Leer en español
Ler em português
The top executives of the large, mature, publicly held companies hold the conventional view when they stop to think of the equity owners’ welfare. They assume that they’re using their shareholders’ resources efficiently if the company’s performance—especially ROE and earnings per share—is good and if the shareholders don’t rebel. They assume that the stock market automatically penalizes any corporation that invests its resources poorly. So companies investing well grow, enriching themselves and shareholders alike, and ensure competitiveness; companies investing poorly shrink, resulting, perhaps, in the replacement of management. In short, stock market performance and the company’s financial performance are inexorably linked.
Or are they? What if no correlation exists between a company’s profitability and the short-term—and even long-term—performance of its shares? What would be the point of retaining earnings and reinvesting them if return on equity is no measure of the wealth returned by the corporation to its equity holders?
A close examination of 50 of the largest mature, publicly held U.S. companies for the 1970–1984 period (with adjustments to account for such variables as market fluctuation) shows just that. Many companies’ profits simply never found their way to shareholders, either as dividends or as higher stock value over time. For more than half these companies, a large portion of retained earnings simply disappeared. That list includes many renowned corporate champions, Coca-Cola, Procter & Gamble, and American Express to name three.
How could we be unaware of this for so long? Part of the answer is that our familiar, traditional systems are not designed to track profit from Wall Street to Main Street, or to see whether it even arrived there.
Deferred Dividends
If we remove the rose-colored glasses through which we often view our corporate financing system, we discover that the company’s health—instead of shareholders’ wealth—has become the end rather than the means. But I maintain all a company’s profits belong—sooner or later, in one form or another—to equity owners. They should receive these profits either as dividend checks or as higher share price. This view, of course, stems from the foundations of our market system, not from any moralistic defense of investors’ rights. They own the store, so whatever net benefits its operations produce should be theirs.
This notion implies that the board of every mature company should pay 100% of its profits as dividends, unless it believes that investing the funds would raise the company’s market value by more than 100¢ for every $1 retained. The resulting higher stock price would ostensibly enrich an investor more than a dividend check.
Let’s say a company with 2,000 shares outstanding nets $1,000. The board could pay each investor a dividend of exactly 50¢ per share. This 50¢ would be the minimum possible shareholder enrichment, a starting point. To enrich the shareholder more, the market must evaluate any retained earnings at more than 100¢ on the dollar—that is, it must place a premium on the company’s investment opportunities. The board might therefore decide to pay $400 in dividends and retain $600. Subsequently, the market might value the retained $600 on the balance sheet at, say, $700. This means the board could enrich the shareholder at 55¢ per share, or:
My radical assumption here is that (setting aside tax complications) no rational board would knowingly pay the stockholder less than the original minimum of 50¢ per share.
From this perspective, retained earnings just represent deferred dividends—monies the company reinvests solely for long-term shareholder benefit. Adoption of this perspective simplifies the dividend issue with which every board of directors wrestles.
We can actually trace the success of a company’s investments by calculating the real return to the shareholders, which involves following the market’s valuation of a company along with dividends paid. Otherwise, why defer the dividend payment? While it might be argued that some people buy stock to make a profit on the sale—as soon as later that same day—the whole equity system is based on serious ownership, with all that “serious” means. (More on that later.)
If shareholder enrichment falls below the company’s net income, it is because the same authority, the market, has decided that the company is reinvesting profits ineptly. In such cases, the market discounts retained earnings or penalizes the company for deferring dividends. In other words, while the company may report profits, it may not enrich its shareholders at all.
Big Companies, Small Returns
In studying the 50 mature U.S. companies with the largest market value as of 1984, I aimed to discover how much a 5-year investment in each would enrich the long-term shareholder. To avoid the “snapshot” problem in looking at performance for a single period, I used rolling 5-year periods for 15 years. Additionally, I avoided the problems resulting from the usual assumption that investors pour any dividends they receive back into the particular stock. (For details on methodology, please see the Appendix.)
The companies studied are 50 mature, unregulated, profitable U.S. enterprises having the largest market value—meaning stock price times the number of shares outstanding—as of 1984. I excluded a few high-growth companies, which might need to raise funds through issuance of new equity: those acquired during the 15 years we studied, so that data on them were incomplete; a few with net losses for periods long enough to create misleading calculations; and certain regulated utilities. No companies were included where the management group owned a significant portion of the stock.
The analysis focused on the activity of the long-term shareholder. This investor bought stock oblivious of market timing, collected dividends for five years, and sold at a set point in the fifth year. To ensure this “blindness,” Lane Birch and I averaged the high and low prices for the years of purchase and sale. So total shareholder enrichment becomes the sum of paid dividends over five years plus the change in the stock’s market value. Since we compared the companies over the same periods, we didn’t need to correct for inflation or discount rates.
The results avoid any market aberrations in a particular year or those caused by market cycles. To do this, we selected many successive overlapping 5-year periods, 1970–1974, 1971–1975, and so on, concluding with 1980–1984. The 15-year span was long enough to cover several market cycles. The result for each company was eight to ten rolling averages. We averaged company profits for each 5-year period, thereby permitting comparison with shareholder enrichment over the same time.
A statistical analysis of the data shows no significant correlation between shareholder enrichment (S/E, CMV/RE, and ROSI) and company performance (P/E, ROE, payout ratio, beta, and three other conventional parameters). A slight but unimpressive correlation does exist with earnings growth. This analysis passed all rigorous statistical validity tests with flying colors.
It might at first appear that the heavily disproportionate representation of the oil industry (12 companies, plus 3 others closely connected) would skew the results in some way because of the great upheavals in that commodity in the past 15 years. They performed no differently, however, from the nonoil companies we tracked. In the shareholder enrichment-corporate profits ratios, both sets of companies produced very similar curves. This implies that the methodology is robust and skirts any problems produced by industry or period peculiarities.*
*For more on methodology and statistical analysis, send a stamped, self-addressed envelope to Katherine Halkias, Harvard Business Review, Boston, MA 02163.
My underlying premise was that shareholder enrichment (S) should equal or exceed net earnings (E) over time. Exhibit I shows that more than half of these companies produced S/Es well below the acceptable minimum of 100%.
Exhibit I How much did the shareholders’ investment benefit from their companies’ profits? (Shareholder enrichment/net earnings)
Over a 15-year period, the average 5-year investor in Schlumberger, top ranked in S/E, received $3.46 in enrichment—that’s dividends plus share-price appreciation—for every $1 of reported company earnings. If Schlumberger had paid out all its earnings in dividends, its investors would have received only an amount equal to earnings (thus producing an S/E of 100%). But Schlumberger very effectively exploited its retained earnings, which is to say the stock market placed a premium on its reinvestment.
The same holds true to lesser degrees for the next 20 best performing companies. For a few in the middle of Exhibit I—Pfizer, Phillips, Sun, Chevron, and Caterpillar—shareholder enrichment closely approximated earnings. Whether through dividends or market valuations, investors in these companies did receive the profits, about 100¢ for each $1 of reported net income.
We expect such performance. But fewer than half of the big corporations studied produced even this minimal return. For the rest, the market valued retained earnings at less than 100¢ on the dollar. For those companies at the bottom of the S/E survey, the shareholders received significantly less than the earnings. For example, the average five-year investor in General Electric or General Motors got only about half as much enrichment as those companies earned. Their shareholders would have been richer if they had just received all the companies’ earnings in dividend checks.
An investor in 44th-ranked Coca-Cola received only 12% of its net earnings. Yet Coke was singled out by Fortune last year as one of ten “most admired” companies (the others were IBM, 3M, Dow Jones, Merck, Boeing, Rubbermaid, P&G, Exxon, and J.P. Morgan). Seven of these ten appear in my survey; all but one of the seven have S/Es well below 100%. Ironically, two of these low-ranking companies, IBM and Coca-Cola, were rated one and two by Fortune in “long-term investment value.”1
But the worst news is at the bottom of Exhibit I. Shareholders of five companies actually lost money, even though the companies continually reported healthy earnings. These are not shoddy, fly-by-night operations; they represent a strapping chunk of corporate America—Lilly, Westinghouse, Kodak, Sears, and Xerox. Xerox stockholders lost $1.19 for every $1 the company reported in earnings. For a long time, the market gave retained earnings in these companies a negative value, which canceled out the dividends they paid out.
It’s worth remembering that the S/E gap between high- and low-ranked companies is not due to a difference in overall market behavior at a certain time. It represents the market’s valuation of retained earnings under comparable timing and market conditions over a long period.
Where did the earnings go?
What happened to the “lost” retained earnings? Shareholders probably assumed they appeared as some share-price increase. To track this, I divided the change in market value (CMV) of each stock by any increase in retained earnings (RE), as shown in Exhibit II. The resulting ratio ruthlessly discloses the market’s judgment of the real value of retained earnings, with either a positive or negative value.
Exhibit II How did the market judge the companies’ reinvestmeents? (Change in market value/retained earnings)
For Schlumberger, again the top company, the market increased share price $4.58 for every $1 of retained earnings. By contrast, for Johnson & Johnson, ranked 38, the market lifted the share price a mere 15¢ for every $1 retained. What happened to the other 85¢? The shareholders certainly didn’t get it.
Comparing market value directly with retained earnings reveals three phenomena. First, this ratio has an even greater range than what emerged with S/E: the high numbers are higher and the low ones lower. This could be anticipated, since the inclusion of dividends in S/E partly reduces extremes. CMV/ RE focuses even more clearly on the market’s judgment of the efficacy of each company’s reinvestments.
Second, on average, 16% of the retained earnings of these companies somehow disappeared on their way from Wall Street to Main Street. In other words, the average investor holding a portfolio of these stocks never benefited from 16% of the retained earnings. What happened to that money?
Third, the stock of more than one-fifth of these companies fell in price; some of it fell drastically. So the market inexorably discounted the value of these companies despite an influx of new capital from retained earnings. For example, the market devalued Xerox by $2.20 for every $1 of earnings it retained.
Given that shareholders lost, on average, 16% of retained earnings, how well did they do on the remaining 84%? For my purposes, return on shareholders’ investment (ROSI) is shareholder enrichment divided by share price. The resulting ROSIs for these enterprises ranged from 26% for United Technologies and Boeing to zero and somewhat below for Kodak, Sears, and Xerox (see Exhibit III). These returns seem reasonable; 26% is handsome without seeming excessive. Xerox’s –7% is a disappointing but not disastrous return.
Exhibit III What were the actual returns to the shareholders? (Return on shareholders’ investment/return on equity)
More important, these ROSI figures put the wide range of S/E values mentioned earlier in perspective. Schlumberger’s S/E of 346% is a big number, but it seems less outrageous when viewed beside its eighth-ranking ROSI of 19%, which looks healthy but not enormous. Similarly, Xerox’s S/E of –119% invites cries of calamity, but it is balanced by the less dire ROSI. This further explains how shareholders may endure “their” companies’ submarginal reinvestments, but, because of the standard measures of corporate performance, such losses may not come to light for a long time.
Since return on equity is a popular investment criterion at corporate headquarters as well as with securities analysts and shareholders, it should be scrutinized for its relevance, if any, to shareholder enrichment. The ROE figures (Exhibit III) provide no surprises. One can almost predict their range, from 31% down to 11%, and anyone who follows the stock market pages in the daily newspapers might guess the average of 18%.
A comparison of the actual shareholder return with the return drawn from conventional analysis is revealing. Exhibit III shows the results from dividing each company’s ROSI by its ROE. The make-believe return (ROE) was usually far higher than the real return, the one to shareowners.
The average ROSI/ROE for these companies is only 58%, which means that the average enrichment for shareholders is 42% less than what is generally called “return on shareholders’ equity.” Nevertheless, companies customarily use ROE as a principal decision criterion when considering investments and new ventures.
Despite the big numbers of some corporations, led by United Technologies’ 173%, the shareholders of 85% of them got a lower return on their investments than their long-trusted ROEs led them to believe. Moreover, as the last few companies in the table reveal, the gap between appearances and reality can be wide. The results for long-term investors in Xerox, Sears, and Kodak were all negative fractions.
I hasten to add that my purpose here is not to praise good management or to expose bad management but to identify criteria that have misled shareholders and managers alike. My concern is with the poorly performing system by which we have been measuring, evaluating, and deciding.
Systemic Myths
These companies have tremendous financial and managerial resources at hand. So how could their stockholders take such a beating? Part of the problem rests with the myths woven into our view of the market.
As everyone knows, investors supposedly exercise control over their company by electing the board of directors. The board’s charter is to protect the shareholders’ interest. It hires, and maybe fires, the top executive and oversees company operations during quarterly or monthly meetings. The board retains authority over dividends and financing issues that affect shareholder interests. This group presumably guarantees that the company employs its assets for the shareowners’ benefit without concern for the personal gain of employees and management.
The long-term shareholders’ role in this system seems equally clear. They buy the stock solely to make money and hold it only as long as doing so will make them at least as much money as selling the shares and buying others. (Of course, this especially applies to institutional investors.) Therefore, stockholders care only indirectly about the vicissitudes of the companies in which they hold stock. (To be sure, a few people invest for suprarational reasons like loyalty: “We hold on to our Apple Dumpling stock because it never missed a dividend during the Depression.”) American capitalists raise their flags every morning to the traditional notion of the equity system. But three flaws lurk behind the idealized portrait.
1. Shareholder wealth. The level of earnings may measure a business’s health to some degree. But one thing remains certain about this profit: the shareholders, the nominal owners, cannot buy groceries with it.
Aside from the rare voluntary liquidation, stockholders can be enriched in only two ways. The company can write dividend checks or the market price of its shares can rise. Admittedly, this second way yields no cash unless the shareholder sells the stock. Nevertheless, a higher stock price represents investor enrichment, and ready cash from this enrichment requires just a phone call to a broker.
Of course, even the company cannot call its earnings “cash.” Before arriving at cash flow, a company must separate from its profits adjustments like depreciation and capital expenditures. The shareholder thus stands another step away from actually getting cash from earnings. In fact, as my analysis shows, shareowners can become gradually impoverished as a result of holding stock in companies that regularly report healthy profits.
2. Equity and ROE. A vigorous statistical analysis shows no significant relation between corporate performance and shareholder enrichment.2 In fact, using any of the measurements of corporate performance currently in vogue, share performance remains unrelated to corporate performance. The usual standard is ROE, which is net income divided by the equity on the balance sheet. Everybody uses ROE as a surrogate for shareholder enrichment, but it differs from—and remains unrelated to—any return a shareholder realizes.
The equity that appears on the balance sheet is often used as a measure of stockholders’ interests through the term “shareholders’ equity.” But accountants identify this term precisely as the undiscounted total of paid-in capital and retained earnings over the life of the business. This figure, however, has no direct relation to a current shareholder’s initial investment or to that investment’s market value. The artifact “shareholders’ equity” was never intended to measure the investment, though it’s often cited as such by management, securities analysts, judges and juries, and investors themselves.
3. The investment gulf. Despite the role the board is supposed to play in guarding the shareholders’ interests, owners of stock in large, mature companies are fundamentally estranged from them and powerless to change them. As everyone knows, a purchase of stock in such a company represents only a transfer of ownership; the company receives shareholder capital only on the sale of new stock—a rare occurrence with these companies. So they do not benefit when somebody chooses to “invest” in their stock.
By the same token, though declining performance or a gloomy industry outlook often causes investors to sell, further driving down the market value, a large company can actually grow for a very long time solely on internally generated cash. Apart from the possibility of a hostile takeover posed by a low market price, a mature company can thrive even with a share price approaching zero. This means that the purchase or sale of stock can neither benefit nor threaten a large, mature company’s operations. Moreover, its share price doesn’t affect its operations because the price doesn’t determine its access to capital.
Even in the face of these facts, believers in conventional wisdom keep faith in our system’s “invisible hand.” This market phenomenon supposedly corrects any inefficiencies in a company’s management of its shareholders’ investments. But in fact it corrects nothing.
One of the system’s fairy tales, for instance, asserts the ownership prerogative of discontented shareholders: they can fire the board and thereby indirectly control the company’s management. But this would require a coordinated, energetic campaign, something that almost never happens in the real world (takeovers of course excepted).
Another fairy tale concerns the directors’ accountability to shareholders, who vote them in at the annual meeting. But the shareholders do not really elect the board, nor does the board usually elect management. Rather, the stockholders ritually approve candidates management has selected. The shareowners get no real choice. In this one-party system, the “elected” board subsequently receives from management a slate of officers, which it also ritualistically endorses.
Ironically, some of these “democratically elected” managers may also be board members. Often the chief executive is also the board chairman. This one-person, two-hat scenario is at best a weak link in the chain of accountability: when an executive officer answers to the directors—who represent the shareholders’ interests—they are the same people.
In truth, it is only in an abstract, legal sense that shareholders own the company. The highly fragmented ownership of a large corporation remains impotent; it perceives no need to become involved with the company’s operation (or, if it does, has no opportunity to do so). Actually, if higher dividends or even liquidation would enhance the stock’s performance, investors who might prefer that course are powerless to effect it.
All such key decisions, of course, fall to the directors (read: “company management”). They decide—without the benefit of meaningful shareholder feedback—how much profit to pay stockholders in dividends and how much to keep in retained earnings. In other words, they decide how much shareholders get to invest themselves and how much the board invests for them with neither their permission nor their advice.
The fact that our system works this way does not reflect poorly on the managers or directors of the big corporations, nearly all of whom operate ethically and with the best intentions. As in all evolution, natural forces have simply driven our system to this juncture for the survival of the organism—in this case, the companies.
Stalking the Culprit
This analysis proves that many of our largest companies can—without repercussions or even awareness—continually funnel money into what the market judges to be poor investments. Our system permits and even encourages it.
Unfortunately, there is no easy solution to this state of affairs. One thing, however, is clear: we must move the flow of funds available for investment out of the executive suite and into the hands of investors so they can begin to make the important investment decisions. We could start by eliminating inhibitors to such flows, like the tax provision penalizing earnings distributed as dividends more than those retained by the company. The reverse would be more appropriate.
Another step would be to encourage such flows. For example, a tax waiver on dividends reinvested in equity within a few months would encourage a revitalization of investors’ resources. Perhaps this measure would stir mature companies to pay out more profits in dividends and raise funds for new investments through the issue of new shares. The effect would be to put investment decisions in the hands of the investors.
As I said before, the top executives aren’t the culprits. They do what they’re supposed to do: ride herd on the bottom line and tend to ROEs. It’s not their fault that much of the bottom-line number remains locked in the closed loop of retained earnings. The true culprit is not a person but the metric we employ. We’ve been looking at the wrong numbers. We have discovered that we make big decisions on the basis of the economic equivalent of voodoo. Victims of this delusion range from Joe Sixpack, who owns a single share of Apple Dumpling, to the resident of the White House, who worries at night about that day’s Dow Jones industrial average.
Whether the Dow soars or plummets matters little to the companies that the shares represent. The stock market is irrelevant. Companies affect it little, and it barely affects the companies. It is as if the stock market had become a giant, disembodied spirit floating unattached, with a life of its own. And yet we continue to fret over it with great seriousness, as if it meant something real.
To reap the benefits our system promises, we must revitalize the efficacy of our reinvestment decisions. Wealth need not remain locked up as retained earnings. We need not let it trickle away, forever beyond shareholders’ grasp. A reshaped system could open the gates of pent-up wealth, encouraging and rewarding wise investments and raising shareholder returns.
1. January 6, 1986 issue.
2. Please see the footnote in the Appendix.
A version of this article appeared in the July 1987 issue of Harvard Business Review.