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25814-p.r.(157-166)market stra

25814-P.R.(157-166)Market Stra 8/8/00 9:23 AM Page 157 market telling you
about your strategy?
Kris Bruckner, Stephan Leithner, Robert McLean, Market expectations are hard for managers to understand and even harder for them to change. But there are ways of doing both that are much more science than black magic.
any managers are confounded by the conflicting messages the
M market sends them. Strong improvements in the financial perfor-
mance of a company can be followed by a sharp fall in the price of its shares.
Results that moderately exceed consensus forecasts can propel its share priceto new heights, leaving managers to wonder how they can possibly achievethe superhuman feats the market expects from them. Either way, they throwup their hands, rail at the market’s irrationality, and go on running theirbusinesses as they always have.
Given the market’s habit of regularly defying logic, it is not surprising thatmany managers do not use total return to shareholders (TRS)—dividends plus The authors acknowledge the contributions of the McKinsey strategy metrics team—including AndreyBelov, Bernhard Brinker, Klaus Droste, Tony Kingsley, Serge Milman, Frank Richter, Detlev Schäferjohann,Somu Subramaniam, and Christian Weber—to the ideas presented in this article. They also wish to thankHouston Spencer, formerly a communications consultant in McKinsey’s Sydney office, for his contributions.
Kris Bruckner is a consultant in McKinsey’s Sydney office; Stephan Leithner is an alumnus of the
Munich office; Robert McLean is an alumnus of the Sydney office; Charlie Taylor is a principal in the
Jakarta office; Jack Welch is a director in the Boston office. This article was originally published in
The McKinsey Quarterly, 1999 Number 3. Copyright 1999 McKinsey & Company. All rights reserved.
This article can be found on our Web site at www.mckinseyquarterly.com/corpfina/whma99.asp.
25814-P.R.(157-166)Market Stra 8/8/00 9:23 AM Page 158 S T R AT E G Y I N T H E N E W E C O N O M Y
appreciation in share prices—as their primary decision-making tool. They oftenlook instead to measures of postfinancing returns, notably net present value(NPV) and economic value added (EVA). Such metrics focus on the cash flowsof the underlying business and on the ability of initiatives to provide economicreturns above and beyond a company’s cost of capital.
But running a company is like managing a sports team: owners and fans wanta winner. Like it or not, TRS is the way they keep score. NPV and EVA cangive you a clearer sense of whether strategies and projects are worthwhile, butthese tools don’t tell you what you need to know to generate a superior TRS:will the resulting performance exceed the market’s expectations? Of course, most managers frustrated by the share prices of their companiesunderstand that traditional measures, such as price-to-earnings ratios (P/Es),provide some insights into what the market anticipates: a high P/E suggeststhat they need to deliver strong growth; a low one suggests that the marketexpects static or declining performance. This understanding is cold comfort, however, because those managers do not know whether their compa- Running a company is like
and fans want a winner. Like it ornot, TRS is the way to keep score In reality, the answer to this vexingproblem lies no further away thanthe nearest copy of your daily news- paper: in your company’s share price and those of your competitors. But ourway of analyzing this information differs significantly from traditional tech-niques: it not only provides additional insights, turning much of the market’sblack magic back into science, but is also a valuable strategic tool (see sidebar“Choosing your metrics,” on the next spread).
Investors and analysts make explicit forecasts about the short-term performanceof your company. The market implicitly values its longer-term performanceas well. This readily available information allows you to quantify both themagnitude and the timing of the market’s expectations for your company. Bycarefully analyzing these short- and long-term performance expectations andmaking an honest effort to decide whether the market is actually right, youcan come to understand what it is telling you about your strategy.
What does the market expect?
To increase the share price of your company, you must know what the marketexpects of it today. If the market anticipates more than your strategy candeliver, you probably face bad news down the road. If your strategy isn’t get- 25814-P.R.(157-166)Market Stra 8/8/00 9:23 AM Page 159 W H A T I S T H E M A R K E T T E L L I N G Y O U A B O U T Y O U R S T R A T E G Y ? ting enough credit from the market, you may surprise the stock pickers andhand your shareholders a tidy gift. The key to increasing the price of yourcompany’s stock is to raise expectations about growth—particularly long-term growth.
The market uses expectations about the current operating performance of a company and its short- and long-term growth prospects to price its shares.
The value the market expects to see from both kinds of growth is actuallyquite easy to determine.
First, identify the por- E X H I B I T 1
Structure of cash flows by industry
Pharmaceuticals
Networking
Publishing
Software
Multibusiness
value of current perfor-mance). Second, divide Utilities
1Based on analysts’ consensus estimates of five-year growth in earnings per share.
Source: Value Line and long-term compo-nents, treating investors’and analysts’ short-term forecasts as reliable. We define short-term expecta-tions as the market’s estimate of a company’s performance in a definite fore-cast period—usually two to five years.2 Long-term expectations reflect acompany’s performance beyond the explicit forecast period.
Compare the value of your company if it realized the analysts’ short-termexpectations with the value of its current performance; the difference is thevalue expected from short-term growth. Whatever gap remains between theshort-term value of the company and its share price represents the antici-pated value of long-term growth. These long-term expectations of financialperformance are particularly critical, for they make up the lion’s share ofmarket value (Exhibit 1).
1The concept of stock prices formulated by Richard Brealey and Stewart Myers in Principles of Corporate Finance (second edition, New York: McGraw-Hill, 1984), their best-selling textbook on the subject, influ-enced our own conception. Brealey and Myers believe that stock prices reflect (i) the present value of a levelstream of earnings and (ii) growth opportunities. A “level stream of earnings” is defined as the “capitalizedvalue of average earnings under a no-growth policy”—that is, no reinvestment or payout of earnings. Thevalue of “no-growth” cash flow is simply earnings per share (EPS) divided by the cost of equity, or EPS/r.
Since we do not treat changes in EPS resulting from inflation as contributors to growth, the result is a “no-growth” value of EPS/(r–i). This approach assumes that investment at depreciation suffices to maintain current financial performance and that nonoperating assets are not significant.
2Consensus earnings forecasts are readily available from such sources as Zacks Investment Research.
25814-P.R.(157-166)Market Stra 8/8/00 9:23 AM Page 160 S T R AT E G Y I N T H E N E W E C O N O M Y
Armed with the knowledge of what the market expects from your companyin the short and long terms, you can identify the major strategic challengesyou face in generating and sustaining its TRS (Exhibit 2, on the next spread).
The company will fall into one of four classes. The first comprises “worldchampion” companies, which the market expects to surpass their competitorsboth in the short and the long term (see sidebar “Cisco Systems: Great expec-tations,” on the next spread). Such high expectations set a tough hurdle formanagers, since strong improvements in performance are required merely tosustain current share prices. Adequate initiatives must be in place to deliveron the short-term expectations of the market and to maintain its confidence Choosing your metrics
The decomposition of share prices and total They fail to distinguish earnings generated by return to shareholders (TRS) has a number of operating assets from those generated by non- advantages over more traditional metrics: for operating ones. And they tell you nothing about when the expected performance is supposed to anticipated performance improvements are occur—an important failing, since in comparing supposed to occur and to isolate management’s the performance of companies, it is often more contribution to past performance. Traditional useful to know this than to know the P/E and measures don’t do these things at all well.
Analysts’ forecasts are useful for several rea- We looked at some US electric utilities and com- sons. To begin with, analysts often test their pared P/Es with short- and long-term growth near-term forecasts for a company with its estimates. The P/Es fell within a very tight band: managers, who attempt not to be too positive 16 of the sample 22 companies had P/Es between because they want to avoid the risks of negative 14 and 16. Much greater differentiation among the earnings surprises. Second, since analysts talk companies showed up in derived estimates for to managers at a number of companies in an short- and long-term growth expectations (exhibit).
industry, the viewpoint of each can be compared One implication is that benchmarking based simply on P/Es is fraught with danger. A jump in the near- term performance of a peer company following a Another metric, the price-to-earnings ratio (P/E), performance dip, for example, could underlie its has several benefits: it is easy to calculate, widely P/E. Since your company may have avoided that and well understood, and accepted as a basis for problem, the short-term rebound implicit in the assessing the plausibility of growth expectations.
peer P/E is an inappropriate comparison.
Even so, P/Es have a number of limitations. They don’t reflect a company’s previous success in gen- Yet another metric, the market-to-book ratio (M/B), erating the returns that the market anticipated.
doesn’t reveal the extent of the improvement the 25814-P.R.(157-166)Market Stra 8/8/00 9:23 AM Page 161 W H A T I S T H E M A R K E T T E L L I N G Y O U A B O U T Y O U R S T R A T E G Y ? in the company’s long-term growth prospects. But the really difficult strategicchallenge of generating a rising TRS is the need to surpass high performanceexpectations. Managers must look beyond the market’s current vision—forexample, by redefining the competitive arena of the company or seeking toexploit its built-in expectations by financing M&A-driven growth with equity.
From companies in the second class, the market expects big things in theshort term but relatively little down the road. These companies — the“sprinters”—are classic turnarounds in mature industries. To sustain shareprices, managers must ensure that they have put in place initiatives that aresufficient to meet the market’s short-term expectations. To generate the market expects: a high M/B can reflect strong resents TRS less a capital charge based on the current performance rather than anticipated cost of equity. But MVA does not distinguish growth. Moreover, the M/B of a company reflects between returns from improvements in short- its decisions about whether to own the assets it term earnings and from long-term growth.
uses or to outsource its business functions.
Moreover, it doesn’t remove the impact of financial market changes on TRS, so it cannot Finally, market value added (MVA), one more isolate returns resulting from changes in eco- common corporate performance scorecard, rep- P/E vs. time-based metrics: Utilities, November 1999
Two-year forecast EPS
Long-term EPS growth,1
growth, percent per year
Duke Energy
PG&E
Southern
Wisconsin Energy
Dominion
Pinnacle West
Texas Utilities
DTE Energy
FirstEnergy
Baltimore G&E
Rochester G&E
CalEnergy
1Assumes constant reinvestment of earnings per share (EPS) across sample companies.
Source: Compustat; Zacks Investment Research; McKinsey analysis 25814-P.R.(157-166)Market Stra 8/8/00 9:23 AM Page 162 S T R AT E G Y I N T H E N E W E C O N O M Y
E X H I B I T 2
Identifying strategic challenges
Sprinters
World champions
Short-term
expectations
relative to
Out-of-shape runners
Marathon runners
competitors
Long-term growth expectations
relative to competitors
about building a plau-sible long-term growth story, perhaps by repositioning the company in sectors with more attractiveprospects in the long run or by building pipelines of growth options thatcould raise long-term expectations.3 Companies in the third class—the “marathon runners”—generate smallexpectations in the short term but great ones over time. This third classincludes many Internet companies (Exhibit 3, on the next spread), whose current valuations imply performance expectations comparable to thoseMicrosoft has delivered on since its float in 1986. Whether the wide array of Internet stocks priced at these multiples can live up to such expectationsremains to be seen.4 Managers of companies in the third class must not onlyimprove the performance of their core businesses to raise short-term expec-tations but also do whatever is possible to reinforce the market’s belief in theirfuture prospects. Those managers should also try to understand what com-peting companies that generate greater short-term expectations are doing, aswell as identify and carefully communicate the factors underpinning theirown company’s expected long-term growth.
In the fourth and final class—“out-of-shape runners,” such as IBM before LouGerstner’s arrival—companies are doubly cursed: they inspire equally lowshort- and long-term expectations, and their share prices suffer accordingly.
These companies must usually be restructured to increase the earnings of theircore businesses and repositioned for long-term growth, as IBM is seeking todo with e-business, which now represents 25 percent of its revenues.5 3See Mehrdad Baghai, Stephen Coley, and David White, The Alchemy of Growth, Reading, Massachusetts: 4Pfizer, too, ranked in this third class in 1997, when its short-term performance lagged, but it had a number of wonder drugs, including Viagra, in the pipeline. Since then, Pfizer has benefited from surging short-term expec-tations as its new drugs have come to market, and it has stormed its way into the world champion group.
5Wall Street Journal, May 13, 1999.
25814-P.R.(157-166)Market Stra 8/8/00 9:23 AM Page 163 W H A T I S T H E M A R K E T T E L L I N G Y O U A B O U T Y O U R S T R A T E G Y ? The foregoing discussion implies that to generate real strategic insights, youmust compare the analysts’ expectations for your company with their expec-tations for its competitors. Benchmarking of this sort neutralizes the effectof industry cycles on short- and long-term expectations and also makes itpossible to avoid punishing or rewarding companies because they happen tocompete in slow- or fast-growth industries.
Cisco Systems: Great expectations
Long-term beliefs about a company’s future can tributed an additional $44 billion, representing the have a staggering impact, as demonstrated by balance of the rise in Cisco’s market capitalization.
the case of Cisco Systems, which makes routers and Internet access equipment. The company The market’s expectations for Cisco imply that it has generated huge long-term expectations in will consistently enjoy earnings growth of a very the market. Between 1993 and 1998, the lion’s robust 30 percent through 2002—the short- share of Cisco’s total return to shareholders (TRS) term forecast period. The market expects the came from changes in expected long-term eco- same for the ten years thereafter, followed by nomic performance (exhibit). During that six-year growth that permanently tracks changes in the period, Cisco’s market capitalization rose by $58 gross domestic product. On the other hand, the billion. Although Cisco does have a reputation for market could really be saying that it expects meeting or exceeding short-term expectations, earnings beyond 2002 to grow at a rate of 11 short-term factors—earning the cost of equity, percent in perpetuity. Is either of these scenarios lower interest rates, and changes in short-term plausible? If Cisco’s share price is reasonable, expectations—account for only $14 billion of one of those propositions would also have to be that increase. After all, the five-year forecast reasonable. We have found a “what-you-would- period accounts for only 5 percent of Cisco’s have-to-believe” analysis useful in assessing the value. Changes in long-term expectations con- valuation of Internet stocks as well.
Cumulative decomposition of total returns to shareholders: Cisco, 1993–98
Stock price
Changes in
Short-term
Long-term
Stock price
August 1, 1993
financial
August 1, 1998
Changes in expectations of
economic performance
1Adjusted for stock splits.
Source: Compustat 25814-P.R.(157-166)Market Stra 8/8/00 9:23 AM Page 164 S T R AT E G Y I N T H E N E W E C O N O M Y
Viewing share prices through the lens of short- and long-term growth expec-tations makes no less sense for companies with businesses in a number ofdifferent industries, sectors, or geographies than for companies that focus on only one. But for multibusiness companies, the undertaking is more complex: you must cascade the market’s aggregated expectations to the divi-sional or line-of-business level and compare the performance expectationsfor those entities with the expectations generated by corresponding unitselsewhere. Often, analysts’ reports provide the disaggregated informationthat can be used for this purpose. Who has it right?
If the market expects your company to underperform its peers, either in theshort or the long term, is the market right or is the company? The market tends to overshoot or undershoot because of the informationthat happens to be available to it at any given time. In the early 1990s, forexample, News Corporation was making bold strategic initiatives in broad-casting (by developing a fourth television network in the United States) andin pay television (in the United Kingdom). Although these moves concernedbankers and investors alike and thus led to asset sales to reduce the com-pany’s debt, Rupert Murdoch stuck to his strategy and has rewarded share- E X H I B I T 3
Embedded expectations of Internet stock performance
Initial expectations = price-to-sales ratio Delivered performance1 = price x discounted Amazon.com
America Online
Broadcast.com
RealNetworks
(since 2Q ’83)
Microsoft
(since 2Q ’86)
1Discounted (at a rate of 19%) using average of Yahoo! and America Online risk levels.
Source: Datastream; Microsoft and Intel annual reports; Hoover’s Online ings growth do theyimply? If your business plans match these expectations, you can assume that your company is fairlyvalued. If your expectations exceed those of the market, reexamining yourcompany’s plans and expectations will usually show who has gotten thingswrong: you or the market. Should you then be confident that the plans ofyour company are sound, you may wish to have it buy back its stock tomake the point that it is undervalued.
25814-P.R.(157-166)Market Stra 8/8/00 9:23 AM Page 165 W H A T I S T H E M A R K E T T E L L I N G Y O U A B O U T Y O U R S T R A T E G Y ? Managers of a company in this position should also ask themselves how wellthey are communicating the company’s growth options or the timing andmagnitude of its turnaround. One energy company, whose shares were per-forming less well than those of its peers, had earlier failed to deliver onexplicit promises of higher earnings. In discounting its shares, the marketmight have seemed to be wondering if the company was in denial about itsproblems. But an investigation highlighted other issues. First, the market hadhanded the company a 20 percent share price discount when it abandonedcertain growth options; investors had understood the risks they posed butknew of little else in the pipeline that could replace them. Second, this com-pany’s investor communications lacked transparency and credibility. Thecompany responded to these discoveries by explaining its earnings andgrowth options more clearly, and the “expectations gap” between manage-ment and the market disappeared.
In a bull market, many companies face exactly the opposite problem: strongTRS performers have to try to keep the market from overshooting manage-ment’s expectations. Indeed, attempts to dampen its enthusiasm sometimeslead to bizarre signaling rituals intended to avoid unpleasant surprises. A number of outstanding TRS performers go to great lengths to keep themarket’s expectations in line with their own.
Lagging TRS performers face a very different predicament: if they talk downtheir performance, they risk unnecessarily disappointing investors whosehopes are already low, but they cannot escape the challenge of generatingmore optimistic short-term expectations. The best course for such a com-pany is to communicate its position to the market accurately—otherwise,the credibility of its management and board is at risk—and then to launchturnaround efforts involving changes in senior management and the disclo-sure of new growth options to raise expectations.
A rat aboard ship
No matter whose expectations you think are sound — the market’s oryours—evidence clearly shows that the market’s expectations matter. Weexamined the correlation among TRS, EPS surprises, and variables that arenot related to market expectations. In most of the 12 industries we studied,EPS surprises explained the TRS performance of companies better than anyother variable. In high-technology businesses, such as software and semi-conductors, EPS surprises explained as much as 58 percent of all changes in the TRS of companies in the sample. During the third quarter of 1997, for instance, the revenues and earnings of Intel shot up by 20 percent, anenviable result to most people, yet its share price dropped by almost 10 per-cent in the three days following the announcement. Why? Analysts were 25814-P.R.(157-166)Market Stra 8/8/00 9:23 AM Page 166 S T R AT E G Y I N T H E N E W E C O N O M Y
expecting EPS of 91 cents, and Intel delivered only 88. Of course, since then(up to May 1999) Intel has delivered a strong TRS of 42 percent a year.
Managers know perfectly well that negative earnings surprises have a hugeimpact on TRS. Considering how much of a company’s value is tied up inlong-term expectations, it is an interesting quirk that short-term performancedisappointments play a crucial role. After all, given Intel’s positive medium-and long-term prospects, you would not have thought that a three-cent EPSshortfall would provoke a price drop of 10 percent. Why do EPS surprisesaffect TRS so profoundly? The reason is that a bad quarter, or even a quarterless good than analysts expect, is a bit like a rat on a ship: when you findone, you assume it has company. If the announcement for just a singlequarter seems to prefigure more serious problems, management’s credibilityplummets. Conversely, stock prices can rebound from negative earnings sur-prises if communications with shareholders deal accurately and forthrightlywith the results of the previous quarter or two.
Should questions arise over the quality of earnings, the market will respondeven more swiftly and emphatically. Sunbeam’s share price rose from $12.50in July 1996 to $52 in March 1998. But a series of press articles questionedthe methods used to increase the company’s profits. By August 1998, afterSunbeam’s announcement that it would restate its 1998, 1997, and, possibly,1996 profits, its stock had sunk by almost 90 percent, to $5.88. Meanwhile,shareholders had filed a class action lawsuit.6 When attempts at “earningsmanagement” become public, they altogether destroy a company’s credibilityand precipitate governance and managerial changes.
In fact, the whole issue of managing expectations is fraught with ambiguityand complexity. As Arthur Levitt, the chairman of the US Securities andExchange Commission, said last year, “Increasingly, I have become concernedthat the motivation to meet Wall Street earnings expectations may be over-riding commonsense business practices. Too many corporate managers, audi-tors, and analysts are participants in a game of nods and winks. In the zealto satisfy consensus earnings estimates and project a smooth earnings path,wishful thinking may be winning the day over faithful representation.”7 Still, legitimate strategic and communications issues can’t be ignored. Marketexpectations are hard for managers to understand and even harder for themto change, but there are ways of doing both that are much more science thanblack magic. There had better be: the careers of executives and the success oftheir companies depend on doing both well. 6Sunday Times (London), June 21, 1998.
7“The Numbers Game,” delivered at the New York University Center for Law and Business on

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