Consistently increasing the value of a business for shareholders
Shareholder value analysis sees the worth of a company as the long-term value it creates for shareholders. Originally proposed by Alfred Rappaport, it can be applied to the whole company, a business unit or specific project and is used to determine a company’s direction and to measure progress.
Dealing with long-term profit forecasts, it focuses efforts on creating long-term shareholder value. Freeing strategic thinking from the limitations of other financial measures that can be overly focused on past data or short-term issues, it better informs a company’s strategy and puts the focus on securing future financial stability and growth. This makes it particularly important for determining the long-term direction of a company or business unit. A significant advantage is that it can be used across a range of operating units, regardless of any differences between financial measures that are in place.
The method
Obviously, the calculations involved in shareholder value analysis are many and complex. The following is designed to show the general principle of what is being determined.
• First, estimate the total net worth of a company, unit or project – that is, assets minus liabilities. (This involves using discounted cash flows and subtracting expected capital costs.)
• Then divide this by the number (or value) of shares. This reveals the return to shareholders:
(total net worth – liabilities) ÷ number of shares = return
• If this return is higher than the costs involved, then value has been created for shareholders – clearly, the larger this difference between return and costs (also known as equity return and equity costs), the more shareholder value is added.
return – costs = shareholder value
Limitations
Awareness of its limitations and being clear about what you expect to get out of the process will help you to use shareholder value analysis effectively.
• It involves painstaking assessment, valuation and analysis – these take considerable time and money.
• Predictions about future cash flows and costs can never be accurate. As well as basing the value of a company on guesses, these figures are subject to unforeseen changes.
• It can skew strategy to only considering shareholder value as a measure of worth. Not all value in a company lies in its return to shareholders. It is important not to lose sight of other factors, with different measures – such as corporate social responsibility, customers and employees.