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Having come out of three tough years since the economic meltdown of 2008, business leaders may be forgiven for thinking that maybe Nietzsche was right—that which doesn’t kill you makes you stronger. Before 2008, growth was comparatively easier to come by, but the problem with growth is that it often disguises mistakes and bad managerial hygiene. To grow profitably in real economic terms, without unsustainable leverage and without buggering up the balance sheet, is not simple. Now in its fourth year, the Wealth Creation Index (WCI), created in partnership with Applied Finance Group and Drew Morris of Great Numbers!, separates the steady wealth creators from those who occasionally get lucky but do not have the discipline to maintain a steady return on real capital. With the low-hanging fruit behind us, those companies that remain at the top usually take a disciplined approach to managing capital returns. They have a solid plan for remaining prosperous, the initiatives in place to pull it off, and the balance-sheet discipline not to overpay for acquisitions, for example.
The WCI seeks to measure companies that generate real economic value—as opposed to mere GAAP accounting value. The index relies heavily on the idea of Economic Margin (EM), which measures the degree to which the company is making money in excess of its risk-adjusted capital cost. It’s expressed as a percentage of invested capital and calculated as operating cash flow minus a capital charge all divided by invested capital. Companies with positive EM (greater than zero percent) are creating wealth; those with negative EM are destroying it.
This article originally appeared in Chief Executive magazine. Click here for the article and complete ranking charts.
While no single metric is the Holy Grail in running one’s business, EM comes closer than most, as it looks at a business the way any true owner would. How effectively is every dollar invested in this business working? It’s a discipline that applies to any firm, public or private, from a local chain of dry cleaners to General Motors. Many private equity firms use some variation of EM in doing their own evaluations; it is useful to know how people whose careers depend upon it size up one’s performance. The rankings look at public companies (minus REITs) in the S&P 500, where the CEO has been running the enterprise for at least three years, in order to fairly judge a leader’s impact on the company.
St. Louis-based Express Scripts, a large pharmacy benefit manager (PBM), landed the top position in 2011, following previous years where it was ranked #57 and #47. The company rose through the ranks largely due to to its success delivering growth through acquisitions, notably the PBM business of WellPoint in 2009, while maintaining and improving profitable operations. Express Scripts has proved skillful in integrating acquisitions, something few companies are capable of getting right.
If the proposed Express Scripts merger with Medco Health goes through, it will be a game-changing deal, doubling ES market share to about 35 to 40 percent in this industry—one where scale is everything. Needless to say, there is much potential synergy on costs, once the two are combined and retail pharmacies are potentially squeezed further. [This explains why the National Community of Pharmacists Association (NCPA) has testified before a Congressional subcommittee against the merger.]
CEO George Paz points to two factors that contribute to his company’s performance: its independence from Big Pharma and its diligence in using research to drive out waste and to make medicines safe and affordable in order to optimize health outcomes. “You can look across the healthcare industry and be hard-pressed to find any sector that makes money when it saves its clients money, yet that is exactly what we do,” he says. “We offer clients innovative ways to lower prescription drug costs and, more importantly, improve health outcomes of members.”
Other firms that consistently rank among the top performers in recent years are Aflac, Apple, Autozone, Gilead Sciences and C.H. Robinson Worldwide. Mike Burdi, Applied Finance Group senior analyst, points to several common elements that these enterprises share. “Do your customers care whether you stay in business?” he asks. “It’s one thing to say that one is customerfocused; most claim to be as a matter of course. But would your customers really miss not having access to what you offer?”
Apple (#5) is a poster child for using these elements, as is Amazon.com (#87). Meanwhile, Netflix (#25) will soon find out where it stands on that front. Apple’s challenge will be to maintain its allure after the loss of Steve Jobs. “In most research on what high-capital-return companies have in common, the common thread is the ability to consistently fulfill an unmet customer need, often when the customer didn’t really realize the need was unmet,” notes Burdi. “This is equally true whether one is big cap or small cap.” – J.P. Donlon
Top 10 Wealth Creators
- Express Scripts, CEO George Paz
- Exelon, CEO John W. Rowe
- Priceline.com, CEO Jeffery H. Boyd
- Varian Medical Systems, CEO Timothy E. Guertin
- Apple, [former] CEO Steven P. Jobs
- Philip Morris, CEO Louis C. Camilleri
- Halliburton, CEO David J. Lesar
- Gilead Sciences, CEO John C. Martin, Ph.D.
- Linear Technology, CEO Lothar Maier
- MetroPCS, CEO Roger D. Linquist
Top 10 Wealth Destroyers
- Monster, CEO Salvatore Iannuzzi
- Alcoa, CEO Klaus Kleinfeld
- Dean Foods, CEO Gregg L. Engles
- PerkinElmer, CEO Robert F. Friel
- Micron Technology, CEO Steven R. Appleton
- Nasdaq OMX Group, CEO Robert Greifeld
- Tenet Healthcare, CEO Trevor Fetter
- Stanley Black & Decker, CEO John F. Lundgren
- Nisource, CEO Robert C. Skaggs, Jr.
- Electronic Arts, CEO John S. Riccitiello
Ranking CEO Wealth Creation by Drew Morris and Michael Burdi
Our ranking is based on the performance of companies in the S&P 500 Index (and their CEOs) for the three years ending on June 30, 2011. It considers reported financial results during that period and estimates for the next 12 months. Only companies whose CEOs were in their roles for the entire July 2008 through June 2011 period were ranked. Not ranked are the 13 REITs in the 2011 S&P 500.
The four components of the ranking, explained below, were developed and calculated by the Applied Finance Group (AFG), an independent equity research advisory firm, using their proprietary metrics and data. An again-proprietary weighted combination of each company’s component rankings, taking into account the industry the company is in, is used to produce an overall score: 100 is awarded to the best wealth creator; 1 to the worst. (The list itself shows these overall scores as a sequential ranking.) The component rankings are shown as letter grades with companies in the top 20 percent of each component metric receiving an A grade; the bottom 20 percent receiving an F.
Market (or Enterprise) Value/Invested Capital (MV/IC)
This measure shows the degree to which investors consider the company’s assets valuable, relative to their cost. Market value is what a buyer would have to pay to buy the company outright, that is, to purchase all of the stock and pay off all of the loans, leases and other obligations. Note that market value depends on the stock price. Invested capital is the inflationadjusted total of all of the investments in the business. It does not depend on the stock price. So by its nature, MV/IC reflects the market’s take on the value of the investments made in the business.
The Average of the Past Three Years’ Economic Margins
Economic Margin (EM) measures the degree to which the company is making money in excess of its risk-adjusted capital cost—riskier businesses get relatively higher capital costs. EM is expressed as a percentage of invested capital. It’s calculated as (Operating Cash Flow – the Capital Charge)/Invested Capital. Companies with positive EM (greater than 0 percent) are creating wealth; those with negative EM are destroying it.
EM Change
This is a 12-month forecasted EM, based on the ratio of the most recent EM to the 3-year average.
Management Quality
This AFG-proprietary measure rewards a company with positive EM for growing its asset base, and penalizes one with negative EM for doing the same thing. In other words, if a company is making money and it adds assets in such a way that it can make even more, that’s good. So is selling off a money-losing division. That said, it’s also valid that adding scale can dramatically increase profitability in a business with high fixed costs.
A Validity Check on the Ranking Method
The top 50 companies in the ranking delivered an average Total Shareholder Return (TSR) of 68.5 percent between January 2008 and June 2011 (the period covered in the reported financials). The bottom 50 companies’ TSR averaged -9.3 percent, while the S&P 500’s average was 14.9 percent (without its 14 REITs). The top 50’s median TSR was 40.7 percent; the bottom 50’s was -11.7 percent.
Total Shareholder Return
| Top 50 | Average | 68.5% |
| Median | 40.7% | |
| Bottom 50 | Average | -9.3% |
| Median | -11.7% | |
| S&P 500 | 19% |
As the table above shows, the top 50 companies in the wealth creation ranking far outperformed the bottom 50 companies and the S&P 500 between July 2008 and June 2011. Note: TSR = (Change in Share Price over Period + Dividends)/Start-of-Period Share Price.
For more on Economic Margin and how companies scored, see http://www.economicmargin.com/moreinfo.htm.
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