Corporate Short-Termism and How It Happens

In this excerpt from his forthcoming book, A Cure for Corporate Short-Termism, Greg Milano begins by noting that many corporate management teams “unwittingly foster a culture of short‐termism” that ends up reducing the long‐run value of their companies. Such a culture starts with the process that surrounds quarterly earnings, in which managers seek to “guide” and then beat the analysts’ consensus for EPS. But even if the market seems to deal harshly with companies that “miss” consensus, the author’s own research shows that when viewed over periods of a year or more, it is the changes in earnings and cash flows that drive returns for shareholders, and not management’s consistency in meeting the analysts’ expectations.

What’s more, this process of managing expectations—which the author calls “sandbagging”—goes on not only between companies and their investors, but also between corporate headquarters and the unit managers in annual budgeting that is often used to set incentive plan targets.

According to the author, such sandbagging may be “the worst managerial behavior problem facing U.S. public companies.” Measuring managers’ performance against plan as the basis for their bonuses gives them strong incentives to understate the expected profitability and growth of their businesses. And the predictable result is mediocre plans that can be easily beaten—not a prescription for outstanding performance.

Compounding the problem, many companies these days focus heavily on improving returns on capital or equity, and other efficiency measures, and much less on growth. But as the author emphasizes, encouraging the managers of already high-return businesses to increase or “maximize” their returns is a sure prescription for underinvestment. (After all, if you’re already earning 40% on capital, taking on projects that are expected to earn anything less will reduce your average return—and with it your bonus.)

The proposed solution—which is presented in detail in later chapters of the book—is a corporate performance measurement and reward system based on a measure of economic profit called “residual cash earnings,” or RCE, which is based on cash earnings less a capital charge on gross investment. Such a measure has the virtue of spreading the NPV out more smoothly over the life of an investment, which allows value-creating investments to drive up the measure much more quickly than with traditional return and economic profit measures. And by tying their managers’ bonuses to, say, annual increases in RCE, such a system can help companies accomplish a number of goals: (1) get more reliable budgets (by eliminating any incentive for sandbagging) from their unit managers; (2) encourage smaller capital requests from low-return businesses, but larger requests from high-return businesses; (3) limit the corporate tendency to succumb to “herding” and “recency bias,” as reflected in massive overinvestment at the tops of business cycles and far too little investment at the bottoms; and (4) create and reinforce a longer-term focus and ownership culture of accountability in which managers throughout the organization participate in and assume responsibility for their decisions and performance.

Authored by Greg Milano

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