Exhaustive research shows that profit and revenue don’t actually predict stock price, but some other, little-used metrics do.
A new study provides perhaps the strongest evidence to date that certain human-capital metrics can predict a company’s performance in the stock markets.
The research was nothing if not robust. Through extensive use of regression analysis, it tested the relationships between a set of human-capital metrics and stock-price movements at 22,100 companies over a 16-year period, 1996 through 2011.
A key finding of the study – performed by Jeff Higgins, CEO of the Human Capital Management Institute, and Pepperdine University professor Donald Atwater – may surprise investors, stock analysts and finance executives themselves.
Generally speaking, a company’s net income and to a lesser extent revenue are considered the gold standards for shaping expectations of its stock’s future performance. But the research found net income per full-time-equivalent employee (FTE) and net revenue per FTE – both commonly used financial metrics – to be the poorest predictors among the studied human-capital metrics. In fact, both are statistically insignificant, as is pure net profit without association with any human-capital metrics.
Instead, two metrics used by some human-capital analysts, but few other people, are powerful predictors of stock price, the research found. One, called “Return on Human Capital Investment” (Return on HCI), compares “Total Cost of Workforce” (TCOW) to net operating profit. (TCOW includes: all direct and indirect cash or equity compensation for employees and contingent workers; paid employee benefits, perks and rewards; retirement-related costs for both current and former employees; and costs for worker training, recruiting, employee relations, and severance and legal settlements.)
The other highly predictive metric is “Human Capital ROI Ratio.” It measures the ratio of return on revenue (net of non-workforce expenses) to TCOW. For example, say a company has $1 billion in revenue and $800 million in total expenses, $500 million of which are people costs. To arrive at HC ROI ratio, subtract the $300 million nonpeople costs from revenue, leaving $700 million, and divide that by the $500 million in people costs.
In essence, the two metrics are different ways of measuring the percentage return on $1 invested in the work force, assuming all other factors remain constant. In the above example for Human Capital ROI Ratio, the result is expressed as 1.40, or a 40-cents positive return on the invested dollar.
Less predictive than those two metrics, but still statistically significant, are TCOW as a percentage of operating expenses and as a percentage of revenue.
“Everyone thinks net profit drives stock price,” says Higgins, a former CFO, “and in my old finance world I thought so too. But what really drives stock price is productivity. Some might say Return on HCI and Human Capital ROI Ratio are synthetic profit metrics, but we see them as productivity metrics – the return on people’s productivity. And when those numbers improve, your stock price jumps.”