Stern Stewart examined the wealth creation performance of 500 listed companies across 20 sectors over a five-year period. Five years were chosen so that the findings would take account of long-term strategy and not be unduly influenced by short-term performance blips or market forces. Companies included in the study had a listing record in either the Bombay Stock Exchange or the National Stock Exchange for a period of at least five years beginning December 1998. Thus, a few big names like i-flex and Bharti Tele-Ventures that were listed after 1998 were not part of the survey. In addition, companies that were classified in the Z category by SEBI at any time during this period, were also excluded from the survey.

What Is Wealth Added?

Wealth added measures the total wealth flow over a given period time (cash flows to the investor through increase in market value of equity, dividends and share buybacks, net of new equity issuances) over and above the investors' expected return on the market value of a company's equity. The most logical proxy for the expected return is the Cost of Equity, which is a function of the risk profile of the company.

Wealth Added is calculated thus:

WAI= Market Cap - Required Return + Dividends - New Equity Issues, where Required Return = Market Cap at beginning of equity x Costof Equity

The Cost of Equity is calculated using the Capital Asset Pricing Model, which is, Re=Rf+b(Rm-Rf), where Rf is the return of the risk-free asset, Rm-Rf is the difference between risk-free return and average market return, and b is the measure of the stock's performance versus the market.

While measuring the Wealth Added, over a multi-year period, the annual wais are aggregated on a time-adjusted basis to arrive at the overall figure (see the table Infosys-Measuring The Wealth Added for an illustrative example).

Over the five-year period, the information technology services company provided a time unadjusted gross return of Rs 30,538 crore to shareholders. This wealth flow came from anincrease in market capitalisation of Rs 30,212 crore and Rs 346 crore paid out in new dividends. These returns were adjusted downwards by Rs 350 crore to factor in shares issued during this period, giving a time unadjusted wealth flow of Rs 30,208 crore.

Next, we calculated the absolute rupee value of the shareholders' required return for Infosys in each year. The shareholders' required return for the year ended December 31, 1999, is calculated as the absolute rupee value of the market equity on December 1998, multiplied by the cost of equity for Infosys for 1998. The same process was repeated each year.

Annual changes in cost of equity are driven primarily by changes in the annual risk-free rate and the market risk premium. The annual Wealth Added over the five period was then adjusted by discounting it at the relevant cost of equity.