Executives, board members, the press, and investors regularly look at total returns to shareholders (TRS) as an important metric of value creation. Yet TRS, like any performance metric, is instructive only when users understand its components. Actual corporate performance, for example, is only part of the mix, as TRS is also heavily influenced by changes in investors’ expectations of future performance. Sophisticated managers know that a failure to grasp how the various components work together can generate unrealistic expectations among companies or their investors and even steer companies to pursue more growth or take on more risk—without any value creation.

Sadly, most traditional ways of understanding TRS are flawed. Many of them, for example, define TRS as the sum of the percentage change in earnings plus the percentage change in market expectations—as measured by the price-earnings ratio (P/E)—plus the dividend yield. This simplistically connects TRS with changes in earnings, as if all forms of earnings growth created value equally. Not so. Earnings growth creates more value when it is rooted in activities that generate high returns on capital—such as the discovery of new customer segments for a company’s products—than in activities with low returns on capital, such as many acquisitions...