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What Is 'Shareholder Value'

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What Is 'Shareholder Value' 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 equity (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 G it has developed the best method of appraise companies – fund managers, opposing views? Has shareholder value evaluating businesses – by compar- analysts and financial journalists. a net present value or not? ing the cash flow return on capital In business, strategies are developed First, one minor complaint. with the cost of capital, 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. economic value added (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 finance with its G 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- corporate finance 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 valuation 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 G it is based almost exclusively on cash ital to arrive at present values of com- are taking the easy option. 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 stock 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 G 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 dividend 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 G 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 debt 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.
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