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From Wikipedia, the free encyclopedia

Shareholder value is a business buzz term, which implies that the ultimate measure of a company's success is to enrich shareholders. It became popular during the 1980s, and is particularly associated with former CEO of General Electric, Jack Welch. In March 2009, Welch openly turned his back on the concept, calling shareholder value "the dumbest idea in the world".[1]

The term used in several ways:

  • To refer to the market capitalization of a company (rarely used)
  • To refer to the concept that the primary goal for a company is to increase the wealth 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 capital 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 risk. The term in this sense was introduced by Alfred Rappaport in 1986.

Contents

Definition

For a publicly traded company, Shareholder Value (SV) is the part of its capitalization that is equity as opposed to long-term debt. In the case of only one type of stock, this would roughly be the number of outstanding shares times current shareprice. Things like dividends augment shareholder value while issuing of shares (stock options) lower it. This Shareholder value added should be compared to average/required increase in value, aka 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.

History

In 1981, Jack Welch made a speech in Hotel Pierre, New York City called ‘Growing fast in a slow-growth economy’ (8.12.1981).[2] 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.

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 bbmight 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[3], 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 doesn't 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) indicated in the next section (criticism).

Based on these 7 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, you can find HR shareholder value maps, R&D shareholder value maps, etc.

Criticism

The sole concentration on shareholder value has been widely criticized. While shareholder value benefits 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 customers. For example, a company may, in the interests of enhancing shareholder value, cease to provide support for old, or even relatively new, products.

Alternative Definition based upon Criticism: 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. To give an example: 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 shareholder value concept argue that employee satisfaction and usefulness to society will ultimately translate into shareholder value.

See also

References

  1. ^ Financial Times 'Welch condemns share price focus' (13 March 2009)
  2. ^ Betsy Morris, 'Tearing up the Jack Welch playbook' (11.7.2006) Fortune at CNNmoney.com
  3. ^ See: "Corporate Financial Strategy", Ruth Bender, Keith Ward, 3rd edition, 2008, p. 17

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