When faced with the challenge of improving total shareholder return (TSR), most executives grow by default. However, as long as investors value growth, they want to see that companies can manage their capital efficiently.
Different paths to TSR
To better understand the relationship between growth, capital investment and TSR, EY experts have recently analyzed value creation for S&P 500 companies using a proprietary predictive cash flow model.
Our findings challenge traditional wisdom and reveal sharply different paths to positive TSR, depending on the return on investment capital (ROIC) of a company.
This study divided the sample company into high and low rock groups based on the average historical ROIC over the 3 years of 2021-2024, and examined how each group operates on TSR. (The analysis included 360 S&P 500 companies, but excluded the Financial Services sector, companies that came and went in and out of the S&P 500 during the observation period, and some companies in the sector that were still severely affected by the Covid-19 destruction during the period, such as cruise operators, airlines, casinos and more.)
Turtle vs. Rabbit, grasshopper vs. Ant
The morals of analysis reflect the morals of two possible stories: “turtles and rabbits” and “grasshoppers and ants.”
For companies with low ROICs (turtles and fleas race towards a common goal), the priority should be to acquire the right to grow by improving their ability to gain the most value from their investments. Meanwhile, companies with high ROICs (where grasshoppers and ants each have opposite strategies) should prioritize deploying new capital with attractive returns.
The findings have deep lessons for companies in each of the high or low ROIC or TSR quadrants.
Companies with low ROIC: Turtles and fleas
•Low ROIC companies, like turtles who win races through stable determination, have succeeded by improving investment efficiency and focusing on stable and disciplined growth.
•In contrast, rabbits represent overconfidence. It is a low ROIC company that has continued to pursue growth without addressing underlying inefficiencies.
• Over time, turtles outperformed the knolls by focusing on strategic improvements.
Companies with high ROIC: Ants and grasshoppers
• Like Ali, companies with high ROICs are disciplined and organized planners. They systematically expanded profit margins and made the most of their High Rock’s power to drive sustainable growth in TSR through careful investments in return opportunities.
•And other companies, like carefree Grasshoppers, who have started overinvestment in low ROIC return assets, have disrupted shareholder value and reduced TSR.
• Grasshoppers’ futile approach contrasts with Ants’ focused strategies.
Turtle: Repositioning for Growth
The research turtle companies have succeeded in treating low ROIC as a more prioritized concern. They limited the capital deployment (the impact of 15 points TSR), improved ROIC by 44% with a combination of better capital efficiency and increased profit margins, generating a 59% net contribution to TSR.
Knoll: Go anywhere fast
In contrast, Hare Companies doubled its growth by deploying significantly more capital to low-performing businesses despite low ROICs (compared to 56%, compared to 15% of turtles). Continuous weak ROIC offsets the value of your investment (-26% impact).
The net effect of these factors was that TSR only grew half of the slowly permeated peers (30% vs. 59% impact). Investor concerns about this approach had an additional -39% TSR impact as expectations fell, resulting in a total net effect of -9% TSR. The lesson is that management cannot grow ways to get out of low-turn problems without first showing capital discipline.
Ali: Invest thoughtfully
And what about the ROIC leaders? What should they do to maintain the outcome?
Companies fortunate to have a lucky ROIC should invest in growth, but they must do so in a disciplined way, not to dilute strong ROICs. The data shows that companies in this category have a very different ability to do this.
Both high-TSR performers and low-TSR performers (anti and grasshoppers, respectively) deployed more capital and increased sales. Ali did so by investing while maintaining or strengthening capital efficiency and margins, increasing investor confidence and increasing TSR by 73%.
Grasshoppers: Waste Benefits
The results of Grasshoppers, a low-TSR segment, show that it’s expensive to get it wrong. These companies deployed capital at a high level (84 points vs. 61 points contribution to TSR), but their reduced ROIC denied profits at -74 points. Investors have once again lowered expectations (the impact of -20 points). The result was a TSR gain of just 10% compared to 73% of the high-performing ants. Grasshopper companies invested inefficiently, lost investor confidence, and wasted high historic ROICs.
Become an ants or turtles
To find a path to positive TSR, companies need to take two steps.
Understand Roic
Leaders need to determine whether they have gained the right to grow by assessing how effectively they are using their balance sheet. A key benchmark is whether the ROIC exceeds the cost of capital. Depending on where they land, companies using this scale can choose one of two paths to success.
Choose your path to success
Companies with low ROICs need to emulate turtles. It focuses on improving capital efficiency and margins, including poorly performed units, sales of non-core assets, and operational improvements. Once Roic exceeded the cost of capital, they acquired the right to invest in growth.
Companies that already have a healthy balance sheet and high ROIC have more options than others. But by making wise investment decisions that build future values and avoid wasting their benefits, they must be systematic like the ants of the f story.
Read the full EY Research Report that has earned the right to grow and learn more about how EY teams can help companies rethink their company and their growth strategies and understand value creation.
Mitch Berlin is the strategy and dealing of partners at Ernst & Young LLP and EY US vice-chairman.
Whit Butler is a partner at Ernst & Young LLP and consulting to EY America Vice-Chair.
The views reflected in this article are those of the author and do not necessarily reflect the views of Ernst & Young LLP or other members of the Global EY organization.
