“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:
- The value of a business is equal to the present value of its expected future CF.
- Revenue growth and return on capital (ROC) drive CF.
- 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.