Advantages And Disadvantages Of Shareholder Value Approach Finance Essay

Nowadays shareholder value approach reflects to a modern management philosophy, which implies that an organization measures its success by enriching its shareholders. Shareholders or stockholders are individuals or institutions that owns in a legally form shares of a corporation. They are considered to be a subset of stakeholders, which are all individuals or communities, who have a direct or indirect interest in the business entity (e.g. suppliers, customers, government, competitors etc.).

The philosophy of the shareholder approach attempts to increase the organization’s value by enhancing firm’s earnings, by increasing the market value of corporation’s shares and by increasing also the frequency or amount of dividend paid [1] . Furthermore according to many business analysts shareholder value approach provides managers with clear mission and it facilitated decision making. Whether is it reasonable or not for the managers and the overall welfare of the organization, this is something, which is analyzed later on the seminar paper.

All these objectives, companies strive to achieve, make this value analysis a traditional business measurement used in business today. The idea is that shareholder’s money should be used to earn a higher return than it could by investing in other assets with same amount of money and risk. It was developed in the 1980’s by Alfred Rappaport and it can be used to estimate the value of shareholder’s

Stake in a company or a business unit and also as basis for meeting and evaluating strategic decisions.

Furthermore there is a pervasive consensus that managers should strive to maximize shareholder value and by doing so helps the organization to maximize social welfare. According to Hansmann and Kraakman, 2000, most widespread arguments is that “corporate managers should act exclusively in the economic interest of shareholders” and that “the best means to this end, the pursuit of aggregate social welfare, is to make corporate managers strongly accountable to shareholder interest”.

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In fact a precious tool for measuring all the above is the “Shareholder Value Analysis”, which follows later on the seminar paper, examining also the advantages and disadvantages of its implementation and function. Furthermore will be discussed the financial arguments and the reasonability of the Shareholder Value Maximization as long as relationship between the shareholder value, ethics and social responsibility as well.

SHAREHOLDER VALUE ANALYSIS

Shareholders value analysis (SVA) is also known as value based management. It’s lead by the principle that the management of a company should take into consideration the shareholder’s interest and advantages before meets any decision, set short-term or long-term objectives and decide company’s strategy as well. SVA is a characteristic substitute for trade business measurement, which has improved a lot by time passing. Due to the fact that company’s value is calculated based on the value returned to its shareholders, in the past had been criticized for being either short-term measured or only based in past figures. SVA takes a longer-term view and is about measuring and managing cash-flows over time. [2] The shareholder value is calculated by estimating the total net value of the company and dividing the figure by the value of shares. Once the value has been calculated the company can set targets and objectives for improvement and measure also its managing performance.

For a successful implementation of shareholder value analysis first managers should understand and calculate the organization’s shareholder value and gain top management commitment. SVA believes that to assess business performance though maximization of shareholder value is an objective to be accepted by the top management to be achieved and part of the root of the organization. Furthermore managers should identify the key value drivers of the organization and set performance targets providing a framework also with assigning responsibilities to individual managers, reviewing the financial performance of the business and developing strategic plans. To continue with, the approach should be communicated and the staff must be trained. In many case in order to effectively reach the SVA companies are willing to change also the organization’s information systems to monitor and measure performance. It is important also to mention that the creation of sustained value will require permanent monitoring and that’s mainly the reason for the managers to monitor review progress and refine the targets. [3] 

ADVANTAGES OF SHAREHOLDER VALUE ANALYSIS

Shareholder value analysis has as principal that the management of a company should first consider the interest and the advantage of the shareholders, before it meets any decision. The Advantages of Shareholder Value Analysis are performed as follows:

It provides a long term financial view on which to base strategic decisions

It provides a universal approach that is not subject to the particular accounting policies that are adopted. It is therefore internationally applicable and can be used across sectors

It forces the organization to focus on the future and its customers, in particular the value of future cash flows.

DISANDVANTAGES OF SHAREHOLDER VALUE ANALYSIS

However disadvantages of the shareholder value analysis are performed as follows:

Estimation of future cash flows, a key component of SVA can be extremely difficult to complete accurately. This can lead to incorrect or misleading figures forming the basis of strategic decisions.

Development and implementation of the system can be long and complex.

Management of shareholder value requires more complete information than traditional measures. [4] 

PRINCIPLES AND DECLARATION ABOUT SHAREHOLDER VALUE MAXIMIZATION

The commitment of an organization among shareholders is not a theoretical future goal of an organization but is very often stated to the company’s mission statement. Usually firms aim at shareholder value creation and maximization when they make claims such us “we create value for our shareholders”, “we want to provide excellent return for our shareholders”, and we have a responsibility to our shareholders.

“Our mission is to remain a strong and independent financial services organization creating value for shareholders, customers, employees and the communities where we do business, while maintaining the highest standards of business ethics.”

Mission statement, Chemung Canal, Trust company

Many academics through the years had an overall perspective that managers should strive to maximize shareholder value and that doing so maximizes social welfare. According to this belief managers should act in the economic interest of their shareholders and that’s the fundamental objective of the shareholders. As the shareholder value is difficult to influence directly by any manager, it is usually broken down in components or value drivers, such us revenue, operating margin, cash tax rate, Investment in Working capital, Cost of capital and competitive advantage period. [5] Though it is important to mention that quick profit doesn’t give return to shareholders; usually competitive advantage takes care of it. If a business choose to sell lower standard products to reduce cost and gain quick profit it may have the danger that its reputation will be destroyed, will lose competitive advantage and the price of its shares will be reduced.

Is the shareholder value maximization a healthy defined target for the organizations?

Nowadays no country, not even the shareholder-friendly USA has a legal requirement that managers act absolutely in shareholder’s advantage and in fact the law makes it legal for directors to consider also other interest. Although firm that are willing to have an openly commitment to shareholders seem to do better in comparison with others, there is no case that make shareholder’s value maximization the society’s most desirable corporate target or that competitive markets for goods, capital and labor pressure managers to seek on that specific goal. [6] 

Furthermore, markets are incomplete; meaning that profit maximization is not well defined and possible conflicts of interest cannot be prevented or in many cases resolved. Under this assumption financial researches have shown that stakeholder-oriented firms are usually more successful than shareholder-oriented firms, because market forces are forcing them to do so.

What role do market forces play in the shareholder value maximization?

Competitive markets are playing a significant role to this argument because they can push managers to act on interest of all stakeholders. Usually they are pushing inefficient firms to cut costs and focus on customer needs rather than shareholder’s interest. Managers can survive the challenges of competition even though they do not maximize economic profits; but capital markets have this role.

It seems that capital markets do not leave managers another way but maximizing shareholder’s interest and doing so maximizing company’s welfare. If investors with many shares of an organization feel that share are going more and more down and start losing money, they may try to take action and influence the decision making, which could mean that managers are risking their jobs.

All in all the combination of the different market forces are those, who can affect or even force managers to act in advantage of stakeholders. A mentioned the basic principles of shareholder value maximization are not clearly defined for the market and even if so, are not in many cases reasonable and possible in the real world. Corporate social responsibility is one of the main targets organizations are focusing, because it keeps them competitive and acting in an ethical way can also achieve the maximization of shareholder value. Let us take a closer look to CSR and how can affect the overall shareholder value approach.

SHAREHOLDER VALUE AND SOCIAL RESPONSIBILITY

How managers and organizations respond to ideas of corporate responsibility is expressed by the idea that organizations have external environment with an interest in, or who are affected by what the organization does. Additional to this are the ethical investors advocating care for the natural environment. With the term ethical investors are mined those people who are investing only in businesses that meet specified criteria of ethical behavior. These stakeholders can affect in a negative way the organization and its environment if they disapprove manager’s policies among things like:

Negative publicity in local and national media

Direct action and protests

Threats or actual legal action

Withholding planning or other permissions necessary for operations

If managers can satisfy shareholders expectation they will maintain their support and they will also increase shareholder value. If not investors will flee from unethical companies or those who are not respecting the responsibility among stakeholders, mistreating for example their employees or the environment. Characteristic examples are Nike, Union Carbide and Exxon Mobil. The expectations of the financially centered investors are not only high return on investment but strong corporate responsibility and reputation as well [7] .

After all corporations have a strong social and environmental impact and role. Businesses need the approval of the society to make profit and as follows to return value to its shareholders. If policymakers, investors and executives want to address corporate responsibility, the corporate governance must be coupled with global corporate social responsibility, which can be defined as business practices based on ethical values and respect for the internal and external environment of the company, such as employees and committees. [8] 

It is important to mention that being social responsible in a proactive way can create an opportunity for the firm to strategically alter production and translate innovation into competitive advantage. This is consistent with Russo and Fouts (1977) who successfully mentioned that “environmental management and the associated performance outcome are integral parts of effective management, whereby a pollution prevention policy builds organizational commitment and increase employee productivity and participation”. In that way they show also a link between the level of social responsibility and the return on invested shares. Managers don’t face a tradeoff between financial performance for the shareholders and eco-efficiency and investors may be able to usefully incorporate environmental information into investment decision. [9] 

However shareholders cannot simply rely on market forces to ensure corporate responsibility because although market has encouraged more and more organizations to act in consideration of social responsibility, market forces have not been sufficient to ensure such a behavior over times. In many case we see that such responsible organizations may have higher costs, which may allow competitors to gain market share.

Does a social sustainable environment return value on shareholders?

Finally is there any relation between companies on best practices in an ethical way and the returned value on their shareholders? In some cases highly ranked companies do outperform the market (e.g. Filbeck, Gorman and Preece, 1977) while in some other case the returned value on their shareholders is significantly low (e.g. Kolodny, Laurence and Ghosh). Many of the socially responsible studies center among big organizations are performed to diversified stock market indices. [10] Many economists do not find statistically significant difference between the earnings of socially responsible funds compared to more traditional funds.

In fact many big organizations in India have made a research over the past ten years in order to explore this relationship between dimension of ethics and CSR and shareholder returns. According to National Stock Exchange of India social responsible companies are not expected to perform higher than companies focused only to the “economical welfare”.

CONCLUSION

To sum up, shareholder value is something more than a simple organizational approach; it’s a management philosophy reflecting on the overall firm’s success, providing managers with a clear mission and facilitating decision making. The most important tool for enhancing this managerial approach is the shareholder value analysis, which gives managers all the principles needed in order to take shareholder’s advantage into consideration before any decision making and also provides them with practical “steps” in order to increase firm’s and investors’ value from top to the bottom.

On the other hand, shareholder value approach often need estimation of future cash flows, which can be very difficult to complete and the development of such a system can be complex for an organization.

According to many mission statements of firms, the increasing of shareholders value maximizes social welfare. But this can be reasonable only with the correct strategies and objectives in order to increase profit, gain competitive advantage and consequently return value to the investors; quick profit through lower quality products can damage not only firm’s reputation but also reduce the price of the shares.

Although there are not legal requirements for the organizations in most countries to act in advantage of shareholders’ interest, and shareholder value maximization is not a clear target for the modern economies, capital markets are the ones which force managers to do so. It is important to mention that this factor is not the most important one for organizations to win competitive advantage, because they mostly have to take under consideration all stakeholders; however is one that could threat their jobs, when investors see their shares undervalued.

Closing and adding to all the above external environment is affected in the same way and maybe more in comparison to the internal one. Ethical organizations and those, who are acting on interest of corporate social responsibility and consequently can affect positively the stakeholders (including customers, communities, society etc.), are able to gain ethical investors and maintain their support. For any business action society is the one, which will give the approval to make profit and as follows return value to the shareholders.

Shareholder Value Approach is a strategic thinking in modern business management. It shows the balance between competitive advantage, value creation and business strategy. I would like to close this project with a phrase that George S. Day, executive director of the marketing Science Institute Cambridge, successfully generates: “For a strategy to win in the marketplace, it must create sustainable advantage; only when a strategy wins in the marketplace can it generate sustained shareholder value.” [11]