What the CEO Wants You to Know: How Your Company Really Works by Ram Charan

Author:Ram Charan [Charan, Ram]
Language: eng
Format: mobi
Publisher: The Crown Publishing Group
Published: 2001-03-14T14:00:00+00:00

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Wealth Is More Than Making Money

SEEING THE BUSINESS LIKE AN INVESTOR

The main task for the CEO of a publicly traded company goes beyond money making. Shareholders (and employees who receive stock options as part of their compensation) expect a CEO to create wealth for them. The best CEOs understand that money making and wealth creation are linked through what is known as the price-earnings multiple—also called the P-E multiple, or P-E ratio. The P is the price of an individual share of stock. The E is earnings per share—how much profit the company made for each share of stock.

Yes, the P-E multiple is a number (P divided by E), but don’t get lost in the calculation. You can get the exact number for your company from people in your finance department or from the stock price listings in the Wall Street Journal.

A P-E multiple of, say, 7 means that for every dollar of earnings per share, the stock is worth seven times that much. Obviously, the higher the P-E multiple, the more wealth is created.

Basically, the P-E multiple represents expectations about a company’s current and future money-making ability. It reflects the quality of the money-making formula—the combination of expected cash generation, margin, velocity, return on assets, and profitable revenue growth—vis-à-vis the competition and in the future. But the P-E multiple is not pure speculation. Most often, it is based on a track record and on investors’ confidence that management will be able to sustain the money-making formula.

P-E multiples vary from industry to industry and company to company, and they can change over time. P-E multiples have been known to plummet when companies miss their money-making goals. Any inconsistency calls into question the predictability of cash generation, margin, velocity, return on assets, and growth. (Investors hate inconsistency and volatility.) On the other hand, P-E multiples can be enhanced by delivering on money-making commitments consistently and predictably over time. (Investors love consistency and predictability quarter by quarter.)

Let’s take an example of what drives the P-E multiple. Compare Coca-Cola and Pepsi. Coca-Cola’s multiple has been consistently higher than arch rival Pepsi’s for more than fifteen years. Managers of both companies work hard. They’re ambitious and aggressive. But for the past fifteen years, Coca-Cola’s P-E multiple has been, on average, 4 points higher than Pepsi’s. Shareholders have valued the stock of Coca-Cola higher than that of Pepsi. This is because shareholders have anticipated that Coke’s combination of cash generation, margins, velocity, return on assets, and profitable revenue growth would be better than Pepsi’s. More recently, Coke has had some setbacks and a change of leadership while Pepsi has been trying to find new areas for growth. It remains to be seen whether investors will continue to expect Coke to do better than Pepsi, as it has for more than a decade.

Even if your company is privately held, the same principles apply. Public scrutiny creates good discipline, but private companies can create their own discipline. Doing the right things day in and day out builds value.

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