The One Number
I was recommended William Thorndike’s book, “The Outsiders”, by a friend about 18 months ago. It is one book that I wish I had come across much earlier in my life. The book answers a simple question: “What makes a successful CEO?” Thorndike’s answer: “it is the returns for the shareholders of that company over the long term.”
Explains Thorndike: “The metric that the press usually focuses on is growth in revenues and profits. It’s the increase in a company’s per share value, however, not growth in sales or earnings or employees, that offers the ultimate barometer of a CEO’s greatness. It’s as if Sports Illustrated put only the tallest pitchers and widest goalies on its cover…In assessing performance, what matters isn’t the absolute rate of return but the return relative to peers and the market. You really only need to know three things to evaluate a CEO’s greatness: the compound annual return to shareholders during his or her tenure and the return over the same period for peer companies and for the broader market (usually measured by the S&P 500).”
The book discusses why this is the most important metric of a CEO’s performance and tells the stories of eight of the greatest CEOs as measured by this number. And key to long-term success is to understand capital allocation. More from Thorndike:
CEOs need to do two things well to be successful: run their operations efficiently and deploy the cash generated by those operations. Most CEOs (and the management books they write or read) focus on managing operations, which is undeniably important.
Basically, CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options. Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.
Essentially, capital allocation is investment, and as a result all CEOs are both capital allocators and investors. In fact, this role just might be the most important responsibility any CEO has, and yet despite its importance, there are no courses on capital allocation at the top business schools.
What I like about Thorndike’s idea is that it distils success down to a single, measurable number – with a focus around capital allocation. This is something I have been thinking a lot about in recent months. It is not something I did earlier – because we never had enough capital to invest. Profits made through the years have now given us money beyond the margin of safety which we can consider deploying for growth.
So, spend a day reading Thorndike’s book – even for early-stage entrepreneurs there are many good ideas to learn as they seek to build their business.
Tomorrow: Part 50