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Rigorous Thinking


Financial and economic commentary reflecting Ativo’s world view:

The Best Way to Measure Company Performance?

Friday, April 23, 2010

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A recent post on the Harvard Business Review website asserts that Return on Assets is “The Best Way to Measure Company Performance.” The authors (John Hagel III, John Seely Brown and Lang Davison) correctly make the case that Return on Assets (ROA) is better than Return on Equity (ROE), but then completely miss the point that both measures are fatally flawed, leading to incorrect comparisons among companies and over time. In our experience, such accounting ratios come up short for several reasons, but the fundamental problem is that by relying on GAAP conventions they fail to capture a firm’s underlying economic performance. Cash Flow ROI addresses these issues, which is why it provides a more accurate measure of company performance and a vastly better link to market valuations.

Michael Jensen of Harvard Business School goes so far as to recommend against using any ratio-type metric to measure company performance. He observes that simply reducing the denominator provides the illusion of improved performance regardless of whether a firm does anything to increase its profits or cash flows.

Just as an outside investor uses Total Shareholder Return (TSR) to measure the performance of an investment, CharterMast defines company performance as the rate at which the firm’s intrinsic value increases over time. We still use Cash Flow ROI to assess trends and to compare firms within an industry, recognizing that profit margins, asset utilization, growth rates and cost of capital are clearly important contributors to value as well. Accounting metrics like ROA have their place, but if the ultimate objective is to create value for shareholders it is hard to see how such metrics could reasonably be considered the “Best Way to Measure Company Performance.”

COMMENTS:

  1. how would youmeasure from the cost management perspective. Given the resources limits at the global level, the company top brasses have a role to play in appropriating the rsources available at the world level and how it uses to the bext advantage of mankind. Even from the shareholders’ perspective, the cost management perspective should determine the bootomline if not the maximum
    \jagannathan.d@gmail.com

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