Posted on Harvard Business Review: March 4, 2010 2:09 PM
Most Wall Street analysts and investors tend to focus on return on equity as their primary measure of company performance. Many executives focus heavily on this metric as well, recognizing that it is the one that seems to get the most attention from the investor community. But is it the best metric?
Even though more sophisticated valuation techniques like IRR, CFROI, and DCF modeling have come along, ROE has proven enduring. At one level, this makes sense. ROE focuses on return to the shareholders of the company. If you are a shareholder, this gives you a quick and easy to understand metric.
But ROE can obscure a lot of potential problems. If investors are not careful, it can divert attention from business fundamentals and lead to nasty surprises. Companies can resort to financial strategies to artificially maintain a healthy ROE—for a while—and hide deteriorating performance in business fundamentals. Growing debt leverage and stock buybacks funded through accumulated cash can help to maintain a company's ROE even though operational profitability is eroding. Mounting competitive pressure combined with artificially low interest rates, characteristic of the last couple of decades, creates a potent incentive to engage in these strategies to keep investors happy.
Excessive debt leverage becomes a significant albatross for a company when market demand for its products heads south, as many companies discovered during the current economic downturn. It actually creates more risk for a company in hard times.
These efforts can become addictive. If underlying profitability continues to deteriorate, more stock buybacks or debt leverage will be necessary to maintain return on equity, further increasing company exposure to unanticipated downturns in consumer demand or financial market crises. But letting ROE decline is often too painful to contemplate since the impact on stock performance can be immediate. The risks on the other side are less immediate and less quantifiable, so there is an understandable temptation to avoid immediate pain.
These issues with ROE led us to pick a different bottom-line metric for corporate financial performance when we constructed our Shift Index last year. We focused on a metric that receives far less attention from executives and investors alike—return on assets (ROA)—to analyze long-term profitability trends across all public companies in the US. Return on assets avoids the potential distortions created by financial strategies like those mentioned above.
At the same time, ROA is a better metric of financial performance than income statement profitability measures like return on sales. ROA explicitly takes into account the assets used to support business activities. It determines whether the company is able to generate an adequate return on these assets rather than simply showing robust return on sales. Asset-heavy companies need a higher level of net income to support the business relative to asset light companies where even thin margins can generate a very healthy return on assets.
Many companies outsource asset intensive manufacturing and logistics operations to more specialized providers in an effort to create "asset light" businesses. Those assets have not gone away—they have simply shifted from one company to another. Someone has to earn a reasonable return on those asset investments. Even intrinsically "asset light" businesses have some limited current assets and fixed assets required to support the business.
Using ROA as a key performance metric quickly focuses management attention on the assets required to run the business. Executives have more degrees of freedom today to outsource management of these assets and related business operations to more specialized companies. The key question is: who is in the best position to earn the highest return on those assets? This question helps executive teams to focus their own operations more tightly on the activities and assets they are best qualified to manage and to spin out other activities and assets to more specialized companies.
There's a powerful alternative form of leverage—capability leverage. As noted earlier, excessive financial leverage becomes a large and inescapable burden in an economic downturn. Capability leverage, in contrast, supports a business through all phases of the economic cycle. Specialized outsourcing providers, because of the scale and diversity of their operations, can provide key assets and capabilities quickly and more profitably to help companies ramp up rapidly during an economic upturn. Variable cost outsourcing arrangements support scaling back during downturns. Readily available financial leverage helped to drive returns to shareholders higher, leading many companies to neglect the potential of capability leverage.
Long-term ROA trends highlight the importance of capability leverage options. Our Shift Index revealed that since 1965 all US public companies experienced sustained and significant erosion in ROA—dropping by 75%. Mounting economic pressures are largely obscured by the metrics and time frames we use. This doesn't just reflect the current economic downturn. These longer-term trends suggest our traditional approaches to business are fundamentally broken. This decline is occurring in spite of a movement to more asset-light business activities and the absence of a crucial asset from the balance sheet—the talent of the workforce.
No single metric is perfect and different metrics are appropriate depending upon the circumstances. But our over-reliance on ROE is problematic on many levels. ROA may foster a better view of fundamentals of the business, including asset utilization. As economic pressures mount, executives would be well advised to ask: which assets are we uniquely capable of managing? And how can we let somebody else own and manage the rest of them, while we focus on my own unique strengths?
What do you think? What are the most useful metrics for measuring bottom-line financial performance? What are the implications of long-term ROA trends? Are companies sufficiently aggressive in pursuing capability leverage? If not, what holds them back?