What is shareholder value?
The short, refreshing, and simple answer is ROIC > WACC.
But the real question is how is shareholder value created?
In an academic world, a company has different means to create shareholder value. In essence, there are three main strategies for improving profitability:
a) increase revenue growth (mainly by increasing prices and sales volumes),
b) increase operating margin (by reducing fixed and variable operating costs), and
c) increase capital efficiency (Inventory management and proprietary technology that increases the company’s edge).
In practice, a company has many more means to create shareholder value, and the most common aspects involve external vectors where the company’s management influence is hard to measure.
Focus on the future
Managers and investors too often focus on the achievements of short-term performance metrics, and in particular earnings per share (EPS) growth, rather than on the creation of value over the long term. When investigating the period prior to FC 2007/2008 and any major financial crisis, one can observe a common denominator: managers, boards of directors, and investors forgot about the guiding principle of long-term shareholder-oriented capitalism. More importantly, considerations should not only focus on shareholders but also on customers, employees, suppliers, local communities, and environmental considerations.
In the real world, investors have only a company’s official financial statements as well as their own assessment of how risky their business is. The recent Greensill Capital and Archegos Capital cases highlight the importance of this. Credit Suisse and other banks clearly underestimated the risks of doing business with hedge funds and other leveraged operations. This stresses the fact that even for insiders it is hard to know exactly how and where financial results are generated. Stakeholders of many companies don’t know with precision which metric led to the improved performance. In absolute terms, to shed light on this crucial question, a company would need to skimp on product development, maintenance, or marketing.
Since investors don’t have the complete picture, it is hard for them to make the right share evaluation. In some extreme cases, management will publish excellent results as a fact of improved operating efficiencies, but in reality, the company cut-short on investments and brand building. Such undertakings become public but only years later. As a consequence, these companies go through painful restructuring processes, and normally, it will take years for the share prices to recover. If so, then the shareholders are lucky—there are cases where the share prices never recovered!
Research suggests that long-term revenue growth, and therefore shareholder value, rely most on:
a) organic revenue growth, and
b) investments in R&D.
With the former in place, the company management evidences the commitment to create value in the long run. In a virtuous world, one can take this point one step further.
Companies dedicated to serious value creation are healthier and more robust. Investing with the objective to create sustainability also builds strong foundations that form the basis for a strong economic system with rising living standards and calls for more opportunities again and again. Statistics actually suggest that value-creating companies create more jobs. When analyzing sources of job creations, McKinsey found that US and European companies that created shareholder value have also, on average, experienced a stronger employment growth.
Strategies can defy logic
Companies pursuing acquisitions sometimes argue about whether the earnings dilution will be important or not. Yet, investors will say that a deal’s short-term impact is not so important since they consider long-term results. However, this comes with a stark contradiction: a downward revision of EPS expectations (so results in 12 to 18 months ahead) will immediately impact the share price and ultimately shareholder value. Yet investors say that they don’t pay attention to transactions of a short-term nature and 12 to 18 months is short-term.
Value creation is inclusive. With ESR and climate change projects taking shape, one would expect that the most polluting industries would be shut down first. In such case, a good starting point would be to close down coal-fired power plants. Accordingly, a society would be able to meet the long-term carbon neutral target relatively quickly. However, if the utility decided to stop operating the existing facility, not only would the company put difficulties on its customers (no power) but also on its share- and bondholders (no repayments of debts and equity losses).
So the question that needs to be addressed concerns which stakeholder’s request is to be addressed first and foremost. One might argue that a free-market approach would be best, allowing creative value creation and value destruction to replace an outgoing technology. But are we really there with that much political interference?