69
5
The Alchemy of Stock 
Market Performance
A commonly used measure for evaluating the performance of a company and 
its management is total shareholder returns (TSR), defined as the percent in-
crease in share price plus the dividend yield over a period of time.1 In fact, in 
the United States, the Securities and Exchange Commission requires that com-
panies publish in their annual reports their TSR relative to a set of peers over 
the last five years. That sounds like a good idea: if managers focus on improv-
ing TSR to win performance bonuses, then their interests and the interests of 
their shareholders should be aligned. The evidence shows that this is indeed 
true over long periods—at a minimum, 10 to 15 years. But TSR measured over 
shorter periods may not reflect the actual performance of a company, because 
TSR is heavily influenced by changes in investors’ expectations, not just the 
company’s performance.
Earning a high TSR is much harder for managers leading an already-suc-
cessful company than for those leading a company with substantial room 
for improvement. That’s because a company performing above its peers 
will attract investors expecting more of the same, pushing up the share 
price. Managers then must pull off herculean feats of real performance 
improvement to exceed those expectations and outperform on TSR. We 
call their predicament the “expectations treadmill.” For high-performing 
companies, TSR in isolation can unfairly penalize their high performance. 
Another drawback is that using TSR by itself, without understanding 
its components, doesn’t help executives or their boards understand how 
much of the TSR comes from operating performance, nonoperating items, 
and changes in expectations.
1 Later in this chapter, we’ll show that we also need to consider the impact of share repurchases as a 
significant source of cash distributions.

70  The Alchemy of Stock Market Performance
The widespread use of TSR over short periods as a measure of manage-
ment performance can create perverse incentives. Managers running full tilt 
on the expectations treadmill may be tempted to pursue ideas that give an im-
mediate bump to their TSR at the expense of longer-term investments that will 
create more value for shareholders over a longer horizon. In addition, TSR 
may rise or fall across the board for all companies because of external factors 
beyond managers’ control, such as changing inflation rates. Strictly speaking, 
such factors should play no part in managers’ compensation.
This chapter starts by explaining the expectations treadmill. It then shows 
an approach to analyzing TSR that isolates how much TSR comes from rev-
enue growth and improvements in return on invested capital (ROIC)—the 
factors that drive long-term value creation—versus changes in expectations 
and nonoperating items. Managers, boards of directors, and investors can 
learn much more about company performance from this granular break-
down of TSR.
Why Shareholder Expectations Become a Treadmill
As we described in Chapter 2, the return on capital that a company earns 
is not the same as the return earned by every shareholder. Suppose a com-
pany can invest $1,000 in a factory and earn $200 a year, which it pays out in 
dividends to its shareholders. The first investors in the company pay $1,000 in 
total for their shares, and if they hold the shares, they will earn 20 percent per 
year ($200 divided by $1,000).
Suppose that after one year, all the investors decide to sell their shares, 
and they find buyers who pay $2,000 for the lot. The buyers will earn only 
10 percent per year on their investment ($200 divided by $2,000). The first 
investors will earn a 120 percent return ($200 dividends plus $1,000 gain 
on their shares versus their initial investment of $1,000). The company’s 
return on capital is 20 percent, while one group of investors earns 120 per-
cent, and the other group earns 10 percent. All the investors collectively 
will earn, on a time-weighted average, the same return as the company. 
But individual groups of investors will earn very different returns, because 
they pay different prices for the shares, based on their expectations of fu-
ture performance.
One way of understanding the effects of this dynamic is through the 
analogy of a treadmill, the speed of which represents the expectations built 
into a company’s share price. If the company beats expectations, and if the 
market believes the improvement is sustainable, the company’s stock price 
goes up, in essence capitalizing the future value of this incremental improve-
ment. But it also means that managers must run even faster just to maintain