Wall Street is often blamed for reducing corporate managers’ understanding of business to a single, gameable measure of success: quarterly earnings versus analysts’ consensus forecast.

The Making of Modern Corporate Finance: A History of the Ideas and How They Help Build the Wealth of Nations, an upcoming book from Donald H. Chew, Jr., seeks to reshape how many investors think about corporations’ arguably excessive focus on simplistic financial measures. He argues that many executives could learn a few things from private equity.

In this new book, Chew, the current and founding editor of the Journal of Applied Corporate Finance, describes how key innovations in financial theory have influenced real-world practice and contributed to America’s exceptional economic performance over the past several decades. (Full disclosure, his book does explore my own work on high-yield bonds.)

Chew argues that the problem is not that corporations focus on a specific quantitative measure of financial performance. Rather, the trouble is that too many focus on the wrong measure. The chief offender among financial metrics is earnings per share, as identified a half-century ago by Joel Stern in the Financial Analysts Journal article “Earnings per Share Don’t Count.”

One example of value destruction arising from a preoccupation with EPS is when a company increases this metric by borrowing money to acquire a company less profitable than itself. While the acquisition will cause EPS to rise mechanically, it will also reduce the company’s return on capital, one number that does deserve management’s attention.

Chew also suggests that widely diffused share ownership frequently enables managers to focus on the wrong measures of success. When companies have no controlling shareholder or assertive board of directors to keep them attentive to profitability, executives often single-mindedly pursue revenue growth, market share, and diversification, with little regard for shareholder return.

 

CAPITAL EFFICIENCY

According to Chew, the best run public companies are those that have adopted the governance practices of private equity, meaning they are not distracted by quarterly EPS games but are instead focused on employing capital efficiently and generating cash flow. One key to such companies’ success is arguably the emphasis on equity-based compensation, which private equity firms helped popularize beginning in the late 1970s. Tying bonuses to share price appreciation gives managers a direct stake to what should be their true objective: increasing shareholder wealth, not manipulating accounting measures.

Private equity, of course, has received its own share of excoriation by critics of modern corporate practices. And Chew does not dismiss these criticisms. For example, he acknowledges Enron as a rather conspicuous example of the potential downside of equity-oriented compensation plans.

He also cites studies showing harmful consequences of private equity buyouts at non-profit colleges and nursing homes. And he notes the “growing evidence” that PE companies have benefited by taking advantage of “government regulations in ways that turn out to have significant social costs.”

But Chew also cites studies highlighting private equity’s positive effects, most of which have not received a lot of media attention. Such studies have found fewer health violations by private-equity-funded restaurants compared to their publicly traded counterparts and relative declines in workplace injuries at PE-backed companies.

In addition, Chew writes, “PE firms have been shown to be more likely than their public competitors to achieve growth by providing new products and in new geographic markets instead of simply raising prices for consumers.”

Finally, he argues that the architects of leveraged buyouts have exerted a positive influence on corporate finance by emphasizing free cash flow over outdated earnings calculations that mismeasure performance in today’s service-and-technology-oriented economy.

What investors should ultimately take away is that setting quantitative targets – and measuring progress against them – is obviously not an obstacle to good corporate performance. In fact, it is essential.

As the motivational speaker Zig Ziglar said, “If you aim at nothing, you'll hit it every time.” The key for management is to focus on numbers that measure genuine success, which, as Chew suggests, often aren’t the ones America’s public companies are obsessing over today.

The Making of Modern Corporate Finance: A History of the Ideas and How They Help Build the Wealth of Nations by Donald H. Chew, Jr., will be published by Columbia Business School Publishing on February 24.

(Marty Fridson is the founder of FridsonVision High Yield Strategy. He is a past governor of the CFA Institute, consultant to the Federal Reserve Board of Governors, and Special Assistant to the Director for Deferred Compensation, Office of Management and the Budget, The City of New York.)

(Writing by Marty Fridson; Editing by Anna Szymanski.)