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Shareholder Value: An Analysis of Current Corporate Reporting Practices.
Shareholder value has been attracting considerable interest in recent times. The pursuit of such approach involves moving the focus of attention away from simply looking at short-term profits to a longer-term view of value creation, the motivation being that if implemented correctly, it will help the business to stay ahead in an increasingly competitive business world.
This dissertation sought to investigate whether companies were implementing the concept of shareholder value. In particular it examines the current standing of shareholder value in corporate reporting practice. It revealed that an increasing number of companies are adopting value creation as a key corporate goal. However, at this present moment in time companies are failing to report their full potential for creating value. Many companies have yet to pick up on value based performance metrics and still use traditional accounting measures.
In general it is the case that UK companies tend to be predominantly focused on profit maximisation as their main objective and measure of performance. Although the focus on profit maximisation has been a long-standing issue, the debate was given a fresh impetus in the UK at least, by a number of well-publicised corporate problems in the late 1980's and more recently. These involved creating accounting, spectacular corporate failures ( for example, the collapse of companies such as Maxwell Communications Corporate (MMC), Polly Peck, Marconi and Enron), the apparent ease of unscrupulous directors in expropriating other stakeholders' funds, the claimed weak link between executive compensation and company performance, and the role played by the market for corporate control and institutional investors in generating apparently excessive short-term perspectives to the detriment of general economic performance (Keasey and Wright, 1997).
In the 1990s creating shareholder value has become the mantra for most corporate boards, especially in the United States. Yet as recently as the mid-1980's, the idea of shareholder value was not an overwhelmingly accepted principle. But as academics began to teach the principle in the business schools around the world, such noted authorities as Professor Alfred Rappaport of North-western University's J.L. Kellogg Graduate School of Management, author of Creating Shareholder Value (Rappaport, 1986), began to apply it to corporate mergers and acquisitions in the 1980s. Shareholder value and in particular free cash flow analysis, become the measurement standard for the 1980s and 1990s and into the 21st century. What is not yet clear is whether it is being fully implemented within UK companies in order to reap the full benefit of implementing shareholder value.
The purpose of this dissertation is twofold. First, it attempts to critically evaluate shareholder value as the superior performance measure (does the new performance measure measure up?). Consideration is given to the factors hindering the implementation of shareholder value, in particular the short-term orientation of UK companies, which contradicts, with the long-term orientation required to implement shareholder value. Secondly, the dissertation reviews the current corporate reporting practices of several large companies and seeks evidence from published accounts and annual reports relating to implementation of shareholder value philosophy. This analysis will give an indication of whether or not companies are starting to become long-term oriented or are they still short-term focused. The chapters are structured as follows:
Chapter 1 reviews the body of existing literature on the objectives of an organisation, shareholder value, and value-based management and performance metrics available for measuring shareholder value.
Chapter 2 explains the concept of shareholder value. What it is? How is value created - the drivers of shareholder value, example of how shareholder value is calculated and what are the possible benefits and problems of implementation?
An examination of approximately 20 large UK and European companies will be conducted to illustrate current reporting practices, and whether they are consistent with the shareholder value philosophy. The methodology of research will be qualitative (principally verbal) -case study based rather then quantitative research. The chapter will also address and examine the issue of Reporting Gap within UK and the extent to which companies are providing forward looking information within their Annual Reports. The final section presents conclusion, which will be somewhat limited due to the scope of research methodology.
Ansoff (1965) described, A business firm is a purposive organisation whose behaviours is directed towards identifiable end purposes or objectives. When made explicit within the firm, objectives become tools of many uses in appraisal of performance, control and co-ordination as well as all phases of the decision process. Their potential persuasiveness is such that objectives have been used as a basis for an integration view on the entire management process, which has become known as 'Management by Objectives'.
Therefore, the imperative question, which must be determined, is what kind of objective(s) should an organisation seek: maximum profit, maximum value of stockholders' equity, or a balanced satisfaction of its stockholders.
The question of the objectives of a business firm would appear to be straightforward and non-controversial at first. Traditionally, a business firm has been regarded as an economic entity, which has developed a measurement of efficient - profit -, which is common and unique to business. Therefore, profit maximisation would appear to be the most natural single business objective. In actual fact, objectives are currently one of the most controversial issues of business ethics. Distinguished writers have sought to remove profit from its position as the central motive in business and replace it with doctrines such as equal responsibility to stockholders, long-term survival, or negotiated consensus among various participants in the firm. Some have branded profit as immoral and socially unacceptable (Ansoff, 1965).
Anthony (1960) argued that most economics texts and college classrooms install the belief that the objective of a business is to maximise profits. Similarly, Doyle (1994) stated that profitability measures are also familiar benchmarks in academic studies of organisational renewal, turnaround and corporate failure (Altman, 1968). It has been argued that the concept of profit maximisation is incorrect both descriptively and normatively. Descriptively, because empirical studies of firms show that while firms do indeed seek profit, they also appear to seek other objectives. Normatively, because of a growth climate of opinion that the firm should accept other goals for its behaviour in additional to profit.
Alfred Rappaport (1986) made the most prominent contribution in this area by publishing his popular book entitled 'Creating Shareholder Value', in which, he criticised short-term profit maximisation as an objective by re-examining the traditional measures and emphasised maximisation of long term shareholder value. Currently, the most intellectually respected business objective is shareholder value (Arnold, 1998). This is because it has considerable legal and conceptual merits. The company is argued to 'belong to' its legal owners who are ordinary shareholders.
Shareholder Value Philosophy
Although profitability still remains the most widely used objective and measurement of performance within Western businesses, shareholder value has succeeded the test of the time, it has moved from being ignored to being rejected to becoming self-evident (Rappaport, 1986).
The relationship between the shareholders and the managers is one of principals and agents. The task of management (the agent) is to maximise the return their shareholders (principal) receive. Management can increase shareholder value in three way: dividend, appreciation of the value of the shares, and cash repayments (Rappaport, 1986). Management that is in pursuit of shareholder value may have significantly different policies that those that are geared towards earnings or acquisitive growth. Several studies have shown that a policy to increase short-term earnings tends to decrease shareholder value (Marsh, 1990). Similarly, the stock market may be sceptical of companies pursuing acquisitive growth strategies and the value of the acquirer's shares may also drop.
The importance of shareholder interests has long been emphasised by corporate managers in their corporate mission statements. However, their actions and resulting corporate performance tells a different story. The weak stock market performance of so many companies is convincing evidence that this objective often has not been achieved (Rappaport, 1986). In many cases, shareholder value appears to have taken back seat to other higher priority corporate objectives such as profit maximisation or manager's own personal goals (Rappaport, 1986; Reimann, 1987). The reason for this is primarily due to the fact that corporate managers are still being evaluated on short-term performance. They are under pressure to achieve short-term Profitability. Agency theory suggests another reason for weak implementation of shareholder value. For a long time economists used to assume without question that managers acted in the best interest of shareholders, but, since early 1930's they have had a lot to say about the possible conflicts of interest and how companies attempt to overcome such conflicts. These ideas are known collectively as agency theory as suggested by Berle and Means (1932) and later formalised by Jensen and Meckling (1976).
However, even if their motives are right and they really want to increase the wealth of their shareholders, corporate managers still fail quite often. The reason is that they simply do not know how to implement it properly. They cannot see any consistent relationship between their corporation's strategic or financial performance and the market value of their stock (Reimann, 1987).
In the UK, a fresh impetus was given to shareholder value due to a number of publicised corporate problems in recent times - such as Enron. This has forced managers to start worrying about the value that the capital markets are assigning to their corporations. Whether they like it or not, their futures, and those of their companies may depend on whether they understand, and can manage this valuation process (Reimann, 1987).
Value Based Management (VBM)
An important first step to VBM is that companies should start to think about their business the same way as investors do, hence, take investor perspectives. Companies are responding to the pressure to create shareholder value by adopting new metrics and models for managing their companies. In pursuit of this goal, some companies have already developed a Value Based Management (VBM) or Shareholder Value Management (SVM) approach to managing their business. Arnold, (1998) argued that VBM brings together the way in which shares are valued by investors which the strategy of the firm, its organisational capabilities and the financial function, hence, it solves the problem of how to attain shareholder wealth maximisation.
Fundamental to VBM is the understanding of how value is created. Arnold (1998) stated that value is created when investment yields a rate of return greater than required for the risk class of the investment (the hurdle rate). Rappaport, (1986), argued that while maximising shareholder value is an important corporate goal, it is not specific and accountable enough for operating management, who must know which factors most influence value and which factors can be easily affected. These factors are called value drivers and they should be primary focus of companies that want to maximise shareholder value.
Rappaport suggested seven drives within a business that can be managed to create value:
- A growth in sales;
- An increase in the operating profit margin;
- A reduction in the cash tax rates;
- A reduction in the working capital investment'
- A reduction in the fixed asset investment;
- A reduction in the weighted average cost of capital (WACC)
- An increase in the competitive advantage period.
Rappaport argued that improvements in these value drives (by actively managing them) would lead to an increase in shareholder value.
However, there are several issues and problems in implementing VBM approach that management needs to be aware of. VBM is a time consuming, complex, costly and difficult process. Hence, to get ultimate benefits it needs to be implemented with care. Cornelius (1997) gives the factors, which requires consideration. These are: (a) top management commitment; (b) communication and training; (c) aimed at operating managers; (d) consistent systems and measures; (e) rewards linked to value; and (f) ongoing commitment.
Ronte, (1998) stated three critical success factors for implementing VBM, these are (1) recognised that VBM is a change process; (2) use VBM to run the business, and (3) select the right measure for the company. Finally, Cornelius (1997) stated that although VBM is intellectually attractive and it addresses topical problems such as the criteria for executive pay and why so many acquisitions destroy value, its also has potential problems.
- the details of the theory becomes unmanageably complex;
- it is also criticised for promoting short-termism;
- danger of company focusing solely on the shareholder value metric;
- it emphasises the financial controls and individual performance in a why that may not be suited to companies with independent business centres where transfer of skill is necessary;
- when it comes to acquisitions, the efficiency of SVA may depend on the type of business;
- unless effectively driven down into the business, there is a danger that VBM could be viewed with suspicion by operating managers as the 'property' of the finance department;
- a large part of the approach is based on making assessment of the expected future performance of projects.
How to measure value is a vital aspect of VBM, since the management of value requires the measurement of value. The company, therefore, needs some way of expressing its guiding objective of a measure or measures that enable it to properly evaluate its decisions and actions in terms of their impact on shareholder value (Cornelius and Davies, 1997).
The next question posed by Carr (1996) is how should we measure the value created by companies -by profits, EPS, cash flows or return on capital? Roath (1998) stated that most companies do agree that creating shareholder value is the role of management. Evidence can be found in their annual reports, press release, and meetings with financial analysis and in the worlds of the chief executives (Lynn, 1997).
Adverse evidence is starting to appear within UK companies regarding the validity of using traditional measures such as profit and EPS to measure a company's performance. There is considerable evidence that share prices reflect a company's expected underlying cash flows. For example, there are several studies, which show that the markets are not fooled by changes in accounting policy, which affect earnings but not affect cash flows and the value of a business (Barfield, 1991).
This is contrary to the common assumption in the UK that EPS is what counts. EPS is important as an indicator, as a signal for future performance. Barfield (1991) states that managing EPS is not the same as managing the value of the business as was evident in the eighties when UK companies bought earnings through debt-financed acquisitions. That did wonders for EPS (and some executive bonuses) but often destroyed shareholder value. The mood has charged. One plc chairman states that he does not even know what his EPS figure is -all his team concentrate on cash flow:
If someone wants to take my arbitrarily determined accounting profit and divide it by the number of shares in issue at a particular time, that's fine by me, but it's got nothing to do with the value of my business Cited in Barfield R. (1991)
To overcome the problems with profit, shareholder value based measures have been constructed which provide a reliable guide to value creation. Cornelius and Davies (1997) stated that shareholder value based measures are divided into two categories: 'market based' and 'internal'. Market based measures provide an insight into how the stock market values a company's performance and therefore represents the ultimate test of shareholder value performance of a company. There are three external market based measures, namely, (1) Market Value Added (MVA), (2) Market to Book Ratio (MBR), and (3) Total Shareholder Return (TSR). To over come the limitations of external measures, a variety of internal measures have been developed to assist managers in identifying value creating and value destroying on a unit-to-unit basis as well as for the entire organisation (Cornelius and Davies, 1997). There are a number of internal measures developed by consultancies (Nichols, 1998): (1) Shareholder Value Analysis (SVA); (2) Economic Profit (EP); (3) Economic Value Added (EVA), (4) Cash Flow Return on Investment (CFROI); and (5) Total Business Return (TBR). These measures should be used to achieve improvement in 'market based' measures of value. All of which is the subject of discussion in chapter 3.
It is highly debatable whether Shareholder Value is really a new Paradigm. The existence of a large body of research regarding different aspects of shareholder value, such as value based management, different performance metrics, remuneration and stakeholder capitalism, would lead us to conclude that its not a new paradigm by any means. After all, the business does inevitably belong to its 'owners' and it only makes sense that management adept Shareholder Value Management approach to managing the business and use performance metrics, which are consistent with the shareholder value philosophy.
Shareholder Value Added
Companies are responding to the increasing pressure to create value by embracing new metrics and new models for managing their companies. 'Many academics, experts and consultancy firms such as Boston Consulting, McKinsey, PA Consulting, PA Consulting (Managing for Shareholder Value), Marakon, Braxton, Harbridge House, Price WaterhouseCoopers (PwC) (Shareholder Value Added (SVA)), and KPMG are preaching the virtues of value based management (VBM)' (O'Reilly, 1998).
The growing popularity of the subject has been due to the following issues: the national debate over executive compensation; the role played by fund managers in influencing the shareholder choice; the use of valued based measures by equity analysis; the globalisation of capital markets; the debate on performance metrics; faster product innovation; and increasing competition.
Against this background, growing number of companies are demonstrating their concern about shareholders by using the SVA approach. This aims to establish an explicit link between an organisation's strategic and operating decisions and their effect on shareholder returns. It also presents a potential framework for aligning executive incentives to the shareholders' interests (Houlder, 1995). Furthermore, it creates a link between the product (source of value) and capital markets (where value is realised and extracted) (Ronte, 1998).
2.1 What is SHV?
One definition of this simply 'corporate value minus debt' - or, put another way, a company's SHV is calculated as the present value of future cash flows of the business discounted at its weighted average cost of capital (WACC), less the value of debt. But the more fundamental principle is that a company only adds value for its shareholders when equity returns exceed equity cost (Black, Wright and Bachman, 1998).
SVA works by explicitly measuring the economic impact of each strategy on the value of a business. Any strategic decision, regardless of whether it involves internal or external investment, should be evaluated. Examples of such strategic decision-making situations include mergers and acquisitions, joint ventures, divestitures, new product development (R&D), and capital expenditures (major plant and equipment investments).
The actual computation of Shareholder Value (SV) links three main factors, namely, cash flow, cash as measured over a given period of time (value growth duration), and risk or cost of capital.
2.2 Corporate and SHV
Corporate value is equal to the net present value of all future cash flows to all investor types, including both debt and equity holders. Shareholder value is the corporate value minus all future claims to cash flow (debt) before equity holders are paid. Future claims typically include short and long term debt, capital lease obligations, under-funded pensions, and other claims such as contingent liabilities - lawsuits brought against the company. A further definition of SHV would be to say that it is the net funds that a company generates that shareholders could receive in the form of a cash payout.
2.3 How is value created: the 'value drivers'
Value is created when investment produces a rate of return greater than required for the risk class of the investment (Arnold, 1998). While maximising shareholder value is an important corporate objective, it is not specific and accountable enough for operating management, who must know which factors most influence value, and which factors can be easily affected. Those factors are called value drivers and they are the primary focus of companies that implement shareholder value. Reppaport (1986) suggested seven such value drivers. The theory is that improvements in those value drivers lead to an increase in shareholder value.
2.4 Free Cash Flow Model of SHV
A Free Cash Flow (FCF) model of SHV uses the seven value drivers - drivers that provide the framework for analysing the economic value of a business. The FCF model can be thought of as looking at three things: growth, returns, and risk. Each of these aspects can be explained by the seven 'value drivers'.
2.5 Value Realisation
Decisions taken by management to increase the value of the company will only have an impact on the company's share price if the stock market is aware of the decision, fully understands its consequences, and agrees with manager's view of its value impact.
There is evidence to suggest that the stock market is efficient, in that share price reflects all publicly available information, and new information is quickly incorporated into share prices without bias (McGoun, 1990). This does not, however, necessarily mean that the market will place the same value on a company that management does. There are three possible reasons for this:
- Management may hold information that is not available to the market as a whole;
- Even if management and market shared the same information relating to future prospects of a company, each may project a different set of cash flows.
- The cost of capital used by management may not be equal to that of the markets.
There are a number of implications of this in the context of value creation. Due to asymmetry of information in the efficient market if management believe its shares are undervalued in the market, then this is either because the market regards management's internal evaluation as unjustifiable optimistic, or because the market does not know, or at least does not fully understand, the merits of the company's chosen strategy.
On the other hand, it is possible that shares are overvalued compared with management's calculations, perhaps because management has 'talked up' the company's prospects publicly, or possibly because shareholders expected the company to be able to invest in opportunities yielding a higher return than that predicted by management.
An important aspect of 'value realisation' therefore, is effective investor communication. The fundamental purpose of investor communications is to provide information, within competitive limits, that enable security analysts to make sound forecasts based on value drivers (Rappaport, 1986).
2.6 The Benefits of SVA
Implementing an SVA approach to managing a company can have substantial benefits. Firstly, by aligning the manager's goals with those of investors, improves decision-making. Evidence from US strongly suggests that companies embracing SVA often report improved stock market performance. SVA can also aid management to address issues more effectively. Issues such as performance measures, executive compensation, acquisition and divestment, transfer pricing, allocation of central costs, capital structure and investor relations.
SVA is by no means a guarantee against managerial inefficiency or poor decisions, but it is likely to assist companies to avoid profitless growth by rejecting opportunities that are less profitable. The approach can also result in a much sharper and rejuvenated planning process. The planning process of even the largest companies can be surprisingly weak. By using SVA such companies can strengthen their planning process and sharpen their basic projections. SVA therefore, provides an additional tool for the financial manager and improves decision-making and long-term financial management.
Allowing financial managers to take a more active role in a company's strategic management process. Above all, it ensures that the primary goal of the company is n 'value' for the shareholders, to whom the management are responsible. Stakeholder activists would argue against this narrow interest. But the stakeholder in a business depends on its ability to generate long-term value in a competitive market. Evidence provided by SCA consulting (1999) shows that over the long term companies that do well for shareholders also look after other stakeholders (SCA Consulting, 1999). It is also useful for resource allocation - better discrimination between value creating and value destroying investment.
Shareholder value analysis might also help directors avoid changes in corporate control (minimises threats of takeover) by ensuring that a rival firm does not spot a value gap. Value gaps generally arise when management does not manage for shareholder value. SVA can also be used to spot opportunities.
2.7 The Problems of SVA
SVA is not by any mean without its problems. One fundamental criticism against SVA is that it could promote short-termism. Although the approach discourages short-termism in that it plays down the importance of short-term fluctuations in EPS, it could be damaging if used to the exclusion of non-financial targets. A research-based company for example can improve its short-term financial performance by deferring R&D expenditure. Also a superficial glance at the behaviour of share prices in the market might lead us to believe that short-termism has priority over long-term evaluation. Companies are therefore, often convinced that investors are driven by short-term targets and do not understand management strategies.
Secondly, details of the theory can become unmanageably complex. Many advisers are also concerned when companies base decisions on Shareholder Value to the exclusion of other interests or broader strategic goals. SVA also tends to emphasise the financial controls and individual performance in a way that may not be suited to companies with independent business centres and the need to transfer skills across different parts of the business. Even when it comes to analysing acquisitions, the efficiency of shareholder value analysis may depend on the type of business under consideration, particularly applicable to 'commodity' type industries where the acquirer is looking for direct cash benefit, rather than indirect cash flow benefits such as strategic fit or improved customer services.
Apart from any theoretical problems, SVA might also encounter problems regarding implementation. Value-based measures can be reasonably simple for firms to calculate. However, incorporating them within the performance measurement system is a much greater challenge, particularly at the divisional level within a firm. The technical barriers to implementation include the need to establish the cost of capital and value the capital employed (required if using the present value of the economic profit of the company into the future, rather than the free cash flows). At the divisional level, there is also the added difficulty of dealing fairly with strategies between divisions. The measures require some fairly detailed adjustments to profit and capital employed figures to move them away from historical profit towards economic value. These adjustments, whilst introducing greater theoretical vigour into the measures, also place a greater demand on a company's resources.
The idea that a businesses performance should be measured by the economic value they create for shareholders is well received within the business community. On the whole, to suggest that a company's primary responsibility is to its shareholders is barely contentious. The idea that management's principal responsibility is to increase shareholder value has gained wide spread recognition in the U.S. since the publication of Creating Shareholder Value (Rappaport, 1986). The interest it shareholder value is also gaining impetus outside the U.S. as a result of changes that are happening in the global business environment. With the globalisation of competition and capital markets and a tidal wave of privatisation, shareholder value is rapidly capturing the attention of executives in the UK and Continental Europe.
Endorsements of the shareholder value approach can be found in an increasing number of annual reports and other corporate publications. However, many corporations still focus on earnings as a key performance measure and the primary driver of stock market values. Although no one can discount the significance of the earnings number or the impact on the stock market of earnings surprises, it is not the fundamental driver. The traditional accounting measurements, such as earning per share (EPS) and return on investment (ROI), do of course give an indication of a company's performance, but they can be misleading in that often they do not measure the increase or decrease in shareholder value. Sustained growth as measured by EPS does not necessarily reflect an increase in stock value.
This dissertation sought to investigate whether companies were implementing the concept of shareholder value. It revealed that majority of companies are stating shareholder value as being their primary corporate objective on the face of their Annual Reports. However, closer examination reveals that few have aligned every aspect of their company towards maximising long-term returns to shareholders. To implement shareholder value a company has to become value based.
There is undeniably a growing appetite within UK and European Companies for shareholder value. However, at this present moment in time, companies are failing to report their full potential for creating value. To do this they must become more forward-looking, must take a long-term perspective and, through greater transparency, provide a clearer account of internal operations in order to present a more complete and consistent picture of shareholder value. For this reason it still remains to see whether the concept of shareholder value is simply a fad or is actually a lasting and valuable addition to the practice of management.
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