We talk all the time about shareholder value. We misspeak. Most of the time we don’t mean value at all, we mean price.
Value can be difficult to measure, whereas price is easy to determine, so we conflate the two concepts. This is more than unfortunate; it has led to a “short-termism” culture whereby the role of the board is seen as maximising share price and shareholder payouts.
We can measure value—we do it when we value a company on fundamentals, using discounted cash flow. We can, for this article, ignore the technicalities of this method, but focus instead on the seven drivers of value, as shown below:
THE DRIVERS OF VALUE
- More profit
1. Increase growth in sales volumes
2. Increase operating profit margin
3. Reduce the cash tax rate (i.e. tax paid, rather than the tax charge in the accounts)
- Out of fewer assets
4. Reduce working capital as a percentage of sales
5. Reduce fixed assets as a percentage of sales
- For as long as possible
6. Increase the period over which the business has a competitive advantage
- At a low cost of capital
7. Reduce the cost of capital
Companies create value by moving any of the value drivers in the right direction. We calculate value by estimating the value drivers. It’s the fundamental behind every good analyst’s model, behind every proper valuation.
Shareholder value is not about next quarter’s profits. As originally construed—and the way I still teach it—it is about the long term.
One of the more important drivers is the one that says we need to run this “for as long as possible”. That means extending the competitive advantage, which almost always means thinking beyond the shareholder’s profit this year to the stakeholders’ needs far into the future.
Timescale is a fundamental part of the shareholder value equation. The best way to think of it is that shareholder value is, basically, Warren Buffett’s philosophy slammed into a formula (his Owner’s Manual at Berkshire Hathaway focuses on just this).
That means there is a trade-off. If you rush for short-term profit, or an artificially low tax rate, you might damage the competitive advantage of the business by upsetting stakeholders.
If you decrease working capital below a reasonable operating threshold, sales could be harmed because you will lose customer confidence.
And if you pay out all of the profit by way of dividend or buy-back, the lack of reinvestment in the business will eventually lead to its decline.
Every board should know which of the drivers matter to their particular business, and make sure that they understand the implications of their decisions.
Who is the shareholder?
The other thing the board should understand is who the “shareholder” is for whom they are trying to create this value. Not all shareholders are created equally, nor do they want the same things.
The shareholder in “shareholder value” is, presumably, the person or institution who owns the shares at that particular point in time. That could be the proverbial little old lady, investing her nest-egg. But more likely, it is a financial institution whose performance is benchmarked quarterly, despite the fact that it might be investing your pension fund for long-term returns.
Or the shareholder might be a hedge fund, with motives that diverge from the company’s long-term benefit. Or, given that high-frequency trading is thought to account for some 40% of UK market trades (and almost double that in the USA), the shareholder is just whoever is left holding the parcel when the music stops.
The difficulties are exacerbated when we realise that in 1992, at the genesis of our governance system, a majority of our listed shares were held by UK pension funds and insurance companies, mostly based in the City of London, geographically close, and knowing each other.
If there was a governance problem with a company then, a few people could meet up and agree how to use their voting power to encourage it to behave. Our code-based governance structure fitted nicely into that system.
However, at last count, more than 50% of the ownership of “UK plc” was by overseas investors—by people who won’t know each other well, and have little incentive to care.
In 2010, Cadbury failed to fight off the takeover bid by Kraft. Roger Carr, Cadbury’s then chairman, said that over the 19 weeks between the disclosure of Kraft’s interest and Cadbury’s final acceptance, 26% of Cadbury’s shares were sold by long-term shareholders. The eight largest buyers were hedge funds or other short-term traders.
Carr said that Cadbury’s board was then forced to accept Kraft’s offer because of its fiduciary duty to shareholders. Different shareholders. And even the “long-term” ones didn’t stick with the company.
Boards cannot run companies to provide value to all of these different types of shareholder, because they all have different requirements, to different timescales.
The only way shareholder value works as an overarching concept is if we consider the (perhaps mythical) shareholder whose holding in the business is a long-term investment, and make our value-based decisions benefit them.
So, what does this mean for boards? Well, they need to appreciate that value has very little to do with share price. Value is about generating cash flow for a long time by improving profits, using the asset base more efficiently, and growing the business.
Because of this, boards should not be running businesses in line with the latest whims of the current investors in the company. For privately held organisations, whether family-owned or backed by, for example, private equity, this is relatively straightforward: the owners and directors can have a sensible dialogue about what will work, and how to achieve it. For companies listed on the stock markets, it becomes a lot more tricky.
Dr Ruth Bender is an associate professor at Cranfield School of Management, and is director of the open programmes The Non-Executive Directors’ Seminar, The Non-Executive Director Programme for Family Businesses, and Finance for the Boardroom. She can be contacted at firstname.lastname@example.org