The continued bull market in the U.S. is directly affecting the wealth of many investors and entrepreneurs in the 1990s. For example, between Jan. 1, 1995 and Dec. 31, 1998 the Dow Jones Industrial Average grew by 139.45%. The Standard & Poor's 500 index grew by 167.65%.

Unfortunately, Canadian investors shared a much lower wealth boost. The Toronto Stock Exchange (TSE) 300 index grew by just 53.93% (an equivalent annual rate of 11%). That's not bad in absolute terms when bank deposit rates are a paltry 3% or so. But it is certainly not as good as the experience south of the border. Neither does it compare well to the expected returns of an equity investor. Moreover, as seen below, this return is a result of excellent performance by a small number of firms. Many Canadian firms continue to destroy shareholder wealth.

Thus, the need for Canadian corporations to create value for shareholders continues to be an important challenge. The continued volatility in the stock market around the earnings news also signifies the severity with which the market is penalizing firms that fail to create value. Additionally, there are increasing indications that value creating firms have recently been the attention of the "buy-and-hold" investors uncomfortable with the valuations of Internet stocks.

In this, our fifth annual survey of the wealth and value creation performance of Canadian companies, we provide evidence of their performance.1 Using a similar methodology described in the Winter 1996 Canadian Investment Review, we document the results based on 452 publicly traded Canadian companies listed on the Toronto Stock Exchange over a four-year period from 1995 to 1998. Our analysis indicates that the stock market on the whole is increasingly recognizing the underlying value creation performance of companies by rewarding value Creators and penalizing value destroyers.

Almost 60% of All Firms Did Not Provide Adequate Returns
We measure the wealth creation performance with the Annual Economic Return (AER) measure. This captures the incremental returns earned by shareholders over and above the return they should have expected given the level of risk.2 The absolute return calculations account for the percentage change in the market value of the common equity of a company, adjusted for dividends and for any new equity that might have been raised during the analysis period. The underlying assumption is that investors would have expected to earn a fair return on both the initial investment and any new equity raised net of dividends received.

A positive AER value indicates that the stock market returns exceeded the shareholders' expected return for the given level of risk, thereby creating incremental wealth. Conversely, negative AER indicates that actual returns were less than shareholders should have expected. As in past years, four-year compounded return performance is presented to focus on the longer-term.

Based on this measure, our results show that only 41% of the 452 companies included in this year's study created shareholder wealth. This means that, on average over the four-year period ending in 1998, almost 60% of all firms did not provide adequate returns to their shareholders (see "Exhibit 1: Top 10 Wealth Creators,").

Leading the pack, up from third place in last year's study, is Ballard Power Systems (with an AER of 116%). The firm's alternative power cell technologies continue to entice investors. The 116% AER for Ballard Power implies that it provided shareholders with a return of 127%, or 116% more than the rate of return (about 11% per year) that should have been expected given the level of risk of owning this common stock.

In second position is Cinar Corporation (84% AER), up from eighth position last year. In third spot, a new addition to the group, is ATI Technologies (72% AER).

Despite the poor average performance, almost all industries had some excellent performers. Exhibit 2 explores the results for the best, the worst and the average four-year AER results for 25 broad industry groupings (see "Exhibit 2: Minimum, Average and Maximum AER by Industry,").

In all industries, except insurance and metals and minerals, there were exceptionally good and extremely poor performers. Thus, although the market is often believed to favour selected industries from time to time, it is clear that there are wealth Creators in each of the industry sectors.

An equally interesting observation is that some firms have been able to generate shareholder wealth in a fairly Consistent manner. For example, in each of the four years of the study, Ballard Power's AER performance ranked in the top 20% of its industry. Exhibit 3 lists 10 other firms that ranked in the top 20% of their respective industries for at least three of the years between 1995 and 1998 (see "Exhibit 4: Consistent Wealth Creators").

More Than Two-Thirds of the Most Prominent Publicly Traded Firms in Canada Destroyed Value
These wealth creation results are based on the AER measure, which may be affected by extraneous macro-economic factors such as interest rates, overall market optimism and investor expectations about the future. Therefore, AER values do not necessarily reflect the ability of current management to create value.

An alternative measure for evaluating the underlying firm's performance is to investigate whether or not management was able to generate a return on invested capital that exceeded the cost of the capital. If that is the case, one can conclude that the economic value created by management was positive. We use this measure to document the value creation performance of our sample firms.

As in past years, we measure value creation by calculating the operating profit (before interest, after tax) to total operating capital employed. We compare this result to the firm's weighted average cost of capital. Thus, firms showing positive Economic Value Creation (EVC) have operating returns that exceed their cost of capital. EVC performance reflects management's combined ability to grow revenue, manage costs (including tax), control working capital, deploy assets prudently and manage the cost of capital.

Over the four years of study, only 146 of the 452 firms were able to create positive economic value, that is they were able to generate sufficient after-tax operating profits to cover the inherent cost of their capital. That means more than two-thirds of the most prominent publicly traded firms in Canada destroyed value.

Of the firms that destroyed value, 166 showed positive "profit." But it was not sufficient to cover the cost of the capital invested in these firms. In fact, the after-tax operating returns to total capital was, on average, 5% less than the cost of capital.

We can try to use this 5% gap to try to explain the lagging performance of the TSE 300 vis-à-vis the U.S. indices by conducting some simple "back-of-the- envelope" estimations. For example, in 1998 the total net operating profit after tax of our sample firms was $31.4 billion. Their market value was $617 billion.3

For a break-even value performance, an additional $28 billion in profits was required to cover the total capital charge (cost of capital x capital employed). We can then estimate the impact of such a potential (hypothetical) improvement on the market value of the sample firms by observing how profitable firms fared.

During the four-year period, the market was valuing a dollar of after-tax profit at 11.5-times for firms with positive profits. If these numbers are taken as an indication of valuation, then the potential increase of $28 billion in after-tax profit can be translated into an increase in the market of all of the sample firms of about $322 billion ($28 billion x 11.5).

That means the market value could have been 52% higher in 1998. Translating this into the TSE 300 equivalent, the TSE 300 would be 52% higher than 6,400 at the end of 1998, or close to 10,000. Clearly, this is a fairly crude estimation. But it may provide a partial explanation of some of the below-U.S. performance of the Canadian stock market.

The Top Three
Ranking our sample firms by their overall value creation performance, the top three value Creators from last year lead the pack again. This year's winner is Cognos Inc., with a return on capital of 62.1% more than the estimated 10% cost of capital. Last year's winner, Hummingbird Communications Inc., finished a close second with an EVC of 57.4%. Sceptre Investment Counsel ranks third again this year with an EVC of 43.3%.

Despite the overall dismal EVC performance of the sample firms, there are companies that outperform in almost every industry. Thus, regardless of the specific dynamics of individual industries, it is clear that some managers can create value, even while (most) others fail. The extremely broad range between the maximum and minimum EVCs by industry confirm the importance of management (see "Exhibit 6: Minimum, Average and Maximum EVC by Industry," below).

In many cases, there is also evidence of value creation dominance by some companies in their respective industries over time. Over the eight-year period ending in 1998, there are a significant number of firms that have Consistently placed in the top 20% of their industry (see "Exhibit 5: Consistent Value Creators").

No less than 18 of the firms in the study have been in the top 20% of their industry for at least six out of the eight years. Some companies, such as Sceptre Investment Counsel, Caldwell Partners and Franco Nevada, have actually led their sectors in all eight periods. Clearly, there are management teams that have found value creating management systems and strategies.4

Losing Tolerance
Considering wealth and value creation results simultaneously is even more illuminating. Over the years, the relationship between internal value creation performance and stock market performance seems to have been converging. Exhibit 7 summarizes the combined AER and EVC results for the last three studies, covering the three overlapping four-year periods between 1993 and 1998 (see "Exhibit 7: Wealth vs. Value Creation Over Three Study Periods").

Value creating firms (those with positive EVC) are shown in the two clusters on the right side of the Exhibit. The first cluster reflects those firms that also created wealth (those with positive AER), while the second cluster reflects those with positive EVC but negative AER.

In the current study (1995-1998) 37 of the 146 firms that created value failed to also generate higher than expected returns for shareholders. Over the years this group has continuously been quite low (6% to 9% of the total sample). This shows that companies that create value also create shareholder wealth.

The left half of Exhibit 7 is even more interesting. Firms in these two groups have Consistently destroyed value. These companies are further sub-divided into those who (in spite of destroying value--negative EVCs) managed to generate high returns for investors and those who destroyed both value and wealth. Curiously, in the study conducted three years ago (1993-1996), there were almost as many firms in each group (31% vs. 30%). In other words, the firms stood an equal chance of doing well in the stock market even though they destroyed value.

However, the recent results (1995-1998) show that firms that destroyed value and were penalized by investors outnumber those that destroyed value and still managed to create shareholder wealth by a margin of three to one (51% vs. 17%). This observation indicates that the market is becoming less and less tolerant of management teams that cannot create value.

In addition, we also created equally weighted portfolios based on the top value creating firm in each of the 25 industries as shown in Exhibit 5. The average AER for the top 25 EVC companies in the 1993-1996 sample during the subsequent year was more than 27%, compared to just over 11% for the total sample. A similar portfolio using the top 25 EVC companies from 1994-1997 resulted in an AER in 1998 of -17.7%, still better than the overall average of -20.3%. These results further indicate that a portfolio of value creating firms seems to generate higher shareholder wealth and that there is a reason for management to focus on shareholder value.

Walking the Walk
It is rare to find a Canadian company which does not explicitly state in its annual report the importance of creating shareholder value. Unfortunately, only about one-third of Canadian corporations seem to "walk the walk."

Our results also indicate that management of value destroying firms can't blame their misfortune on the fact that they belong to a particular industry sector. Clearly there are value Creators in virtually every industry.

The results show that the majority of firms that create value also reward their shareholders with higher than expected gains in wealth, illustrating that the single most important objective of management is to create economic value. Just having a positive bottom line (which ignores the usage of capital) is not sufficient.

The results even suggest that there may be some benefit to monitoring the top value Creators in each industry, since the portfolio containing these firms seems to do well in the years that follow.

Most importantly, however, these latest results show that the market valuation is actually reflecting the underlying value performance, and is not relying as much on promised performance. These results also indicate that a much stronger focus is needed by corporate Canada on creating value if the TSE 300 is to generate returns comparable to those available south of the border. Based on our analysis, if all the firms in our sample created economic value, it could possibly raise the TSE 300 to the 10,000 level.

References
1. Please refer to "Keeping Score," Canadian Investment Review, Summer 1996, p. 19-31, "Updating the Corporate Scorecard," Canadian Investment Review, Winter 1996/97, p. 19-24, "Wealth and Value Creation in Canada," Canadian Investment Review, Fall 1997, p. 24-28 and Fall 1998, p. 24-27. These papers also define and describe the details of the methodology and conceptual issues.

2. In this paper, we estimate the cost of equity capital as the opportunity cost of shareholder investment using the single factor model with Baysian adjustment using the standard Vasicek method.

3. Not surprisingly, given historical multiples, this is a very high valuation.

4. A further analysis of the 109 firms (24%) that created both wealth and value during the 1995-1998 study period shows that these performers Exhibit significantly higher operating margins (1.8-times the rest), and substantially lower financial leverage than their peers (25% lower debt to capital ratio), implying that the cost of capital for the top performers is relatively high since they use less debt than average. The top performers also have slightly higher revenue growth and average working capital turnover.

Vijay Jog is a professor of finance, School of Business, Carleton University in Ottawa. Werner Hofstätter is a principal of the Corporate Renaissance Group in Ottawa and also lectures at Carleton University. Authors are grateful for research assistance provided by Kobana Abukari and Brian Leoni.

For all other exhibits, please refer to the Fall 1999 issue of Canadian Investment Review.