Earlier McKinsey research¹ has explored how investors can assess a company by examining its past performance and its health—that is, its ability to sustain performance over the long run. In an ideal world, we would need only to examine a company's stock market performance to see how well it was doing. Yet this third measure is anything but easy to interpret.

The most common approach to measuring a company's stock market performance is to calculate its total returns to shareholders (TRS)² over time. This approach has severe limitations, however, because over short periods TRS embodies changes in expectations about a company's future performance more so than its actual underlying performance and health. Companies that consistently meet high performance standards can thus find it hard to deliver high TRS: the market may think that management is doing an outstanding job, but this belief has already been factored into share prices.

One way to understand the problem is by way of analogy with a treadmill whose speed represents the expectations of future performance implicit in a company's share price. If managers exceed them, the market not only raises the share price but also accelerates the treadmill. As the company's performance...