Whether you are a manager, an investor, or a research analyst, it’s essential that you be able to identify the differences between great-performing companies and poor-performing ones. This isn’t as easy it is sounds because it’s highly dependent on both the metrics used and the time frame evaluated. Nevertheless, this ability to differentiate between companies is critical in order to choose better investments, to develop better strategies, and to better execute on plans.

First, the yardstick. To measure profitability as it relates to creating shareholder value, many people would look to the “old faithful,” earnings per share (EPS). But because EPS is income-statement driven and misses or misstates large portions of the balance sheet, the business press has begun to actively warn against the pitfalls of it and other traditional metrics.

For many reasons, we can’t depend on EPS as a means for screening for great corporate performance. So, some people define a good company as one that has generated high total shareholder returns (TSR), often accepted as the ultimate de facto standard for corporate performance evaluation. The truth is, we can’t rely solely on stock price changes either to define “great” corporate performance.

Why we can’t rely on TSR

A company’s ability to create value for shareholders is based on management’s ability to continue to “raise the bar” and beat the expectations imbedded in their stock price. Yes, great companies do this year in and year out. But many companies enjoy high TSR in discrete periods of time simply because the market has forecasted exceptionally favorable future performance in the company’s stock.

The lofty forecasts could stem from the company’s ability to convince the market of an extremely bright future. Or the market may make its predictions without the company’s guidance. Either way, that company has the ability to generate tremendously high TSR without the actual operating performance to justify it. Hence, great shareholder returns based on changing forecasts can accompany poor corporate performers over periods of several years—and vice versa.

AMES Department Stores (Delisted as AMES, Relisted as AMESQ)

From 1996 to mid-2001, Ames Department Stores enjoyed one of the better stock price runs of the market. The Northeast-based U.S. retailer steadily rose out of bankruptcy, taking a $2 share price to a fantastic $48 per share five years later. Investors believed in the company’s strategy and forecasted lofty cash flow streams in the company’s future. Unfortunately, the company’s meteoric rise was followed in late 2001 by a return to bankruptcy— with severe cash flow problems and a flurry of layoffs and store closings. What happened?

Investors’ forecasts exceeded reality. In fact, during the five-year period, AMES’s cash flow returns never once exceeded its cost of capital, yet the company continued to invest in its value-destroying business at remarkable annual growth rates. Operating performance and shareholder performance were clearly divergent for many years.

Abbott Labs (ABT)

This Midwest pharmaceutical company generates some of the highest cash flows in any industry. Returns and growth rates over the last 15 years have consistently exceeded corporate averages by hefty margins.

How has the stock performed? Over the last 10 years, Abbott has only generated average corporate TSR, simply consistent with the S&P 500. So why has such a great company with superior returns been a marginal stock performer? A decade ago, investors became so enamored with Abbott’s operating performance that they collectively priced an expectation of continued superior performance into the stock price. This meant that as Abbott continued to deliver incredible operating performance, the company only met expectations, and thus shareholder returns generated only market levels.

Coca-Cola (KO)

Coca-Cola is another company that became the victim of misguided investor forecasts, which has led to its recent abysmal stock performance despite otherwise superior operating performance. Since peaking around $88 per share in July 1998, Coca-Cola’s share price is now floating around $44 in early 2002. Overexuberant investors priced-in growth and return forecasts in 1998 that were all too lofty. As Coca-Cola disappointed on those too lofty expectations, the stock took a tremendous hit.

Is Coca-Cola a poor operator? Not by a long shot. The company’s returns are still the most envied in any industry, and its cash flow performance is still incredibly high. So, why the large drop in stock price? Has the brand lost its value? Is the company’s distribution system losing its power and prowess? Doubtful. Coca-Cola is another example of a great company that—due to misaligned prior expectations—has been a poor investment for shareholders for the last three years.

What does this mean to you?

For investors, the issues are obvious. Professional investors live by what many retail investors fail to understand: that great companies can be terrible investments. Therefore, great investments are made by better understanding the factors that create expectations and forecasts, of which historical operating performance is only one.

The goal of corporate management remains the maximization of shareholder value, but that doesn’t guarantee premium shareholder returns. As you can see, merely meeting the market’s expectations can be a significant problem. The only way to increase share price value on a sustainable basis is to continually beat the performance forecasts implicit in stock price.

Many companies have incorporated stock price performance into their executive compensation schemes. Be wary if you work for one of these companies. The use of stock that is priced with low performance forecasts can lead to huge windfalls for management that may or may not be justified. On the other hand, heavy use of stock as a motivator when the price is based on excessive investor forecasts may provide only average compensation to otherwise superstar managers—an issue that can prompt world-class management personnel to move to other companies.

Compensation is just one of the management processes affected by market expectations. Investor relations, budgeting, forecasting, and target setting can each be improved by actively acknowledging the potential diversion between stock performance and operating performance.

Business strategy implications

During the Internet bubble, companies with great stock performance and otherwise poor strategy and operations were being examined, studied, and written about in a number of publications for their new and innovative business models. Many, if not most, of these companies’ strategies were only “proven” by an incredible stock price climb, not sound economic models. A number of organizations rushed out to pursue flawed business models, using new companies with great stock prices as their benchmark. But as the bubble burst, the flaws in the business models became obvious. Great companies not only have soaring stock prices but are also built with sustainable business models that can be reflected in operating performance.

Management can benefit by following the practices of greatperforming companies and avoiding the mistakes of poor performers. Yet, how flawed will the business strategy models be if the sample of good and bad performers is skewed? If we resolve ourselves to a solid and proven methodology for screening “good” from “bad,” we can create an exceptional framework for evaluating, designing, and developing strategy. That can help drive an organization’s profitability, growth, and the long-term maximization of shareholder returns.

Joel Litman is a principal with DiamondCluster International, a global business strategy and technology consulting firm, where he assists clients in designing, developing, and evaluating business strategies that will lead to maximized long-term financial performance, Return Driven Strategy. You can reach him at joel.litman@diamondcluster.com.

Glenn W.Welling is a partner at HOLT Value Associates, a global financial consulting and research firm focused on helping senior executives link corporate decisions to stock price. He also is the managing director of HOLT’s Corporate and Alliance Services business. Glenn can be reached at gwelling@holtvalue.com.