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Knowledge BaseIncreasing Shareholder ValueBy: Kenneth J. Wasmer
Your business is an asset and, as such, has inherent value. Determining what that value is, and more importantly, how to increase that value, are key aspects of financial management that are too often ignored. Most business owners look first at the P&L, or how much money they "pulled out", and the balance sheet second. Few look at their shareholder value and know how much their business is worth. What is interesting is that almost all, however, will be able to tell you the current value of their real estate or stock portfolio. Conceptually, most people understand "shareholder value". Implementing the principle and using the measurement in your business is a little more complicated.
Let's assume your stock portfolio was your "business'. Which measurement is the most important to you? The "balance sheet equity" is the purchase price of the stocks less any loans. The "income statement" would be dividends received less interest expense and the net gain or loss on trades during the year. The "shareholder value" would be the market value of your portfolio less any loans. If the purpose of your portfolio is to produce current income, the "income statement" would be the most important. However, if, like most, your portfolio objective is to create long term wealth, then the shareholder value will be the most important measurement.
So what is the objective of your business? Is it to provide current income, or to create long term wealth? Given the fact that many owners could make more working for someone else, I believe the majority of business owners are, and should be, more interested in long term wealth creation. With this in mind, a growing contingent of financial managers suggests that your primary business measurement should be shareholder value. This measure should be calculated and reported on a monthly basis just like any other financial statement and should be used in the budgeting and planning process, as well.
Shareholder value is essentially the "value" of the business less all debt and liabilities. Shareholder Value is created when the business generates income over and above the cost of its capital. Its capital is simply the amount the owners have invested in the business. Wealth creation refers to the increase in shareholder value over time.
For public companies, shareholder value is calculated by taking the market price of the company's stock multiplied by the outstanding shares. But what about closely held private companies? Here a company needs to calculate its value. There are several different methods to calculate value. For management to create value, they must have a thorough understanding of the methods to determine value and the performance variables that effect the value of the business.
If your business was growing at reasonable rates from year to year and you were profitable, you may naturally assume the value of your business was increasing. But this might not be the case. Let's look at a different example. Suppose you wanted to buy a house with cash that cost $100,000 today, but you only had about $86,000. Current savings accounts are paying 3%, so you put your money in savings and in five years you had $100,000. From an "income statement" perspective, you were profitable every year, your "income" was increasing every year and your net worth was growing year to year. However, if the inflation rate was 5% you actually lost value. In five years, when you have $100,000, the house you wanted to buy is now over $127,000 due to inflation. You are $27,000 short instead of $14,000 short. And, even though from an accounting standpoint, you have had "profits" and your "asset" has increased in value, you have an economic loss.
The same is true of your business. Just because you "appear" to be gaining ground based upon accounting information, you may actually be losing value in your business.
The total value of a company includes total debt and shareholder value. In other words:
Shareholder value = Business Value - Debt
Before you can determine shareholder value you must determine the Business Value. The Business Value can be estimated based upon the present value of forecasted cash flows. In order to calculate the present value the business's cost of capital needs to be determined. The cost of capital is the weighted average of the costs of debt and equity. The cost of debt is relatively straightforward and is usually equal to the interest rates on the debt.
The cost of equity is the minimum expected return that an investor will require to make an investment in the company. The assumption is that an investor will require a rate equal to a risk free rate of return (equal to various government securities) plus an inflation premium and an ownership/risk factor. Logically, a business with a high degree of risk should provide a greater return on investment to compensate for the greater risk.
In calculating your cost of equity you should look at your business to determine an appropriate level of risk. Factors affecting risk may include years in business, proprietary products, size of company, market demographics, quality of products, technical capabilities, management quality, etc. You can also look at indexes, such as the S&P 500, to determine an expected rate of return, but make sure you add a "premium" for a small company risk. Keep in mind that the S&P 500 is an index of publicly held companies which have built in liquidity. An investment in an average reseller or VAR does not have any liquidity. In other words, you can not simply call your broker and sell your company by the end of business today. With this in mind, it is generally possible to estimate the required rate of return to offset risk based on opportunity rates available in alternative investments.
Once the cost of capital has been calculated you need to prepare cash flow projections. These cash flow projections can then be discounted using your calculated cost of capital in order to determine the net present value of the cash flows.
If shareholder value measurements are to be utilized to the fullest in day to day management it is critical to consider the company's overall aspirations, analytical techniques, and management processes. All need to be aligned to help the company maximize its value by focusing management decision-making on the key drivers of shareholder value.
For example, shareholder value can be increased in one of two primary ways; increase net cash flow or reduce the cost of capital. Cash flow can be increased through revenue growth and reduction of expenses. But, it is important to understand the difference between good growth and bad growth. By also focusing on the cost of capital, management can understand the difference. Good growth will produce net cash flows greater than the cost of capital, while bad growth will produce negative amounts. Lowering the overall risk of the organization, optimizing the capital structure, reducing the cost of debt, etc can decrease costs of capital.
Shareholder value techniques can also be used in the planning and budgeting stage. Evaluating potential acquisitions or expansions on the basis of the shareholder value that is added to the company can greatly enhance the decision-making.
Many suggest that managers would benefit enormously by adopting shareholder-value creation instead of operating income or reported earnings as their basic measure of business performance. Shareholder value creation shifts the focus to long term creation of wealth for the owners of the business.
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