TREASURY PRACTICE General Technical

What is ‘shareholder value’ really worth? The concept of ‘shareholder value’ is all the rage, but is also attracting criticism. Here, Alan Clements of David S Smith Holdings sets out the pros and cons.

hareholder value’ is not only possibly only to be bought back again, flows, not on profits or earnings the flavour of the month in all in pursuit of returns which the (regarded as flawed accounting ‘Sfinance, but also in manage- investor of old never dared dream of. concepts); ment generally, and among those who Where is the truth between these it has developed the best method of appraise companies – fund managers, opposing views? Has shareholder value evaluating – by compar- analysts and financial journalists. a or not? ing the cash flow return on capital In , strategies are developed First, one minor complaint. with the , in order to and businesses are evaluated using it; Shareholder value texts are already lit- see whether shareholder value, i.e. even compensation schemes for senior tered with capital letter abbreviations. (EVA), is management are built up around it, The theory could become, eventually, being created or not; and and investor relations programmes are worse than modern with its similarly, it has produced the best guided by it. EMH, MPT, CAPM, β, DCF, NPV, IRR, method of evaluating companies, We all await the modern text book on APV, APT, ADR, NTV & WACC, to acquisitions and strategies, by dis- with a whole section mention just those I can recall. counting (at the cost of capital) cash devoted to shareholder value – or at Shareholder value has added, to flows, in order to deliver present val- least some do! For many, at any rate, date, EVA or SVA, NOPAT, FCF, MVA, ues which can be compared with cur- shareholder value concepts have SHV, CFROI, TSR, RONA and VBM. We rent or other values, again to reveal amounted to a breath of fresh air, are approaching the point where we whether shareholder value will be imparting practical realism into the oth- need Penguin to publish a dictionary of realised, or not. erwise fuzzy counselling of the financial terms, some of them with more management gurus. than one meaning or connotation! Does shareholder value deliver? Already, however, there are critics What, however, is it that shareholder As it stands at the moment, does share- who claim that newly-installed manage- value claims to bring to the party which holder value really deliver these promis- ment teams, encouraged by sharehold- is new? And does it, in fact, do so es? The answer must be a guarded er value concepts to make their compa- successfully? ‘yes’, but there are problems which nies more ‘focused’, too quickly sell The literature – books as well as arti- need to be resolved before this can peripheral or non-core businesses, pos- cles – is pretty clear; the shareholder become a wholehearted affirmative. sibly borrow a bit more money, and value concept makes three claims which then indulge in share repurchases in are new, or at least reasonably so, in the The basis is cash-flow, order to enhance earnings per share. general body of financial theory. They not earnings or profits They are misled, it is argued, into are: But is it? Where free-cash-flows (FCFs) thinking that price (ie share price) is the are being discounted at the cost of cap- same thing as value, when really they it is based almost exclusively on cash ital to arrive at present values of com- are taking the easy . panies or strategies the answer is clear Furthermore, it is claimed they enough – ‘yes’. become obsessed with short-term, But EVA, the popular technique which rather than long-term, price, and of emphasises the necessity of achieving a course their incentive compensation return on capital in excess of the cost of schemes support what they are doing. capital, is a different kettle of fish. EVA uses NOPAT (net operating prof- A fresh pinnacle it after tax) and it is not immediately The new philosophy or ‘school’ seems obvious that this is a cash flow measure. to reach a fresh pinnacle of financial While tax is deducted on a payments ingenuity in the shape of ‘leveraged basis, how, for example, is an capital’ funds, whose main contribution allowance made for depreciation and to capitalism is a process whereby com- capital expenditure? Only by a close panies, and bits of companies, become examination of the entrails does it merely in trade to be bought and become apparent that depreciation is sold, or floated on the exchange, Alan Clements added back, but that the deduction for

20 The Treasurer – January 1999 TREASURY PRACTICE General Technical

capital expenditure is often assumed to real terms) ranging from 6% to over be the same as depreciation. There was, As it stands at the 11% pa. What is one to do in practice? I seem to remember, an old accountan- moment, does In a talk given in 1993, admittedly on cy tenet that depreciation was the Japanese finance, Merton Miller needed amount which must be reinvested to shareholder value to use a cost of capital figure – I think it maintain the profitability of the business really deliver these was a cost of equity. but if EVA is based, among other things, He said he would use 10% – “what on such principles, it ‘depreciates’ in my promises? The else?”. But when evaluating a strategy, opinion. answer must be a or valuing a company, the problem can- The whole concept seems to become not be dismissed as easily as that. A less factual and more subjective than its guarded ‘yes’ cash flow of 10 per annum (admittedly advocates would have one believe. to infinity) valued at 10% becomes 100; This seems to be borne out by a least the same in the future? at 8%, 125. The appropriateness of the recent article in the Investor’s Chronicle the current market situation – effec- rate is important. So far shareholder on ‘return on equity’, and its role in the tively the company’s current value does not seem to have clarified valuation of equities (24 July 1998). It yield, plus its potential growth rate the issue. hails EVA as a major step forward, but (its NOPAT retention rate multiplied when analysing SmithKline Beecham by its return on equity). This method It has developed the best method EVA produces 1997 equity ‘profits’ of brings into play some of those sub- of evaluating businesses either £1.1bn or £1.6bn, compared jective elements which worry those The method referred to in this claim is with a free cash flow valuation of who seek certainty e.g. what return?, EVA which is arrived at by comparing £0.62bn. what equity? Nevertheless, it is a the cash-flow (or NOPAT) return on cap- Promoting the former figures in pref- method which has its supporters; and ital with the cost of capital. The prob- erence to the free cash flow valuation, it CAPM – the method advocated by lems one faces in trying to use NOPAT proclaims – “Accounting returns, mean- most of the texts, and by the great and the cost of capital have already while, smooth income and costs across majority of the articles on sharehold- been mentioned. The claim would financial years to reflect when the work er value. It seems simplicity itself – a receive more support if only one had was actually done.” The harsh reality of risk-free rate of interest, plus an equi- more confidence in the basic figures! cash, it seems, can be mitigated by the ty premium, the latter adjusted by a superior wisdom of the accountants. So factor which takes into account the It has produced the best method much for the claim that shareholder extent to which the company share of evaluating companies, value is based on the certainty and price moves, up and down, with the acquisitions and strategies inevitability of cash flow! market as a whole (the βeta). Any comment on this claim is rendered Unfortunately, unanimity on the risk- difficult by the fact that the shareholder Cash flows, or EVAs, are free rate, the equity premium and the value literature contains more than one discounted at the cost of capital to validity of the β is conspicuous only method! Fortunately, there are two arrive at ‘present values’ by its absence. principal ones. But just what is the ‘cost of capital’? Let us think in terms of the evaluation Most text books and articles refer, some- The list is by no means an exhaustive of a new business strategy. what quickly, to the capital asset pricing one. To make it complete, one would Strategy one – the entity’s cash model (CAPM) measure of the after-tax have to mention arbitrage pricing theo- flows (preferably free cash flows) cost of capital, and then use something ry, adjusted discount rates, market expected with the strategy and any in the 10%-15% range, or more derived discount rates, and a cost of associated finance are discounted recently a figure even lower than 10%. equity arrived at by using the at the cost of equity to give a present The assumption seems to be that annualised cost of a call option. value – the ‘strategy value’. This can modern financial theory has resolved But just employing the three methods then be compared with ‘pre-strategy this problem, and that one only needs listed above can produce equity costs (in value’ to see whether the proposed to turn to a modern text book to find the strategy does produce extra value or answer. not. Unfortunately, the texts are by no One minor But what is ‘pre-strategy value’? Book means clear. The cost of debt is not a complaint. value as of now? Some writers use it, major problem, but the cost of equity is. others dismiss it summarily. Book value There seem to be at least three methods Shareholder value adjusted to current values, by inflating of arriving at the cost of equity: texts are already historical cost figures at inflation rates experienced since purchase? history – effectively, what sort of littered with capital Tobin1 favoured this method. return, in the form of dividend yield letter abbreviations. Rappaport2, on the other hand, advo- and capital value growth, have cated capitalising current NOPAT, using investors in the company enjoyed in The theory could the weighted average cost of capital the last five, 10 or 15 years of the become worse than (WACC). Others still would simply use company’s history? Will current own- the present day market value of equity. ers, and potential ones, not expect at modern finance... If the decision were left to those

The Treasurer – January 1999 21 TREASURY PRACTICE General Technical

value (calculated at the end of the connected to the criticism that corporate growth period), in order to produce a management does not seem to be Glossary of terms ‘strategy value’. There are problems learning the right lessons from ‘share- with both the opening and the terminal holder value’. EVA, for example, has ADR Adjusted Discount Rate values. been showing returns on the increase, The problem with opening value is while at the same time the cost of capi- APT Arbitrage Pricing much the same as that we experienced tal has been falling. Nevertheless invest- Theory with ‘pre-strategy value’ – how to calcu- ment of an organic nature in the recov- APV late it. Book value is normally frowned ery of the 1990s has been disappoint- βeta The measure of market upon, yet in recent studies showing how ing when compared with that of the risk the S & P Industrials can be valued on 1980s. It has been suggested that a CAPM Capital Asset Pricing an EVA basis, Goldman Sachs used just principal cause of this has been the way Model that. in which ‘shareholder value’ techniques Other bases have their supporters. drive home the necessity of delivering CFROI Cash Flow Return on Perhaps the opening value does not value quickly. Investment matter too much if it is total value one is Organic investment is just too lengthy DCF seeking (a low opening value results in a process when compared with divest- EVA Economic Value Added higher EVAs and a higher terminal ment and acquisition, or gearing up EMH Efficient Market value, and vice versa for a high opening and returning cash to the shareholders, Hypothesis (or Theory) value – the total value must emerge the or a company split, or some other form same, and also equivalent to the pre- of downsizing and outsourcing. FCF Free-Cash-Flows sent value of the FCFs). But, if one is It may well be that ‘shareholder IRR Intended Rate of Return interested in the methodology, one has value’ studies compel management to MPT Modern Portfolio the nagging feeling that the opening concentrate on policies which deliver Theory value ought to have meaning. superior returns, and highlight for them MVA The terminal value is usually calculat- those ‘value drivers’ which constitute the NOPAT Net Operating Profit ed by simply capitalising the EVA of the real basis of companies’ cash flows. last year of the growth period. That But at the same time there is an After Tax value is then reduced to a present value. emphasis on the quick solution, the NPV Net Present Value In many calculations most of the share- speedy turn-round, and the generation NTV Net Terminal Value holder value which emerges stems from of the maximum amount of cash in the PAT Profit After Tax this terminal value. shortest possible time. There is a danger RONA Return of Net Assets But often those who are asked to that ‘shareholder value’ will become SHV Shareholder Value accept the calculations find it difficult to perceived as an integral part of the conceive of the company being valued, management of the relative decline of a SVA Shareholder Value in five to 10 years’ time, on much the large part of the corporate sector, Added same basis as a perpetual gilt. A figure profitably for some but not for all. TSR Total Shareholder which is crucial in justifying the strategy In their standard text on corporate Return somehow lacks the necessary credibility. finance, Messrs. Brealey and Myers, in VBM Value Based These are the main criticisms of the chapter 36, list 16 major problems. Six Management detailed mechanics of shareholder are labelled ‘do knows’, ten ‘do not knows’. Shareholder value is not among WACC Weighted Average Cost value calculations. To some they will seem pedantic, relating as they do in them, but if it were added to the list, I of Capital the main to the valuation of a company fear the ‘do not knows’ would increase now, in five years’ time, in 10 years’ to 11. time, and under the current strategy or advocating the new strategy, it is pretty under a new one. Alan Clements, CBE, is chairman of clear which figure would be adopted. David S Smith Holdings and a Fellow of Perhaps the answer is to use the pre- A serious discipline The Association of Corporate Treasurers. strategy cash flows discounted at the It could be argued that this has been a same cost of equity that is used in the weakness of corporate finance ever 1 Tobin – one of the group of strategy-inclusive NPV calculation. since it emerged as a serious discipline. economists who helped to found and Strategy two – the strategy’s EVAs, It could also be pointed out that EVA is develop CAPM. Also well known for the (i.e. NOPATs) during the period in which extremely useful in looking at the year ‘Tobin-q’, the relationship between they are growing under the impact of by year performance of the company market value and the replacement cost the new strategy (usually 5 to 8 years) and its businesses, and in discovering of a business (a concept ‘borrowed’ are discounted to give a present value. whether or not the returns on capital from Keynes). Because these are differences (a return invested exceed the cost of capital. minus a cost), and because they are val- But the question of valuation is impor- 2 Rappaport – regarded as the real ued for a limited period, to this present tant – after all, it is ‘shareholder value’ founder of shareholder value thinking. value must be added an opening value, we are talking about. And it becomes His book ‘Creating Shareholder Value’ is and the present value of a terminal the more significant when it is a standard test.

22 The Treasurer – January 1999