Share Holder Value Essay Example for Free

Share Holder Value Essay Public and private companies are under a great deal of pressure to create and sustain shareholder value by increasing both returns on capital and growth rates and company’s stock price or equity value. Share holders would like to associate with a firm whose stock prices are not depressed. Who is a Shareholder? A share holder can be defined as the owner of one or more shares of stock in a corporation, commonly also called a stockholder. The benefits of being a shareholder include receiving dividends for each share as determined by the Board of Directors, the right to vote (except for certain preferred shares) for members of the board of directors, to bring a derivative action (lawsuit) if the corporation is poorly managed, and to participate in the division of value of assets upon dissolution and winding up of the corporation, if there is any value. A shareholder should have his/her name registered with the corporation, but may hold a stock certificate which has been signed over to him/her. Before registration the new shareholder may not be able to cast votes represented by the shares. (Enhancing share holder value, Dr William . e. Broxterman Chairman/CEO Chemquest Group,unc). Shareholder value is a business term, which implies that the ultimate measure of a companys 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. 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 higher returns than they could earn themselves by investing in other assets having the same amount of risk. The term in this sense was introduced by Dr Alfred Rappaport in 1986. ) In (1981, Jack Welch made a speech in Hotel Pierre, New York City called) ‘Growing fast in a slow-growth economy’ (8. 12. 1981) this is often acknowledged as the dawn of the obsession with shareholder value. Welchs stated aim was to be the biggest or second biggest market player, and to return maximum value to stockholders. Strategic planning In today’s fast-changing, often business environment, formal systems for strategic planning have become one of top management’s principal tools for evaluating and coping with uncertainty. One of the key roles of Board of directors is to approve and adopt the strategic and annual business plans, the setting of objectives and review of key risk and performance areas. Corporate board members are also showing increasing interest in ensuring that the company has adequate strategies and that these are tested against actual results. While the organizational dynamics and the sophistication of the strategic planning process vary widely among companies, the process almost invariably culminates in projected (commonly five-year) financial statements. This enables top managers and the board to review and approve strategic plans in the same terms that the company reports its performance to shareholders and the financial community. Under current practice the projected financial statements, particularly projected earnings per share performance, commonly serve as the basis for judging the attractiveness of the strategic or long-term corporate plan. The conventional accounting-oriented approach for evaluating the strategic plan does not, however, provide reliable answers to such basic questions as: †¢ Will the corporate plan create value for shareholders? If so, how much? †¢ Which business units are creating value and which are not? †¢ How would alternative strategic plans affect shareholder value? Managing 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. 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, giving some guidance to manage. These drivers are, * Revenue, the amount of money that is brought into a company by its business activities. In the case of government, revenue is the money received from taxation, fees, fines, inter-governmental grants or transfers, securities sales, mineral rights and resource rights, as well as any sales that are made. * Operating Margin, the ratio used to measure a companys pricing strategy and operating efficiency, if a companys margin is increasing, it is earning more per dollar of sales. The higher the margin, the better. Can be calculated as: Operating margin=Operating Income/Net Sales. * Cash Tax Rate, the cash a company pays to governments as a percentage, while looking at an unlevered company. * Incremental Capital Expenditure, additional cash invested by a firm in its long term assets in order to generate a dollar of new sales. * Investment in Working Capital, a measure of both a companys efficiency and its short-term financial health. The working capital ratio is calculated as, working apital=current assets-current liabilities * Cost of Capital, equity and debt capital and the related discount rate. * Competitive Advantage Period, advantage over competitors by offering consumers better value either through greater benefits or lower prices. Share holder value, and the Economic value concept The value that a shareholder is able to obtain from his/her investment in a company ,is made up of capital gains, dividend payments, and proceeds from buy back programs and any other payouts that a firm might make to a shareholder. In other words share holder returns exceed the required return to equity, and the company is deemed to have exceeded the required expectation. Share holder value in recent years is being measured using the Economic Value Added Concept (EVA), a measure of a companys financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). Share holder value, and the WACC concept Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Lets say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the companys return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere. It measures a trend of improving or declining share holder value and it helps managers to focus on projects, businesses, product lines and activities yielding more than a firms weighted average cost of capital WACC (The return that both debt holders and equity holders expect, WACC, in other words, represents the investors opportunity cost of taking on the risk of putting money into a company. Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Lets say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. Current value of a business is fairly expressed by the share price, there fore increasing EVA should move prices upwards. This means an earning return greater than its cost of capital. Value creation for shareholders through strategic acquisition Acquisitions have known to create value for share holders, however this has to be done strategically, for example in the study of industry acquisitions in 1998(1999 The Chemquest Group. Inc) describing the adhesives industry, such acquisitions have integrated a number of companies in to a single unit with a positive EVA have added significant value and enhanced shareholder value of the company. In order for an acquisition to create share holder value it must generate a positive NPV. In other words it behaves the same as a capital investment. By carrying assets that maximize long term value of the firm for example outsourcing activities such as manufacturing. Dell investments are involved extensively in marketing but out sources distribution, inventory and manufacturing. Also hiring of employees should be strategic. Share holder value and capital structure design Share holders wealth can be improved with increasing leverage by using more debt in place of equity and or dealing judiciously with debt and equity, designing a capital structure that will reduce WACC and increase the value of the firm. This is based on the fact that the composite cost of debt lies between the least expensive debt and the more expensive equity. This approach enables the maximization of corporate profits and shareholders equity. By keeping an eye on the capital market for the firm, the Financial Manager should keep an eye on capital markets for the firm, substituting methods for more effective ones which can improve the firms value and so the shareholder value. Areas such as interest on loans and normal dividend rates as dictated by the market should be examined for decisions. Share holder value and expansion and diversification A company can increase shareholders wealth by diversifying for example addition of a new product line. When BOC gases wanted to expand its business there was consideration by the board for an acquisition of a business in a similar industry, Carbacid. Although this did not succeed, the focus to grow through this product is still on and there is a plan to buy a carbon dioxide mining well. Nakumat seeks sh 1 billion for expansion and is talking with commercial banks for a syndicated loan. The loan is a long term five year loan to be used for stocking new branches recently opened in Rwanda Kigali( Business Daily pg 23). Share holder value and replacement and modernization Finlay Kenya in kericho the tea producing company has replaced a large number of manual labor, with machinery for plucking tea leaves; in a bid to modernize the labor market, to improve on productivity and to reduce labor costs and there fore shareholder value. Boc gases is evaluating an investment for an additional air separation in order to improve performance of machinery (Annual Report 2007). As a firm continues to grow, it may consider improving its retail centers, availing information to customers , displaying sales ware while encouraging caller customers to come and buy the goods in the retail shop. Investors Africa transformation fund, are trying out new methods to tap Africa Agriculture aimed at double digit returns with programmes to boost food production. ( Top News Business Daily pg 3 Dec 6 2010). Share holder value and investment decision rule Through sound capital budgeting techniques, a firm may come up with appraisal techniques to measure economic worth of an investment project for example, coming up with an unambiguous way of separating good projects from bad projects, ranking projects according to profitability, and choosing amongst a number of projects, the project that maximizes wealth. Investment decision can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the short-term balance of current asses and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers), for example treasury has signed up for a new World Bank fronted bonds trading plan, which should help the central bank in diversifying its forex reserve mix and cushion the shilling against wild swings(professor Njuguna Central Bank of Kenya Governor, Business Daily Dec 6). Share holder value and discounted/non discounted cash flow methods By recognizing that bigger and early cash flows are preferred, the shareholders value can be improved. Using discounted cash flow methods such as NPV and PI. When NPV is +ve, the project should be accepted and when it is –ve it should be rejected. In the decision rule for profitability where PI is less than 1, then the project should be rejected while where PI is greater than 1 then the project should be accepted. In the non-discounted cash flow method, projects with higher ARR are preferable. In order to make the right investment decision, it is important that the project is thoroughly analyzed using available tools, remembering that the resources are minimal and can not be wasted. Increasing or liquidating part of shareholding This can be achieved by shareholders taking up shares and so increasing their investment in the business, or selling their rights and liquidate part of their investment. In theory, share splits have a positive effect on the shareholders wealth because they encourage beneficial price movements. This should be in line with the dividend policy. Cash cycle and cash management Firms should ensure that there is a match between accounts payable and accounts receivables and that payment to creditors is delayed while receivables are collected earlier. These may seem like daily chores but can cost the shareholder dearly if poorly managed. Many firms have closed down because of not managing accounts receivables appropriately. Summary In summary Strategies selected in creating share holder values should be strategic in the real sense. Strategies selected will usually cover three to five years and will incorporate the big picture. Strategies of substance that have been tested will ensure that the right programs for growth of the firms share value are selected and implemented.