Creating Shareholder Value
Creating Shareholder Value

Creating Shareholder Value

Many companies, particularly those in mature industries such as oil, allocated their very substantial excess cash flow toward uneconomic reinvestment or ill-advised diversification. (Location 179)

Consistent with the above premise, at least four major factors will induce management to adopt a shareholder orientation: (1) a relatively large ownership position, (2) compensation tied to shareholder return performance, (3) threat of takeover by another organization, and (4) competitive labor markets for corporate executives. (Location 215)

While the top executives in many companies often have relatively large percentages of their wealth invested in company stock, this is much less often the case for divisional and business unit managers. And it is at the divisional and business unit levels that most resource allocation decisions are made in decentralized organizations. (Location 220)

Corporate management, however, has neither the political legitimacy nor the expertise to decide what is in the social interest. (Location 255)

This emphasis on long-term cash flow is the essence of the shareholder value approach. (Location 292)

When confronted with a conflict between customer value and shareholder value, management should resolve it in favor of shareholders and the long-term viability of the business. (Location 306)

Theproblem instead is its misuse or nonuse, which has led to value-destroyingdownsizings for companies and their shareholders and uncalled-for dislocations and pain (Location 339)

The relationship between the change in economic value and earnings is further obscured by the fact that investments in working capital and fixed capital needed to sustain the firm are excluded from the earnings calculation. (Location 424)

An increase in the level of inventory clearly involves cash payments for materials, labor, and overhead. (Location 440)

Cash flow from operations = Sales - Operating expenses including taxes +expenses including taxes Depreciation and other noncash items - Incremental working capital investment - Capital expenditures (Location 478)

This difference is due to the fact that outflows of $440,000 for increased working capital and $150,000 for capital expenditures need to be deducted from earnings, and depreciation of $100,000 and an increase in deferred taxes of $30,000, both noncash items, need to be added back to earnings. (Location 482)

Economic value calculations explicitly incorporate the idea that a dollar of cash received today is worth more than a dollar to be received a year from now, because today’s dollar can be invested to earn a return over the next year. (Location 486)

earnings growth does not necessarily lead to the creation of economic value for shareholders. (Location 490)

Assume that with an investment of $30 million Gamma’s sales growth next year will be 20 percent, but its return on incremental sales will be 10 percent rather than the 15 percent rate projected earlier. (Location 512)

In summary, an increase or decrease in earnings may not give rise to a corresponding increase or decrease in shareholder value because the earnings figure does not reflect the company’s level of business and financial risk, nor does it take into account the working capital and fixed investment needed for anticipated growth. (Location 519)

More fundamentally, the change in the share price component of total shareholder return is driven by changes in expectations about future shareholder value creation. (Location 526)

led to the popularity of accounting-based return on investment (ROI) and return on equity (ROE) as financial performance standards. (Location 546)

The essential problem with this approach is that ROI is an accrual accounting return and is being compared to a cost of capital measure which is an economic return demanded by investors. Comparing one with the other is clearly an example of comparing apples with oranges. (Location 551)

Computing an average ROI for several periods would reduce but certainly not eliminate this problem. (Location 572)

Consequently ROI comparisons between, for example, drug companies which are very R&D-intensive and other industrial companies with relatively low R&D-intensiveness can be seriously misleading. (Location 589)

Faster-growing companies or divisions will be more heavily weighted with more recent investment projects leading to higher book value denominators. (Location 596)

While the restaurant investment is expected to yield an economic return of 15 percent, the ROI results are substantially different. (Location 615)

As the above example illustrates, accounting ROI typically understates rates of return during the early stage of an investment and overstates rates in later stages as the undepreciated asset base continues to decrease. (Location 621)

The use of ROI as a standard for evaluating strategies and performance at the business unit or corporate level can lead to a substantial misallocation of resources. (Location 638)

The third limitation in using ROI for financial planning and control involves the sometimes countereconomic effect of changes in financing policy on ROI. (Location 655)

ROI is the more commonly used measure at the business unit or divisional level; ROE is the more popular measure at the corporate level. One of the principal reasons that management focuses (Location 667)

Because ROE is so similar to ROI, it necessarily shares all the shortcomings of ROI enumerated earlier. (Location 669)

ROE increases come from three sources: improved profit margins, increased asset turnover, or increased leverage defined as assets divided by stockholders’ equity. (Location 678)

The growing percentage of investments directed toward intangibles such as information, training, and research rather than tangible fixed assets also has had a profound effect upon the usefulness of ROI and ROE as valuation benchmarks. (Location 693)

This value of the business is called “corporate value” and the value of the equity portion is called “shareholder value.” (Location 717)

Corporate value = Present value of cash flow from operations during the forecast period + Residual value + Marketable securities (Location 727)

Operating profit margin is the ratio of pre-interest, pretax operating profit to sales. (Location 745)

incremental fixed capital investment is defined as capital expenditures in excess of depreciation expense, that is: (Location 747)

However, capital expenditures usually rise each year owing to inflationary forces and regulatory requirements such as environmental controls. (Location 758)

The cost of capital rate incorporates the returns demanded by both debtholders and shareholders because pre-interest cash flows are discounted—that is, cash flows on which both debtholders and shareholders have claims. (Location 779)

Book value reflects historical costs that generally have little correspondence to economic value and therefore it is not relevant to current investment decisions. (Location 792)

First, while residual value is a significant component of corporate value, its size depends directly upon the assumptions made for the forecast period. (Location 848)

Value-creating strategies are those that produce excess returns over those demanded by capital markets and thereby produce positive net present values. (Location 854)

If operating profit (before depreciation) in any year is abnormally high or low, it will yield misleading results when serving as a basis for the perpetuity calculation. (Location 877)

If, after the end of the forecast period, the firm continues to grow but earns exactly its cost of capital, then we can calculate the value of the business at that time—that is, its residual value—as if the cash flows were going to remain constant. (Location 902)

For those who wish to err on the side of conservatism, the standard perpetuity model is the logical choice. (Location 943)

Under the P/E ratio method, residual value is simply the product of earnings at the end of the forecast period times the projected P/E ratio at the end of the forecast period. (Location 950)

The threshold margin represents the minimum operating profit margin a business needs to attain in any period in order to maintain shareholder value in that period. (Location 1013)

The threshold margin concept is particularly well suited to facilitate this linkage because the operating profit margin has widespread acceptance from both security analysts and corporate management as an essential ratio for assessing a firm’s operating profitability and efficiency. (Location 1018)

The incremental threshold margin is the operating profit margin on incremental sales that equates the present value of the cash inflows to the present value of the cash outflows. (Location 1030)

when a business is operating at the threshold margin sales growth does not create value. (Location 1046)

(1) sales growth, (2) incremental threshold spread, that is, profit margin on incremental sales less incremental threshold margin, and (3) the duration over which the threshold spread is expected to be positive, that is, the value growth duration. (Location 1052)

value drivers—sales growth rate, operating profit margin, income tax rate, working capital investment, fixed capital investment, cost of capital, and value growth duration. (Location 1059)

primarily in three value drivers: sales growth rate, operating profit margin, and income tax rate. (Location 1061)

increasing inventory levels and capacity expansion are reflected in the two investment value drivers: working capital and fixed capital investment. (Location 1062)

To obtain shareholder value, the final valuation component, debt, is deducted from corporate value. (Location 1071)

formulating business strategies and valuing business strategies. (Location 1093)

governing industry attractiveness ultimately impact shareholder returns because they influence prices, quantities sold, costs, investments, and the riskiness of firms in the industry. (Location 1122)

Specifically, price and quantity determine sales growth. (Location 1124)

Operating profit margin is affected by costs relative to prices and quantities sold. (Location 1124)

Finally, risk is conditioned by an industry’s business risk and financial risk, which is determined by the capital structures chosen by companies in the industry. (Location 1126)

A business unit may find itself in a very attractive industry, but a poor competitive position may nonetheless seriously limit its value creation potential. (Location 1128)

Competitors may exercise different strategic options in areas such as product quality, technology, vertical integration, cost position, service, pricing, brand identification, and channel selection. (Location 1135)

Competitive position must be analyzed in the context of the industry segment in which the business chooses to compete. (Location 1138)

More precisely, sustainable value creation, that is, developing long-run opportunities to invest above the cost of capital, is the ultimate test of competitive advantage. (Location 1152)

Thus it becomes important not only to identify advantages, but also to project their sustainability. (Location 1155)

Imitation by competitors is blocked by one-of-a-kind advantages such as geography, copyrights, patents, durable brand names, “private” relationships with clients and customers, or ownership of an information network. (Location 1159)

Once commercialized, fast-cycle products and services do not require complex organizations to support them. (Location 1169)

establishing competitive advantage and creating shareholder value. (Location 1197)

A business creates competitive advantage when the long-term value of its output or sales is greater than its total costs, including its cost of capital. This advantage can be achieved by providing superior value or lower prices. (Location 1201)

Only investors who correctly anticipate changes in a company’s competitive position that are not yet reflected in the current stock price can expect to earn excess returns. (Location 1209)

There are three factors that determine stock prices: cash flows, a long-term forecast of these cash flows, and the cost of capital or discount rate that reflects the relative riskiness of a company’s cash flows. (Location 1225)

In pricing shares the market implicitly assigns a finite time period to the company’s expected ability to create value or, equivalently, to find opportunities to invest at above the cost of capital. (Location 1233)

When investors believe quarterly earnings reports provide new information about a company’s long-term cash-flow prospects, reported earnings per share will affect market value. (Location 1247)

At the business level, strategy is product-market driven. It is governed by questions such as: What does the customer want to buy? (Location 1355)

Once the initial value is calculated, it becomes important to identify which of the value drivers have the greatest impact on shareholder value. (Location 1546)

Two of the guiding principles for shareholder value management are: invest only in opportunities with credible potential to create value and return cash to shareholders when value-creating investments are not available. (Location 1579)

Dividends are paid to all shareholders of record. Shareholders presumably reinvest dividends at the opportunity rate of return. In contrast, the proceeds from stock repurchases go only to selling shareholders. (Location 1603)

capital. In the above case, management should target investments in the 10 to 14 percent range for further scrutiny. (Location 1649)

First, there is the “corporate return” or the rate of return that the company earns on its real investments. (Location 1736)

Second, there is the “shareholder return,” which is the rate of return shareholders earn on their investment in the company’s shares. (Location 1737)

The only way in which the new shareholder will receive a return higher than the cost of capital is if the company unexpectedly generates greater cash flows and expectations are revised upward correspondingly. (Location 1747)

value of increases in NOPAT when discounted at the 27.17 percent corporate rate of return (R) is equal to the cumulative present value of incremental investments of $16.97 million. (Location 1766)

However, if the hurdle rate is viewed properly as the minimum acceptable return and management believes that collectively its investments will yield approximately the rate implied by the market price, then the 10 percent hurdle rate becomes much more reasonable. In setting hurdle rates, management needs to consider the following questions: (Location 1792)

the cost of capital, the corporate rate of return implied by the current price of the company’s shares, and management’s forecast of the corporate rate of return. (Location 1817)

the cost of capital, the corporate rate of return implied by the market price, or the corporate rate of return forecast by management. (Location 1825)

The argument in favor of this approach is simply that the essence of corporate strategy is to develop sustainable value creation and managers who contribute to its accomplishment should be rewarded commensurately. (Location 1827)

Their primary responsibility is to maximize shareholders’ total return from dividends plus increases in the price of the company’s shares. (Location 1861)

No board should initiate an incentive plan that can provide significant option profits for a level of performance that could also become grounds for dismissing the CEO. (Location 1886)

First, unlike ordinary shareholders, option holders share in all the upside but bear no downside risk. (Location 1893)

Finally, a number of companies, including Apple Computer and Advanced Micro Devices, have repriced their CEO’s options several times, lowering the exercise price as the company stock declined. (Location 1896)

These operating units are essentially “private” companies owned by a publicly traded company. (Location 1930)

The obvious problem is that value is based on highly uncertain forecasts of long-term cash flows. (Location 1936)

operating managers following their own financial self-interests may be motivated to maximize current profit rather than the long-term competitiveness of the business. (Location 1945)

Value creation, however, is a long-term phenomenon. Looking at a single year reveals little about the long-term cash generation capability of a business. (Location 1952)

To add value over time the operating cash inflow or “cash” NOPAT must increase at a rate that more than compensates for the incremental investments made by the business. (Location 1976)

After-tax operating margins are forecasted at 10 percent and incremental investment in fixed and working capital at a constant $120,000 each year. (Location 1981)

Management consistently was close to achieving the cash flow (before investments) and profit targets in the operating budget, but invariably its actual annual capital expenditures were substantially over the budgeted amount. (Location 1998)

exclusive reliance on annual cash flow and profit targets to the following variable SVA plan. (Location 2001)

NOPAT targets were established by taking into account actual capital expenditures. (Location 2002)

Linking cash-flow growth targets to the level of incremental investment using the SVA model has another important organizational advantage. (Location 2004)

Residual income is defined as net operating profit after taxes (NOPAT) minus a charge for invested capital. (Location 2011)

they can generate significantly different answers for the value added in any given period. (Location 2024)

First there is the question of how to estimate total value added over the measurement period. (Location 2028)

business’s current cash flow level as its beginning value. Annual SVA is simply operating cash flow plus the end-of-the-year baseline value minus the beginning-of-the-year baseline value. (Location 2030)

The SVA model deducts capital expenditures in the period they are made. (Location 2038)

Despite the fact that value driver forecasts for sales growth, operating profit margins, and incremental investment are assumed to be identical for all three businesses, residual income results vary widely. (Location 2061)

Clearly, what is driving the dramatically different results are accounting numbers, not the economics of the businesses. (Location 2064)

While economic book value may be a better estimate of the cash invested in the business than book value, it is still a historical, sunk-cost measure. It is not the base against which investors measure their returns. (Location 2082)

The initial investment, book value, and economic book value are irrelevant to the investor’s expected return. (Location 2087)

If properly calculated, change in invested capital will be identical to incremental investment in the SVA formula. (Location 2093)

It is surprising that despite all the shareholder value talk so many companies continue to measure and reward operating unit managers based on annual results, thus reinforcing a short-term management orientation. (Location 2119)

But even a three-to-five-year horizon will not capture most of the value-creation potential in high-growth businesses and businesses such as pharmaceuticals that invest for long-term returns. (Location 2121)

My own experience suggests that for most businesses focusing on perhaps three to six leading indicators covers a significant part of their long-term value-creation potential. (Location 2128)

Some managers perform extraordinarily well in low-return businesses while others may do poorly in high-return businesses. (Location 2163)

When a company engages in a number of different businesses, expectations analysis becomes more difficult, since the value of aggregate expectations from operating units must approximate the total market value of the company. (Location 2167)

Operating managers, like CEOs and other senior executives, should be rewarded for superior performance. (Location 2182)

That is, bonuses are based on the preceding three to five years of performance. (Location 2186)

The third catalyst to the current merger wave is the race to become bigger. This is a management mindset that sees mergers as a means “to acquire the size and resources to compete at home and abroad, to invest in new technologies and new products, to control distribution channels and guarantee access to markets.” (Location 2211)

the acquisition called for 13 percent sales growth and pretax operating margins of 15 percent. (Location 2436)

For example, assume that the pre-merger sales growth expectation of 13 percent is also reasonable after the acquisition. To justify the Kodak purchase price, pretax operating profit margin would have to increase from 15 percent to 21 percent. (Location 2442)

Sirower7 found that market-adjusted returns for cash acquisitions were consistently better than acquisitions for stock. (Location 2454)

Paying for an acquisition with truly undervalued shares makes the acquisition more expensive. (Location 2460)

Value is driven by long-term, risk-adjusted cash flow performance, not short-term earnings. (Location 2676)

Not all growth is value-creating. (Location 2677)

“Value-creating projects” embedded in value-destroying strategies are poor investments. (Location 2677)

When a CEO sees the level of long-term performance needed to justify the current stock price an important intellectual milestone is reached. (Location 2712)

In some cases the long-term performance implied by the stock price is even more aggressive than the frequently optimistic five-year business unit plans. (Location 2713)

Additionally, there was agreement that incentive compensation was not adequately tied to value creation. (Location 2725)

It repeatedly asked business-unit managers to improve operating cash flow (before capital investment) only to see significant amounts of capital spent in pursuit of marginally profitable investments. (Location 2727)

returns on net property (RONP). (Location 2728)

The first step is to value each business unit. The aggregate business unit value minus debt is then compared to the company’s market value. (Location 2761)

For example, assuming the company has excess cash or debt capacity, it may wish to consider a share repurchase to signal management’s belief that the stock is undervalued. (Location 2764)

sales growth, operating profit margin, incremental fixed capital investment, incremental working capital investment, cash tax rate, cost of capital, and value growth duration. (Location 2782)

To be useful, operating managers must establish for each business the micro value drivers that influence the seven financial or macro value drivers. (Location 2785)

allows management to focus on those activities that maximize value and to eliminate costly investment of resources in activities that provide marginal or no potential for creating value. (Location 2787)

This involves identifying the micro value drivers that impact sales growth, operating profit margins, and investment requirements. Figure 9-4 presents a value driver map for the retailing operating costs of a petroleum marketing business. (Location 2792)

Therefore, quantifying sensitivities is a valuable exercise for both operating and senior management. (Location 2804)

Once the strategic analysis is converted to formal plans, it becomes important that these plans are credible. (Location 2836)

events, such as technology changes and strategic moves by competitors, are damaging to the value creation efforts of the business and the credibility of its managers. (Location 2838)

Management also must decide at what stage in the overall shareholder value implementation process to introduce new performance measurement and incentive compensation plans. (Location 2885)

The LEK/Alcar Consulting Group, publishes annually The Shareholder Scoreboard, which focuses exclusively on performance for the investor with rate of return rankings for the one thousand largest companies that account for about 90 percent of the stock-market value of all U.S. stocks.1 (Location 2904)

Outstanding long-term relative returns can be traced to superior management. (Location 2914)

The answer lies in determining the level of future performance implied by the company’s current stock price and then assessing the likelihood that the company’s performance will warrant an increase in market expectations. (Location 2931)


CHANGING THE RULES (Location 2949)