Creating Shareholder Value

Written by Dilan Moragolle

Introduction

During the past two decades, shareholder value has become one of the core principles of corporate governance in America and Europe. According to Lazonick & O’Sullivan (2000), Shareholder interest has become the first and foremost interest of the CEOs and management of the companies. Therefore, the concept of shareholder value is more important today than before (Mauboussin, MJ 2011). However, is it a widely misunderstood concept??According to Mauboussin (2011), three issues need to be taken into account when creating shareholder value.

1. Need to internalize the meaning of shareholder value
2. Understanding of capital markets
3. Need for effective communication with shareholders.

Some companies focus on maintaining short-term share prices by any means necessary. That is a profound mistake. The proper way of creating shareholder value is to build value within the company and let the stock price follow (Mauboussin, MJ 2011).

?Value Creation

According to Fernández (2002), shareholder value is created when the return on the investment is higher than the investment made. Malekian (2007) empathizes that long-term free cash flow plays a vital role in value creation. Therefore, businesses need to manage relationships with all of the stakeholders to maximize long-term free cash flow. The stock market value of a company and the actual value of a company are expected to be similar value. To achieve this company executives are expected to engineer results through value drivers.?In case of a?gap between share price and company calculated value (actual value), there are certain?measurements that can be taken to remedy or even take advantage of the situation. If the share price is lower than the calculated value, the company can simply buy back the share and when the share price is higher the company can either sell or issue shares (Mauboussin, MJ 2011).?

It is important to understand how resources rely on each other in the process of value creation. Therefore, resources are used and allocated effectively?and it is important to have a thorough?understanding of value drivers (Pike, Roos, & Marr 2005). Rappaport (2006) in his article in Harvard Business Review points out ten ways to create shareholder value.

1. Do not manage earnings or provide earnings guidance
2. Make strategic decisions that maximize expected value
3. Make acquisitions that maximize expected value
4. Carry only assets that maximize value
5. Return cash to shareholders when there are no credible value-creating opportunities to invest in the business
6. Reward CEOs and other senior executives for delivering superior long-term returns
7. Reward operating unit executives for adding superior multiyear value
8. Reward middle managers and frontline employees for delivering superior performance on the key value drivers that they influence directly
9. Require senior executives to bear the risks of ownership just as shareholders do
10. Provide investors with value-relevant information.

How to Measure Shareholder Value

There are several ways of calculating shareholder value in a firm. The value of the total shares in the stock market is one of these measures. It can be considered as an indicator of future financial performance and a tool to measure the long-term measure of value. However, stock market value is?considered more as a traditional measure and there are several modern methods available (Anderson, Fornell & Mazvancheryl 2004). Stock returns are used to illuminate arbitrary division of shareholder value created by share price and convert to a common baseline. However, stock returns do not take risk factors into account (Anderson, Fornell & Mazvancheryl 2004). “Tobins’q”?is another capital market-based measure that is in use. It is perceived as a more accurate measure than stock price and stock returns because, it takes, capital market data, accounting data, and risk factors into consideration. According to Anderson, Fornell & Mazvancheryl (2004), the use of Tobins’q?is becoming popular. Tobin’s q can also be used to measure brand equity.

According to Young & O’byrne (2001), the best measure available to calculate shareholder value is by using Economic Value Added (EVA). Traditional measures can easily be manipulated and the cost of equity is ignored.?Market-based measures can only be applied to public companies. The cash flow measure does not consider the cost of equity and the cost of debt. Young & O’byrne (2001) points out that the accuracy of EVA is higher than other measures because it only accounts for the debt financing and equity financing costs.

Value Drivers

Value drivers are the factors that enhance value in a business (Amit & Zott 2000). According to?Frykeman & Tolleryd (2012), value drivers can be described as operational value drivers and financial value drivers. Value creation map can be used to identify strategic value drivers that can be used to increase value creation (Marr 2006).?If a company can identify key value drivers that have high market influence, the company can focus on those drivers to increase value. Factors that can influence value creation such as price optimization, customer satisfaction, management quality are considered as value drivers. Value drivers can be divided into two separate categories.

1. Internal Value Drivers
2. External Value Drivers.?

Internal value driver related to the internal environment of the business and external environment related to the external macro-economic environment.?

Some of the Key-Value Drivers and their impact on value creation

According to Rappaport (2006), cashflow is one of the key value drivers in any business. Cashflow, customer satisfaction, and business relationships are some of the value drivers that have a significant impact on value creation.

By enhancement of cash flow could lead to the growth of shareholder value. To increase cash flow a company could increase sales volume or sales price can be increased. At the same time cost can reduce as well. Cash flow can be volatile and vulnerable from time to time. Using the SCM process cash flow vulnerability can be reduced. With the help of product innovation, cash flow volatility can be reduced (Rappaport 2006).

Customer satisfaction positively influences customer retention. Customer retention secures future cash flows and reduces costs of customer transactions such as marketing, promotions, and services related to sales. As a result of that net cash flow can be expected to go higher. Customer retention leads to a stable customer base and it can be considered as a source of measuring future cash flows. Because of that customer retention has a positive impact on shareholder value (Anderson, Fornell,& Mazvancheryl 2004).?

Business relationships plays important role in value creation. The way a company manages its relationships with customers, suppliers, shareholders, government and other stakeholders have both direct and indirect influence on the business. Business relationships affect efficiency and efficacy. According to Wimmer & Mandják (2002), it also can be an effective tool for measuring success. Long-term contracts with suppliers and customers are a sign of good business relationships.

Conclusion

The concept of shareholder value gained importance during the last two decades. There is several experts have illustrated the importance of shareholder value. It has been pointed out that shareholder value is the core of a business and it is the key responsibility of the CEO and the management of the business. Tools such as the stock market value of the company, Tobins’q, economic value added (EVA), etc. are used to calculate shareholder value or company value.?Value is created through value drivers. Value drivers are mainly divided into internal and external. Cash flow, customer satisfaction, and business relationships are some of the important value drivers.?