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Companies Need to Focus More on Cash Flow and Return on Capital

March 1, 2024
in Business
Companies Need to Focus More on Cash Flow and Return on Capital
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“If you attempt to assess intrinsic value,” investor Warren Buffett once said, “it all relates to cash flows. The only reason for putting cash into any kind of an investment now is because you expect to take cash out.”

Despite Buffett’s timeless observation on cash flow (CF), there’s a surprising disconnect between what organizations should be talking about, according to basic business theory, and what they actually talk about.

In business school, corporate finance professors teach three well-established principles about value:

1. The value of a business is equal to the present value of its expected future CF.

2. Revenue growth and return on capital (ROC) drive CF.

3. For growth to create value, ROC must exceed the cost of capital.

Given their importance, CF, growth and ROC should be highly visible themes in business strategy, aligning the actions of investors, boards of directors, CEOs and CFOs, top executives and line managers. Curiously, however, this is often not the case.

To determine what organizations consider most important to their strategies, Ernst & Young LLP recently studied the largest 200 US-listed companies in the S&P 500 (excluding financial services and real estate investment trusts, or REITs) to create a data set of compensation incentives and frequency of mentions on quarterly earnings calls.

The study revealed that many organizations focus too much on their profit and loss statement (P&L) and not enough on cash and return on capital.

Two interesting findings highlight this misalignment:

• Underweighted Metrics in Executive Compensation. In 2022, 38% of companies included neither CF nor ROC in their compensation incentives to a meaningful degree.

• Missing metrics from analyst dialogues. Organizations have discussed cash and ROC infrequently in their quarterly calls over the past 10 years.

These findings are even more perplexing given the current higher-interest-rate environment, in which investors increasingly scrutinize companies’ use of capital to ensure its effective use for value creation.

Why is this breakdown happening? Herein lies the mystery of the missing metrics.

Underweighted Metrics in Executive Compensation

To investigate, we built a data set using information from 200 proxy statements, capturing more than 1,000 compensation weights, to understand how large companies create incentives for their executive officers.

What we found surprised us. Only 40% of companies include a meaningful CF component in either their short- or long-term compensation schemes, and only 36% of companies include ROC to a similar degree. This means that most companies do not use these measures to create incentives for their executives, so they may not be aligning management’s goals with value creation.

Missing Metrics from Analyst Dialogue

Earnings calls are also a good indicator of top-of-mind topics for executives. To gain insight into what is getting leaders’ attention, we reviewed 8,000 quarterly transcripts of these 200 companies from the past decade, capturing more than 460,000 mentions of metrics.

As with the findings on executive compensation, the results were puzzling. Executives discussed cash and ROC infrequently, citing “cash” only one-tenth as often as other financial metrics and “ROC” only one-hundredth as often. The executives cited “sales” and “sales growth” the most by far, in one-third of these mentions, along with “costs” at 17% of all mentions and “earnings” at 21%.

It’s also surprising that investment analysts, who estimate the intrinsic value of companies based on free CF, do not demand more discussion of cash and ROC.

Addressing the Mystery by Starting at the Top

Neither executive compensation metrics nor the dialogue with analysts fully align with what business schools tell us about value creation. What does this mean – and what should companies do differently?

First, start at the top. It is incumbent upon boards of directors and compensation committees to fulfill their responsibility for setting incentives and ensuring that they align with value creation.

Second, in their dialogues with analysts, executives should continue to emphasize topline growth, but they also need to demonstrate to investors that they are focused on that gradual growth in ROC and on how they will optimize the cost structure and asset base to fund this growth.

At the same time, analysts have an opportunity to raise the bar on the companies they study and ensure that they hold managers accountable on all drivers of value.

There are more culprits to examine in the case of the missing metrics beyond compensation and investor dialogue. Systems rarely produce the right reports to see ROC and CF at a granular enough level. Incentives inside functions are often misaligned. And, perhaps more fundamentally, the level of awareness and education beyond the P&L – especially on CF and ROC – is low.

These are topics for another day. The first step starts with the board and the executive team setting the tone at the top.

Learn more about how EY teams are helping companies reimagine their enterprises and growth strategies through a deeper understanding of value creation.

Paul Carbonneau is a partner and the EY Americas Strategy and Transformation Co-Leader, Ernst & Young LLP. Jeremy Redenius is an EY-Parthenon principal for Enterprise Reimagined, Ernst & Young LLP. Daniel Burkly is a principal for Strategy and Transactions, Ernst & Young LLP. Rich Cleary is a senior manager for Strategy and Transactions, Ernst & Young LLP.

Methodology: For this study, we created a database of the metrics and their weighting that appeared in the short-term and long-term incentive compensation plans for each of the largest 200 US-listed companies in 2022. Natural language processing was used to search the quarterly call transcripts of the same companies from 2013-2022 to assess the frequency of mentions of key financial terms. 

The views reflected in this article are the views of the authors and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.

>>> Read full article>>>
Copyright for syndicated content belongs to the linked Source : Harvard Business – https://hbr.org/sponsored/2024/02/companies-need-to-focus-more-on-cash-flow-and-return-on-capital

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