While many companies are focused on generating shareholder value, defining shareholder value and measuring its growth can be challenging. Shareholder value, which reflects many tangible and intangible elements of a corporation, is a complex, multifaceted concept that can be measured in many different ways, including through corporate valuation techniques, different return measures and growth metrics. While each of these techniques has its strengths and weaknesses, one additional way to measure shareholder value is through a technique called Shareholder Value Analysis, which compares a company’s equity return to its cost of equity capital. This article reviews Shareholder Value Analysis and discusses its application to the area of strategic planning.
Measuring Shareholder Value
The idea of shareholder value rose to prominence during the end of the 20th century as part of the larger concept of value-based management. This concept was based in significant part on the Friedman Doctrine, which holds that the moral obligation of a company is to the company’s shareholders. Preoccupation with shareholder value continues to have a major impact on business planning and investment decisions.
If increasing shareholder value is taken to be one of the most important goals of a company, the question then becomes: how exactly can it be calculated? This presents significant analytical challenges, because a corporation and its value are the product of a great many internal and external variables that are constantly changing, including the ability to execute its business, its revenues and costs, its competitive position in the market and macroeconomic trends in the markets where it operates. Which of these factors are most important?
Many corporate analysts and investors take the view that shareholder value is a function of company value as derived through standard corporate valuation techniques, such as through the application of a market multiple or through Discounted Cash Flow valuation. To take a simple example, if we assume that the yearly EBITDA of a company is $10 MM, the applicable EBITDA valuation multiple for the company’s sector is 7x and the company has $7 MM in debt, shareholder value can be readily calculated as $63 MM.
Four ways to measure shareholder value growth are: deriving shareholder value from corporate value; using return metrics; measuring firm growth; and Shareholder Value Analysis.
There are essentially four general ways to measure shareholder value growth.
Corporate Valuation Approaches. The first way to calculate to calculate shareholder value is to derive it from corporate value. As suggested above, if shareholder value is based on a corporate valuation technique, shareholder value growth can be calculated by simply comparing the company’s equity value at one point with its value at another. This is calculated by subtracting the company’s debt from its Enterprise Value.
Financial and Investment Return Metrics. A second way to calculate whether shareholder value is increasing is through return metrics, such as Return on Equity or Return on Invested Capital. Based on this technique, shareholder value growth is a function of an increased return.
Growth Measurement. A third way is through different types of growth, such as a company’s capitalization or dividends paid to shareholders.
The fourth measurement technique is through a technique called Shareholder Value Analysis which we will now look at in more detail.
Shareholder Value Analysis
Shareholder Value Analysis takes as a starting point the view that shareholder value creation should be viewed against the benchmark of the company’s cost of equity capital. When a company seeks equity financing, in an efficient market the cost of that equity capital is based on the risk in connection with its future cash flows.
Shareholder Value Analysis compares the company’s return on equity to the cost of its equity capital.
This means that if the cost of equity capital for a private agriculture company is 12%, assuming that the company’s risk profile is similar to that of its industry peers, an investor would not accept less than a 12% return on its equity investment. This is due to the fact that if the company demanded that capital be provided at a cost of 10%, the investor would simply invest in an industry peer company at the higher rate of return.
With this as a starting point, Shareholder Value Analysis then considers the relationship between the company’s return on its equity capital and the company’s cost of capital. If the company’s cost of capital is 12% but the company generates a 14% return on its equity, the company has created shareholder value.
One of the major strengths of Shareholder Value Analysis is that it permits the analysis of shareholder value independent of market direction. If the market is declining and sector risk is increasing, a company could be valued at $100 MM one day at $80 MM the next, a loss of value from a corporate valuation perspective of $20 MM. However, if a falling market causes the company’s cost of equity capital to rise from 12% to 16% (due to increased market risk which negatively impacts the firm’s business) and the company can generate a 18% return, it will according to Shareholder Value Analysis have created shareholder value even though its corporate value has fallen according to many other shareholder value calculation metrics.
Because it compares company performance to cost of capital, one of the advantages of Shareholder Value Analysis is that it permits the analysis of shareholder value creation in down as well as up markets.
Value Drivers and Value Driver Distribution
Apart from its analytical flexibility, a key insight of Shareholder Value Analysis is that shareholder value creation ability is not symmetrically distributed across sectors or even within firms. In very simple terms this means that while two firms exhibit the same level of shareholder value growth, the components of that growth can be completely different.
A key insight of Shareholder Value Analysis is that shareholder value creation ability is asymmetrically distributed across markets, sectors and firms.
To analyze shareholder value growth, Shareholder Value Analysis breaks firms down into different value drivers. These value drivers can include:
- Firm capital structure and capital costs
- Firm overall cost structure
- Sales volume and product price
- Firm operating costs
- Firm investment returns
- Financing costs
- Tax rates
Each of these value drivers can be the basis for creating shareholder value.
| Value Driver | Shareholder Value Growth |
| Firm capital structure and capital costs | Reducing cost of capital through increasing % of debt or reducing the cost of debt capital |
| Firm overall cost structure | Reducing costs while maintaining or increasing revenues |
| Sales volume and product price | Increasing sales and prices disproportionately to cost increases |
| Firm operating costs | Reducing operating costs while maintaining or increasing revenues |
| Firm investment returns | Increasing investment returns while maintaining or decreasing costs |
| Financing costs | Reducing financing costs |
| Tax liability | Reducing effective tax liability |
Firms with different value driver profiles can create value through very different pathways. Some firms may have low sales but a very efficient capital structure. Another firm may have an inefficient capital structure but do business in a jurisdiction with very favorable tax rates.
Even within the same firm, value distribution capability may be unevenly distributed. Some firms may have extraordinarily strong sales teams but a highly inefficient cost structure. This means that a comprehensive view of the firm’s overall value creation ability may be disguising the fact that some parts of the firm are creating little if any value while others are essentially pulling the vast majority of the value creation weight. This insight has important implications for strategic planning.
Strategic Planning
The insights that value creation ability is distributed asymmetrically is very useful in the area of strategic planning which requires the allocation of firm resources to different firm activities.
Through value driver analysis, a firm can better understand not only what is really driving value growth but also where it has competitive advantages. For example, if the firm has a lower cost of capital than its sector peers, it can aggressively reinvest the capital cost savings in other firm value drivers, such as new technology. In addition to generating operational efficiencies and lowering costs, this can make the firm more resilient which in turn can have a positive impact on other value drivers and overall shareholder value creation ability.
On the other hand, through the application of Shareholder Value Analysis a firm can understand that certain firm value drivers may be highly exposed to risk, which could cause a firm’s value to suddenly drop. For example, let’s say that the firm’s value creation ability had been heavily based on setting prices far lower than those of competitors which the firm will be able to sustain for only a limited period of time. If the firm is forced to raise prices without retaining the benefits of increased market share, its value will suddenly fall. Thus, a useful application of Shareholder Value Analysis is that it can point firm management to areas where additional resources should be allocated to reduce downside value driver risk.
Yet another benefit of Shareholder Value Analysis is that it put firms in a good position to articulate firm strengths to new potential investors and clearly articulate the relationship between planned uses of capital and firm value drivers. This clarity can increase the likelihood of attracting higher quality investors and reducing capital costs.
Conclusion
Throughout continuing market changes, market shocks and competing views about what the purpose of a corporation should be, the creation of shareholder value remains a driving business performance concept. While there are many ways to measure shareholder value and its growth, Shareholder Value Analysis is useful because it permits a detailed analysis of the specific value drivers of the firm. This is highly useful in understanding a firm’s unique value creation profile, analyzing value driver risk and making strategy formation decisions.
A special thanks to Shankar Athreya, who very helpfully suggested that I consider the link between Shareholder Value Analysis and shareholder value creation.