May 12, 2014


You have probably heard about shareholder value. Perhaps your company has declared a commitment to shareholder value. Fortune magazine called shareholder value “the real key to creating wealth.” You might have read in some of the chairman’s speeches, references to share holder value creation. You may have seen some of the seminar brochures on this topic or on various acronyms associated with this area: EVA, SVA, CFROI and VBM. This paper aims to explain what shareholder value means, and how the present emphasis on shareholder value management as a strategic initiative developed in management practice and the present day tools and techniques of shareholder value management.

What is shareholder value?

The total economic value of an entity such as a company or business unit is the sum of the values of its and its equity. This value of the business is called “corporate value” and the value of the equity portion is called “shareholder value.” In summary;

Corporate value = Debt + Shareholder value

The debt portion of corporate value includes the market value of debt, unfunded portion of employment benefits if any, and the market value of other claims such as preferred stock.

Shareholder value is reflected in the market price of equity shares of a company. Shareholder value can also be understood as the market capitalization of the equity capital of the company at any point of time.

Is the concern for shareholder a new idea in management?

“Finance theory rests on the premise that the goal of the firm should be to maximize the wealth of its current shareholders.”(Prasanna Chandra, 2001)

Corporate finance theory since from its origin was developed on the above premise. The financial managers are supposed to take decisions, which help to create additional value or wealth for current shareholders of the company. This goal probably remained as the goal of the finance management function only and rest of the organization may not be assessing its decisions on the touchstone of shareholder value or wealth building. Also, even today shareholders are given accounts of past transactions only. They do not know what the management is going to do in the future and how it is going to protect their wealth and increase it. The financial reporting profession mandated that only audited record of the past transactions are made available to capital market participants to make their decisions regarding fair prices to buy and sell equity shares in the market.

The new movement of Shareholder value management

The publication of Creating Shareholder Value by Professor Alfred Rappaport of Northwestern University, Illinois in 1986 can be said to be the beginning of the current movement of shareholder value management. He subsequently founded the Alcar group, a company dedicated to the production of software to help companies achieve some of the goals laid out in his book. Rappaport introduced the free cash flow (FCF) model of business and equity valuation and showed how the normal discounted cash flow techniques used in project evaluation can be put into use in valuing ongoing business firms and companies.

This was followed in 1987 by, Managing for Value, by Bernard Reimann, which discussed linking shareholder value creation (SHV) to the art of running a company. Management consultants took the initiative from there and developed a new practice area of shareholder value creation and management.

Tom Copeland and others from McKinsey Group published the book, Valuation in 1990. This book contained a detailed exposition of the issues of valuing companies, so that companies can act in the direction of increasing the value.

In the year 1991, G.Bennett Stewart authored The Quest for Value, which introduced the idea of economic value added (EVA). The book focused more attention on the detailed measurement of a firm’s balance sheet, and how certain items need to be treated differently from the way accountants usually handle them.

Andrew Black and others from PricewaterhouseCoopers brought out in search of shareholder value in 1998 and argued that shareholder value management is a necessary activity in the era of shareholder activism.

The book EVA and Value-Based Management: A Practical Guide to Implementation by S. David Young and Stephen F. O’Byrne was published in 2001. Stephen O’Byrne was a former senior vice president at Stern Stewart & Co. and is the president of Shareholder Value Advisors Inc., a firm specializing in shareholder value management.

Today, there are a series of booklets and brochures published by all top management consulting firms in the area shareholder value management. This is an area where actual practice is being attempted in a large number of companies in many countries in the world where capital markets provide bulk of the resources for corporate sector.

What is the imperative?

Three forces in particular have contributed to a growing awareness of the importance of shareholder value and value-based management. They are the increasing role of private capital in capital formation in various countries; the globalization of markets; and the information revolution including the internet.

In the first half of the 20th century, there was a loss of faith in capital markets and people accepted the expansion of the state into areas of commercial and financial life on a massive scale in many countries of the world. In particular, many states entered into long-term obligations in the areas of pensions, health and social security. Combined with demographic developments – increased life expectancy, for example-this has meant that in the last 20 years these states have hit the limits of their taxing and borrowing powers and have begun to withdraw from at least some of their commitments and to shift provision back to the individual. The individuals are placing their long-term and retirement-funds with institutional investors. These institutional investors are demanding actions that lead to adequate shareholder returns from corporate concerns.

Since 1970s, true global markets have developed in an increasing range of goods and services, accompanied by various agreements under GATT and WTO. By the 1980s, along with widespread domestic financial de-regulation, most restrictions on capital flows had been removed by the OECD countries. Following the establishment of global markets for financial assets, it has become possible to invest internationally in a much more proactive way than before. Companies across the world are now competing not only for customers, products and employees, but also for capital. The major criterion for attracting capital is creation of shareholder value. Even in capital rich countries, local companies can no longer expect to gain access to funds as cheaply as before. Many of the larger companies in countries such as Germany and Japan are not able to get capital from banks etc. and they also have to approach capital market for funds.

The increased sophistication of telecommunications and computers means that money can now travel across the world in a matter of seconds. The advent of PC-based modeling software enabled investors to make more complex calculations related to valuation of shares. The quantity and quality of information available to investors are far superior now. Edgar database provides immediate access to US financial filings. Many companies are now spending considerable amount on investor relations and communications through internet and media. You can’t hide from the markets by not communicating. Any company that wants to attract investment and any management that wants to stay in the saddle have to submit themselves to the scrutiny of the people whose money it is using.

Agreed. We want to manage our shareholder value. What should we do?

Do you understand how equity shares are valued in the stock market? Every finance text has a chapter on valuation of securities to provide inputs in this area to finance students. But how many of us really understand this chapter and value shares using the methodology given. How many finance executives in a company can come out with their estimated value for their companies’ shares with an underlying methodology. If we want to talk of operating executives, the number will be negligible. Why so? Because so far shareholder value is not a management issue most of the time except when the company is planning a right issue or a public issue.

The first step in the process has to be understanding of how investors in the stock markets practically determine the value of equity shares and trade them. No doubt, in the stock market there are many participants with divergent motives. There are participants who act as market makers and buy a share and sell the same share in the next deal for little bit extra. There are promoters of companies who plan to keep the shares within their family for generations. We have to understand the valuation process in this complex market where different people speak different languages. To gain the perspective we can have a look at the criteria for valuation of equity shares proposed by Benjamin Graham, hailed as the father of the subject of Security Analysis.

Benjamin Graham’s Quality and Valuation Criteria for Value Stocks

1. Adequate Size

For India let us specify that it has to be Rs.100 crore in sales (Graham- Rao Method for India)

2. Strong Financial Condition

Current assets should be at least twice current liabilities.

Long-term debt should not exceed the net current assets


Total Debt-equity ratio is to be less than 1:1

3. Earnings Stability

Some earnings for the common stock in each of the past ten years.

4. Dividend Record

Uninterrupted dividend payments for at least the past 20 years.

5. Earnings Growth
A minimum growth rate equal growth in national income over the last 7 years.

6. Moderate Price/Earnings Ratio

Current price should not be more than 20 times average earnings of the past seven years for the best companies. To give a more specific instruction, set the multiplier equal to the growth rate in EPS in percentage in the last 7 years subject to a maximum value of 20.


Current price should not be more than 15 times average earnings of the past three years for the best companies.

7.Moderate Ratio of Price to Assets

Current Price should not be more than 1.5 times the book value last reported.

As a rule the product of the multiplier times the ratio of price to book value should not exceed 22.5.

Rules of Graham highlight the importance of earnings per share (EPS) as a determinant of share prices and values. Benjamin Graham taught Security Analysis at Columbia University during 1928 to 1956. Prior to Graham the book value of the company was the important benchmark for the valuation of equity shares. Despite the popularity of Graham’s classes and books the valuation principles of Graham were not embraced wholeheartedly by the stock market participants. Most of the active investors preferred P/E ratios based on single year EPS figures. Also the emphasis was much more on fluctuations. Hence there were no clear cut guidelines on the ratio to be applied. One thing became a rule, increases in EPS are generally welcome and are likely to be followed by share price increases. Decreases in EPS are followed by share price declines. In this paradigm, companies concentrated on reporting increasing EPS figures.

J.B. Williams brought discounting of dividends into the share valuation methods. The infinite growth model and two-stage growth model became the popular valuation formulas. But the implementation of the formulas required future dividend estimates till infinity and cost of capital estimates. Companies were not providing such estimates. Investors and analysts on their own could not come with such estimates with the required level of confidence. Warren Buffett is credited with using dividend discounting models extensively for his investment decision making. He is said to use yield rate on 30-year government bonds in USA as the discount rate. He will buy only those shares which are available at 50% discount to the fair value estimated by him using dividend discount formula.

Modern portfolio theory gave birth to the capital asset pricing model which came out with the formula for expected return on securities. According to this formula the expected return on a security is equal to the risk free return plus the sensitivity coefficient (called beta) multiplied by the excess return on a market portfolio having all the risky securities. The market portfolio is generally taken as a representative share price index in the country. Thus a formula to calculate cost of capital of a listed company emerged.

Rappaport came out with his free cash flow model to value companies and equity shares. According to the free cash flow model, excess cash flows generated by the company after taking care of requirements for increased capital spending and working capital investments are a cash return to the security holders and these cash flows can be discounted at the cost of capital to determine the value of shares. It is also hypothesized that in any industry, free cash flows above the cost of capital are earned by the companies for few years. Competitors enter an industry till free cash flows are positive for existing companies. Hence stability will come in an industry only when the free cash flow earned is equal to the cost of capital. Thus to estimate and value free cash flows company managers and analysts have to estimate the competitive advantage period during the company concerned will earn excess free cash flows.

Rappaport’s model is accepted by the management thinkers and consultants as best suited for shareholder value management. Some of the consultants have come out with their variations like EVA, CVA etc. But the underlying foundation is Rappaport’s argument. Understanding and managing the free cash flows, competitive advantage period and cost of capital for the firm form part of the value management process. Management has to keep the market informed of the results of present value creating activities and as well as plans for future value creating activities. This reporting process is being christened as Value Reporting.

Approaches to Shareholder Value Estimation

1. Marakon approach
2. Alcar approach
3. McKinsey approach
4. Economic value added approach
5. BCG approach

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