Measuring Shareholder Value - Term Paper Example

 The expression shareholder value refers to that value which a shareholder gets from the investment he/she has made in a given company. It constitutes dividend payments, capital gains, buyback programs proceeds plus any other payouts that may be obtained by a shareholder from the company. A dividend payment is that payment that is usually declared by the board of directors of a company and which is granted to the shareholders of that company. It forms part of a given periods retained earnings. Most of dividends are paid out in cash form, sometimes as stock or even property. These dividends form an incentive to the shareholders to hold a company’s stock. Capital gain is the gain that if gotten above an assets original buying price upon disposal. Any realised capital gain forms an investment that has been disposed off as at a profit. An unrealised capital gain may on the other hand refer to an investment which is yet to be disposed off, but would lead to a profit if it was disposed off. Assets that can realise capital gains may include options, bonds, shares/stock, or businesses. A buyback kind of program involves a situation where a company repurchases its bond or stock that it had issued previously. In that case, the amount of stock that is outstanding reduces and this gives the shareholders that are remaining a bigger ownership stake of that company in the process. (investorwords.com, 2011) Investors in the world over have gotten more informed and, thus, if they have made an investment in a stock and that stock has proven not of much return as they would have wanted, then, they are unlikely to continue holding on to that stock. Thus, this escalated demand for shareholder value has led to a lot of pressure upon finance managers of various organisations. They have to ensure that the companies are earning reasonable profits and besides that they have to come up with a very appropriate measure to shareholder value. This way, shareholders can monitor the performance of their investments. The task of getting the befitting measure for that can be an uphill one to most managers. In the recent times executives have adopted numerous metrics to determine shareholder value and these are with the inclusion of cash flows, operating profits, economic performance, and return on assets. All of these metrics can be applied one at a time or all of them in entirety instantaneously. In the recent past another metric was introduced by Stern Stewart and Company and this metric was known as EVA (Economic Value Added). EVA is said evaluate shareholder value through computing the magnitude by which profits surpass the given company’s cost of capital. However, cynics have said that EVA has proven inapplicable to such companies as internet companies. (Leahy, 2000) Cash flows Cash flows are usually used to determine shareholder value and this metric has been applied for a while. As per the book by Holler the cash flows of interest to the person seeking to measure shareholder value are the cash flows emanating from operations. Variances from these cash flows would show how the company in question is performing. A rise in the level of cash flows would, thus, translate to a positive performance of an investment. (Holler, 2009 p152) Use of discounted cash flows as a model of a company’s valuation has been applied for a while to measure customer satisfaction. Growth of these cash flows results to customer satisfaction plus less cash flow volatility. It should not be mistaken that this measure serves customer only; it is also a major metric to determine shareholder value. Actually as per this 2005 article by Gruca and Rego, customer satisfaction is measured through growth in cash flows and this translates to shareholder value growth. Thus, a growth in customer satisfaction eventually translates to shareholder value growth. According to this article, healthy future cash flows can only be secured through customer satisfaction and through this shareholder value can be enhanced. (Gruca and Rego, 2005) Merits of using cash flows to measure shareholder value are; that it is said to be a superior kind of measure that provides accurate type of valuations, it is also not distorted and it is not affected by things like depreciation and inflation. A major demerit with regards to cash flows is the need to estimate future cash flows of a company and it becomes even complex where cash flows of each of the components to be applied in the computation has to be estimated. (valuebasedmanagement.net, 2004) EVA EVA is defined as that residual wealth. The definition by the moneyterms.co.uk says that it is computed by removing aggregate costs of carrying out business operations from total revenues. Aggregate costs of doing business operations may include taxes, and operating outlays. It is basically taken as a measure that determines by what magnitude the returns related to a business go above the set cost of capital by the supplier. This translates to how much the company has grown the wealth of the shareholders. Thus, the formula to compute this is given as follows: EVA = P – WACC*(D + S) Where, P stands for Net operating profits after tax, WACC is the weighted average cost of capital, D stands for the amount of debt capital and S stands for amount of equity from shareholders. The amount of operating profit utilized is usually adjusted of numerous things like amortization. The amount utilised as capital is usually the amount after various adjustments as well with the inclusion of Research and Development as well as operating leases. (moneyterms.co.uk, 2011) According to Waters in his book, EVA was the key metric for shareholder value or performance evaluation during its time. (Waters, 2010 p44) Some of the merits associated with EVA are; its efficiency where it leads a company’s management and the overall company towards efficiency. It results to the accomplishment of more in monetary terms using little capital. Therefore, much is created with the little capital that has been employed. It serves as an incentive to the management where managers meet more often due to EVA and that can lead to better performance with reference to the management. It is also quite applicable universally. The main demerit is that even if it appears simple, EVA as a method can be a complex metric. (Rago, 2008) ROCE Return on Capital Employed (ROCE) is another financial metric often used to measure variance in shareholder value. A shareholder value is made once the level of profitability is more than the prospects that are measured through cost of capital. The most unfortunate thing about this metric is that most companies do not utilise the same method while measuring the level of an investment’s profitability. This way, it makes it a very hard task for the managers of a given company to note the operations that are performing dismally so as to do corrective actions. ROCE is the operating profit subsequent to tax over the net capital that has been employed. Net capital is obtained through summing up the equity on the business’ balance sheet and debt. The formula would, thus, look like this; ROCE = Operating profit after tax/ Net capital employed The main predicament associated with ROCE plus other measures that apply a company’s profitability to measure shareholder value is that they do not put into consideration capital employed and operating profits in the manner that investors do. Investors are usually concerned with the economic profits of the company as well as the amount of equity and debt in that particular company. The amounts mentioned may vary to a very high extent with the ones that have been reported in the financial statements of the company. This is since the accounting system of the company is usually set for different reasons. Some of the known aspects that bring about the variances may include accounting reserves that may lead to an understatement of the economic profits as well as the amounts of the equity capital that has been employed in that company. Obligations that are not usually stated in the balance sheet of the company like receivable programs of a factory, operating leases may as well lead to an understatement of the outstanding debt capital. Due to these shortcomings of ROCE as a metric for the measurement of shareholder value, it is concluded that very little guidance is given by this measure with regards to the profitability of the company relative to the prevailing cost of capital. The only way, thus, to make ROCE applicable to measure shareholder value is by adjusting these profits to meet the standards that investors use as opposed to the standards fit for reporting. Some of the adjustments that are likely to lead to its usability are; Adjusting for permanent accounting reserves such that they are added back to the company’s component of equity, Operating profits should also be adjusted to include other accounting reserves LIFO reserves of accounting should be added back to the company’s equity since they are a representative of real economic value Setting-up of the outlays incurred during acquisitions the actual prices paid among others. (Lupia, 2000) Value-Driven Chain It is not always that financial metrics are applied to measure shareholders’ value. There are other non-financial measures as well as Bidgoli notes. This measure is the nonfinancial supply chain measure. A value-driven kind of supply chain is viewed by its equivalent management as a new kind of light. It is said to be a very vital tool that impacts on all the drivers of growth, capital usage and profitability- all of which form part of a company’s financial performance. The linkage of shareholder value to the management of supply chain is seen to serve as a way to enhance executives’ ease in noting supply chain initiatives and value gaps which bring about the biggest value to the company while considering all the trade-offs that impact on the drivers that determine financial performance. These drivers may be with the inclusion of escalated costs of transport versus decreased inventory. (Bidgoli, 2010 p200) Reference list: Bidgoli, Hossein. (2010). The Handbook of Technology Management: Supply Chain Management, Marketing and Advertising, and Global Management. Edition illustrated. John Wiley and Sons. p200. Gruca, Thomas S and Rego, Lopo L. (2005). Customer Satisfaction, Cash Flow, and Shareholder value. Retrieved 2 November 2011 http://docs.google.com/viewer?a=v&q=cache:gXX- SU5pjJgJ:citeseerx.ist.psu.edu/viewdoc/download%3Fdoi%3D10.1.1.67.1343%26rep%3 Drep1%26type%3Dpdf+measure+of+shareholder+value- +cash+flows&hl=en&gl=ke&pid=bl&srcid=ADGEESgrbRLmLxofjX33oagMTa6yLf_P UFneQKjaUPhQJYAkXDyOsQwEsOfVpyrXHOit_893xaed- fiEui_WXBrB8q2SEInE5RG1psEdiJgB4lurG5JaAs4YigXSCb30JRX6oTeRqYSQ&sig= AHIEtbQFLX08zTFn17FLJAVv5XWTbwExYQ Holler, Annette. (2009). New Metrics Value-Based Management: Enhancement of Performance Measurement and Empirical Evidence on Value-Relevance. Gabler Verlag. p152. investorwords.com. (2011). Shareholder Value. Retrieved 2 November 2011 http://www.investorwords.com/5960/shareholder_value.html Leahy, Tad. (2000). The Holy Grail of Shareholder Value Measurement. Retrieved 2 November 2011 http://businessfinancemag.com/article/holy-grail-shareholder-value- measurement-0201 Lupia, David T. (2000). Measuring Shareholder Value. Retrieved 2 November 2011 http://www.dlupia.com/articles/David%20T.%20Lupia,%20Inc.%20- %20Measuring%20Shareholder%20Value.pdf Michael Rago. (2008). An Analysis of Economic Value Added. Retrieved 2 November 2011 http://digitalcommons.liberty.edu/cgi/viewcontent.cgi?article=1031&context=honors&sei - redir=1&referer=http%3A%2F%2Fwww.google.co.ke%2Furl%3Fsa%3Dt%26rct%3Dj% 26q%3Deconomic%252Bvalue%252Baddition%252B%28EVA%29%252Bconcept%25 2Bmerits%252Band%252Bdemerits%26source%3Dweb%26cd%3D2%26ved%3D0CCQ QFjAB%26url%3Dhttp%253A%252F%252Fdigitalcommons.liberty.edu%252Fcgi%252 Fviewcontent.cgi%253Farticle%253D1031%2526context%253Dhonors%26ei%3Ddmqx TuifMMbtsga1mb1f%26usg%3DAFQjCNEAXs2PLnTEOu2eo6ghLOpLZ_SOpw#searc h=%22economic%2Bvalue%2Baddition%2B%28EVA%29%2Bconcept%2Bmerits%2B and%2Bdemerits%22 moneyterms.co.uk. (2011). EVA (Economic value added). Retrieved 2 November 2011 http://moneyterms.co.uk/eva/ valuebasedmanagement.net. (2004). Maximising Shareholder Value: Achieving clarity in decision-making. Retrieved 2 November 2011 http://www.valuebasedmanagement.net/articles_cima_maximizing_shareholder_value.pd f Waters, Donald. (2010). Global Logistics: New Directions in Supply Chain Management. Edition 6, illustrated. Kogan Page Publishers. p44. Read More