The accurate measurement of company performance is the foundation of corporate governance and compensation planning. Yet despite its importance, performance measurement is poorly understood. Many people believe that total returns to shareholders (TRS)—that is, share price appreciation plus dividends—is the cleanest way to measure performance. Though TRS has many merits, we believe that it cannot be uniformly applied to all companies in all situations. Incorrectly used, as it often is, it can give rise to misunderstandings about performance that in turn distort management incentives, lead to bad decisions, and alienate outstanding managers.

The analysis of corporate performance cannot be boiled down to a single number, although it can be a systematic and rigorous process. It should consider the financial market's assessment of a company (which includes but goes beyond TRS), the company's underlying performance, and its expected future performance as reflected in its market value. When a company has taken all of these elements fully into account, it can proceed to build a solid foundation for the governance and compensation decisions that are so critical to success.

The flaws in TRS

Any performance measure must incorporate a company's share price performance. If they do nothing else, investors will look...