The perils of playing to quarterly expectations: focusing on the short term in order to please investors can be a destructive trap. Two consultants argue that longer-term goals for building value should set the agenda.
Given these pressures, it's hard to resist the temptation to set short-term financial goals to meet analysts' quarterly estimates. However, giving in to this temptation can make matters worse. For starters, a focus on short-term targets often stands in the way of building the capabilities and making the investments required to increase a company's longer-term value. It can actually destroy value in the long run.
How can top management avoid these traps? By understanding what truly drives growth in intrinsic value and adopting a new approach to setting long- and short-term goals. The approach, which has helped companies like Lloyds TSB and Coca-Cola Co. sustain exceptional value growth over time, ensures that short- and long-term goals are in harmony with the drivers of value.
In our experience, this requires top managers to redefine their role: to deliver solid near-term results and create a more valuable business for the long run. To do so, the process of setting financial and operational goals must strike the right balance between short-term stretch and long-term sustainability.
Executives who set goals just to meet short-term EPS expectations typically assume that strong capital market performance is the result of delivering what the market wants. So, if investors anticipate 15 percent EPS growth in the quarter, these executives would expect 15 percent EPS growth to result in 15 percent share price growth. This, of course, assumes price-earnings multiples hold steady, which they do only if investors' long-term expectations don't change. More likely, though, is that P-E multiples will change as investors revise their outlook for long-term growth and returns, which suggests that delivering only in the near term is not sufficient to drive sustained value growth.
Consider California-based Network Associates. Early last year, the computer network security firm announced that it had topped fiscal fourth-quarter expectations. Yet its shares fell by about 17 percent that day and continued falling in the subsequent weeks. Why?
Despite exceeding analysts' short-term EPS estimates, the company found that its customers were delaying technology investments or eliminating significant parts of their IT budgets. This raised investor concerns about Network Associates' ability to sell some of its core corporate security applications. As a result, investors' longer-term expectations fell, dropping the company's P-E multiple from 69 to the 20s in a matter of weeks.
The fact is, superior value growth is driven both by delivering in the short term and creating positive changes m long-term expectations. Market behavior and simple math prove this out.
Many senior executives acknowledge this, yet their actions suggest that they feel compelled to deliver what the market asks for each quarter. The pressures on short-term performance heavily influence the way they set goals, both in terms of the metrics and time frames they coven This creates a culture that is all about meeting quarterly expectations--often at the expense of longer-term value creation.
In seeking rapid impact, they make shortsighted decisions such as cutting R&D activities, pulling back from marketing investments and delaying projects with long-term payoffs. Those moves are sure to cut costs significantly and ratchet up earnings in the near term. Over time, however, they can rob a business of its growth drivers.
Many executives are quick to point out that they won't be around in the long term if they can't produce in the short term. While that is a Valid concern, they are more likely to get the boot because shareholders [via the board) lose confidence in their ability to deliver in the long term. In fact, there are many examples of investors rewarding long-term performance much more than short-term EPS.
Between 1992 and 2002, Wachovia Corp., the large North Carolina-based financial services firm, grew annual earnings by 22 percent and posted a 9 percent annualized total shareholder return (TSR), On the other hand, Ohio-based Huntington Bancshares delivered less than half of Wachovia's EPS growth but generated a 10-year TSR that was a point higher.
Similarly, New Jersey-based pharmaceuticals company Wyeth reported 15 percent EPS annual growth over the same period and an 11 percent TSR, whereas Merck & Co., also in New Jersey, produced only 11 percent yearly EPS growth but posted a 13 percent shareholder return. In both cases, the market was looking for more than just short-term (or in these examples, even medium-term) EPS growth.
'Cracking the Code'
Executives who avoid the short-term trap start with a well-grounded view of what really drives long-term value growth--increasing the company's short- and long-term performance potential. They realize that the process for setting performance goals is a powerful tool for adopting the right mindset for value creation. Leading companies focus their goals--both those managed internally and those communicated externally--on near-term objectives that are in the context of a longer-term value ambition.
They have the foresight to set goals that not only help them achieve top-tier financial performance in any given period, but also lay the groundwork for sustaining that performance over time. In essence, their goals deliver in the near term while creating a more valuable business for the long term (see the adjacent sidebar discussing Nordstrom's strategy). In turn, investors have more confidence about the future performance potential of the company and raise their expectations, thereby increasing the company's share price.
Experience shows that companies that successfully use performance goals to break out of the quarterly EPS game share three core practices:
1. They redefine "exceptional performance"--The first step is to change the definition of exceptional performance away from just meeting the market's quarterly expectations to growing the company's long-term intrinsic value. For example, instead of setting performance goals in line with short-term EPS targets, managers should set goals based on a longer-range value growth ambition, such as doubling the value of the company within four or five years. This no doubt will require managers to deliver in the short term. But it will also demand that they explicitly consider how to grow and sustain superior performance over time.
Coca-Cola stepped out from the pack in the 1980s when it clearly stated that its ultimate ambition was to increase the value of the company--not sales (or even profits). Then-CEO Roberto Goizueta was a pioneer in translating a capital market ambition--top-tier shareholder returns relative to peers over time--into a clear economic profit standard and then translating that profit stream into a set of operational performance drivers (such as units sold, profit per unit) around which he could set concrete goals further down in the organization.
Goizueta knew that volume growth, particularly in Coke's core soft drinks business, was a significant driver of the company's value. He also knew that setting a volume goal without understanding how to deal with trade-offs between volume and margin could have managers chasing the next unit at any cost. So he set volume growth standards in file context of understanding file incremental profitability of each unit and used this to guide a profitable growth strategy for achieving a much higher "share of stomach."
These standards--volume growth and profit per unit--were enduring, and provided the underlying performance framework for the company. They spanned years rather than just a particular quarter, and became a critical component of increasing Coke's value throughout the 1980s and mid1990s by nearly 40-fold.
2. They use performance goals as a way to fight "business as usual" internally--The standard practice of delivering incremental improvement over last quarter's results often creates real pressure to "run harder" in the near term, without developing breakthrough ideas to help managers meet those stretch targets. In his Harvard Business Review article, "Leading for Value," Sir Brian Pitman, former chairman and CEO of U.K.-based financial services firm Lloyds TSB, writes that using goals to "stretch for success" was a key component of his company's remarkable performance through the 1990s.
From 1983 to 2001, the bank's market capitalization grew 40-fold, and at one point was the largest of any bank in the world. By defining Lloyds' peer set as the best companies in the world (rather than just the other U.K. banks often cited as "comparables" by stockbrokers), Pitman and his management team infused a new level of ambition into the organization. That stimulated a search for new and better ideas, for the short term and--more importantly--for the long term.
Among other fixings, Lloyds' management pulled out of California, a business unit that was generating positive earnings (8 percent return on equity) hut was not earning returns over the cost of capital. While this decision hurt near-term performance, it was the best decision for maximizing value growth in the long run.
3. They use goals to change the dialogue with investors--In many cases, senior managers end up in long meetings discussing quarterly EPS estimates because they believe that's what investors want to hear. On the other hand, some companies are starting to provide more transparency on the true drivers of intrinsic value and how those drivers are expected to impact performance over time.
Take The Gillette Co., the Boston-based consumer products company, which has increased quarterly net income by nearly 90 percent since the first quarter of 2001. Gillette CEO James Kilts has criticized short-term EPS guidance as creating a "circle of doom"--that is, a cycle in which companies sacrifice now to deliver on next quarter's target, after which the target for the following quarter is ratcheted up even higher. Managers respond by pushing harder and cutting deeper to meet the next quarter's numbers. This repeats itself until the company has created a reinforcing cycle of self-destruction.
Kilts started breaking the circle of doom by setting the right internal goals and consequences for missing them. He then used those goals to drive external communications, rather than the other way around. This allowed Gillette to be on the right foot with investors--shaping the dialog around the underlying drivers of value (such as new product launches, product mix and cost reductions) rather than focusing on a point-in-time financial target.
As straightforward as they may seem, these changes can be incredibly difficult to make. Internal budget processes and incentive systems are often short-term-oriented. Even strategy development is frequently an annual process that focuses on business model changes over just the next year or so. Externally, it feels like a real risk to walk away from quarterly EPS goals.
Companies like Gillette and Coke remain the exception rather than the rule. Nonetheless, top executives would do well to remind themselves of what really drives shareholder value--long-term growth in the intrinsic value of the company, not "consecutive quarterly EPS targets hit." Adopting this mindset and then setting financial and operational goals that are aligned with sustained value growth is the first step in delivering on that promise.
How Nordstrom Set Short-Term Targets From Longer-Term Value Goals
In the late 1990s, Nordstrom Inc.'s top management was determined to break out of the prevailing department store retailing mindset: that both growth and profitability were constrained by market conditions (including slowing demand for high-price-point apparel) and the increasingly attractive apparel offer of discounters, like Target.
Nordstrom executives accomplished this by establishing a "stretch" value growth goal that would put the company in the top quartile of its peer set in shareholder returns (in this case, around 15 percent annually). From that value growth goal, they derived targets for key operating measures such as comparable-store sales growth, new-store square footage growth, gross margins, SG&A, working capital turnover and capital expenditures. These targets could be cascaded as far down as the buyer level (with gross margin return on inventory, or GMROI, targets).
In this way, they were able to push ambitious, value-based performance goals down through the organization, linking the operational targets that drive near-term performance to the company's long-term value growth ambition. At the same time, top management's agenda was overwhelmingly focused on the relatively few operational variables that it now understood to be critical linchpins to delivering on those value goals.
Nordstrom has also moved toward weaning analysts from the quarterly earnings "fix." Last year, management announced it would change the focus of its quarterly guidance from EPS and other short-term measures to longer-term value drivers, and would track its progress against a three-year performance plan. Already, the company has begun to deliver on its longer-term targets, particularly key ones like comparable-store sales growth, SG&A reduction and inventory turnover improvements.
In the past three years, Nordstrom has returned 31.4 percent annually to shareholders, versus 8.6 percent for the U.S. retail sector overall.
Paul Favaro (firstname.lastname@example.org) is a partner in Marakon Associates' Chicago office and an adjunct professor of management and strategy at Northwestern University's Kellogg School of Management. Greg Rotz (email@example.com) is a senior manager in Marakon's New York office.
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|Date:||Jan 1, 2004|
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