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Chapter 6. In Search of Excellence: Are ... > What Is a Good Company? - Pg. 103

In Search of Excellence: Are Good Companies Good Investments? 103 · History backs you up. If you look at a portfolio of companies that have done well in the stock market over long periods, you inevitably will find well-managed companies that have succeeded by offering needed products to their customers. Based upon this, some investors and investment advisors argue that you should put your money into companies with good products and man- agement and that you will reap the rewards from this investment over long periods. Better man- agement, you are told, will deliver higher earnings growth over time while finding new investment opportunities for their firms. · Well-managed companies are less risky. This is a secondary reason that is offered for buying well-managed companies. If one of the risks you face when investing in companies is that man- agers may make poor or ill-timed decisions that reduce value, this risk should be lower for com- panies with good management. The combination of higher growth and lower risk should be a winning one over time. What Is a Good Company? It is difficult to get consensus on what makes for a good company since there are so many dimen- sions by which you can measure excellence. Many people measure excellence in terms of financial results; good companies earn high returns on their investments and reinvest their funds wisely. Some investors believe that good companies have managers who listen and respond to their stock- holders' best interests and that corporate governance is the key. Finally, still others believe that good companies respond not just to stockholders but also to other stakeholders, including their customers, employees and society. Thus, you can have companies that make it on one list and not another. For instance, GE delivered superb financial results under Jack Welch but corporate gov- ernance was weak at the company. Conversely, Ben and Jerry's was ranked highly for social re- sponsibility in the 1990s but faced financial disaster during the period. Financial Performance The simplest and most direct measure of how good a company is and how well it is run by its management is the firm's financial performance. A well-run company should raise capital as cheaply as it can, husband well the capital that it has to invest, and find worthwhile investments for the capital. In the process, it should enrich investors in the company. Most measurements of company quality try to measure its success on all of these dimensions. To evaluate the company's success at raising and investing capital, you can look at the return it earns on invested capital and the cost of that capital. The difference between the two is a measure of the excess return that the firm makes and reflects its competitive advantages. In the 1990s, for instance, a dollar measure of this excess return, called economic value added (EVA), acquired a significant following among both managers and consultants. It was defined as follows: Economic Value Added = (Return on Invested Capital ­ Cost of Capital) (Capital Invested) For instance, the economic value added for a firm with a return on capital of 15%, a cost of capital of 10% and $100 million in capital invested would be: Economic Value Added = (15% - 10%) (100) = $5 million A positive economic value added would indicate that a company was earning more than its cost of capital, and the magnitude of the value would indicate how much excess return the firm created over the period. The advantage of this measure over a percentage spread is that it rewards firms that earn high excess returns on large capital investments, which is much more difficult to do.