A decade of refinement has gone into our method for picking Europe's top-performing companies
Any method for ranking companies based on financial performance is imperfect. But for this year's European BW 50 list, which is drawn from the universe of the Standard & Poor's Europe 350 stock index, we have used an improved methodology that we first devised in 2007 to better identify top performers.
First, we focused on two core financial measures—average return on capital and sales growth—both tallied over the previous three years. For our measure of profits we used earnings before taxes to eliminate the accounting issues that show up in net earnings. The earnings measure also excludes distortions from non-operating items, as defined by our data provider, Standard & Poor's Compustat (MHP). We then put these profit numbers into context by figuring them as a percentage of the value of invested capital—basically long-term debt and shareholder equity.
For financial companies, we calculated return on shareholder equity using pretax profits as our earnings measure, to better align our figures with the nature of the finance sector. For our measure of sales growth for nonfinancial companies we included gains from operations and from mergers and acquisitions, as reported by Compustat. For financial companies, we used asset growth instead.
Greater Weight to Return on Capital
Second, we compared companies with others in their sectors. (The companies in the Standard & Poor's Europe 350 fall into 10 sectors.) This break from our practice prior to 2007 lets us identify companies that are good performers relative to their peers, even if their sector of the economy is not booming. This helps avoid the situation, for example, where oil companies jump to the top of the list when oil prices are rising and then drop when oil prices are falling. It also explains how companies with negative shareholder returns were able to make it to the top of this year's list: In most cases (especially given recent market turmoil) it means they fared less badly than peers.
Within each sector we ranked companies separately by our two measures—return on capital and growth—and then combined the numerical rankings, giving substantially greater weight to return on capital. The top company in each sector, according to the combined ranking, was given a 1, and the bottom company received a 0, with all the intermediate companies receiving a score according to their ranking.
A list was then constructed of all the companies we analyzed, according to their scores. We applied a tiebreaker where necessary. Finally, this list was reviewed by a panel of editors and correspondents, applying an important lesson we have learned from 10 years of compiling the BW 50: Financial measures applied mechanically sometimes miss the mark. Based on discussion, the panel thus made a small number of adjustments in the ranking.
Given that it is based on financial performance from prior years, our list is inescapably backward-looking. And indeed, a small number of top-ranked companies have announced disappointing quarterly earnings or annual forecasts for 2008 since the Apr. 30 cut-off date for our analysis. Yet a review of this year's results vs. those from prior years reveals how many companies show up again and again near the top of the list. While no quantitative ranking is infallible, strong businesses and good management, it seems, do win out over the long term.