Business owners raise funds by inviting venture capital and private equity investments. Venture capitalists and private equity firms want to predict their return on investment, so they will calculate your company’s TSR (total shareholder return).
As a business owner, you must understand TSR and how it matters.
Total Shareholder Return Explained
TSR helps gauge a company’s financial performance (corporate performance) by indicating the overall returns an investor earns from the shares of the company’s stock. So, it is also a measure to evaluate the performance of an investment from the investor’s perspective.
TSR also comprises a set of metrics used by management to run the company while maximizing its short- and long-term value creation.
It is beneficial in analyzing venture capital and private equity investments, which involve multiple cash investments over the life of the business and a single cash outflow at the end via a sale or an initial public offering (IPO).
Calculating Total Shareholder Return
TSR is expressed as a percentage: it is the total of what the investors have received from a company’s stock. It factors in the capital gains (current share price less the purchase price of the shares) and dividends the company has paid its investors over the shareholding period of the investors in question. It may also include warrants, stock splits, special distributions, and other corporate actions that have impacted the investors’ gains.
TSR = ((Current Price Per Share – Purchase Price Per Share) + Dividend Per Share received / Purchase Price Per Share) Ã— 100
So, to calculate TSR, subtract a stock’s current price per share from the purchase price per share paid by the investor. Add the amount received as a dividend per share and any other special distributions or payouts, such as the stock buyback amount per share. Divide this total by the stock’s purchase price per share, then multiply it by 100 to get a percentage figure for the total shareholder return.
A hypothetical example to understand the TSR calculation:
Suppose an investor invested $5,000 three years ago and bought 500 shares of a company’s stock at $10 per share. The investor still owns the stock. And it is currently trading at $14 per share. The company has paid a total of $2.50 in dividends per share during the investor’s holding period.
So, what is the TSR over those three years for the investor?
It can be calculated as:
$14 – $10 (current share price – original purchase price) = 4
plus $2.50 (the amount of dividends per share received) = 6.5
divided by $10 (original per share purchase price) = .65
multplied by 100 to get a percentage = 65%
Therefore, the TSR would be 65%. As an equation:
TSR = (($14 – $10) + $2.50) Ã· $10 = .65 Ã— 100 = 65%
If you do not prefer TSR as a percentage, you may calculate the Stock return cash value by doing just the first two steps and show $6.50 per share as your total shareholder return.
Why Does Total Shareholder Return Matter?
Total shareholder return is an excellent indicator of corporate success, as it represents the overall financial benefits generated for stockholders. TSR reveals how the market evaluates a company’s overall performance over a specific period. One of the primary goals of every business is to increase value for its shareholders.
TSR helps achieve this by serving as a system of management to create value. There are many ways to start working with this system and maximize value creation.
Suppose company management aims to return to industry-leading performance and valuation, achieve a strategic distinction, and improve the companyâ€™s resource allocation. They could change the company’s top-tier metrics and incentive compensation to achieve those goals. For example, they could add TSR to the scorecard and link the pay rates for their top 50 executives to TSR. Or, the management team could incorporate new organizational behaviors, performance goals, management processes, and strategies.
Managing for top-tier TSR is a powerful approach that can create and sustain a high-performance company with accelerating growth. Such a company attracts highly motivated stakeholders and employees.
Connect with our best-in-class advisory team to understand more about managing for top-tier TSR.
TSR also has certain limitations:
- TSR is a measure to calculate corporate performance at the overall level for publicly traded companies, not at divisional levels.
- TSR calculates the overall returns on the investor’s investment only when investments come with one or more cash inflows after purchase.
- TSR focuses externally and reflects business performance from the market’s viewpoint. So, any sharp, short-term drop in share price for any reason (negative publicity or quirky stock market sentiment/behavior) negatively impacts TSR.
- TSR does not measure the investment size or its return, which means TSR may favor investments with high rates of return, even when they offer a smaller dollar amount. For instance, a $5 investment returning $15 has a higher TSR than a $10 million investment returning $20 million.
- TSR is not a useful measure to calculate overall returns on an investment that generates interim cash flows.
- TSR does not factor in the cost of capital and is not used to compare investments over different periods.
From an investor’s perspective, total shareholder return (TSR) helps determine the overall returns from an investment. It reveals how much the investor has earned from the invested capital within a specific period. It considers both the appreciation in share price and the dividends received on those shares. Although it has certain limitations like any other financial metric, it shows a complete picture of the return on investment, rather than only revealing the gain in the stock price.
From the business owner’s perspective, TSR acts as an essential metric to maximize value creation. By managing for top-tier TSR, corporate executives can achieve industry-leading performance and valuation.