Simply put Shareholder Value is the "the total worth of a company to its shareholders"
Increasing shareholder value is of prime importance for the management of a company. So the management must have the interests of shareholders in mind while making decisions. The higher the shareholder value, the better it is for the company and management. For this to happen, management must exercise efficient decision-making so as to earn/increase profits, thereby increasing shareholder value. On the other hand, faulty decision-making using unfair tactics might damage shareholder value.
How to Create Shareholder Value
In order to maximize shareholder value, there are three main strategies for driving profitability in a company: (1) revenue growth, (2) operating margin and (3) capital efficiency.
source: Corporate Finance Institute
- Revenue Growth: For any goods and services businesses, sales revenue can be improved through the strategies of sales volume increase or sales price inflation.
- Increasing Sales Volume: A company would want to retain its current customers and keep them away from competitors to maintain its market share. It should also attract new customers through referrals from existing customers, marketing and promotions, new product and service offerings, and new revenue streams.
- Raising Sales Price: A company may increase current product prices as a one-time strategy or gradual price increase throughout several months, quarters, or years to achieve revenue growth. It can also offer new products of advanced qualities and features and price them at higher ranges.
- Operating Margin: Besides maximizing sales, a business must identify feasible approaches to cost reductions leading to optimal operating margins.
- Cost of Goods Sold (COGS): When a company builds a good relationship with its suppliers, it can possibly negotiate with suppliers to reduce material prices or receive discounts on large orders. It may also form a long-term agreement with the suppliers to secure its material source and pricing.
- Selling, General, and Administrative (SG&A) Expenses: SG&A is usually one of the largest expenses in a company, therefore being able to minimize them will help the company achieve an optimal operating margin. The company should tightly control its marketing budget when planning for next year’s spending.
- Capital Efficiency: Capital efficiency is the ratio between dollar expenses incurred by a company and dollars that are spent to make a product or service, which can be referred to as ROCE (Return on Capital Employed) or the ratio between EBIT (Earnings Before Interest and Tax) over Capital Employed. Capital efficiency reflects how efficiently a company is deploying its cash in its operation.
- Property, Plant, and Equipment (PP&E): To achieve high capital efficiency, a company would first want to achieve a high return on assets (ROA), which measures the company’s net income generated by its total assets.
- Inventory: Inventory is often a major component of a company’s total assets, and the company would always want to increase its inventory turnover, which equals to net sales divided by average inventory. A higher inventory turnover ratio means that more revenues are generated given the amount of inventory.
How to Calculate Shareholder Value?
Making money on an investment is every investor's goal, so it's important to know how to calculate your shareholder value. Fortunately, it can be done in four easy steps.
- Subtract the company's preferred dividends, which it has promised to preferred shareholders, from its net income. For example, if a company has a net income of $80,000 one year and must distribute $20,000 of it to preferred shareholders, subtract $20,000 from $80,000 to get $60,000. This is the income available to shareholders.
- Divide the income by the total number of outstanding shares. For example, if the company has issued 15,000 shares, divide $60,000 by 15,000, to get $4. This is the value of earnings per share.
- Add the stock price to this value. For example, if the stock sells at $25 per share, add $4 to $25 to get $29.
- Multiply the earnings per share by the number of shares that the shareholder owns. For example, if the investor owns 20 shares, multiply $29 by $20, to get $580. This is the shareholder value.
History of Shareholder Value
On August 12, 1981, Jack Welch made a speech at The Pierre in New York City called ‘Growing fast in a slow-growth economy’. This is often acknowledged as the "dawn" of the obsession with shareholder value. Welch's stated aim was to be the biggest or second biggest market player and to return maximum value to stockholders.
In March 2009, Welch criticized parts of the application of this concept, calling a focus on shareholder quarterly profit and share price gains "the dumbest idea in the world". Welch then elaborated on this, claiming that the quotes were taken out of context.
Mark Mizruchi and Howard Kimeldorf offer an explanation of the rise in prominence of institutional investors and securities analysts as a function of the changing political economy throughout the late 20th century. The crux of their argument is based upon one main idea. The rise in prominence of institutional investors can be credited to three significant forces, namely organized labor, the state, and the banks. The roles of these three forces shifted or were abdicated, in an effort to keep corporate abuse in check. However, “without the internal discipline provided by the banks and external discipline provided by the state and labor, the corporate world has been left to the professionals who have the ability to manipulate the vital information about corporate performance on which investors depend”. This allowed institutional investors and securities analysts from the outside to manipulate information for their own benefit rather than for that of the corporation as a whole.
Though Ashan and Kimeldorf (1990) admit that their analysis of what historically led to the shareholder value model is speculative, their work is well-regarded and is built upon the works of some of the premier scholars in the field, namely Frank Dobbin and Dirk Zorn.
During the 1970s, there was an economic crisis caused by stagflation. The stock market had been flat for nearly 12 years and inflation levels had reached double digits. Also, the Japanese had recently taken the spot as the dominant force in auto and high-technology manufacturing, a title historically held by American companies. This, coupled with the economic changes noted by Mizruchi and Kimeldorf, brought about the question of how to fix the current model of management.
Though there were contending solutions to resolve these problems, the winner was the Agency Theory developed by Jensen and Meckling, which will be discussed in greater detail later in this entry. As a result of the political and economic changes of the late 20th century, the balance of power in the economy began to shift. Today, “…power depends on the capacity of one group of business experts to alter the incentives of another, and on the capacity of one group to define the interests of another. As stated earlier, what made the shift to the shareholder value model unique was the ability of those outside the firm to influence the perceived interests of corporate managers and shareholders.
However, Dobbin and Zorn argue that those outside the firm were not operating with malicious intentions. “They conned themselves first and foremost. Takeover specialists convinced themselves that they were ousting inept CEOs. Institutional investors convinced themselves that CEOs should be paid for performance. Analysts convinced themselves that forecasts were a better metric for judging stock price than current profits”. Overall, it was the political and economic landscape of the time that offered the perfect opportunity for professionals outside of firms to gain power and exert their influence in order to drastically change corporate strategy.
Does the Management of a Company really have a duty to maximize Shareholder Value?
It is commonly understood that corporate directors and management have a duty to maximize shareholder value, especially for publicly traded companies. However, legal rulings suggest that this common wisdom is, in fact, a practical myth - there is actually no legal duty to maximize profits in the management of a corporation. The idea can be traced in large part to the oversize effects of a single outdated and widely misunderstood ruling by the Michigan Supreme Court's 1919 decision in Dodge v. Ford Motor Co., which was about the legal duty of a controlling majority shareholder with respect to a minority shareholder and not about maximizing shareholder value. Legal and organizational scholars such as Lynn Stout and Jean-Philippe Robé have elaborated on this myth at length.
The Downside of Shareholder Value
Shareholder value involves increasing the amount of free cash flow. The additional cash can then be used to either pay dividends to investors or further expand the business, which may increase the market value of their shares. Shareholder value is a core concept of business management, which drives the need to continually increase cash flow over the long term. However, an excessive focus on shareholder value can lead to issues in other areas, such as:
- Driving down costs to an excessive extent, which can result in shoddy products
- Forcing down compensation levels, leading to an increased amount of employee turnover
- Outsourcing to low-wage locations, thereby driving work away from the home country
- Engaging in environmentally unfriendly activities, such as dumping hazardous waste irresponsibly
- Engaging in tax management ploys to pay less than their fair share of taxes
- Another offshoot of a tight focus on shareholder value is an increased risk of financial reporting fraud, as managers are more likely to be tempted to falsely report optimistic results in order to further increase the share price.
Yet another possible outcome of using the shareholder value concept is the increased use of debt instead of equity. This additional level of leverage can increase earnings per share but puts an organization at risk of not being able to pay back loans if there is an economic decline.
These issues have led to an increasing outcry against an excessively tight focus on shareholder value. A more responsible business is now considered to be one that allows increased expenses in the areas just noted in order to be a better partner to employees, customers, and local authorities.
- ↑ Cambridge Definition of Shareholder Value -Dictionary
- ↑ What is Shareholder Value?-Economic Times
- ↑ How to Create Shareholder Value -CFI
- ↑ How to Calculate Shareholder Value? -Pocketsense
- ↑ History of Shareholder Value -Wikipedia
- ↑ The Shareholder Value Maximization Myth-Investopedia
- ↑ The Downside of Shareholder Value -Accounting Tools
- Ten Ways to Create Shareholder Value HBR