The meaning of TSR and the role of IR

ALEXANDER WOOD

According to PYI-Op8 data, SET-listed companies achieved total shareholder returns (TSR) of around 47% in 2007, while the overall profitability of the same companies fell in the same year by about 10%. How can companies achieve outstanding shareholder returns with falling profits? And why is an IR consulting firm such as Op8 interested in TSR? Can good investor relations help improve TSR?

TSR, the combination of share price appreciation and dividend returns, is often seen as the ultimate yardstick of financial performance. This is true with one qualification. A company can be said to have "created value" for its shareholders only if its TSR is greater than its minimum required rate of return, otherwise known as its "cost of equity".

A company's share price may go up -  it may even pay a dividend -  but if the combined return is 10% and the company's cost of equity is 11%, the company has actually destroyed value.

The concept of cost of equity is poorly understood and is often distorted by random fudge factors by less discerning practitioners, but the best way to estimate cost of equity is by using the CAPM formula or "Capital Asset Pricing Model".

CAPM combines a "risk free rate" and the expected return premium on a diversified stock market portfolio multiplied by a beta (the extent to which the return from a particular investment is likely to vary in relation to the return from the diversified portfolio).

TSR doesn't normally have that much to do with profits in any particular year. While dividend payouts are related to some extent to profits -  and while companies have a lot of control over these payouts -  dividends are usually just seen by the market as a sign of healthy financial discipline and do not normally form a large portion of TSR.

The principal component of TSR and value creation is share price appreciation. For a listed company with a decent level of share trading liquidity, its share price should be a reflection of the market's view of the company's equity value.

A company's equity value has to do with the "expected" free cash flows (which do not necessarily look much like their accounting cousins, net profits or earnings) over the expected life of the company. These are discounted back to a present value using an appropriate cost of capital, with adjustments for financing side-effects and dividends (going forward) -  and after deduction of any net interest-bearing debt today.

Share price appreciation tends to relate mainly to changes in expectations about those critical future cash flows -  and all the variables that may affect them (demand, prices, output levels, operating costs, overheads, capital expenditure, taxation, and so on).

In practice, of course, international capital markets are prone to many different inefficiencies and imperfections. As such, share prices don't always reflect "fair value" and share price movements don't always reflect changed expectations about the fundamentals of a company's future cash flow generation potential.

At the macro level, money may move in or out of the SET more because of problems in the US or Europe than because of changed expectations about local companies -  but this will nonetheless affect share prices negatively.

At a micro level, a low free float, poor disclosure or ineffective investor communication can all affect a company's share price performance and the extent to which share prices reflect fair value.

This is where investor relations (IR) comes into play. While a company can't do much about international capital flows, it can ensure that its own IR programme is in line with "best practice" and that, as much as possible, its share price tends to track its fair value in a relatively consistent and meaningful way.

So to close the loop back to the question of TSR: Yes, if a company's share price is lower than its fair value, an effective IR campaign can directly improve TSR by closing the gap. Thereafter IR can support TSR performance by ensuring that as the company makes value-creating decisions (e.g. through new investments, cost rationalisation schemes, better marketing etc) the stock market shows recognition of these developments in share price appreciation. With these considerations in mind, here is Op8's short four-point guide to effective IR:

1. Know your company's fair value: A company should have a user-friendly discounted cash flow model and people with good valuation skills (not easy to find) to update and interpret it on a regular basis. Once you know your fair value, you can identify "gaps" between your share price and fair value. Battling these gaps is an IR team's main job.

2. Get regular feedback from investors:  Interaction with investors should be two-way. Equity research and business media should be regularly examined. Has the investment community really understood your long term strategy? What do they think your biggest risks are? What are they excited about? How are they valuing your assets (e.g. are there any assets or projects to which they are attributing zero or minimal value and if so why)?

Each quarter the IR team should present an internal review to the CEO and senior management. The main discussion should be around why your share price has performed as it has, whether you can identify any significant "fair value gaps" and whether any misunderstandings may be causing these gaps.

3. Use analysts' meetings and IR materials strategically: Use quarterly results presentations to correct misunderstandings (as per item 2) -  and to focus attention on the company's long term value-creation strategy and dynamics.

Don't just give in to the clamour for short term earnings guidance or be discouraged by a seeming lack of interest in the company's fundamentals. If you treat your analyst audience like dummies they may behave like dummies.

Feed analysts and investors with information that you think is critical to a balanced understanding of the fair value of your company. Spend time explaining how your business works, what the main risks are, how these risks are managed, your analysis of market trends -  and the rationale behind your investment and financing decisions. With some patience and determination the result should be more intelligent questions during meetings, more insightful equity research reports -  and more meaningful buy/sell recommendations.

4. Use effective communication techniques: Your IR audience doesn't have time to read large amounts of text or sit in meetings that go on forever -  so be concise. If they want more detail they'll ask for it. Use of language and illustrations should be unambiguous and easy to understand. Someone should be able to look at a PowerPoint slide and understand the main message within seconds. Structure communication in line with the logic of your argument and back up your points with sourced evidence.

Make sure the figures, messages and general format of your communication are consistent across all IR materials (website, corporate profile, analyst presentations, etc). Information should be disclosed in a transparent manner -  including news that may have a negative impact on your share price. This approach builds investor confidence over time. Last, but not least, CEOs, CFOs and IR officers should all be accessible, responsive and friendly to investors.

Alexander Wood is a Director of two strategy consulting firms: AWR Lloyd (energy and metals) and Op8 (other sectors). He has been IR advisor to Banpu Plc since 2002 and to Raimon Land Plc since 2006, e-mail wood@awrlloyd.com and wood@pyi.co.th.