Shareholder value
Encyclopedia
Shareholder value is a business term, sometimes phrased as shareholder value maximization or as the shareholder value model, which implies that the ultimate measure of a company's success is the extent to which it enriches shareholders. It became popular during the 1980s, and is particularly associated with former CEO of General Electric
, Jack Welch
.
The term used in several ways:
. In the case of only one type of stock
, this would roughly be the number of outstanding shares times current shareprice. Things like dividend
s augment shareholder value while issuing of shares (stock options) lower it.
This shareholder value added should be compared to average/required increase in value, making reference to the cost of capital
.
For a privately held company, the value of the firm after debt must be estimated using one of several valuation
methods, s.a. discounted cash flow
or others.
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.
As shareholder value is difficult to influence directly by any manager, it is usually broken down in components, so called value drivers. A widely used model comprises 7 drivers of shareholder value, giving some guidance to managers:
Looking at some of these elements also makes it clear that short term profit maximization does not necessarily increase shareholder value. Most notably, the competitive advantage period takes care of this: if a business sells sub-standard products to reduce cost and make a quick profit, it damages its reputation and therefore destroys competitive advantage in the future. The same holds true for businesses that neglect research or investment in motivated and well-trained employees. Shareholders, analysts and the media will usually find out about these issues and therefore reduce the price they are prepared to pay for shares of this business. This more detailed concept therefore gets rid of some of the issues (though not all of them) typically associated with criticism of the shareholder value model.
Based on these seven components, all functions of a business plan and show how they influence shareholder value. A prominent tool for any department or function to prove its value are so called shareholder value maps that link their activities to one or several of these seven components. So, one can find "HR shareholder value maps", "R&D shareholder value maps", and so on.
. While a focus on shareholder value can benefit the owners of a corporation financially, it does not provide a clear measure of social issues like employment
, environmental
issues, or ethical
business practices. A management decision can maximize shareholder value while lowering the welfare of third parties
.
It can also disadvantage other stakeholders such as customers. For example, a company may, in the interests of enhancing shareholder value, cease to provide support for old, or even relatively new, products.
Additionally, short term focus on shareholder value can be detrimental to long term shareholder value; the expense of gimmicks that briefly boost a stocks value can have negative impacts on its long term value.
However, this concept is difficult to implement in practice because of the difficulty of determining equivalent measures for usefulness to society and satisfaction of employees. For instance, how much additional "usefulness to society" should shareholders expect if they were to give up $100 million in shareholder return? In response to this criticism, defenders of the stakeholder value concept argue that employee satisfaction and usefulness to society will ultimately translate into shareholder value.
General Electric
General Electric Company , or GE, is an American multinational conglomerate corporation incorporated in Schenectady, New York and headquartered in Fairfield, Connecticut, United States...
, Jack Welch
Jack Welch
John Francis "Jack" Welch, Jr. is an American chemical engineer, business executive, and author. He was Chairman and CEO of General Electric between 1981 and 2001...
.
The term used in several ways:
- To refer to the market capitalizationMarket capitalizationMarket capitalization is a measurement of the value of the ownership interest that shareholders hold in a business enterprise. It is equal to the share price times the number of shares outstanding of a publicly traded company...
of a company (rarely used) - To refer to the concept that the primary goal for a company is to increase the wealthWealthWealth is the abundance of valuable resources or material possessions. The word wealth is derived from the old English wela, which is from an Indo-European word stem...
of its shareholders (owners) by paying dividends and/or causing the stock price to increase - To refer to the more specific concept that planned actions by management and the returns to shareholders should outperform certain bench-marks such as the cost of capitalCost of capitalThe cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
concept. In essence, the idea that shareholders' money should be used to earn a higher return than they could earn themselves by investing in other assets having the same amount of riskRiskRisk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
. The term in this sense was introduced by Alfred Rappaport in 1986.
Definition
For a publicly traded company, Shareholder Value (SV) is the part of its capitalization that is equity as opposed to long-term debtDebt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
. In the case of only one type of stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
, this would roughly be the number of outstanding shares times current shareprice. Things like dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
s augment shareholder value while issuing of shares (stock options) lower it.
This shareholder value added should be compared to average/required increase in value, making reference to the cost of capital
Cost of capital
The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
.
For a privately held company, the value of the firm after debt must be estimated using one of several valuation
Valuation (finance)
In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...
methods, s.a. discounted cash flow
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
or others.
History
On August 12, 1981, Jack WelchJack Welch
John Francis "Jack" Welch, Jr. is an American chemical engineer, business executive, and author. He was Chairman and CEO of General Electric between 1981 and 2001...
made a speech at The Pierre in New York City
New York City
New York is the most populous city in the United States and the center of the New York Metropolitan Area, one of the most populous metropolitan areas in the world. New York exerts a significant impact upon global commerce, finance, media, art, fashion, research, technology, education, and...
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.
Maximizing shareholder value
This management principle, also known under value based management, states that management should first and foremost consider the interests of shareholders in its business decisions. Although this is built into the legal premise of a publicly traded company, this concept is usually highlighted in opposition to alleged examples of CEO's and other management actions which enrich themselves at the expense of shareholders. Examples of this include acquisitions which are dilutive to shareholders, that is, they may cause the combined company to have twice the profits for example but these might have to be split amongst three times the shareholders.As shareholder value is difficult to influence directly by any manager, it is usually broken down in components, so called value drivers. A widely used model comprises 7 drivers of shareholder value, giving some guidance to managers:
- Revenue
- Operating Margin
- Cash Tax Rate
- Incremental Capital Expenditure
- Investment in Working Capital
- Cost of Capital
- Competitive Advantage Period
Looking at some of these elements also makes it clear that short term profit maximization does not necessarily increase shareholder value. Most notably, the competitive advantage period takes care of this: if a business sells sub-standard products to reduce cost and make a quick profit, it damages its reputation and therefore destroys competitive advantage in the future. The same holds true for businesses that neglect research or investment in motivated and well-trained employees. Shareholders, analysts and the media will usually find out about these issues and therefore reduce the price they are prepared to pay for shares of this business. This more detailed concept therefore gets rid of some of the issues (though not all of them) typically associated with criticism of the shareholder value model.
Based on these seven components, all functions of a business plan and show how they influence shareholder value. A prominent tool for any department or function to prove its value are so called shareholder value maps that link their activities to one or several of these seven components. So, one can find "HR shareholder value maps", "R&D shareholder value maps", and so on.
Criticism
The sole concentration on shareholder value has been widely criticized, particularly after the late-2000s financial crisisLate-2000s financial crisis
The late-2000s financial crisis is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s...
. While a focus on shareholder value can benefit the owners of a corporation financially, it does not provide a clear measure of social issues like employment
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
, environmental
Natural environment
The natural environment encompasses all living and non-living things occurring naturally on Earth or some region thereof. It is an environment that encompasses the interaction of all living species....
issues, or ethical
Ethics
Ethics, also known as moral philosophy, is a branch of philosophy that addresses questions about morality—that is, concepts such as good and evil, right and wrong, virtue and vice, justice and crime, etc.Major branches of ethics include:...
business practices. A management decision can maximize shareholder value while lowering the welfare of third parties
Third party beneficiary
A third party beneficiary, in the law of contracts, is a person who may have the right to sue on a contract, despite not having originally been an active party to the contract. This right, known as a ius quaesitum tertio, arises where the third party is the intended beneficiary of the contract,...
.
It can also disadvantage other stakeholders such as customers. For example, a company may, in the interests of enhancing shareholder value, cease to provide support for old, or even relatively new, products.
Additionally, short term focus on shareholder value can be detrimental to long term shareholder value; the expense of gimmicks that briefly boost a stocks value can have negative impacts on its long term value.
Alternative: stakeholder value
The intrinsic or extrinsic worth of a business measured by a combination of financial success, usefulness to society, and satisfaction of employees, the priorities determined by the makeup of the individuals and entities that together own the shares and direct the company. This is sometimes referred to as stakeholder value.However, this concept is difficult to implement in practice because of the difficulty of determining equivalent measures for usefulness to society and satisfaction of employees. For instance, how much additional "usefulness to society" should shareholders expect if they were to give up $100 million in shareholder return? In response to this criticism, defenders of the stakeholder value concept argue that employee satisfaction and usefulness to society will ultimately translate into shareholder value.
See also
- Adjusted present valueAdjusted present valueAdjusted Present Value is a business valuation method. APV is the net present value of a project if financed solely by ownership equity plus the present value of all the benefits of financing...
- Economic value addedEconomic value addedIn corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co., is an estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors . Quite simply, EVA is the profit earned by the firm less the cost of...
- Enterprise valueEnterprise valueEnterprise value , Total enterprise value , or Firm value is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others...
- Internal rate of returnInternal rate of returnThe internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...
- Financial modelingFinancial modelingFinancial modeling is the task of building an abstract representation of a financial decision making situation. This is a mathematical model designed to represent the performance of a financial asset or a portfolio, of a business, a project, or any other investment...
- Flows to equityFlows to equityThe Flow to Equity-Approach is one of three commonly used discounted-cash-flow methods of corporate valuation, the other two are Adjusted Present Value and Weighted Average Cost of Capital ....
- Market value addedMarket value addedMarket Value Added is the difference between the current market value of a firm and the capital contributed by investors. If MVA is positive, the firm has added value. If it is negative, the firm has destroyed value...
- Net present valueNet present valueIn finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
- Sustainable ValueSustainable ValueSustainable value is a way of managing and measuring sustainability performance. The concept was developed by researchers who are working today for and the...
- Valuation using discounted cash flowsValuation using discounted cash flowsValuation using discounted cash flows is a method for determining the current value of a company using future cash flows adjusted for time value. The future cash flow set is made up of the cash flows within the determined forecast period and a continuing value that represents the cash flow stream...
- Time Value of MoneyTime value of moneyThe time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....