Valuation: Short-Termism Runs Deep

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Excerpted with permission of the publisher, Wiley, from Valuation: Measuring and Managing the Value of Companies by McKinsey & Company, Tim Koller, Marc Goedhart, David Wessels. Copyright (c) 1990, 1994, 2000, 2005, 2010, 2015, 2020 by McKinsey & Company. All rights reserved.

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Short-Termism Runs Deep

Despite overwhelming evidence linking intrinsic investor preferences to long-term value creation, too many managers continue to plan and execute strategy-and then report their performance-against shorter-term measures, particularly earnings per share (EPS).

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As a result of their focus on short-term EPS, major companies often pass up long-term value-creating opportunities. For example, a relatively new CFO of one very large company has instituted a standing rule: every business unit is expected to increase its profits faster than its revenues, every year. Some of the units currently have profit margins above 30 percent and returns on capital of 50 percent or more. That’s a terrific outcome if your horizon is the next annual report. But for units to meet that performance bar right now, they are forgoing growth opportunities that have 25 percent profit margins in the years to come. Nor is this an isolated case. In a survey of 400 chief financial officers, two Duke University professors found that fully 80 percent of the CFOs said they would reduce discretionary spending on potentially value-creating activities such as marketing and R&D in order to meet their short-term earnings targets. In addition, 39 percent said they would give discounts to customers to make purchases this quarter rather than next, in order to hit quarterly EPS targets. That’s no way to run a railroad-or any other business.

As an illustration of how executives get caught up in a short-term EPS focus, consider our experience with companies analyzing a prospective acquisition. The most frequent question managers ask is whether the transaction will dilute EPS over the first year or two. Given the popularity of EPS as a yardstick for company decisions, you might think that a predicted improvement in EPS would be an important indication of an acquisition’s potential to create value. However, there is no empirical evidence linking increased EPS with the value created by a transaction. Deals that strengthen EPS and deals that dilute EPS are equally likely to create or destroy value.

If such fallacies have no impact on value, why do they prevail? The impetus for a short-term view varies. Some executives argue that investors won’t let them focus on the long term; others fault the rise of activist shareholders in particular. Yet our research shows that even if short-term investors cause day-to-day fluctuations in a company’s share price and dominate quarterly earnings calls, longer-term investors are the ones who align market prices with intrinsic value. Moreover, the evidence shows that, on average, activist investors strengthen the long-term health of the companies they pursue—for example, challenging existing compensation structures that encourage short-termism. Instead, we often find that executives themselves or their boards are the source of short-termism. In one relatively recent survey of more than 1,000 executives and board members, most cited their own executive teams and boards (rather than investors, analysts, and others outside the company) as the greatest sources of pressure for short-term performance.

The Importance Of Impact On EPS

The results can defy logic. At a company pursuing a major acquisition, we participated in a discussion about whether the deal’s likely earnings dilution was important. One of the company’s bankers said he knew any impact on EPS would be irrelevant to value, but he used it as a simple way to communicate with boards of directors. Elsewhere, we’ve heard company executives acknowledge that they, too, doubt the importance of impact on EPS but use it anyway, “for the benefit of Wall Street analysts.” Investors also tell us that a deal’s short-term impact on EPS is not that important. Apparently, everyone knows that a transaction’s short-term impact on EPS doesn’t matter. Yet they all pay attention to it.

The pressure to show strong short-term results often builds when businesses start to mature and see their growth begin to moderate. Investors continue to bay for high profit growth. Managers are tempted to find ways to keep profits rising in the short term while they try to stimulate longer-term growth. However, any short-term efforts to massage earnings that undercut productive investment make achieving long-term growth even more difficult, spawning a vicious circle.

Some analysts and some short-term-oriented investors will always clamor for short-term results. However, even though a company bent on growing long-term value will not be able to meet their demands all the time, this continuous pressure has the virtue of keeping managers on their toes. Sorting out the trade-offs between short-term earnings and long-term value creation is part of a manager’s job, just as having the courage to make the right call is a critical personal quality. Perhaps even more important, it is up to corporate boards to investigate and understand the economics of the businesses in their portfolio well enough to judge when managers are making the right trade-offs and, above all, to protect managers when they choose to build long-term value at the expense of short-term profits.

Improving a company’s corporate governance proposition might help. In a 2019 McKinsey survey, an overwhelming majority of executives (83 percent) reported that they would be willing to pay about a 10 percent median premium to acquire a company with a positive reputation for environmental, regulatory, and governance (ESG) issues over one with a negative reputation.

Investors seem to agree; one recent report found that global sustainable investment topped $30 trillion in 2018, rising 34 percent over the previous two years.

Board members might also benefit from spending more time on their board activities, so they have a better understanding of the economics of the companies they oversee and the strategic and short-term decisions managers are making. In a survey of 20 UK board members who had served on the boards of both exchange-listed companies and companies owned by private-equity firms, 15 of 20 respondents said that private-equity boards clearly added more value. Their answers suggested two key differences. First, private-equity directors spend on average nearly three times as many days on their roles as do those at listed companies. Second, listed-company directors are more focused on risk avoidance than value creation.

Changes in CEO evaluation and compensation might help as well. The compensation of many CEOs and senior executives is still skewed to shortterm accounting profits, often by formula. Given the complexity of managing a large multinational company, we find it odd that so much weight is given to a single number.