Comprehension: The most important requirement for the data used in the…

Comprehension:

The most important requirement for the data used in the strategic review process is that they should be objective. In addition, the criteria should be familiar, well – understood, and accepted measures of financial performance. There are two reasons. First, the ultimate responsibility of the board is to understand the impact of a given strategy on the value of the owners’ investment. This obligation implies evaluating performance in financial terms. Second, although it is inevitable that much of the evidence on the success of an evolving strategy is subjective, managers’ familiarity with the details of product market and company-specific issues, and their access to an incredible amount and variety of data give them an advantage over outside board members. Objective data consistently presented and reinforced by the cumulative evidence of past performance can strengthen the power and credibility of the board’s opinion. Standard financial indicators facilitate discussion in terms all parties can understand.

Some will argue that using such indicators is just one more example of a myopic preoccupation with the corporate bottom line, leading to short term decisions that erode long-term competitive strength and profitability in domestic and international product markets. I must disagree. Although I think that financial criteria should be the central focus of board oversight, I do not think such a focus prevents the board from considering other kinds of progress. It should certainly weigh all objective – or even subjective – evidence of strategic progress demonstrating long – term competitive superiority. But it is equally important for the board to intervene when it sees persistent, long – term erosion of the investment base, on which all corporate activity depends.

The criteria best suited to the strategic oversight process share two important characteristics. They focus on the sustainable rate of return on shareholder investment produced by the corporate income stream. They also permit objective comparisons among the company’s separable income streams and with alternative investments in other companies inside or outside the industry. These data should help the board determine whether the company’s chosen strategy, or a particular decision, will contribute to a long-term return of shareholder investment equal or superior to other investment alternatives of comparable risk. They should also allow a comparison of the promise of future returns with the reality of past performance.

In the final analysis, these criteria should reflect a fundamental economic reality: The long – term loyalty of equity holders depends solely on sustaining a competitive return on investment. Without that, no product market strategy is safe. Although professional managers might find this dictum hard to accept, it is never the less the reality of the public capital markets in which they operate. Just doing better than all major competitors in the same industry may not, in the end, be good enough to justify continued investor support.

With this in mind, boards will find that several criteria satisfy the basic criteria of a strategic review process. One is the reported return on book investment (ROI), particularly when it is disaggregated into its prime components. It has the advantage of being based on data familiar to shareholders and management. It shows profit per unit of sales (profit margin), sales per unit of capital employed (asset turnover), and capital employed per unit of equity invested (leverage). When multiplied together, these ratios transform profit margin into return on equity.

This particular set of measurements has two weaknesses, however. First it may be subject to random changes in accounting practice, so that users may have to make appropriate retroactive adjustments to the raw data. In addition, it does not provide an external standard of comparison. The underlying components of the corporate income stream need to be broken out, and comparable data on companies inside and outside the industry, gathered. The data of review should also encompass information on investor response including price – to – earnings and market – to – book – value ratios. These data reveal evidence of investors’ reaction to published information on company performance and are a measure of confidence. They are an essential supplement to any measurement based primarily on company – specific data.

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