Creating Shareholder Value - Term Paper Example

?What is Shareholder Value? Shareholder Value is the measure of value that the management of a company is able to deliver to its shareholders throughits ability to grow earnings, dividends on shares, and the share price. It refers to the concept that by making wise investment decisions, the management is able to give its shareholders a return superior to one that the shareholder would get if they invested in another asset with the same associated risk. A shareholder invests in a share to derive value in two ways: earn dividends on the shares they own, and sell the share at a higher price than their buying price to earn profit. Shareholder value refers to the measure of this value of a shareholder’s investment. Focus on shareholder value started gaining prominence in the 1980s and by the start of 21st century had become a key element in corporate governance in the US, UK, and most of leading European nations like Germany, France and Sweden; so much so that the OECD, in their document released in 1999, emphasised that firms be run first and foremost in the interest of shareholders. They further reinforced this thought in their 2004 release of OECD principles of corporate governance (OECD 2004). As the fad of focus on shareholder value began spreading, the understanding of the concept seemed to have started to erode somewhat as many executives began to focus on quarterly earnings as a key driver of their stock prices. The concept of shareholder value does not, however, imply that companies should target a short-term “never-before” high stock price at any cost. A company targeting only short-term stock price gains is likely to suffer in the long-term as it would be subject to making decisions that may seem beneficial in the short-term but could likely produce a negative long-term effect. Instead, the concept of shareholder value means that if a company builds value, its stock price will trace it; the objective for a firm’s management is then “to build value and let the stock price reflect this value” (Mauboussin, 2011). And, the value creation of a company is reflected in its ability to secure and increase its long-term cash flow. It is thus essential to understand how to and, more importantly, how not to create shareholder value. Creating shareholder value is not just about getting the numbers right in the short-term but more about taking the right decisions that create sustainable long-term value for the firm. For example, in order to “increase the shareholder value”, a firm could cut its cost on pollution abatement and lead to environmental damage; such actions, however, are not sustainable in the long-term and when the time comes to take corrective measures in the long-term, the associated costs could be several times higher. Another very recent example is how banks and other lenders blindly lent money to create the housing bubble in the US. From short-term perspective, the sub-prime lending seemed extremely attractive for creating value and seeing the stock prices skyrocket but it was probably not the best decision from long-term cash flow perspective. Thus, from the long-term perspective and in retrospection, the overlooking of fundamentals of lending without considering the ability of people to repay and the short-term focus on numbers was probably not the best strategy for creating value. This ideology of focussing on short-term was even criticised by Jack Welch, former CEO of GE, and a chief proponent of the idea of “shareholder value”. In an article on Financial times, Welch called the short-term focus on share price as an indicator of shareholder value as “the dumbest idea” (Guerrera, 2009). He said that rather than setting share price as their objective, managers should focus on aligning their short-term profits with an increase in the long-term value. It is therefore important to understand that the principle of shareholder value is the right one only as long as it is understood properly and in the right sense; that is constantly focussing on the long-term and not looking to improve short-term gains by foregoing “right” decisions that create long-term value for the firm. Financial Metrics to measure Shareholder Value There are several financial metrics employed to measure shareholder value. However, none of these can be said to perfectly reflect “shareholder value” for all industry sectors companies or even for all companies within one sector. We now look at 7 major financial metrics for measuring shareholder value. 1. Shareholder Value Analysis (or Cash Value Added) The Shareholder Value Analysis (SVA) is also known as the Cash Value Added (CVA). This analysis was first developed by Alfred Rappaport in 1980. This analysis can be used to ascertain the value of a company or that of a business unit of a company. The value is determined by discounting the free cash flow from operations at an appropriate cost of capital. Thus the marketable securities and investments are added to and the value of debt is subtracted from the business valuation. The free cash flows are taken from operations and do not thus include financing related cash flows like share issues, dividends, and interest payments. In order to be accurate, one must determine the free cash flows for all future years. However, as the information is generally not always available/accurate for all future years, the free cash flows for future can be determined under two steps: present value of free cash flows from planning horizon and present value of free cash flows after planning horizon. The total value of the business is then the sum of these two present values of cash flows. This method is very useful in determining the value of business units within a company, and also evaluating various strategic decisions. However, as the analysis involves predicting future variables, the value determined thus is very sensitive to the assumptions of future performance. The free cash flows are thus derived as: Sales Less Operating costs Operating profits Plus Depreciation Less Cash tax on Profits Operating profits after tax Less Investment in Fixed capital Less Investment in Working capital Free cash flows from operations The free cash flows from operations are then discounted to arrive at the value of the business. 2. Economic Profit The basic approach for calculating Economic Profit (EP) was developed by Alfred Marshall in 1890. EP describes the additional surplus earned by the company after accounting for all expenses including the cost of using shareholders’ capital in the business. Thus EP can be calculated in two ways: EP = Invested capital x (return on capital – WACC) Or EP = Operating profits after tax – Capital Charge Essentially, the cost of equity capital is accounted for in calculating the EP. The operating profits after tax used for the second method are not simply profits before interest less the tax. In some countries, interest received is taxable, and interest paid on debt can be excluded from taxable income. Thus, for calculating the EP, operating profit after tax must exclude the effect on tax due to interest (receivable and payable). Thus, the after-tax profits are first adjusted to reverse the effect of tax due to interest received/paid. Although this calculation of EP is based on a single period performance, it does still reflect the long-term nature of business as mathematically, the long-term value which is the present value of future cash flows is equal to the sum of present value of all expected future EPs. EP is also a much better measure than looking at net profit as net profit does not account for equity related cost although it includes charge for debt capital. Thus, companies that may be profitable according to their income statements could actually be on a negative EP meaning that short-term profit making does not necessarily reflect added shareholder value. 3. Economic Value Added The Economic Value Added (EVA) is a more refined version of the EP. It is calculated as: EVA = Adjusted invested capital x (adjusted return on capital – WACC) EVA = Adjusted operating profits after tax less capital charge EVA = Adjusted operating profits after tax less (adjusted invested capital x WACC) The EP suffers from several accounting factors that distort the calculations and do not reflect the true cash position of a company. These factors arise from non-cash and accrual based accounting, prudence in reporting numbers, investment write-offs, and one-off non-recurring gains/losses on the income statement. Under the EVA, 164 adjustments are recommended to measure the operating profit and capital on which EVA is based. One of the two most common of these adjustments for example is to add the cumulative goodwill written-off to the value of capital. However, not all 164 adjustments are needed to be made. The decision of whether or not an adjustment must be made can be determined by using 4 questions, if all answer yes (Stewart, 1994): a) Will the adjustment have a material impact on the EVA? b) Can managers influence the outcome? c) Can the operating people readily grasp it? d) Is the required information relatively easy to track or derive? Thus, EVA includes all the positive points of the EP and addressing its accounting related weaknesses. 4. Market Value Added Market Value Added (MVA) is the present value of all future EVA; the EVA being discounted at cost of capital. MVA = EVA1/(1+c) + EVA2/(1+c)2 + EVA3/(1+c)3 + … Where EVAn represents the EVA estimated for the nth year. 5. Cash Flow Return on Investment The Cash Flow Return on Investment (CFROI) is the internal rate of return on existing investments based on real future cash flows. It is calculated as: CFROI = (Gross cash flow – Economic depreciation)/ Gross Investment Gross investment is the existing assets of the firms obtained by adding back all the accumulated depreciation and inflation adjustments to the book value. Gross cash flow is the sum of operating income after taxes and non-cash charges like depreciation. Economic depreciation is the equivalent of an annuity to cover the replacement cost of assets. It is calculated using the current value of assets, the salvage value of assets, the real cost of capital, and the expected life of assets in years (Damodaran, 2002). 6. Strategic Profit Model The strategic profit model measures the Return on Net worth (RONW) of a company. It is calculated as: RONW = Financial leverage x Return on Assets Thus the measure of RONW is influenced by three key drivers – financial leverage, net profit, and asset turnover (sales divided by total assets of a company). This measure is quite relevant to measuring the shareholder value as all the components of this measure are well under the control of the management of the company. By using financial leverage, the equation also incorporates the relationship between total equity and the amount invested by the shareholders thus making the measure more relevant to the concept of shareholder value. However, as all the components for this measure are derived directly from the income statement and balance sheet of the company, this measure, like EP, suffers from the limitations due to accounting procedures. 7. Total Shareholder return The Total Shareholder Return (TSR) is used to compare the stock performance of different companies. A firm must, however, not use the TSR alone to judge the shareholder value it creates over a period of time as the TSR looks at short-term performance only and does not necessarily incorporate long-term value added.. TSR is calculated as below: TSR = (Pe – Ps + D)/Ps Where Pe = Price at the end of the period being studied Ps = price at the start of the period being studied D = Dividends paid during the period As seen in the formula, the TSR looks at past performance only and it does not necessarily reflect the future performance unless stock prices have taken it into account which may not always be the case. Thus, TSR can be used to see whether the share price reflects the true value of the company. References Booth, L. (1998). What Drives Shareholder Value? “Creating Shareholder Value” conference,. Toronto, Canada: Federated Press. Damodaran, A. (2002). Value Enhancement: EVA, CFROI, and Other tools. In Investment Valuation (p. Chapter 32). Wiley Finance; ISBN-13: 978-0471414889. Guerrera, F. (2009). Welch condemns share price focus. Financial Times . Lazonik, W., & O'Sullivan, M. (Feb 2000). Maximizing Shareholder Value: a new ideology for Shareholder Value. Economy and Society, Volume 29 Number 1 , 13-35. Mauboussin, M. J. (2011, October 3). What Shareholder Value is Really About. Retrieved October 27, 2011, from HBR Blog Network: http://blogs.hbr.org/cs/2011/10/ceos_must_understand_what_crea.html OECD. (2004). Principles of Corporate Governance. Paris: OECD. Stewart, G. I. (1994). EVA: Fact and Fantasy. Journal of Applied Corporate Finance, Vol 7, No. 2 , 71-84. Viswanandham, N., & Luthra, P. (2005). Models for measuring and predicting shareholder value: A study of third party software service providers. Sadhana Vol. 30, Parts 2 & 3, April/June , 475-498. Warner, A., & Hennell, A. (2001). Shareholder Value Explained. 2nd Edition. Read More