Human metrics best predictors of stock price activity

Human metrics

Photo courtesy of Randy Le’Moine Photography on Flickr.

Rob Swystun, Pristine Advisers

What are the metrics that best determine how well stock price will perform?

If you said net income and revenue, then you’d be with the majority but you would also be wrong. At least, according to a study performed by Jeff Higgins, CEO of the Human Capital Management Institute, and Pepperdine University professor Donald Atwater.

Their study, published as the white paper Linking Human Capital to Business Performance, found that human-capital metrics actually predict a company’s stock performance and stock price best.

The study used regression analysis to look at the relationships between a set of six human capital metrics and stock price movements for 22,100 companies from 1996 – 2011.

Among the human capital metrics studied, net income per full-time-equivalent employee (FTE) and net revenue per FTE turned out to be the poorest predictors of stock price performance, both being statistically insignificant.

The two human-capital metrics that were the best at predicting stock price performance were Return on Human Capital Investment (Return on HCI) and Human Capital ROI Ratio (HCRR).

Return on HCI

Return on HCI compares Total Cost of Workforce (TCOW) to net operating profit.

And what does TCOW include?

  • All direct and indirect cash or equity compensation for employees and contingent workers
  • Paid employee benefits, perks and rewards
  • Retirement-related costs for both current and former employees
  • Costs for worker training, recruiting, employee relations, and severance and legal settlements

Human Capital ROI Ratio

HCRR, on the other hand, measures the ratio of return on revenue (net of non-workforce expenses) to TCOW.

Using some nice, round numbers, let’s take a look at an example of this. A company has $1 billion in revenue and $800 million in total expenses. $500 million of those total expenses are costs related to the organization’s people. To get the HCRR, subtract the $300 million of non-people-related costs from the revenue. This leaves $7 million. Then take that and divide it by the $500 million in people-related costs. This leaves us with 1.40.

But what does that 1.40 mean?

It’s a percentage return on $1 invested in the workforce (assuming that all other factors remain constant). So you can read the 1.40 as 40 cents of positive return on an invested dollar.

Other metrics that are less predictive than those two but still statistically significant are TCOW as a percentage of operating expenses and as a percentage of revenue.

“Everyone thinks net profit drives stock price,” says Higgins, who is also a former CFO, “and in my old finance world I thought so too. But what really drives stock price is productivity. Some might say Return on HCI and Human Capital ROI Ratio are synthetic profit metrics, but we see them as productivity metrics – the return on people’s productivity. And when those numbers improve, your stock price jumps.”

So just how accurate are these metrics?

A 10% gain in the three most predictive human-capital metrics — those being: Return on HCI, HCRR and TCOW as a percentage of operating expense — meant stock price rose by 5.73% on average. A 10% jump in net income, on the other hand, was associated with a stock-price increase of just 0.8%.

For every 10% gain in human capital metrics, stock prices rose (or fell as in the last case) in the following industries by the following amounts:

  • Wholesale Trade – 29.6%
  • Finance & Insurance – 9.6%
  • Arts & Entertainment – 8.8%
  • Manufacturing – 7.5%
  • Admin Support, Waste Management – 5.3%
  • Transportation/Warehouse – 3.3%
  • Accommodation & Food Services 2.5%
  • Mining – 2%
  • Professional & Technical Services – 1.6%
  • Real Estate – 1.4%
  • Healthcare – 0.6%
  • Utilities – -0.7%

In the financial services sector, those three human-capital metrics taken together were almost eight times more predictive of stock price movement than net income. In the transportation and warehouse sector, the predictability of those three metrics were 2.53 times more significant than either profit or revenue per FTE.

In fact, good performance in profit or revenue per FTE can actually hide bad results. Median revenue per FTE climbed by 21.8% over the study period in the investment banking sector (a sub-sector of the finance & insurance sector). But the median HCRR dropped by 29% and TCOW inflated by 47.5%, negatively affecting investment banks’ share prices.

Those results indicate that fewer high-earning employees are getting paid an increasingly larger share of industry revenue, Higgins says. He also notes that it calls into question whether investment-bank shareholders have been properly rewarded for their investments.

Obviously there are myriad reasons behind the rise and fall of stock prices. These can including macroeconomic reasons that aren’t even under a company’s control. In addition to net income for each company, variables controlled for by regression analyses in the study included:

  • real gross domestic product,
  • bank prime loan rate,
  • actual vs. natural unemployment rate,
  • producer price index,
  • consumer price index,
  • industrial production index
  • and the S&P 500 index.

The study found that even after controlling for those variables, human-capital metrics had significant predictive capability.

And when the researchers combined these factors plus the three most predictive human capital metrics of Return on HCI, HCRR and TCOW as a percentage of operating expense, they found that they could explain between 35 – 64% of movements in stock price depending on industry sector.

By comparison, net profit alone, meaning without any connection to any human-capital metrics, explained only 1% of stock price movement.

This is just the latest study showing a link between human-capital metrics and equity market performance. In fact, labor economist and CEO of consulting firm McBassi & Co. Laurie Bassi has been operating a fund that has significantly outperformed the S&P 500 index. What’s so special about Bassie’s fund? It’s populated with stocks of companies known to be leaders in the field of human-capital management.

So don’t forget your most important metrics. Power to the people!

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