SHAREHOLDER VALUE

MICHAEL HAKEL

OCTOBER 2000

Michael Hakel Shareholder Value

Fremdsprachliches Seminar WS 2000 / 2001

1. INTRODUCTION ............................................................................3 2. DEFINITION ...................................................................................3 3. THE SHAREHOLDER VALUE ANALYSIS ....................................3 4. IMPLEMENTING SHAREHOLDER VALUE...................................4 5. THE SHAREHOLDER SCOREBOARD .........................................4 6. PROBLEMS WITH SHAREHOLDER VALUE ................................5 7. APPENDIX .....................................................................................6 8. BIBLIOGRAPHY ............................................................................8

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Michael Hakel

Fremdsprachliches Seminar

Shareholder Value

WS 2000 / 2001

1. INTRODUCTION Due to wrong decisions making in management like missing of opportunities to redeploy cash to value-creating growth or in absence of profitable investment opportunities to distribute the cash to shareholders the market penalized the company’s shares. This leads to the “value gap”, i.e., difference between the book value and the market value. A positive “value gap” is an invitation for corporate raiders to bid for the company and replace the management. The only compelling takeover defense is to close the “value gap”. This can be achieved by the delivering of superior shareholder value.

2. DEFINITION Shareholder value is the total benefit to shareholders from investing in a company. The question now is how this benefit can be evaluated. The common accounting methods like ROI (Return On Investment) and ROE (Return On Equity) are not quite reliable as their data depends on book keeping principles like depreciation or the length of a period.

3. THE SHAREHOLDER VALUE ANALYSIS The shareholder value network (Appendix A) can be used to show the influence of management decisions on shareholder value. Operating:

Decisions such as pricing, product mix, distribution, customer service level etc. affect primarily on the three value drivers (valuation parameters): sales growth, operating profit margin and income tax rate. Investment:

Decisions such as increasing inventory levels and capacity expansion affect mainly the two value drivers: working capital and fixed capital investment. Finance:

The cost of capital value driver is determined by the risk of business and management’s financing decisions.

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Michael Hakel

Fremdsprachliches Seminar

Shareholder Value

WS 2000 / 2001

The final value driver, which is the value growth duration, is the management’s best estimation of how long the investment will achieve a rate of return. Shareholder value depends on three valuation components: 1. Cash flow from operations 2. Discount Rate 3. Loan capital (debt)

Shareholder value = Corporate value – Debt Corporate value = Present value of cash flow from operations during the forecast period + Residual value + Marketable securities

4. IMPLEMENTING SHAREHOLDER VALUE Implementation of shareholder value will vary among companies, depending on its size, global reach, employee mix, culture, management style and sense of urgency. Shareholder value is typically implemented in three phases: 1. Management must be convinced of a genuine need for change 2. The details of change must be defined and introduced to all levels 3. Change must be reinforced to ensure that it is sustained

5. THE SHAREHOLDER SCOREBOARD There is no shortage of rankings of publicly traded companies. The major business magazines rank companies by size of sales, profit, assets or total stock market value. These magazines also emphasize financial measures such as earnings per share and ROE to assess corporate performance. However, the main consideration for investors is neither size nor historical financial performance but the total rate of return that is, dividends plus share price increases. The Shareholder Scoreboard (Appendix C) is annually published and focuses exclusively on performance for the investors with ranking of the rate of return. It serves not only to remind CEOs and boards of directors of their fundamental responsibility to shareholders but also provides a performance database for the public. 4

Michael Hakel

Fremdsprachliches Seminar

Shareholder Value

WS 2000 / 2001

Total return to shareholders is the measure of performance for pension funds and mutual funds. It shows clearly which companies are concerned about shareholder value and which are not. It is important to understand that shareholder value and rate of return may not be exactly the same but they are closely linked together. These figures can only give us an idea of what it is as no one can predict the future. Nevertheless shareholder value analysis provides information on which companies are worth to invest in.

6. PROBLEMS WITH SHAREHOLDER VALUE Companies are social beings, operating as part of the society with ethical and moral

responsibilities

government,

and

to

now

their

employees,

increasingly

to

the

customers,

suppliers,

environment.

There

the are

responsibilities that go with this social existence and it may seem that the discharge of these responsibilities may sometimes be wealth destroying for the shareholders. As a result there is a conflict of shareholders interest to that of other stakeholders (Appendix B). But is the conflict real? It may rightly be in the very short term, but over a reasonably long period of time there is no real contradiction between the interests of the shareholders and those of the other stakeholders. A company, which is not profitable because it has been tending more to its employees or anyone other than its shareholders, will destroy wealth by using useful economic resource less efficiently and reduce the possible investments in the economy, a situation to the disadvantage of all stakeholders. At the end of the day, the only thing that really counts is shareholder value as the people that have borne the risk by investing in the business need to be rewarded. If they are not, the business will find it difficult to find others in the future who will, and existing investors will seek to get out in favor of better investments. Such a business is doomed to shrink and die. Obviously such a situation is good for none of the stakeholders as well.

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Michael Hakel

Fremdsprachliches Seminar

Shareholder Value

WS 2000 / 2001

7. APPENDIX A. The Shareholder Value Network1

Corporate Obective

Shareholder Value Added (SVA)

Valuation Components

Cash Flow From Operations

!

Value Drivers

!

Value Growth Duration

Management Decisions

1

! !

Sales Growth Operating Profit Margin Income Tax Rate

Operating

Shareholder Return ! Dividends ! Capital Gains

Discount Rate

! !

Working Capital Investment Fixed Capital Investment

Investment

Debt

!

Cost of Capital

Financing

Rappaport, Alfred (1998, p.56)

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Michael Hakel

Fremdsprachliches Seminar

Shareholder Value

WS 2000 / 2001

B. Problems With Shareholder Value

Corporation

Customers

Employee

Suppliers

Government

Shareholder

C. The Shareholder Scoreboard

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Michael Hakel

Fremdsprachliches Seminar

Shareholder Value

WS 2000 / 2001

8. BIBLIOGRAPHY Rappaport, Alfred (1998): Creating Shareholder Value: A Guide For Managers And Investors, 2nd. Edition, New York http://www.endries.de/ref.htm http://www.trainart.de/shareholder.htm http://www.peterkeen.com/emgbp012.htm http://www.manager-magazin.de/news/artikel/0,1113,48539,00.html http://www.cabs.de/c30help/c31h0100.htm http://www.bztrust.ch/bz_broschueren/bz_broschuere1/shareholder.htm

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