May 20, 2014

Return on Capital and Shareholder Return

The market often takes a long time to reward shareholders with a return on stock that corresponds to a company's return on capital. To better understand this statement, it is crucial to separate return on capital from return on stock. Return on capital is a measure of a company's profitability, but return on stock represents a combination of dividends and increases in the stock price (better known as capital gains). The two simple formulas below outline the return calculations in more detail:

Return on Capital: Profit / (Invested Capital) 

Sometimes known as ROIC (Return on Invested Capital)

Return on Stock: Shareholder Total Return = Capital Gains + Dividends
This is measured on capital appreciation from beginning of the year until the end of the year. Example. January 2, 2014 - stock price USD100.00. By December 30, the stock price is USD150.00. [(USD150-USD100)/USD100] That would mean it has given Shareholder return 50%.

The market frequently forgets the important relationship between return on capital and return on stock. A company can earn a high return on capital but shareholders could still suffer if the market price of the stock decreases over the same period. Similarly, a terrible company with a low return on capital may see its stock price increase if the firm performed less terribly than the market had expected. Or maybe the company is currently losing lots of money, but investors have bid up its stock in anticipation of future profits.

In other words, in the short term, there can be a disconnect between how a company performs and how its stock performs. This is because a stock's market price is a function of the market's perception of the value of the future profits a company can create. Sometimes this perception is spot on; sometimes it is way off the mark. But over a longer period of time, the market tends to get it right, and the performance of a company's stock will mirror the performance of the underlying business.

(Source: Morning Star)

Total Shareholder Return and competitiveness
I’d like to start off the series with a look at Total Shareholder Return, or TSR, and its usefulness in helping us measure Shell’s competitiveness and attractiveness to investors. In later installments, I will describe some of the key performance indicators that contribute to it. 

TSR is a measure that combines changes in our share price with the dividends (the ongoing cash “reward” for making an investment - currently $1.68 or around 5% per share per year), and is regarded as the total financial return to the owner of Shell shares.

Calculated over a period of time - usually from one quarter or one year to the next - TSR makes an assumption that shareholders reinvest their dividends in Shell shares. In reality, that may not be the case, but this assumption gives us an easy way to compare ourselves with competitors.

Sometimes people ask me why TSR matters when stock markets seem so unpredictable and our business model depends on solid performance over long periods of time. Well, put simply, TSR reflects all the publicly known information about our company. That includes financial numbers, but also the effects of important news and events, which are mirrored in our share price. As such, TSR becomes the simplest and most important reflection of performance for investors to judge us by. 

Reputation counts
The share price reflects the value that investors believe reflects Shell’s capability to create future returns such as earnings (or profit), cash flows (the amount of money entering and leaving the business), and its dividend payments. In this context, what plays a crucial role is investors’ confidence in Shell’s ability to keep performing into the future. 

Like any other company, Shell’s future value depends on how good we are at extracting value from existing assets and creating new business opportunities. For us, that means delivering new Upstream projects or building new Downstream markets as two examples. But it also depends crucially on our ability to operate existing assets safely and reliably, at a competitive cost. Other important factors are quality of technology and strength of management.

More than ever before, investors are concerned about the challenges our industry faces. These include responsible safety, social and environmental performance, addressing the climate change challenge, gaining access to upstream resources and growing downstream markets. If anybody doubted the value of safety and environmental factors to investors, they would only need to see the effects of the Deepwater Horizon incident on BP.

All these factors contribute to our overall reputation, and all can influence investor confidence. In turn, that influences our share price.

By Simon Henry - Royal Dutch Shell Chief Financial Office.