Shareholder value is misunderstood

We’ve already told you about value-based management, and you might be wondering (or, thinking about implementing VBM in your company’s management processes):  What can I do to go ahead and create value? First, we need to debunk the myth about what shareholder value is all about. Michael Mauboussin, an adjunct professor at Columbia Business School and investment strategist, tells us that “[t]he premise of shareholder value, properly understood, is that if a company builds value, the stock price will eventually follow. The objective is to build value and then let the price reflect that value.”

Now that we’ve gotten that sorted out and wrapped up that brief digression let’s go back to some practical ways we can maximize shareholder value. According to Harvard Business School professor Alfred Rappaport, there are ten solid principles that companies can put into practice.

Do companies put all ten into place in real life?

The answer to that is an astounding no. Just about every company doesn’t religiously follow all ten. But, there is an exception. What is it? Berkshire Hathaway, Warren Buffett’s firm. As Rappaport claims, it is a pity that companies don’t follow through on them all because Berkshire’s shareholders have undoubtedly reaped the benefits of holding stock in a level 10 (the term Rappaport coined for companies that followed all ten of their principles) company.

What can we learn about creating shareholder value from Mr. Buffett?

Warren Buffett is not only one of the world’s wealthiest men but holds a privileged position when it comes to his prowess as a business owner. How did he get there? Buffett is Berkshire Hathaway’s largest shareholder, and therefore, he says: “I’m a better businessman because I am an investor and a better investor because I am a businessman. If you have the mentality of both, it aids you in each field.” This quote gives you an idea why looking and implementing these ways of creating shareholder value into your company’s financial operation are beneficial.

And now, here they are:

Do not manage earnings or give earnings guidance

To Rappaport, this is the most basic of these shareholder valuing-creating principles because “[c]ompanies that fail to embrace this first principle of shareholder value will almost certainly be unable to follow the rest.” The bad news is that making earnings the basis of everything rules out a large swathe of corporations. Why’s this such a bad thing? Rappaport says it’s due to three things. First, it’s because of something we saw in our breakdown of accounting versus corporate finance: “…the accountant’s bottom line approximates neither a company’s value nor its change in value over the reporting period.” The second is prioritizing short-term earnings gains over investing; the sin has two different forms-either by choosing not to invest (underinvesting) or overinvesting at rates below capital costs (overinvesting). The last one is a lesson from disgraced former companies like Enron and WorldCom: “the practice of reporting rosy earnings via value-destroying operating decisions or by stretching permissible accounting to the limit eventually catches up with companies. Those that can no longer meet investor expectations end up destroying a substantial portion, if not all, of their market value.”

Why do so many companies break the cardinal rule? 80% of the 401 financial executives that John Graham and Campbell Harvey of Duke and the University of Washington’s Shivaram Ragjopal in 2005 surveyed reported: “they would decrease value-creating spending on research and development, advertising, maintenance, and hiring in order to meet earnings benchmarks.” Not only that, but 66% of the 654 corporations that responded to a National Investor Relations study from 2006 claimed that they regularly gave profit guidance to analysts on Wall Street.

Only hold value-maximizing assets

How can companies reduce capital while increasing value? The two tricks are an everyday part of corporations’ possibilities: either by outsourcing low-value activities when others can perform them for less money than your company can or by focusing on the activities that are both high-value and where your company has a competitive advantage. How can you identify these opportunities? The keyword here is analysis: “value-oriented companies regularly monitor whether there are buyers willing to pay a meaningful premium over the estimated cash flow value to the company for its business units, brands, real estate, and other detachable assets… failure to exploit such opportunities can seriously compromise shareholder value.”

Expected value-maximizing acquisitions are good, even if it means sacrificing near-term earnings

Acquisitions can either make or break the earning potential for companies, even more than the day-to-day activities primarily responsible for making the company function. There is a risk in the metric that management and their investment bankers examine when evaluating merger and acquisition (M&A) options: earnings per share (EPS). Comparing the EPS can make a specific M&A possibility more attractive, but it’s not the only criterion. M&As have more significant implications. When it comes to M&A, the opportunities for value creation are at the heart of sound decision-making. Not only that, companies also need to assess the risk that perceived synergies prior to the move may not materialize. To manage this risk, companies that believe there won’t be that many risks will offer cash to shareholders, and if not, they’ll merely offer stock instead to minimize that risk.

The same for acquisitions goes for strategic decisions

When evaluating strategic decisions, the mistake yet again comes from looking at the wrong criteria. What you should be looking at is the expected incremental value of future cash flows instead of the estimated impact on reported earnings (which is what almost everybody’s doing).  How do arrive at the expected value? It’s the sum of all the possible scenarios. This math isn’t overly daunting: you just need to “multiply the value added for each scenario by the probability that that scenario will materialize, then sum up the results.” This will give you the power to find out each scenario’s impact on value, which one most maximizes value, and then you can go ahead and evaluate the other variables that come into play.

When there are no value-creating investment opportunities, give your investors cash

Not holding onto excess liquidity has a quid-pro-quo benefit for the investors and the company itself. That excess money could get invested into a value-killing initiative (especially foolish acquisitions at too high a price). But, by the shareholders getting some money from buying back stock or through dividend payments, they can take the cash to get more return in another entity. While many companies will employ share buybacks to improve EPS, the corporations following this principle only buy back shares when “…the company’s stock is trading below management’s best estimate of value and no better return is available from investing in the business.”

Reward those performers based on the way the critical value drivers they directly influence fare.

Three of these principles relate to prizing the appropriate people in the organizational chart based on how they’re working to uphold value-creating pillars. Why? The logic’s pretty simple: “[c]ompanies need effective pay incentives at every level to maximize the potential for superior returns.” In the case of those further down in the organizational chart (employees as well as middle managers), you first need to find the right metrics. You’d have to do a little bit of work because each company needs to figure those out in the context most appropriate for them. One piece of advice is avoiding broad measures like operating margins and sales growth because they’re more suited for financial objectives and not specific enough for the employees you’d want to track. If one of your significant challenges is keeping regular staff members in your marketing department, you can follow and reward the person in HR responsible for those hiring processes if the employee turnover rate reduces over time.

Reward senior executives and CEOs for exceptional performance over several years

Now, for those at the top, the natural inclination is that you’d have to have compensation be appropriate to the prowess of these people at this level. However, what’s typically considered a stock options package isn’t going to cut it because they reward below the levels of superior performance. What can you do to remedy this caveat? There are two options: either adopt a DERO (discounted equity risk option) plan or a discounted index-option plan. For a discounted index-option plan, you must create a reasonable peer index. Why? It’s because “[i]ndexed options reward executives only if the company’s shares outperform the index of the company’s peers—not simply because the market is rising.” If you can’t guarantee that, just go ahead and adopt a DERO.

Unit managers also need appropriate compensation too

For this part of the organizational chart, advanced stock options are not going to cut it. Rappaport recommends creating shareholder value added (SVA) metrics for every operating unit to go back on. Here’s how you calculate it: “apply standard discounting techniques to forecasted operating cash flows that are driven by sales growth and operating margins, then subtract the investments made during the period.” What’s good about it? SVA’s basis comes from cash flows, so you’re protected from possible distortions arising from accounting, making it superior over other traditional indicators. But wait, what about the timing? The hack is this: for SVA measures, if you extend the performance evaluation period to several years (Rappaport gives a three-year rolling cycle as an example), you merge annual and long-term performance evaluations into one comprehensive study. This also gives you an alternative to budget-based cutoffs for performance-based incentives: “…companies can develop standards for superior year-to-year performance improvement, peer benchmarking, and even performance expectations implied by the share price.”

Make sure the information you give to investors is value-relevant

The key here is communication, especially when it comes to financial reports. By disclosing better, you not only quell the short-term earnings obsession but also helps to “lessen investor uncertainty and so potentially reduce the cost of capital and increase the share price.” A corporate performance statement is a good start. This statement covers (in this order) operating cash flows, revenue and expense accruals, and an analysis and discussion of the results including both financial and nonfinancial key performance indicators and how you’ve arrived at these assumptions. All this information in one document can be a good way to stop shareholders from questioning “…whether management has a comprehensive grasp of the business and whether the board is properly exercising its oversight responsibility.”

Senior managers should harbor as much risk as the shareholders

Many top executives often end up cashing out their stock options, thus not making them the equals of other shareholders. While many companies have taken the step of putting minimum ownership requirements, it’s failed to solve the risk inequality. Therefore, “[c]ompanies need to balance the benefits of requiring senior executives to hold continuing ownership stakes and the resulting restrictions on their liquidity and diversification.” They need to have enough equity, so they don’t become either too risk-averse or squarely focus on maintaining their undiversified portfolio’s value, and they should also be forced to hold the stocks for a more extended period. Not only that, another solution would be to exclude restricted stock grants from the shares that qualify for senior executive minimum ownership levels. This way, the businessmen will benefit from the dual perspective that Warren Buffet enjoys that we mentioned earlier.

Why put shareholder value creation at the heart of your business model?

Most companies greatly benefit from this change from short-term earnings to long-term priorities. Stock prices, let’s remember, are all about the current business’s possibility of future growth. This will also help your business to keep surviving (and hopefully thriving in the long term). Why do you ask? It’s because, as Rappaport says, “[f]or most organizations, value-creating growth is the strategic challenge, and to succeed, companies must be good at developing new, potentially disruptive businesses.”

Ready to put these principles into practice?

If you’re eager for more tips and tricks about maximizing shareholder value in Embedding Finance in Everyday Decision Making, download your informational brochure. If you’re set to join us, get started on your application right now.