End the Religion of ROE

1:51 PM Thursday October 20, 2011 by Chris Meyer & Julia Kirby

There is no more powerful question in a U.S. corporation than "what's the ROE on that?" Social media spending? Wellness checkups? Better working conditions? Return-on-equity hurdles threaten them all. Conversely, why market cigarettes? ROE justifies the means. We think there's more to business success and that something as straightforward as a simple equation could put capitalism on a better path. To an extent not widely recognized, it was an equation in the first place that gave ROE the power to dominate not just investment decisions, but an entire business culture. A hundred years ago, the focus on squeezing every drop of return out of equity capital made great sense. As the industrial revolution progressed, society was enjoying enormous benefits from mass production, which brought former luxuries within middle class reach. Just as electronic commerce would later sweep business, mass production came to one industry after another. But unlike websites, factories were capital intensive. The revolution ran on equity capital, which was in short supply. Anyone would have concluded that allocating capital according to expected return on equity would be optimal for growth. The ability to do that rose to a new level in 1917, when General Motors was in financial difficulty and DuPont took a major position in the company. (GM represented an important channel for Dupont's lacquer, artificial leather, and other products, and Pierre du Pont was on GM's Board.) DuPont sent Donaldson Brown, a promising engineer-turned-finance staffer, to Detroit to sort things out, and sort them out he did. Brown noted a simple fact: Return on equity can be broken down into a three-part equation. It is logically the product of return on sales times the ratio of sales to assets times the ratio of assets to equity. By parsing ROE into the DuPont Equation (very rapidly to become a business school mainstay), he provided the basis for organizations divided into functions with their own objectives. He reasoned that if marketers worked on maximizing return on sales, production managers were rewarded for the sales they squeezed out of their physical plant, and finance managers focused on minimizing the amount of equity capital they needed, ROE would take care of itself. Thus Brown not only sowed the seeds of the today's hated silos, he also set three "runaways" in motion. That is to say, he created objectives with such strong feedback loops that they were pursued single-mindedly, even to unhealthy excess. Biologists use the term "runaway" to describe what happens when a single criterion dominates the mating choices of a species to the exclusion of other valuable traits. Among peacocks, large tails so charm the peahens that the male tail has grown to the point where the males are stressed by the nutritional burdens of growing and carrying the stupendous appendage, and are more subject to predation because of its weight. Even as the population of peacocks declines, peahens persist in their preferences. Runaway feedback reduces the fitness of the species. (And here's a simpler version, courtesy of lab experiments in the 1950s: given a lever to stimulate the pleasure centers in their brains, rats will allow themselves to die of starvation and exhaustion. The feedback from pressing the lever overwhelms the positive sensation they would experience from eat or sleep.) In the case of ROE, spurred on by the DuPont equation, society came to suffer from similarly entrenched corporate runaways. In their pursuit of margin, marketers sought market power even to the point of monopoly, requiring antitrust laws to cry stop at the last moment of the end game. Similarly, production engineers treated their factories royally and their labor as expendable, until unions and labor laws intervened. Financial managers, supported by their bankers, increased their debt-to-equity ratios until capital requirements were imposedoops, we mean until there was a catastrophic financial crash and a depression. Then banking regulations were imposed. (Apparently unconvinced of the causal link, in the 1980s we re-ran the experiment. Once again, stimulating the financial pleasure center proved irresistible and near-fatal.)

The lesson: Return on Equity, like peacock tail splendor, is a very poor guide for allocating resources. It fails for two reasons. First, fixating on ROE fails to maximize the benefit of business to society because it measures value in terms of returns to only one stakeholder; second, it allocates human resources as if maximizing the efficiency of financial capital were critical to growth of social welfare. So it's time to address our measurement system seriously at the firm level. It would help to have a new equivalent of the DuPont Equation that propels individuals and organizations forward just as powerfully but does not send capitalism off the rails. What might that look like? Most fundamentally, the objective of business must be broadened beyond ROE. Structurally, too narrow an objective function leads to runaways, in particular the fetishizing of financial return and measurements. And functionally, there is no longer a need to ration financial resources; there's more money available than can be productively investedwhich is why the financial industry is only minimally about investing, and all about flipping, swapping, hedging, engineering, and other forms of lever-pressing. Instead, the measure of value creation should take into account the benefits perceived by all stakeholders, not just equity holders. (Note that this means accounting for negative externalities like health effects on neighboring populations, as well as positive ones like contributions to education.) In addition, the measures should be broad enough to take into account variations in valuation around the world. As Richard Dickinson and Kate Pickett show in Spirit Level, a value like equality, for example, is prized more highly in Norway than in the U.S. And in terms of its effects on managerial decision-making, the new system should create feedback and incentives that nudge managers toward innovating for tomorrow's world, not optimizing for today's. When ROE holds sway, a more or less certain return on a cost-reduction investment nearly always trumps a speculative bet on a new business model. That only makes sense if you are operating in a state of equilibriumwhich might have been close enough to the truth in some sepia-toned time. Now we need managers to shift from a mindset of optimizing an equilibrium to adapting to and capitalizing on a dynamic business ecology. New measures can help reverse that priority, creating incentive systems that encourage enterprises to invest in the growth of their ecologies. So here's our candidate: we believe that corporations would do better for all their stakeholders and avoid the risks of runaways by focusing on Return on Innovation. An innovation-based measure would lead to an acceleration in investment with positive benefits for growth. A new DuPont equation would measure the growth in value created by innovation (and again, that is value defined broadly). And like the original, NuDu would decompose this measure into three components:

The value of an organization's innovation per person affected

The number of people affected by an innovation

The frequency with which the entity innovates

Arithmetically, that's equivalent to saying:

(http://blogs.hbr.org/hbr/meyer-kirby/assets_c/2011/10/equation-1224.html) How does this guide decisions and actions in a different way? First, by stressing that the point is innovation. A dynamic
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economy requires growing companiesthose that increase their value-added contribution over time. To maximize this, a company should prioritize the innovation that leads to the greatest value. That value must be measured across all stakeholders. Second, an innovation should have the widest possible market. As the late C. K. Prahalad pointed out, the "bottom of the pyramid" is a market and not a social problem. In a recent talk at MIT, Infosys founder Narayana Murthy put it this way: "Technological innovation is all about reducing cost, reducing cycle time, making life more comfortable. Therefore: who needs new technology more than the poor? And third, the battleground of competitiveness now goes beyond time to market, to include the frequency with which a firm brings valuable innovations to market. GE, by creating independent local development teams, is adding to the diversity of ideas and the opportunity to recombine them, and hence the likelihood of having innovations to bring to market more often. "More products at more pricepoints" is their name for this strategy. Looking at Apple, you'd conclude it had been using this equation for a long time. It has focused on building an ecology, earning its fair share of the rewards but leaving plenty for others who can earn them (at the expense of those who have historically extracted margin from market power by restricting the market). Apple's offers are more highly valued than its competitors ' largely for intangible reasons ranging from design to sustainable disposability and have extremely broad appeal globally. And it has brought true innovation to market more frequently than perhaps any other consumer products company ever. If our new feedback loop were put in place, managers would take seriously the objectives it targeted and start trying to make themselves as good by that standard. Enterprises and this formula applies equally to businesses, government agencies, and NGOs would find ways to organize around its components. It's impossible to imagine all the ramifications when even superficial incentives are changed, and therefore even as we propose this change we don't pretend to know what unintended consequences it might cause for companies and society. After all, ROE was a good thing for decades, until it wasn't. Measurement systems first educate people on what's valuable, then enlist them in figuring out unanticipated ways of creating that value, and finally degenerate into mindless games played for artificial advantage. Could this happen to measurement system based on growth of value for all stakeholders through innovation? Absolutely. But it will buy capitalism a lot of time to figure those out in the meantime.

CHRIS MEYER & JULIA KIRBY

Chris Meyer's mission is to anticipate and shape the future of business. Julia Kirby is a senior editor at Harvard Business Review.

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