How not to measure a business


I have just read that the fiduciary duty of a chief executive is to achieve the highest return on shareholders’ equity. Put to one side for a moment the question of fiduciary duty – the responsibilities of directors are the product of the legal system and the objects of the company. Would a chief executive whose principal goal was to increase the wealth of his stockholders fulfil that objective by achieving the highest possible return on equity?

Well, would you rather have a 20 per cent return on £1,000 or a 25 per cent return on £500? Ideally, you would like to find a company that would offer a 25 per cent yield on any capital you invested in it, but such opportunities do not exist. If you could not do that, you would like to have both the 20 per cent and the 25 per cent projects, but you will often have to choose between alternative routes to the same objective, or different financial models for the same business. So should you always choose the higher return on equity? The answer is not obvious. If you can expect to earn at least a 15 per cent return on your other investments, then you will be better off taking the 25 per cent proposition. If you cannot – and you probably cannot – then the lower, but still exhilarating, 20 per cent return on the larger amount is a better choice.

All good introductory finance texts explain that ranking projects by their rate of return is not an appropriate means of choosing between them. Most suggest an alternative way of approaching the problem. Measure the opportunity cost of funds, based on the risk adjusted returns available elsewhere. In a world in which even long-term borrowing by the US Treasury costs less than 4 per cent, that figure is unlikely to be very high – let’s put it at 7 per cent. Then investing £1,000 at 20 per cent yields £200 a year, and investing £500 at 25 per cent and £500 at 7 per cent only £160. And £200 is always better than £160. Money, not percentages (or relative performance), pays the grocer and the yacht chandler.

But that simple message has not got through. Large companies think their investment appraisal techniques are sophisticated if they compute internal rates of return. It is more and more common for them to highlight the rate of return on their equity in their annual reports.

I have always found it hard to interest people in measurement issues, but the way we record things in business and finance has a large effect on what people do. And to understand how the use of return on equity as a metric affects behaviour, it is necessary to look at the origins of returns on equity.

Profits come from three sources: they represent a return on the shareholders’ contribution to the physical capital employed in the business, they represent a return on the risk inherent in the business, and they include the stockholders’ share of the revenues the company derives from its brands, its intellectual property, its systems, its resources and its market power. For many modern businesses tangible assets are simply not important. For companies such as Apple or Microsoft, these tangible assets mostly consist of cash accumulated from their undistributed earnings.

One way of improving return on equity is to increase profits. But other methods are equally effective, and often easier. Raising the level of risk will increase expected earnings. Shrinking the equity base increases the return on capital. Neither of these latter actions adds anything to the expected wealth of shareholders. But they may add a lot to the wealth of managers, if that wealth is linked directly or indirectly to return on capital employed or earnings per share.

Among banks, a macho pursuit of rates of return – which were unattainable by soundly financed businesses in control of their risk exposures and operating in a competitive market – led, not to efficient companies, but to the near collapse of the global financial system. There are many lessons from that episode, but one is that you should never judge a business – or anything – by a single metric. Especially not the wrong one.

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