Thursday, April 20, 2006

WSJ's SmartMoney's Fuzzy Thinking

Efficiency. Effectiveness. Productivity. Oh, what the heck...does it matter which term we use?

Actually, it matters very much. As I first realized ten years ago, when I wrote a paper on the detailed relationships between these terms, their misuse has been the source of much bad thinking and writing in business publications.

This past Thursday, the Wall Street Journal featured its "SmartMoney Stock Screen" on page D3. The subtitle of the boxed piece was, "Efficiency Experts." It discussed how to use and interpret ROE for a company, alternately describing it as "managerial effectiveness," and "how efficiently its managers are using the plants, equipment and other resources...."

Well, it can't be both. So which is it?

I prefer to call ROE a "total factor productivity" measure. It can be deconstructed into labor productivity (Value Added/# Employees), operating efficiency (Net Income/Value Added), and Capital Intensity (# Employees/Equity). The benefit of this decomposition is to provide a view of the resources typically used by any business: people, capital, and expense dollars. Using value added removes the distorting effects of revenue attributed to a business that was, in fact, merely passed through as a purchase from a vendor.

Thus, ROE, or ROI, for that matter, as it was also mentioned in the WSJ article, may be interpreted as both total factor productivity measures, as well as simple equity or capital employed productivity measures.

I have found that efficiency typically refers to inputs. As such, what most economists and business writers call "efficiency," and measure with dollars/input unit, I find more sensibly called "volume efficiency" and measured with units/input unit. How a firm efficiently produces a product or service may be understood irrespective of the market-provided value of that product or service. I find this leads to clearer appreciation of the production efficiency issues typically under consideration when discussing "efficiency."

For labor productivity, I prefer value added divided by the number of employees, as this does provide a valuation measure for an input. The same is true for operating efficiency, which measures the productivity of expense dollars in producing a dollar of net income.

After much thinking and wrestling with the terms I found at hand in 1996, it became clear that more terms were needed, not fewer.

And certainly not a perspective that equates "efficiency" and "effectiveness." Good Lord! Can you get any fuzzier than that?

By the way, as is this deliberate, or, more sadly, unrecognized obfuscation was not sufficient, the writer, Jack Hough, concluded with the comforting sentence, "As always, please remember that stock screens produce research lists, not buy lists." What the heck does that mean? I just wasted my time reading his piece, only to find he really doesn't believe anything he just wrote? That he wants to publish his "research," but for God's sake, don't use it to actually, you know, buy a stock! Just mull it over, and talk about it at your next weekend dinner party.

No wonder the public is better-served by just buying managed funds, rather than individual stocks. With "help" like this, can you blame them?

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