Shareholder Value as a Criterion for Assessing Company Performance - Assignment Example

Appropriateness of Using “Shareholder Value” as a Criterion for Assessing Company Performance Introduction There was a time when businesses were justified entirely by the realization of maximum profit. The principle in a nutshell is expressed by the familiar saying, “Business is business,” which usually meant that the profit motive was the principal goal and standard in the pursuit of a commercial activity. Businesses created jobs and spurred other businesses, for which reason the profit goal became a reasonable excuse for commercial firms operating the way they did. As long as their activities were legal, though of questionable ethics or morality, a business firm was justified in gearing for maximum profit. Recently, however, the trend of contemporary business philosophy has been to elevate commercial activity beyond the pursuit of maximum profit. Increasingly stringent consumer legislation and tort litigation, and social responsibility campaigns by elements of civic society have driven home the point that business must be made to assume a more active role as corporate citizen. Shareholder profit has ceased to be the sole and overriding concern; good governance, observance of business ethics, and corporate social responsibility have become as salient as the financial bottomline in measuring the performance of a firm. This study shall examine the implications of shareholder value analysis and its use of metrics as the ultimate standard by which to assess company performance. It shall also explore the social, political, legal, economic, and technological influences of the current milieu on the evolving concept of shareholder value, and resulting implication in the strategy, metrics, and management of contemporary company performance The Financial Measure of Company Performance The concept of “value” dates back to the 19th century economic theory, where the concept of residual income was first developed. Traditionally, shareholder value refers to company revenues net of operating and administrative expenses, and after interest to creditors have been paid. Profit must be measured in comparison to the cost of capital employed to generate the profit. Most companies, particularly in the UK, have a low debt-to-equity ratio, indicating that ownership funds in the form of proceeds from common shares or earnings retained account for the greater proportion of the capital that runs the business (CIMA, p. 5). Importance of shareholder participation is thus heightened, as well as the risks they assume in investing in the business. It must also be kept in mind that real economic value is only generated when revenues exceed stockholders’ expected returns. While the cost of equity capital may be a theoretical concept, it is a real consideration, because failure of a firm to meet stockholders’ expectations may result in investors moving their funds to some other investment. It is common knowledge that equity holders who purchase shares will only part with their money if they perceive a chance of higher returns than they would otherwise realize from depositing their funds in a safe, interest bearing account. If there was no such possibility, then shareholders will avoid purchasing these shares and the firm suffers for lack of funds. It is evident, therefore, that appreciation of shareholder value is important to meet the cost of equity capital – the expected returns of stock investors. The higher risks these investors assume justifies the higher returns they expect over the risk-free interest they could realize from deposit accounts. Implications of the term “shareholder value” While the importance of determining and maximizing “company performance” is held without question (for after all, “performance” means the manner by which its tasks and duties have been discharged to attain a goal), the question of the importance of “shareholder value” became contentious because this purports to be the ultimate goal of the business. Upon reading several treatises, it has become apparent to this author that the term “shareholder value” has several shades of meaning. Its academic or accounting definitions appear to be “the present value of the future dividend stream expected to be generated by a company” (Beech & Chadwick, 2009), or alternatively, “the value that a shareholder is able to obtain from his/her investment in a company. This is made up of capital gains, dividend payments, proceeds from buyback programs and any other payouts that a firm might make to a shareholder” (TFAL, 2009). Shareholder value means, succinctly, the weath realized by a firms’ common share owner. Notice, however, that to CEO of General Electric, Jack Welch, “shareholder value” is a “business buzz” term implying shareholder enrichment. “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy…Your main constituencies are your employees, your customers and your products.” It is ironic that Jack Welch is generally acknowledged to have become the father of the “shareholder value” movement when he made a speech in 1981 that he claims was “misplaced”. Welch decried present-day over-emphasis on setting share price increases as their ultimate goal. He stressed that short-term profits should be allied with an increase in the long-term value of a company. (Guerrera, 2009). The implication of his statement is clear, that the “father of shareholder value” felt that importance placed on shareholder wealth clashed with the interests of employees, customers and products, and emphasizing one de-emphasizes the others. In contrast, an article by Alfred Rappaport stresses the overriding importance of shareholder value, and describes it as “the interests of long-term shareholders… Management’s responsibility is to… pursue long-term value maximization…” Rappaport describes ten principles of shareholder value maximization: 1. Do not manage earnings or provide earnings guidance. 2. Make strategic decisions that maximized expected value, even at the expense of lowering near-term earnings. 3. Make acquisition that maximize expected value, even at the expense of lowering near-term earnings. 4. Carry only assets that maximize value. 5. Return cash to shareholders only when there are no credible value-creating opportunities to invest in the business. 6. Reward CEOs and other senior executives for delivering superior long-term returns. 7. Reward operating-unit executives for adding superior multiyear value. 8. Reward middle managers and employees for delivering superior performance on the key value drivers that they influence directly. 9. Require senior executives to bear the risks of ownership just as shareholders do. 10. Provide investors with value-relevant information. (Rappaport, 2006) What is apparent from the foregoing, is that Rappaport drew a line between short term earnings reports and long-term value creation. Short term earnings would impact on interim share prices, but do not necessarily add value to the business. On the other hand, long-term shareholder value is realized only when strategic decisions are made, assets are acquired for their usefulness, and middle managers and employees are duly trained and rewarded for their competence. Contrary to the concept of value as earnings to shareholders, Rappaport specifies that payout to shareholders should only occur when no good opportunities exist for investment. Furthermore, senior officers should bear the risk of doing business together with the shareholders, meaning that poor performance should mean a commensurate slash in their compensation. What, then, Welch refers to as shareholder value is different from what Rappaport means by the same term. Welch views value to shareholders as separate and distinct from the value attributed to the other publics or stakeholders of the business – the employees, customers, suppliers and affiliates – and that the interest of shareholders is an either-or proposition with that of the other stakeholders. Rappaport sees these are interests are collaborative; if the business is run for its long-term value, everyone wins. It is as Booth (1998) said: share value should not be created by merely transferring existing value to the shareholders, at the expense of the other claimants to company value – precisely Rappaport’s guideline of not focusing on or reporting earning to shareholders (Principle 1), only value-relevant information (Principle 10). This is consistent with Bosse, Phillips and Harrison (2008), that viewed the amount of value a firm captures as that portion of the value it creates that is not distributed to its non-shareholder stakeholders. Indeed, Cabrera (2009) said it perceptively when he urged that the fallacy should once and for all be rejected that being a steward of the greater good is incompatible with creating competitive returns for shareholders; in the long term, the two go together. Evolving demands upon business organizations (PESTEL analysis) According to Comite (2009), the enterprise is a social phenomenon, and thus is situated in a milieu that is unstable and dynamic. As such, recurrent financial scandals that involve shareholders, partners, investors, even third parties such as political candidates (e.g., on the issue of illegal campaign contributions) prove that the company’s bottomline is no longer an adequate measure of the company’s performance, at least not as the only parameter. The environment that surrounds business entities have many and varied implications. Examples of these are: Political. Certain business establishments have been implicated in illegal campaign contributions, to cull the favor of government officials who, once sitting, are expected to pass bills favourable to private business interests but possibly detrimental to the public welfare. (Clinard & Yeager, 2006). Economic. The mishandling of investment funds and abuses wrought on the financial system exacerbated the sub-prime mortgage crisis and turned it into a full-blown economic depression. Much of these development are traceable to business decisions that aimed at the obsessive pursuit of financial gain, even when conservative theory has signalled warning bells of excessive risk taking and indifference to the public’s best interest (Adam, 2009; Jo & Kim, 2007). Social. Social and humanitarian issues abound when the desire for more profits relegates concern for human rights and welfare to the background. For instance, the rapid global expansion of multinational enterprises have enabled corporations in richer countries to exploit cheap labor in poorer countries, and wash their hands and plead innocence on the basis of subcontracting agreements. Public condemnation, however, has taken the likes of Nike to task on the issue of sweatshops in third world countries; the same is true for call centre operators and fastfood franchises such as McDonald’s, that circumvent labor rights and legislation in the name of cost efficiency (Ritzer, 2004). Technological. The generation of increasingly higher profits used to justify the abuse of technological procedures and application of intemperate methods of research and development, such as indiscriminate animal testing and industrial emissions. An extreme case is that of the pharmaceutical industry, which, because it spends millions on drug research, price newly released medication at prohibitive levels behind the protection offered by intellectual property rights. While recovery of investment is a reasonable cause, collusion of doctors with medical representatives of giant multinational drug companies border on the unethical where it compromises patients’ welfare in the illicit pursuit of higher drug sales (Khurana, 2008). Environmental. In the pursuit of profit, businesses have depleted the planet’s natural resources, spawned over-consumption through hard-sell marketing, accelerated the production of non-recyclable waste, denuded forests and watersheds, and released pollutants into the atmosphere that have accelerated global warming. Recently, efforts toward sustainable production processes, green products and services, systematic recycling and recovery, and stringent measures to control carbon emissions have been tagged as important measures by which to gauge corporate performance (Tencati & Zsolnai, 2008). Legal. The current spate of fraudulent financial reporting, typified by the Enron scandal, as well as Bernard Madoff’s sophisticated hedge fund ponzi scheme, show the extent to which misplaced emphasis is given to profit as measure of corporate value (Cabrera, 2009). The Contemporary Viewpoint: Value and Corporate Governance In today’s business environment, it is generally acquiesced that business should comply with not only its profit-making purpose which, after all, is the rationale for its existence, but it should also fulfil the duties imposed upon it by its corporate citizenship. This is usually achieved through the principles of corporate social responsibility discharged through the stewardship of good corporate governance. CIMA’s definition of corporate governance is defined as “the system by which the owners of the corporation ensure that it pursues, does not deviate from and only allocates resources to its defined purpose” (LSE and RSM Robson Rhodes, 2004, as quoted by CIMA Technical Report, 2004, p. 2). The concept of value is never far from corporate governance, because corporate governance is always directed towards achieving that which is defined as the business’ value, its “defined purpose.” Value-Based Management (VBM) is a new buzzword that refers to “the context, tools, techniques and philosophy of managing for shareholder value,” according to the CIMA, which officially defines VBM as “a managerial process which effectively links strategy, measurement, and operational processes to the end of creating shareholder value” (2004, p. 2) In this sense, shareholder value is, as earlier discussed, the long-term potential for sustainable growth of a business in the context of its social milieu. The technical report enumerates the key elements of VBM as: (1) creating value, by exploring ways to actually increase or generate maximum future value; (2) measuring value; and (3) managing for value, through governance, management, organisation, culture, communication. First element: Creating value. There are many theories that define ways by which value can be created. These theories more or less specify relatively similar factors, usually referring to the intangibles – drive, creativity, social responsiveness, customer focus, and so forth. For the purpose of this study, we shall focus on the theory of Bender and Ward (2008:17) wherein seven drivers (expressed through their financial account names) are specified. These drivers are: 1. Revenue – More than just the numerical amount, the focus on “revenue” as a driver of value stems from its source – sales to satisfied customers. By attending to the needs and wants of its customers, revenues from sales increase, which translates to profits. 2. Operating margin – The operating margin reflects the proportion of the revenues that remain after operating expenses are deducted. A good operating margin means that the company has attained cost efficiency, through the elimination of unnecessary expenses and purchasing only assets necessary for delivering value to customers. 3. Cash tax rate – This refers to the proportion of revenues that is paid out to taxes. Through proper choice of location, leverage mix and good legal advice, the tax rate could be minimized and thus more funds channelled to productive activities. 4. Incremental capital expenditure – This refers to the additional expenses that go into increasing capital equipment and, therefore, expanding productive capacity. Additional productive capacity adds value when done in an expanding market characterized by increasing demand. It signals corporate growth. 5. Investment in working capital – Additional funds going to working capital means that the business is allocating more for inventory of raw materials and consumables and, therefore, increased production. This boosts sales and, provided the same efficiencies are maintained, result in higher end returns that could be reinvested in the business. 6. Cost of capital – The cost of capital is what is paid by the firm to fund providers (stockholders and creditors) for the use of their savings. Wise leveraging could lower overall cost of capital for the company and thereby improve the final figure. The mention of cost of common stock would tend to raise eyebrows, as the focus on stockholder returns have been the overriding objection of most critics of shareholder value. However, the stockholder deserves as much attention as other stakeholders, because without the proper incentive to attract capital that assumes the risk of doing business, money would flow out of the company to other investments, and soon there would be no business at all. 7. Competitive advantage period – Of the seven drivers, this is the only non-accounting term and is largely an economic concept. It states that if a business sells sub-standard products to reduce cost and make a quick profit, or if it neglects research, or foregoes investment in motivated and well-trained employees, it damages its reputation and therefore destroys competitive advantage in the future. It is imperative for the business, therefore, to pay attention to all stakeholders, because only by a balanced approach will it ensure its continuance in the long term. Second element: Measuring value. As with naming the drivers of value, value metrics (or the standards by which the level of value created is assessed) also is viewed through different frameworks. One such framework, known as shareholder value analysis, was developed as a concept by Rappaport, using financial tools such as the DCF (discounted cash flow) and EVA (economic value added) in examining and evaluating new strategic options and alternatives (Ameels, Bruggeman & Scheipers, 2002). These are measure based in economic and finance that try to capture the intrinsic long-term value of the business in numerical units more easily comparable to longitudinal (through time) and cross-sectional (industry wide) performance. The basic theory has been expanded by succeeding students of value based analysis, an example of which is shown in the following figure: Figure 1: Algorithm for value drivers analysis based on shareholder value analysis by A. Rappaport (1998) (Source: Kazlauskiene & Christauskas, 2008, p. 27) Third element: Value based management. Once the drivers of value have been identified and classified, and the proper strategies outlined, and when analytical models have been fashioned that link the value drivers with the company goals, what remains is implementation. This gave rise to Value Based Management, or VBM, which is not one thing in particular, but a management direction that places top priority in values creation. There are several exemplary companies that have reported the results of their values-based management as very encouraging and effective. Credit Suisse, for instance, attributes its own value-based approach to Alfred Rappaport’s shareholder value network. The introductory remarks at the beginning of the report shows Credit Suisse’s approach to the concept of “shareholder value”: “Anyone who propagates the concept of shareholder value is a thoughtless egotist who puts short-term, short-sighted profit maximisation above the long-term needs of society.” This is a fairly precise summary of what many people understand by ‘shareholder value’. It is a term which has gained an unfair reputation, often based on ignorance or disinformation. The aim of this study is thus to present the shareholder value concept and its practical implementation in a straightforward manner, to clear up some widely held misunderstandings, and to provide a reasoned analysis and critique, backed by real examples. It shows that a clearly defined – and clearly communicated – strategy is a major factor in creating value for all of a company's stakeholders (Credit Suisse, 2000) (emphasis supplied). In its implementation of the shareholder value approach, Credit Suisse views it as a conceptually consistent, self-contained, market-based model for company valuation. It is conceptually consistent because contrary to common perception, shareholder value management treats all stakeholders’ interests as harmonised and directed towards the same objectives (as the foregoing quote shows, the view of many is that conflict exists where in actuality there is consistency). The approach is self-contained because internal efficiencies are created as a result of the value drivers. Finally, it is market-based because it is attuned to the satisfaction of customers’ needs and wants, in a manner that fosters a lasting relationship. Rappaport’s shareholder value network, as implemented by Credit Suisse, is show in the diagram that follows (Source: Credit Suisse, 2000) The foregoing shareholder value network identifies the various drivers for value creation, several of which were developed earlier in this paper. The figure provides a visual map of how management decisions pertaining to the chosen value drivers eventually contribute to valuation components in delivering the expected strategic improvements towards the attainment of shareholder returns. It will be noted that value contributed to customers’ interests (sales growth), product development (working and fixed capital investment) and concentration on the proper incentives for employees (operating profit margin), are requisites for shareholder returns to be realized, and for the business to continue operating profitably well into the future. Conclusion At the commencement of this research, this author was under the impression, which is likewise held by many, that increasing shareholder value detracts from the share of the fruits of business activity that should go to employees, customers, and other stakeholders in the firm. As earlier mentioned, it was mistakenly surmised that value is a pie divided into the returns that accrue to the different stakeholders, and increasing the portion of one would compromise those of the others. The visual model is not an entirely accurate one. The idea of shareholder value management should be viewed more as a pyramid. Each step of the pyramid represents the value created for succeeding levels of stakeholders, and at the top is shareholder value. In the operation of a business, the interests of employees, customers, creditors, suppliers, and the community in general are requisite steps to be met before the shareholder could realize any value at the top. Trying to attain shareholder value without creating a solid, long-term foundation for the pyramid would cause the undertaking to be weak and untenable; this is what happens when emphasis is placed on short-term earnings that do not reflect true value. For the business to prosper well into the future and in the process become a valuable contributor to all its stakeholders – shareholders included – then value analysis and management built on value drivers become a consideration that is not only appropriate, but a vital tool in meeting the expectations of all stakeholders concerned. References Adam, A & Schwartz, M 2009 Corporate Governance, Ethics, and the Backdating of Stock Options. Journal of Business Ethics, Feb2009 Supplement 3, Vol. 84, p225-237 Ameels, A; Bruggeman, W; & Scheipers, G 2002 Value-Based Management Control Processes to Create Value Through Integration: A Literature Review. Unpublished research. 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