What Makes for an Exceptional Company?

Deloitte blows up conventional thinking on the assessment of financial performance.
David McCannJanuary 14, 2015
What Makes for an Exceptional Company?

Just how confident are you that your company is performing well financially? Unfortunately, you may be experiencing delusions of grandeur.

A massive statistical analysis of financial results for every publicly held company in the United States, released on Tuesday by Deloitte, arrives at some surprising conclusions. One of them: the best-performing company is not General Electric, Apple, IBM, Honeywell, PepsiCo or any other widely esteemed household name.

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Apple and OrangeThe top dog is Copart. Who? The company is a $1.2 billion provider of online auction, marketing and related services for sellers and buyers of used vehicles. (CFO expects to publish a profile of Copart in the coming days.) Furthermore, the top 100 companies, according to Deloitte’s analysis, include many other relatively obscure ones.

The rest of the top 10 are Hershey, Panera Bread, Monster Beverage, J.B. Hunt Transport Services, Kimberly-Clark, Steven Madden, Coach, Colgate-Palmolive and 3M. (See Appendix A of this Deloitte report for the full list of the top 100 companies.)

How can a company like Copart be the best performer? The answer lies in Deloitte’s methodology, which was designed to overcome flaws in the usual methods of rating financial performance.

“Typical approaches define specific periods of time — e.g., 10 or 15 years — and compare a company’s business performance to a benchmark, usually a market or industry average for a given measure over that same time period,” wrote the authors of the report, Michael Raynor and Mumtaz Ahmed.

Overcoming Flaws in the Status Quo

There are three especially debilitating flaws in this method, they continued. “First, performance is typically measured along only one dimension. Some studies look at growth, others at shareholder value creation, others at profitability…. But how much better is it to have a common basis for identifying which companies have delivered standout performance on a number of important measures of business performance?”

To overcome that flaw, Deloitte employs a rich mix. To gauge profitability, it measures return on assets, return on equity and free cash return on assets. Then it factors in revenue growth, and it measures value creation using Tobin’s q, or the ratio of a company’s market value to the replacement value of its assets.

In addition, Deloitte captures company performance on all four combinations of profitability, growth and value (profitability/growth, growth/value, etc.). “Think of it as the difference between winning the triathlon versus winning in each of the three separate events that make up the triathlon,” the report says. Thus, there are seven separate measures of financial performance.

The top seven companies on Deloitte’s list have demonstrated what the firm considers “exceptional” performance on all seven measures over a number of years. Companies ranked 8th through 32nd have been exceptional in six of the measures, and those ranked 33rd through 65th in five measures.

The second flaw in normal performance assessments is that they don’t strip out the impact of industry, size and year effects (since economic and market conditions vary from year to year). The tendency is to simply restrict the analysis to comparisons of companies of similar size from similar industries over similar time periods. Too often, says Deloitte, that practice “so dramatically reduces the sample sizes that the credibility of the results is significantly undermined.”

Addressing that flaw, the methodology uses quantile regression to filter out the effects of industry, size and year. That type of regression analysis enables a company’s performance to be translated into a percentile rank within a much broader population of companies.

Why should a company care how it stacks up against others that aren’t related to its industry? “You can compare yourself to everybody, in which case you may wonder why you bothered,” says Raynor. “So you go in the other direction and compare yourself to similar companies. But how similar is similar enough? At what point is it too dissimilar to be meaningful?

“People make rules-of-thumb judgments about their relevant competitive set,” Raynor continues, “and the comparison ends up being something that’s chosen largely by intuition. But by stripping out what we believe are the relevant dimensions of dissimilarity, what you’re really looking at is how companies stack up as a consequence of their own company-specific behaviors and choices. That gives you a measure of relative importance that is much more informative.”

The third flaw in the typical methods of evaluating companies’ financial performance is that they don’t account for luck, according to Deloitte. “How long it takes for a company to separate itself from the background noise generated by system-level variation in business performance is not something one should simply assume,” the authors wrote. “Pick a period too short, and you run the risk of focusing on the merely lucky. Pick one that’s too long, and you will miss some of the star performers; after all, nothing lasts forever.”

Deloitte’s methodology uses “modeling techniques that draw on hundreds of thousands of data points collected over five decades and millions of simulations” to separate skilled companies from lucky ones.

“We run a simulation for the overall economy and get a distribution for how frequently any given performance outcome occurs,” says Raynor. “Then we look at an actual company’s actual performance, and if it’s well out into the right tail of that distribution, we’re in a position to declare that the company is exceptional.”

For example, Deloitte observes that in any one-year period there is a 19.6% probability that a company in the fifth decile of the return-on-assets measure will move into the sixth decile. But companies don’t exist for just a year, and their performance shouldn’t be measured by just a year. For a company with, say, 12 years of observed performance, the simulation enables an estimate of the range of outcomes expected over a 12-year period. That allows a comparison of actual results for companies with 12-year lifespans against these benchmarks.

The More Things Stay the Same

A notable finding of the analysis is that over time, the corporate world’s financial performance is remarkably stable. “For all the talk about inexorable change and everything being revolutionized or disrupted all the time,” says Raynor, “there is an underlying stability to the general level of financial performance that companies deliver, as a group.”

Getting back to the original point, why are so many low-visibility companies on Deloitte’s top-performer list?

“I think it’s the fact that we’re taking a fundamentally different approach to understanding what constitutes exceptional performance,” Raynor says. “We have ranked them in ways that may seem unfamiliar to people. I would say that’s not a bug but rather a feature, because if what we came up with was all the usual suspects, one would wonder whether we’ve added anything to the conversation.”

The difference in this methodology has several key components, he notes: looking at multiple dimensions of performance simultaneously; identifying an exceptional company at any point in time by virtue of its performance over time, not by its performance in one year or the results of a one-time survey; and the efforts to separate skill from luck.

But what, in the end, is the use of this work? What can companies learn from it?

According to Raynor, it helps a company answer three important questions. One is simply, how do we stack up? “Our work suggests that a majority of managers have an inaccurate sense of their relative performance. They just don’t know how well they’re doing, and it’s hard to get better if you don’t know where you’re starting from.”

Second: what is needed to improve? That’s a function of thinking about performance in multiple dimensions. Your profitability may be strong, but you may need to work on growth. And third, by how much do we need to improve?

“We can translate these relative assessments into absolute terms, and as a result it brings a much more analytical and fact-based context to setting financial performance improvement targets,” Raynor says. “The point of this effort, for now at least, is not to say, how can we be like Copart and Hershey and Panera Bread. It’s rather, if you choose to think about performance in this way, and this is the kind of performance profile you aspire to, in order to make your own voyage to exceptional, you need to understand the answers to those three questions.”

(The Deloitte report extends work performed by Raynor and Ahmed on the relationship between return on assets and profitability that resulted in their book, “The Three Rules: How Exceptional Companies Think” (Deloitte University Press, 2013). The three rules: 1. Better before cheaper: Don’t compete on price, compete on value. 2. Revenue before cost: Drive profitability with higher revenue before cost reductions. 3. There are no other rules.)

Photo: Flickr user Michael Johnson, CC BY 2.0