Valuation, 7th Edition

5The Alchemy of Stock Market Performance

A commonly used measure for evaluating the performance of a company and its management is total shareholder returns (TSR), defined as the percent increase in share price plus the dividend yield over a period of time.¹ In fact, in the United States, the Securities and Exchange Commission requires that companies publish in their annual reports their TSR relative to a set of peers over the last five years. That sounds like a good idea: if managers focus on improving TSR to win performance bonuses, then their interests and the interests of their shareholders should be aligned. The evidence shows that this is indeed true over long periods—at a minimum, 10 to 15 years. But TSR measured over shorter periods may not reflect the actual performance of a company, because TSR is heavily influenced by changes in investors’ expectations, not just the company’s performance.

Earning a high TSR is much harder for managers leading an already-successful company than for those leading a company with substantial room for improvement. That’s because a company performing above its peers will attract investors expecting more of the same, pushing up the share price. Managers then must pull off herculean feats of real performance improvement to exceed those expectations and outperform on TSR. We call their predicament the “expectations treadmill.” For high-performing companies, TSR in isolation can unfairly penalize their high performance. Another drawback is ...