Here is an excerpt from an article written by Sree Ramaswamy, Michael Birshan, James Manyika, Jacques Bughin, and Jonathan Woetzel for the McKinsey Quarterly, published by McKinsey & Company. To read the complete article, check out others, learn more about the firm, and sign up for email alerts, please click here.
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Among the world’s largest companies, economic profit is distributed unequally along a power curve, with the top 10 percent of firms capturing 80 percent of positive economic profit.
To understand company dynamics better, we analyzed 5,750 of the world’s largest public and private companies, each with annual revenues greater than $1 billion. Together, they made up 65 percent of global corporate pretax earnings (earnings before interest, taxes, depreciation, and amortization) from 1994 to 2016. Our metric for superstar companies is economic profit, a measure of a company’s invested capital times its return above its weighted cost of capital. We focus on economic profit because it reflects the economic value created by a company’s operating activities and investments.
Among the world’s largest companies, as prior McKinsey research has shown, economic profit is distributed unequally along a power curve, with the top 10 percent of companies capturing 80 percent of positive economic profit. The middle 60 percent of companies record near-zero economic profit on average, showing how hard it can be to defy market forces. The bottom 10 percent destroy as much value as superstars create. We label companies in the top 10 percent as superstar companies. These companies come from all regions and sectors and include global banks and manufacturing companies, long-standing Western consumer brands, and fast-growing US and Chinese tech companies. The top 1 percent of these superstar companies, those creating the highest economic value, account for 36 percent of all positive economic profit among large companies.
Part 1
The superstar effect is real
The distribution of economic profit along the power curve has gotten more skewed over the past 20 years. After adjusting for inflation, today’s superstar companies have 1.6 times more economic profit, on average, than the superstar companies of 20 years ago. It is not just economic profit that qualifies these companies as superstars: they are among the world’s most sought-after employers, most valuable brands, and most valuable equity listings.
As economic profits grow larger, so do economic losses at the other end of the distribution. The bottom 10 percent of companies destroy as much value as the top 10 percent create, and today’s bottom-decile companies have 1.5 times more economic loss, on average, than their counterparts of 20 years ago (Exhibit 1). That means for every company that creates economic value, there is another company that destroys economic value. Yet these value-destroying companies continue to survive, holding on to their resources for increasingly longer durations and continuing to attract capital. A growing number are turning into “zombie” companies, unable to generate enough cash flow even to sustain interest payments on their debts. The impact of these economic losses goes beyond these companies’ investors, managers, and workers: it drives down the returns for healthy companies that compete for the same resources or profits.
For the vast majority of the world’s largest companies, those making up the middle 60 percent of the power curve, economic profit is hard to retain. They record near-zero economic profit, on average. For these companies, market forces are powerful constraints on creating and retaining value, forcing them to compete away whatever advantages they may have in the marketplace. For the average company, the skew of economic profit means that it becomes relatively more painful to be in the middle of the pack, and strategy becomes even more relevant.
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Here is a direct link to the complete article.
Sree Ramaswamy is a partner of the McKinsey Global Institute, where James Manyika is chairman and director and Jacques Bughin and Jonathan Woetzel are directors. Michael Birshan is a senior partner in McKinsey’s London office.