards laying the path to outperformance.
Dialing the Right Numbers
Another company that scores highly on our outperformance ranking is Singapore Telecommunications, the S$12.6 billion-a-year (US$7.5 billion) telco. Over the five-year period of the survey, SingTel posted an annual average absolute TSR of -4 percent. However, by declining less than other regional telcos, SingTel scored a positive "company edge" of 10 percent, meaning its managers created an annual average excess shareholder return of US$3.2 billion — a figure that places the company second from top in our value ranking.
Chua Sock Koong, CFO of SingTel, is another who believes that the creation of shareholder value flows from a company's governance of its decision-making processes. "You may have the best of times, you may have the worst of times, but we have always been very disciplined about our investment decisions," says Chua.
That discipline stems from a "value-based management" program that SingTel introduced in early 2000. The main idea behind the new program was to introduce a cost of capital — adjusted for risk — to each of the company's business units so that investment decisions could be based on generating a true economic profit.
What's more, every business unit was required to build an "ROIC tree." Essentially, this is a spreadsheet model of each unit's business, showing the drivers of cost — including a charge for capital — and the drivers of revenue. The models are multi-year, taking into account all future cash flows of each business line, and updated on a regular basis with help from Chua's finance team.
"Now, whenever somebody wants to make a decision, be it a pricing decision or a capex decision, all they have to do is feed their numbers into the model and they can see exactly what sort of impact it will have on the company from an economic profit perspective and hence whether it will create value or not," explains Chua.
Needless to say, setting up the program was tricky. In particular, the process of allocating assets — and hence capital charges — to different business units caused more than a few protests. But as Chua maintains, putting in place this sort of structure is the only way to guarantee that managers make decisions from a value perspective.
Interestingly, SingTel uses a variation on the idea behind "company edge" as part of its long-term incentive plan for senior managers. Based around a performance share plan, managers receive shares in SingTel depending on how the company's TSR stacks up over a three-year period against the MSCI Asia Pacific Telecommunications Index. Only if the company outperforms does the scheme pay out. For the most senior managers, the performance share plan even carries targets for ROIC improvement that must also be met before the scheme vests.
All commendable stuff. But to stay at the top of the value ranking next year, SingTel, and indeed any other company, can't afford to rest on its laurels. As Marakon's Malik points out: "A lot of management teams forget that there's a lot of performance already built into a company's share price. Your company may be performing very well, but if that's in line with what the market expects, then you aren't creating any new value."
The quest for outperformance never ends.
Behind the Numbers
The aim of the survey, conducted by CFO Asia in partnership with the Singapore office of Marakon Associates, was to produce a measure of "company edge" for as many companies in Asia (excluding Japan) as possible. We defined "company edge" as the excess shareholder returns of a company over its regional peers, adjusted for country differences.
Put another way, "company edge" is equal to the country-adjusted total shareholder return (TSR) for a company minus the country-adjusted industry sector TSR for that company. The country-adjusted company TSR is equal to the five-year company TSR less the five-year country TSR. And the country-adjusted industry sector TSR is equal to the regional average of country-adjusted company TSRs for all the companies in that particular sector.
Our ranking is determined by multiplying a company's annual average "company edge" by its market capitalization on the start date of the survey. The resulting dollar figure shows the average annual excess shareholder value created by the company for every one of the five years included in the survey.
Data for the value ranking was taken from Datastream, which excludes certain companies from its database. For example, companies need to have a market capitalization of at least US$100 million and belong to certain stock indices such as the FTSE All World. This filtering by Datastream naturally reduced the number of companies we could include in the study.
The study size was further reduced by our need for companies to have been listed for at least five years. (The period of our study was December 31, 1999, to December 31, 2004.) What's more, we decided to exclude China from our study because too few companies made it onto our final list to represent the wider market.
In the end, our study was whittled down to a sample size of 462 companies. While this represents around 60 percent of the total market capitalization of Asia ex-Japan, the fact that 40 percent of the market is missing may have introduced an element of error into our edge calculations.
There are other caveats, too. Some companies may be listed in one country but operate largely in a different one. In such cases, we have assumed that the company will only be affected by stock-market movements in its country of listing, not that of its operations. Equally, many companies are listed in one country but operate regionally. Again, we have only factored in stock-market movements in the country of listing.
Finally, any measure of "company edge" is only as good as the quality of the financial reporting in the region and the efficiency of Asia's capital markets. To the extent that neither is perfect, our results will be skewed. —J.W.