Managing Shareholder Value - Essay Example

Managing Shareholder Value 0 Introduction There are so many multiples being dealt with the broad spectrum of financial management. However when thequestion of finding out whether any real shareholder value has been created arises , the total system fumbles and it may not really be possible for one to find out the real status with regard to the creation of shareholder value. The standard models dealing with the internal financial management of any firm mostly uses the cash flow analysis for review and decisions on capital expenditures. Similarly the system uses the base of earnings and other multiples like EBITDA or rate of return for evaluating and reporting on the financial performance of the firms to maintain the relationship with the investors. For effectively planning and managing the funds, another scorecard of metrics is being developed with the provision of incentives for bettering the budgeted figures being used. All of these elements when considered individually excel with their simplicity. But when the system as a whole is looked at it turns to be complex with a number of "metrics, methods and messages" which makes the understanding of the finance executives of the shareholder value rather difficult. Hence it becomes vitally important that the CFO of any organization coordinates his efforts in designing the systems of the financial management with the CEO and the directors of the company so that the internal corporate governance is strengthened and if necessary modified to meet the firm's requirements. With this background this paper envisages presenting a report on the degree of profit measure of economic surplus and shareholders funds economic value accurate the metrics of the key economic visions of a firm. 2.0 Shareholder Value: The shareholder value is represented by the wealth a company creates through its profitability for its shareholders. The shareholder value also includes the broad framework in which the firm operates to achieve the shareholder value and it also includes the organizational culture. Thus the process of arriving at a framework to create the shareholder wealth may have considerable impact on different people working with the firm both internally within and externally outside the organization. "The Shareholder Value theory works on the premise that the value created by a business is best represented by the change in its economic value that is, the change in the net present value of its expected future cash flows to shareholders."1 There are a number of Shareholder Value measures which are being used for monitoring and evaluating the performance of the organization as well as rewarding the employees. One of the most popular methods of shareholder Value Measure is the Economic Value Added (EVA) approach. 2.1 Rationale behind adopting Shareholder Value Approach: The Shareholder Value approach has increasingly been adopted due to the following factors: The managers always feel that there exist a difference in the value of the firm as perceived internally and by the shareholders and this approach helps them to bridge the gap It is also necessary that the investors should know the true economic value of the firm for making their investment decisions on the basis of the economic profit of the firms. The accounting statements present rather a historic value and analysis of the performance of a company and it is necessary to have information on the future value of the company. Since the shareholder value is based on projected cash flows allowing for the cost of capital which are also discounted are less influenced by accounting rules and hence project the true value of the firm. Due to the globalization there is a delay in accessing the standard measures of performance Due to increased contribution to business by the information technology the expectations of investors has increased to get more clear measures of performance. The above factors necessitate adopting a proper measure for the assessing the value of a firm from a shareholder's perspective and Economic Value Added measure go well with achieving the objective of measuring the economic value of profits as may be perceived by the shareholder. 3.0 Profit Measure of Economic Surplus: Under Economic Value Added method of financial management capital cost is the most important aspect that is being considered to arrive at the true economic value of the firm. Under conventional form of accounting though most of the companies appear to have large profits they may not possess a true economic profit to the extent they project. Peter Drucker states in his article in the Harvard Business Review "Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resourcesUntil then it does not create wealth; it destroys it." Under the Economic Value Added method the cost of capital is given the due recognition in that it is an established principle that when a business employs some amount of capital to run its business it is important and necessary that the firm should provide for some cost towards the capital so employed by it. Any profits earned by the firm can be counted as profit only after the firm is able to make good the cost of capital. Thus by taking the all costs of capital including the cost of equity capital into account the EVA arrives at the physical value of the wealth , that a business has created or the amount of wealth deteriorated by way of losses during an operating period. In other words EVA can be regarded as the profit as defined by the shareholders. This can be explained by the illustration that if a shareholder expects a return of 12 percent on his investments it means that the return is equal only to the extent that their share of after-tax operating profit exceeds 12 percent of the equity capital. Any money earned before such appropriation is the" minimum acceptable compensation" for the capital invested in the business which represents the risky venture. 4.0 Economic Value Added (EVA) Measure of Economic Profit: Economic Value added is a performance evaluation method which facilitates the calculation of the true economic profit of any organization. This method gained its popularity due to its simplicity and also it is possible to apply this measure to calculate the business earnings at a divisional or strategic business unit level. Unlike the measures that are used to value the stocks, EVA is a flow and can be used to measure the performance of the firm over a period of time. "Unlike accounting profit, such as EBIT, Net Income and EPS, EVA is Economic and is based on the idea that a business must cover both the operating costs AND the capital costs."2 The EVA measure of economic profit is capable of binding the various financial management applications and other incentive plans together and integrates them into one common framework. "It is unique in its ability to play that role because as a measure of profit, EVA is conceptually easy to understand, and as a measure of performance, it is the only one that directly ties to NPV and the creation of shareholder wealth and that legitimately qualifies for a mission of continuous improvement. EVA is truly the hedgehog of finance, and the key to value-focused management."3 4.1 Uses of the EVA Method: The following are some of the areas in which the use of EVA method may be found suitable: The EVA method can be used to set the organizational goals in terms of profitability The evaluation of the performance of the firm is made simpler and accurate It provides a clear way of arriving at the bonuses for surpassing of the budgets Meaningful communication with the shareholders and investors is possible with the help of the EVA method It provides as the best means of motivating the managers and executives Effective ways of making the capital budgets is also possible to achieve An accurate corporate valuation can be arrived at by using the EVA method Based on an exact valuation using the EVA method an efficient analysis of the securities can be attempted. 4.2 Calculation of EVA: EVA can be calculated as the net operating profit after taxes less the opportunity cost of capital invested in the firm calculated at a certain percentage. "As such, EVA is an estimate of true "economic" profit, or the amount by which earnings exceed or fall short of the required minimum rate of return which shareholders and lenders could get by investing in other securities of comparable risk"4 5.0 Aligning Financing Decisions with Shareholder Wealth: The finance managers have a choice of adopting two basic principles of financial management in their decision making process. They are: 1. The primary objective of any financial management decision is that such decision should result in the maximization of the shareholders' wealth and 2. The value of a company is based upon the extent to which the future profits of the company is able to exceed the cost of its capital and the value of the firm is reduced to the extent of shortfall in the profits as against the cost of capital. It may be noted that any increase in the EVA of a firm would automatically increase the market value of the company. This is true in respect of all kinds of organization. While the current performance is aptly reflected by the fluctuations in the share prices, the continuous enhancement in the EVA results in a continued growth in the shareholder wealth in relation to the firm. 5.1 Familiarity of EVA with Non-financial Managers: It is important for any organization to succeed in terms of its profitability the line managers representing the core of non-financial managers of the organization understand the financial goals of the company in a cohesive manner so that they would be able to contribute towards the achievement of such preset goals. In this respect the EVA is placed in an advantageous position, since the principles of this method are simple and can be explained easily to the non-financial managers. As the calculation of the EVA is so simple in that a fixed percentage of cost towards capital employed in the particular firm or division is to be deducted from the operating profits. This is easy to explain and to understand by the managers concerned. EVA by introducing the concept that there exist a cost for the capital makes the managers recognize the need to manage there assets and income carefully and also enables them to arrive at a proper balance between the assets and the income by attributing a value on the capital being employed by them in the form of assets which they manage. This also enables the managers at all levels to have a broader economic perspective of the profit and better manage their divisions or units. 6.0 Conclusion: Most of the business firms presently are struggling to create wealth for their shareholders with poorly designed and inadequate financial management models. The standard 'fuzzy' financial models with their application of cash flows, earnings, rates of returns and scorecard metrics make the financial management system more cumbersome with the result that the finance executive are not at all made fully accountable for delivering the shareholder value. Such system with the poor models do not also provide for any rewards for an efficient and effective performance in the areas of financial management. "CFOs need to assert control over the design of their financial management systems. They should champion a cross-functional effort to streamline and simplify the overall system and establish a transparent, comprehensive focus on creating shareholder value."5 In order to improve the performance in the areas of financial management EVA is one tool that can be best relied on as true measure of economic profit of an organization and it also directly links the NPV and the creation of shareholder wealth. Hence under EVA the profit measure of economic surplus and shareholder funds measure of economic value accurate to the fullest extent the economic visions of a firm. Word Count: 2020 Bibliography: Bennett Stewart 'Focused Finance' http://www.evadimensions.com/library/FocusFinance061603.pdf 'Shareholder Value Measures in General Insurance Working Party' 2000 General Insurance Convention http://www.actuaries.org.uk/files/pdf/library/proceedings/gen_ins/gic2000/0197-0237.pdf Stern Stewart & Co 'About EVA' http://www.sternstewart.com/evaabout/whatis.php Value Based Management.net 'Economic Value Added' http://www.valuebasedmanagement.net/methods_eva.html Read More