Governance. The growing demand for corporate probity and better governance has reinforced the CEO’s pivotal leadership role. Board meetings therefore represent a useful opportunity — and discipline — for testing the organization’s resilience to pressure and change over time. As we have seen from our survey, directors are eager to redirect their attention to this task. The need for resilience is greatest when investments take a long time to pay off, as they generally do for natural-resource and pharmaceutical companies and public-sector bodies. CEOs and boards lack rapid performance feedback in such cases and thus need to keep a close eye on a range of considerations: regulatory influence, marketing and supplier partnerships, and organizational skills.
Given the current economic and regulatory environment, a focus on short-term performance is understandable, but it is nonetheless unbalanced. Companies must again learn how to meet next year’s earnings expectations while at the same time implementing the platforms needed to deliver strong and sustainable earnings growth year after year. Achieving this dual focus involves thinking about strategy, communication, and leadership in new ways. And it calls for the creation of a carefully designed set of metrics — balanced across the business and linked to the creation of value over the short, medium, and long term — that can help management teams and boards monitor their ability to stay on course.
About the Authors
Richard Dobbs is a director and Keith Leslie is a principal in McKinsey’s London office; Lenny Mendonca is a director in the San Francisco office.
The Stock Market Values Health as well as Performance
The fixation of a few analysts on the short-term results in next quarter’s earnings announcements shouldn’t blind management to the reality that these announcements also contain objective and reliable information about long-term performance. And that is why most investors pay attention to them.
However, an examination of share prices shows that expectations of future performance are the main driver of shareholder returns: in almost all industries and almost all stock exchanges, cash flow expectations beyond the next three years account for 70 to 90 percent of a share’s market value. These longer-term expectations in turn reflect judgments on growth and long-term profitability — a lesson relearned after the dot-com bust.
Long-term expectations vary from one industry to another. Cash flows in the global semiconductor industry, for example, must grow by more than 10 percent a year during the next ten years to justify current market valuations. In retailing and consumer packaged goods, the required growth rate ranges from 3 to 6 percent; in electric utilities, it is around 2 percent.
Future expectations also clearly drive the stock price of individual companies, thus explaining the often widely differing P/Es or market-to-book ratios of companies with similar reported earnings. In the pharmaceutical sector, for example, the market ascribes great value to a healthy drug pipeline, despite the fact that it will not affect earnings in the short term.
Even the private equity sector, renowned for its focus on short-term operational improvements, believes that health matters. Most private equity firms look to realize their investments in a five-year time frame, but they must still have a credible proposition for future earnings and cash flow growth to underpin a sale or IPO.