Analysis of Shareholders Value - Essay Example

? SHAREHOLDERS VALUE By Shareholders Value Shareholder value is the measure of a company’s success in the extent to which it enriches shareholders through management’s ability to grow earnings, dividends and share price. The management is increasingly under pressure to increase shareholder value and minimize the arising agency conflicts between shareholders and the management (Bick, 2009, p. 117). The pressure to meet short-term targets has made managers opt for value reductions in long-term investments in order to achieve the short-term goals. This may seem okay in the short term but it destroys the shareholders’ value in the long term. The escalating global competition has forced companies to focus their efforts on creating shareholder value in order to remain relevant. In the recent past, companies are adopting the value based management approach which is a formal systematic approach used in managing companies with an aim of achieving the objective of maximizing value creation and shareholder value (Chapman, Hopwood, & Shields, 2009, p. 1248). Value based management focuses on the key drivers of value thus helping companies achieve their objectives (Starovic, Cooper, & Davis, 2004, 2004, p.15-17). Increasing focus on core competencies has forced companies to outsource some services to ensure that they remain relevant in terms of their revenues and expenditure in comparison with their competitors. Knowing a company’s position is important because it is useful in defining and redefining strategies to improve profit margins and to capitalize on company’s strengths to enhance shareholder value creation (Starovic, Cooper, & Davis, 2004, 2004, p.10-17). Various methods have been used to measure the shareholder’s value but the most commonly used are the profitability analysis, Strategic Profit Mode (SPM), and the Economic Value Added (EVA) method. One of the common methods used to measure profitability is Return On Capital Employed (ROCE) which is the operating profit after tax divide by the net capital employed. However, a major criticism on this method is that it does not measure operating profits and capital employed the way investors do. Investors are concerned about economic profits and the amount of debt and equity invested in the business but these amounts may disagree with those used in company’s financial statements because of the accounting practices in use. For instance, accounting reserves which have to be accounted for in financial statements tend to understate economic profits and the amount of equity capital actually invested in the business. ROCE provides little guidance on the profitability level because of its shortcomings. Given the shortcomings of ROCE, SPM and EVA models are preferred because they enable the company to focus on shareholder value and provide a long-term orientation in their analysis. SPM and EVA are reliable, consistent, and therefore preferred over ROCE method. The Strategic Profit Model (SPM) measures the Return On Net Worth (RONW) of a company which is a tool used to measure the changes in the shareholder value in an organization. RONW is made of three components, which include net profit, asset turnover, and financial leverage. These components are used in the calculation of RONW and they can be controlled by the managers of a company (Viswanadham and Luthra, 2005, p.478). Net profit is the difference between sales and expenses and from it net profit margin is calculated which measures how efficiently a company manufactures and sells its products. Net profit margin is the net profit as a percentage of sales. Asset turnover is the sales divided by the total assets of a company and it shows how efficiently a company employs its assets to achieve a given level of sales. The Return On Assets (ROA) is arrived at by multiplying the net profit margin with the asset turnover and it relates the profitability of a company to the value of assets employed. The financial leverage of a company provides the relationship between the total equity of the firm and the amount invested by the shareholders. Financial leverage is the total assets under the control of management divided by the net worth of shareholder’s investment in the company. RONW is arrived at by multiplying the return on assets by the financial leverage and it indicates whether a company is utilizing the investment made by shareholders in a recommendable manner or not. RONW can be increased by increasing sales, reducing operating expenses or reducing total assets (Viswanadham and Luthra, 2005, p.478). The Economic Value Added (EVA) method helps managers in decision making. The method incorporates two concepts in finance, one of ensuring maximization of value created for the shareholders and the other the fact that the value of a company is dependent on shareholder’s expectation of the earnings to be greater than or less than the cost of capital. An increase in EVA results in an increased market value of the company. EVA has many advantages that accrue from its use. EVA highlights areas that create value in the company and this enables managers to make decisions on increasing the efficiency of the capital and operations by focusing work on areas of higher productivity (Bhanawat & Chundawat, 2012, p 8; Koller, Dobbs, & Huyett, 2011, p.10). EVA ensures that the managers’ decisions are in line with the objective of creation of shareholder wealth. EVA is arrived at by subtracting the capital charge of a company from the net operating profit after tax and it shows the amount of wealth created or destroyed (Koller, Dobbs, & Huyett, 2011, p.10). The net operating profit after tax is the return on the company’s total capital invested whereas the capital charge is a suitable charge for the opportunity cost of all capital invested in a company. Shareholders value is mainly determined by the reward the owners of a firm get. The return on capital invested is influenced by the composition of capital in a firm. In most companies, it is cheaper to acquire equity capital which poses various risks to the company. When acquiring equity finance, decisions should be made to avoid risks associated with financiers that have restrictive demands. Stakeholder conflicts should also be considered while acquiring equity finance (Phalippou, 2009, p.147). This is mainly reflected by the shareholders expectations of getting high rewards in terms of dividends and the management’s duty of ensuring that the company earns enough profits to repay the shareholders. Another risk associated with equity finance is the fear of not being fully reimbursed in case of winding up or being declared bankrupt. Another risk of equity financing is that partial ownership is given up and this leads to transfer of decision-making authority over the business. In addition, the business may miss out on growth opportunities because of distributing part of their profits to shareholders instead of reinvesting the same (Neil & Demand, 2013, p.1). The shareholder value can be used to decide on take over on merger strategies of a business. This poses risks to the business because bidders who want to take over quote higher values than the existing ones in the company. The management should ensure that it remains high to avoid being sold by the existing majority shareholders or in a hostile bid (Das & Basu, 2004, p.27).  Shareholders’ value is of great importance to a company and therefore, it is important to select the best method to come up with the value. A good measure of the shareholder’s value reduces the stakeholder conflicts between shareholders and the management. It is also important in evaluating whether the company achieves its core objectives or not. Works Cited Bhanawat, S, & Chundawat, D 2012, 'Prediction of Shareholders' Wealth: A Quantitative Analysis', IUP Journal Of Accounting Research & Audit Practices, 11, 3, pp. 7-16, Business Source Complete, EBSCOhost, Viewed 13 March 2013. Bick, GC 2009, 'Increasing shareholder value through building Customer and Brand Equity', Journal Of Marketing Management, 25, 1/2, pp. 117-141, Business Source Complete, EBSCOhost, Viewed 13 March 2013. Chapman, C. S., Hopwood, A. G., & Shields, M. D 2009, Handbooks of Management Accounting Research 3-Volume Set, Elsevier Burlington, Retrieved 15 March 2013, http://www.myilibrary.com?id=228701 Das, R., & Basu, U. K 2004, Corporate restructuring: enhancing the shareholder value, Tata McGraw-Hill Pub. Co., New Delhi. Koller, T., Dobbs, R., & Huyett, B 2011, ‘Value the four cornerstones of corporate finance,’ John Wiley & Sons, Hoboken, N.J., Retrieved 15 March 2013, http://www.books24x7.com/marc.asp?bookid=40868. Lupia, D n.d, ‘Measuring Shareholder Value,’ Retrieved 15 March 2013, http://www.dlupia.com/articles/shareholder_value.html  Neil, K & Demand, M 2013, ‘The Advantages And Disadvantages Of Debt And Equity Financing’ Chron, Retrieved 15 March 2013, http://smallbusiness.chron.com/advantages-disadvantages-debt-equity-financing-55504.html Phalippou, L 2009, ‘Beware of venturing into private equity,’ The Journal of Economic Perspectives, 23(1), 147-166. Starovic D., Cooper, S., & Davis, M 2004, ‘Maximizing Shareholder Value,’ Retrieved 15 March 2013, http://www.valuebasedmanagement.net/articles_cima_maximizing_shareholder_value.pdf Viswanadham, N and Luthra, P 2005, ‘Models for Measuring and Predicting Shareholder Value’ Retrieved 15 March 2013, http://www.ias.ac.in/sadhana/Pdf2005AprJun/Pe1306.pdf Read More