DE HAVILLAND BUSINESS SCHOOL , UNIVERSITY OF HERTFORDSHIRE

[What do you understand by the term shareholder value?What are the

main financial metrics employed to measure shareholder value?]

MBSP 0177 Financial Markets

Muhammad Aldy Prakoso
10246702
November 11th 2010
 1. Introduction
Shareholder value is very common term use in any level of company. It is also most celebrated
corporate goals over the years(Chartered Institute of Management Accountants, n.d.). The most
memorable moment in the history of the shareholder value was the speech from Jack Welch the
former CEO of General Electrics1, in that occassion welch stated that his aim was:
“to be the biggest or second biggest market player, and to return maximum value to
stockholders;”
Because of that speech Jack Welch is known as the father of shareholder value movement. Later on
2009 he made a shocking statement by referring to shareholder value as:
“the dumbest idea in the world;”
Later on the interview he elaborate what he meant by previous statement:
“I was asked what I thought of "shareholder value as a strategy." My response was that the
question on its face was a dumb idea. Shareholder value is an outcome—not a strategy;”

Eventhough most of company accepted the idea of shareholder value as goal or objective, the
implementation of the shareholder value is very hard due to the difference of time horizon of the
shareholder (Johnson, 2004), balancing between shareholder’s interest (Miller, 1987), agency problem
and the rise of stakeholder value believer.

2. The Definition of Shareholder Value

Shareholder Value has a lot of meaning and there is no consensus on what is the definition of
shareholder’s value. The most commonly used definition for shareholder value is the amount of
common stock outstanding multiply by the price of the common stock2. Another definition of
Shareholder value is the value that the investor obtain for putting their money into a company.

Despite the ambiguous nature of the definition, shareholder value also have different interpretation
whether it is use as a strategy or an outcome/goal of a company. According to Welch (2009),
shareholder value is an outcome of successful strategies not strategy itself, because shareholder value
is not the thing that drives one company business. Tirole (2001) also agree that shareholder value is a
mission to achieve by the management of the company.

3. The Issues of Implementing Shareholder Value Term in The Company

1
http://en.academic.ru/dic.nsf/enwiki/632122
2
http://en.wikipedia.org/wiki/Shareholder_value
 “corporate managers should act exclusively in the economic interests 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 interests” (Hansmann and Kraakman, 2000).
Despite the clear statement that the manager of the company have to serve the interest of
shareholder, sometimes the management of the company having difficulty in balancing one interest
to the other. Loderer, et al. (n.d.) confirm the confusion of the manager through their paper, they said
that the larger the number of shareholder, the more heterogenous the interest to serve. Moreover, the
manger of the firm often has their own purpose to serve (Agency Problem).

3.1. Long Term Objective Versus Short Term Objective

The first problem regarding shareholder value is about the concept of shareholder value itself
sometimes make the management to focus only on short term objective. Most of manager these days
refer shareholder value as maximizing stock price. Therefore, their action mostly to serve short term
objective (focus on how to increase stock price). Bogoslaw (2009) said that in the recent years more
and more company calculate their shareholder reward of ownership on very short periods, usually no
more than 3 months and sometimes they only seen the shareholder value through the stock price of
the company. Focusing only on short term objective can bring disaster to the future of the company,
Chartered Institute of Management Accountants (n.d.) found that the collapse of Enron Corp. and
Parmalat is the result of not taking the long term goal into the account. According to Loderer, et al.
(n.d.), management should forget the short term stock market gyrations and focus on increasing the
future value of the firm within the horizon that they can estimate or forecast reliably, for example one
year horizon. The impact of focusing on short term objective can be devastating. The objective of
shareholder value is value creation not value destruction. Focusing on short term objective often make
the management to act aggressively and recklessly. They tend to recognize the revenue before the
time and deffered the expense. Graham (2004), found that 78% company in United State of America
admitted that they practice income smoothing and sacrificing shareholder value in order to meet, or
beat, Wall Street expectations. Moreover He found that 55% of the company passed on the chance of
creating more shareholder value by not taking the project with very positive NPV, they are afraid not
to meet the consensus earnings.

3.2. Balancing Between Shareholder’s Interest

Public company has a very large number of shareholder. Each of them has different interest and
investment horizon. Miller (1987), said that suppose the manager spot that the stock price of the
company is undervalue. There are two action that the manager can take, either signaling the market
that the stock is undervalue or taking no action about it. The first action will benefit the sell side
investor and the other one will serve the purpose of buy and hold side investor. He also said that in the
case of investor’s different time horizon and interest, the shareholder value is a hard objective to
accomplish.

3.3. Shareholder Value Versus Agency Problem

The agency problem arises when there is a separation between owner (shareholder) and operator
(management) of the company, the management is the one who responsible for the shareholder value.
Yet, there is always a chance that the management do not act in the best interest of the shareholder of
the company (Chartered Institute of Management Accountants, n.d.).

3.4. Shareholder Value Versus Stakeholder Value

The company is a social being and a social being company has social responsibility to their
employees, customers, suppliers and environment where they operate. The pursue of shareholder
value wealth sometimes neglect the stakeholder value interest and lead to unfair wealth distribution
(Blair, 1995). Zingales (2000), add that employees frequently are or should be residual claimants.
These two views are not always in conflict, Chartered Institute of Management Accountants, n.d,
confirm that keeping the stakeholder value will in turn make the shareholder happy. Hakel (2000) said
that the conflict between shareholder and stakeholder is only temporary, in the long term there are no
real contradiction between the two.

4. The Metrics of Shareholder Value

Measuring shareholder value is no easy task, in measuring the shareholder value we can not relly on
accounting profit because accounting profit is prone to manipulation and only focus on net profit.
Moreover, having accounting profit does not always translate as shareholder value creation.
“The most egregious error accountants are now making is to treat equity capital as a free
resource. Although they subtract the interest expense associated with debt financing ,they do not
place any value of the fund that shareholders have put, or left, in a business. This means that
companies often report accounting profits when they are in fact destroying shareholder value.”
(Stewart, 2003)
The statement by Stewart (2003), imply that the company needs to measured the profit relatives to the
cost of capital employed to generate such profit. Rappaport and Stewart are among the first person to
recognize the flaw of accounting profit and create their own shareholder value metric. As a result of
recognizing the flaw, Rappaport and Stewart developed their own value metric. The most significant
metrics are:
• Shareholder Value Analysis (SVA)
• Economic Profit (EP)
• Economic Value Added (EVA®)
 • Market Value Added (MVA)
• Total Shareholders Return

4.1. Shareholder Value Analysis (SVA)

This metric developed by Alfred Rappaport in 1980s. This metric can be use to estimate the value of
the shareholders’ stake. This metric also usefull in formulating and evaluating strategic decisions.
Rappaport use present value of operating free cash flow as base of the computation, he also added that
we have to include the marketable securities and exclude the value of the debt. The following is the
formula to compute the operating free cash flow:
Operating Free Cash Flow = sales – operating cost + depreciations - cash tax on profits -
investment in fixed capital - investment in working capital (1)
Rappaport devided the operating free cash flow into 2 time period:
1. PV (present value) of free cash flows during planning horizon: on this time period we
have to estimate the future value of free cash flow during our planning horizon. There are
simplified way to use this metric, we can use 7 value drivers to determine the free cash
flow. The 7 value drivers are:
• The percentage annual sales growth rate
• Operating profit margin (before non-operating items such as interest payable
and tax)
• Cash income tax rate (that excludes deferred tax)
• Incremental fixed capital investment rate
• Investment in working capital rate
• Planning horizon
• Cost of capital
The first five of 7 value drivers will help us to determine the operating free cash flow
more easily rather than to compute it separately on year on year basis. The operating free
cashflow will be discounted by the suitable cost of capital which is the weighted average
capital cost of capital (WACC).
2. PV of free cash flows after planning horizon (“continuing value”): this value often called
continuing or terminal value. In this period we assume that the bussiness will earn as much as
its cost of capital and grow for infinite period. Additionally, the company will create nor
destroy any value.
4.2. Economic Profit (EP)
The economic profit metric also known as residual income. The seed of this metric can be traced back
to the work of Alfred Marshall in 1890. This metric measure shareholder value by deducting cost of
using capital from after tax operating profit but it is not the only way to compute the economic profit.
Another way of computing economic profit is to multiply invested capital with return of capital minus
weigted average cost of capital (WACC).
EP = Invested capital x (return on capital – WACC)
EP = Operating profits after tax - capital charge

4.3. Economic Value Added (EVA®)

The next shareholder value metric is developed by Stern Stewart in 1991. The EVA metric is the
improvement from Economic Profit Metric. The formula for this metric are:
EVA = Adjusted invested capital x (adjusted return on capital – WACC)
EVA = Adjusted operating profits after tax less capital charge
EVA = Adjusted operating profits after tax less (adjusted invested capital x WACC)
Eventhough the formula for EVA seems very similar with the economic profit metric, stewart pointed
out the weakness of calculating EP and made serious adjustment toward the EP. He said that the basic
EP calculation is undermined by three distorting factors. The factors are:
1. Non cash transaction resulting from acrual accounting. Do not represent the true cash.
2. The fundamental accounting concept of prudence
3. Successful efforts accounting. The accounting treatment will write off the unsuccesfull use of
capital that will tend to understate the true capital

4.4.Market Value Added (MVA)

The MVA metric want to measure the change of shareholder value through capital gain and market
value of the company. To compute the market value added first we have to compute the market value
of the company as following:
MV= Total shares outstanding X shares price on the market
Whereas,
MVA= MVt – MVt-1
4.5. Total Shareholder Returns (TSR)
The total shareholder return metric calculated as follow:
TSR= (MVt + Dt) – (MVt- + Dt-1)
MVt: Latest Market Value
MVt-1: Market Value previous year
Dt: Latest Dividend
Dt-1: Dividend previous year

Tabel 1: Advantage and Disadvantage of Each Shareholder Value Metric

Advantage Disadvantage
Shareholder Value Analysis Can be used to value bussiness, Hard to predict the variable
(SVA) Can be used to evaluate required in the analysis
strategic decision
Economic Profit (EP) Can be used to value busssiness Still using accounting profit
Can measure performance
Economic Value Added All EP advantage Wide range of adjustment.
(EVA®) Fix the accounting related Costly and time consuming
weakness

5. Conclusion

In conclusion, shareholder value is the value for shareholder for investing in the company,
shareholder is the residual claimanth of the wealth of the company after the debt is paid. The
shareholder value is a goal or objective of the company not the strategy of the company.

The first problem of the shareholder value is to balance the long term and short term objective of the
company. In the case of confusion, the management should always go with the long term objective of
the company. Enron Corp. And Parmalat are the example if management only focus on the short run
basis.

The next problem is how to balance or meet the interest of shareholder. In this case the confusion
happen when there are more than one interests, in these case manager will have a difficulty of
determining which shareholder value has to meet first. In most cases the manager will meet the
majority interest because their job security is closely related to how they satisfy the majority interest
The agency problem relate closely to the creation or destruction of shareholder value. To reconcile the
problem the company have to make renumeration base on maximizing the shareholder value, that way
it will align the interest of shareholder and the management.

The rise of stakeholder view make the job to maximize shareholder value even more harder. The
stakeholder value practicioner argue that as the social entity the company also have social
responsibility. To reconcile this problem manager can set aside the corporate social responsibility
fund.

The most widely used shareholder value metric is economic value added. But the easiest measure of
shareholder value is market value added and total shareholder return because the data is readily
available in the market and do not need complicated computation.

Reference
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Twenty-First Century, Washington, DC, Brookings Institute.

2. Bogoslaw, david, 2009. Shareholder Value: Time for a Longer View?. Available at:
http://www.businessweek.com/investor/content/mar2009/pi20090317_247202.htm

3. CIMA Report, n.d. Maximising Shareholder Value Achieving clarity in decision-making

(online).
Availableat:http://www.valuebasedmanagement.net/articles_cima_maximizing_shareholder_
value.pdf
4. Graham,JR et al (2004),The Economic implications of corporate financial reporting.
Available at:
www.faculty.fuqua.duke.edu/~charvey/Research/Working_Papers/W73_The_economic_impl
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5. Hakel, Michael. 2000. Shareholder Value. Unpublished

6. Hansmann, H. and R. Kraakman, 2000, “The End of History for Corporate Law,” Yale Law
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7. Haslam, C., 2010. Lecture 2: Seminar 2, Accounting for shareholder value, 7BSP0177 -
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8. Johnson, W.T., 2004, “Predictable Investment Horizons and Wealth Transfers among Mutual
Fund Shareholders,”Journal of Finance 59, 1979-2012.

9. Loderer et al, n.d. Shareholder Value: Principles,Declarations, and Actions.

10.Miller, M.H., 1987, “The Informational Content of Dividends,” in R. Dornbusch, S. Fischer,
and J. Bossons, Eds., Macroeconomics and Finance: Essays in Honor of FrancoModigliani,
Cambridge,MA, MIT Press.

11. Rappaport,A (1999) Creating shareholder value: a guide to managers and investors, Free
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12. Stewart III,GB (1991),The Quest for Value, Harper Business

13. Tirole, J., 2001, “Corporate Governance,” Econometrica 69, 1-35.

14. Welch, Jack. 2009. Interview With Financial Times, 12th of March 2009.
15. Zingales, L., 2000, “In Search of New Foundations,” Journal of Finance 55, 1623-1653.

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