The search for a performance measure

The total return to shareholders (TRS) is the most common approach to measuring a company’s stock market performance. However, McKinsey argues that the TRS has severe limitations as it embodies short-term expectation changes about a company’s future more than underlying performance and health. Because a consistently good performing management is already priced into the share price, continuously well-performing companies find it hard to deliver a high TRS.

In “Measuring stock market performance”, McKinsey shows how firms can use complementary measures of stock market performance to compensate for the shortcoming of the TRS, such as the market value added (MVA) or the market-value-to-capital ratio. While the TRS measures the performance against the market's expectations, those indicators measure the financial markets’ view of a company’s future performance relative to the invested capital, i.e. “they assess expectation about its absolute level of performance,” as McKinsey calls it.

However, a company can have low TRS and a high MVA due to two reasons: Unrealistic market expectations or the firm’s inability to realise its potentials. In a second step, McKinsey advises to assess if a company’s market value is in line with its intrinsic value creation potential. Thereby, the share price needs to be reverse engineering the share price using a DCF model and estimating the required performance using the ROIC. How to do so is explained using the example of Home Depot on mckinsey.com.