McKinsey: What led Lloyds TSB to focus on shareholder value as its core measure of performance?

Pitman: It started with some interesting philosophical discussions that I had with the board just after becoming chief executive of Lloyds in 1983. At that time, we had all the usual motherhood objectives about being good to shareholders, good to staff, and good corporate citizens. However, these fine aspirations had no impact whatsoever on our performance. So we decided to ask ourselves what our goals should be.

I conducted a survey of our general managers, and they all told me how successful we were. But I informed them that at least one group of people did not agree: our shareholders. You only had to look at our share price, which was below our net asset value, as it was for most banks at that time.

I felt that unless we had a clear understanding of what we were trying to achieve, we couldn’t establish the right performance measures. So we had several discussions on the board about what constituted success, and whether we needed several objectives or just one. It was important to have that debate; some companies never do.

We decided we would adopt a single objective: to double shareholder value every three years. Of course, we still had to improve customer satisfaction, motivate employees, and so on, but these things were means to an end, not an end in themselves.

How did you translate this objective into a real measure?

It was a gradual process. In the mid-1980s, we were earning a return on equity of about 12 percent. We believed we needed to earn 10 percent above the rate of inflation. But a board member from Shell pointed out that what we really had to do was earn a return in excess of our cost of equity. The trouble was, no one had the faintest idea what our cost of equity was.

The search was on. All the executives came up with their own notions of what our cost of equity was, and over the next few months I had every financial theory under the sun thrown at me. What we discovered wasn’t good news. However we calculated it, our cost of equity came to between 17 and 19 percent after tax. To make life simple, we agreed, in the British spirit of compromise, to accept 18 percent.

But the exact figure wasn’t the issue. What really mattered was the realization that the cost of equity in banking was way above the average for companies in the FTSE index. That made us think that if any part of our business was not earning a return of over 18 percent after tax, it might be a candidate for special treatment, and perhaps divestment.

A lot of people in the organization tried to rubbish this idea. They accused us of short-termism and warned us that we would have nothing left if we went down this road. You have to remember that in the mid-1980s, hardly any banks in the world—and very few companies of any kind in Britain—were using cost of equity. It was suspected of being a management fad.

Who was involved in these debates—just the board, or other senior managers throughout the organization?

It started in the executive committee, with eight or so top managers, but since they didn’t know the answer, they asked their people. Some had been to business school and had heard of cost of equity. The discussion opened up; anyone could ask anyone else. Then it spread to other companies, and we found a few that were well ahead in understanding this concept.

Shell was one of them. It had to know about the cost of equity because it was always making long-term investments, and needed some kind of measuring rod for people to use when they made decisions.

Once everyone realized what an impact cost of equity was going to have, people who were earning 8 percent after tax in their particular segment suddenly sat up and took notice. Less than half of our businesses earned more than 18 percent after tax at that time. It became clear that the easiest way to raise our return on equity, long before we started to improve strategy, would be to get rid of underperforming businesses.

Once senior management had agreed on cost of equity, how did you make sure the rest of the organization knew about it?

We introduced new performance measures. Every business had to show what return it was earning in excess of the cost of equity. Quite a few people got shivers down their spines when they had to confess to a negative figure. They came up with forecasts showing that it wouldn’t be long before they were earning more than the cost of equity, and produced strategies for turning a dud business into a shining star. But if we discounted the figures back, they got a big shock.

We said, "OK, so you will be earning above the cost of equity in year 7. Let’s just discount these cashflows back over a seven-year period to see whether this has a net present value or not."

We had never used net present value before. When we did, we saw that producing profits seven years out discounted back at 18 percent cost of equity was totally unrealistic. They would never manage it.

So we said, "You must be joking. What magic are you going to perform to double your profits every year for the next seven years?"

These methods helped the organization develop discipline and logic. And when we started in 1985 to dispose of businesses to show that we meant what we said, our share price went up.

After a year or two, we began to see that there was a way to reduce the cost of equity so that we didn’t have to earn more than 18 percent after tax to make a profit. The thing to do was to dispose of the businesses that the market perceived as particularly risky. This solution got an enthusiastic reception, because it offered a lifeline: businesses that were under the water at 18 percent might not be if we got the cost of equity down to 15 percent.

Once we started to get the cost of equity down and the return on equity up, the share price began to move. We were taking actions ahead of the market, before other people, and there is nothing like success for getting people to sign up and take part in what you are trying to accomplish.

We then went through a further period of learning as we caught on to the concept of creating shareholder value—another great discovery. Instead of focusing on internal returns, we began to look outside. As soon as we could calculate total shareholder returns, we started to publish them in our annual report and accounts. For the past five years, we have been able to say, "We have created this amount of value, and it puts us among the best financial services companies in the world."

What employee incentives did you use to reinforce your new focus?

We introduced performance-related pay in 1984 for top management. If we set the right kind of goals, we thought, we could change behavior.

One man in the top management team came to me and said he didn’t want to join the new scheme. He had only three years to go before he retired, and he had worked out how much pension he would get if his pay rose by the rate of inflation over that period. He preferred knowing he would get what was a static amount in real terms to the possibility of making more money through a scheme that carried some degree of risk.

I told him that if he felt like that, we couldn’t have him on the top team. If he thought the best he could hope for was to stay still, he didn’t belong. In the end, he agreed to join the scheme.

That incident taught me a lesson. Even at the top of the organization, we had someone who craved certainty. When we introduced the scheme to the next group of employees, many might worry about the new value system we were adopting, and fear they were at risk.

Before, there had been a kind of egalitarianism—a belief that everyone would get the same pay rise no matter what their performance. But as cost of equity began to sink in, behavior started to change at the top. When we introduced performance-related pay for general managers, we used the phrase "head and shoulders above the rest." I was willing to accept that 20 percent of general managers could be outstanding, but no more. The interesting thing was that people knew when they were not head and shoulders above their peers, and everyone agreed which managers were.

When did you move to the goal of doubling market value every three years?

We had a discussion where we used the expression "to be the best and most successful company in the financial services industry." That was our vision. But the board said, "Well, that’s a wonderful statement, but what does it mean?" We didn’t have an answer, so we had to find out.

We started by comparing ourselves with British financial services companies, but the board wouldn’t have it. Being the best would be too easy in this field, they thought. So we resorted to the most admired American companies. Identifying them was no problem, but it was hard to tell what made them special. After a while, we discovered that they focused on shareholder value, and that the best among them doubled their value every three years.

That was when we moved from quoting total shareholder return to seeing how long it took to double the value of the company. Studying the Americans confirmed our impression that if you were the best at creating value for shareholders, you were also the best at attracting capital, satisfying customers, and looking after your people. And understanding the driving force behind these companies led us to the idea of trying to match the best in the world.

So we went back to the board and said, "We know what the best is, we can define it, and we can measure it, so that every year we know whether we are up with the best in the world at creating value for shareholders." And the board bought it.

Does being the best always mean being a market leader?

Oh yes; we don’t want to be in a market unless we can be a leader.

Again, we went to great lengths to define what we mean by leadership. Having the biggest market share doesn’t necessarily make you a leader; it simply means you have more customers. The hallmark of leadership is earn-ing a much higher return on capital than the average for the industry. I could show you quite a few businesses where the market as a whole is not particularly attractive, but the leaders earn high returns.

The financial services industry has the image of being terribly unambitious; by comparison with, say, car makers, we seem babes in arms. But competition is coming now that the people who manage the businesses are becoming more ambitious for their companies. There is a strong belief here that we have to get ready for the next wave and lead the competition, not follow.

What part do acquisitions play in this?

What we are trying to do all the time at group level is to upset the competitive equilibrium in our favor. Clearly, if you can use an acquisition to get you to the top of the pile, you are doing just that.

When we acquired C&G, I said it would change the game in mortgages in this country, and it did. I knew we were going to be the lowest-cost producer in the United Kingdom, and we could make price promises that we never could before and give them absolute hell in the mortgage market. It wasn’t long before other societies converted, and now 70 percent of the market is in banks rather than mutuals.

So we are constantly striving not only to improve our competitive position, but also to make life hard for our competitors, which is different.

How do you keep up the momentum of doubling market value? Does it ever get out of control?

Quite honestly, you can turn it on its head. By that, I mean that you can use shareholder value as a way of raising management performance. Far from it getting harder, because of the radical steps we took to get where we are now, we are actually more prepared for change, and in a better position to go on beating the competition.

If your costs per unit are quite a lot better than the industry average, as ours are, you have more choices open to you. You can decide to be exceptionally aggressive on price, to make competitors scream for mercy. That’s an obvious strategy, but not one you can follow unless you have got the lowest costs. Yet I have seen high-cost producers try to start a price battle in this country; they obviously don’t understand business at all. If you want to kill yourself as a high-cost producer, start a price battle, because it’s the last thing you want.

Similarly, acquiring more and more customers gives you a competitive advantage. If your market share increases, your cost per unit is likely to fall. So being ahead actually makes things easier; it forces you to take action before the competition. I think some of our competitors would have to divest thousands of people to get level with us now.

Do you think a time will come when Lloyds TSB has to look outside the financial services industry for growth?

Financial services is a growth market—that’s one of the best things about it. I believe it will continue to grow, and we are as well placed as anyone in the world to participate in that growth.

Although we are great ones for sticking to our knitting, you can’t define your ambitions too narrowly, or you will miss opportunities. We were the first bank to buy a life company, for instance. Insurance represented a tiny slice of our profits a few years ago; now it represents a big chunk. Mortgages are the same.

We could see that banking, defined as taking in deposits and granting loans, was not going to be the business of the future. It was too commoditized. But we think financial services will be the business of the future.

We are willing to go on changing in order to double the value of the company—to stretch ourselves beyond the things we are doing at the moment. Since we believe in understanding what we are doing, and doing it better than anybody else, we are not about to buy a dairy. But I think the definition of financial services is expanding the whole time. To some extent, you make these decisions yourself.

Companies making good profits from markets they know are sometimes reluctant to invest in new businesses that offer much lower returns. How do you deal with that problem?

One of the messages I try to convey is that there are only two things that stop us doing new things: a lack of ideas, or a lack of courage. I don’t know any truly outstanding business that hasn’t had to take big risks in order to get where it is. People who aren’t willing to take risks should realize that there’s no such thing as a risk-free future. You take an enormous risk by not doing something. In a rapidly changing world, thinking that you have the formula, that all you have to do is sit tight and do nothing, won’t get you very far.

Most of the companies I have known as a banker have at one stage or other been at breaking point. They are in a terrible mess, they may go broke, they don’t know if they can survive. Often, it is the making of them. How many people have gone bankrupt, learned from the experience, and built another business?

If you get to the stage in a big business where you are scared to get your feet out of the warm, comfortable water here because it looks a bit icy over there, you are in trouble.

One thing you always have to watch out for is that somebody else might upset the competitive equilibrium for you. You can sit in your wonderful planning office and imagine you control the world, but somewhere out there, someone is scheming to do something that could make you most unhappy. So you must have the spirit that you will take risks, you will get it wrong sometimes, you will fail sometimes.

If your organization believes in this style of management, you pick yourselves up and say, "We all believed in it, we were not successful, we have learned something from the experience, and next time we will get it right."

Do you think your hard economic measures help you to be more creative?

Absolutely. That’s why I say we use shareholder value to raise management performance, rather than the other way around. We use shareholder value as a way of spurring new ideas. There is no way you can carry on doubling the value of a company every three years unless you have bags of ideas.