Shareholder Value

Shareholder Value

Today we will be talking about shareholder value (SV),  a concept that has been in the news over recent months. Terry Smith wrote a couple of articles in the FT recently, and Merryn has also shared her views on Money Week.

A person’s definition of SV says a lot about their approach to investment. A short-term trader is likely to be happy with a definition based on an increase in the share price, whereas a long-term investor is more likely to demand ongoing increases in the genuine value of the firm.

Shareholder value – and particularly the trader’s definition – is also closely related to shareholder activism. Activists are usually trying to influence corporate behaviour in such a way as to “create additional shareholder value” by pushing up the short-term share price. We’ll talk more about shareholder activism next week, but for now we’ll focus on what exactly SV means.

Defining shareholder value

This is far from clear – it’s something that everyone seems to be in favour of1 even though Merryn quotes James Montier as demonstrating that “the underlying return generation of companies has fallen significantly” since shareholder value became a key indicator.

So are we all talking about the same thing, or are some people using SV as a trojan horse, to smuggle through something a lot more dangerous?

Terry Smith

I’m with Terry, who defines shareholder value as a company “creating additional wealth for its ultimate owners, and whether its managers are acting appropriately to achieve this.” By this he means that the company returns are consistently more than the cost of capital used to generate them.

Such a company will become ever more valuable and it will be in the interest of the shareholders that some of the profits are reinvested to generate further excess returns, rather than using them all for dividends or share buy-backs.

Calculating shareholder value – ROCE

Terry’s definition of returns is ROCE (return on capital employed) – operating cash flow divided by the sum of equity plus net debt. Working out the cost of capital for a company is more difficult. Cost of debt is simply the interest rate being paid, but what is the cost of equity?

Most people use the CAPM method of a risk-free rate – adding a “risk premium” to the “risk-free rate” (usually taken as the yield on government bonds). The risk premium is derived from actual equity returns over bonds.

The recent financial crisis has made this calculation more difficult. Bonds have outperformed equities as interest rates – and bond yields – track ever lower, and some would question that government bonds remain risk-free (though for those of is in the UK, the government’s control of sterling means that gilts effectively are).

Problems with EPS

Because ROCE is difficult to calculate, many people use earnings per share (EPS) as a proxy. It (like its related valuation measure, price/earning ratio or PE) is simple to calculate – profits after tax divided by the number of shares.2

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Terry uses the recent example of Tesco3 as demonstration that EPS can increase at the same time as increasing levels of capital are being used at decreasing rates of return. Tesco was destroying shareholder value whilst increasing EPS.

Manipulation of ROCE

Even management teams who stick to using ROCE as a target can run into problems. To improve ROCE, they can either focus on increasing the numerator or reducing the denominator, or both:

To increase operating profit, they may:

  • raise prices (risking loss of market share and providing an opportunity for competitors)
  • cut costs (which is not sustainable, or linked to growth)4
  • cut R&D and marketing spend (again not linked to long-term growth)
Share buy-backs

To reduce the capital employed, they will likely use cash – and then debt – to buy back shares.5 Low interest rates have only made things worse, since the short-term impact of extra debt is reduced.

Terry uses IBM as the best example of why share buy-backs to boost EPS are a bad idea. In 2014 IBM abandoned a long-standing target of of $20 per share EPS, since it was clearly no longer possible.6

IBM’s 2010 Roadmap had the primary aim of doubling EPS over five years, using three tactics:

  1. Roughly 40% was to come from revenue growth / acquisitions;
  2. 30% from “operating leverage” (cost-cutting)
  3. 30% from share “buybacks”

Acquisitions, cost cutting and share buybacks are not a source of high-quality growth, and at least the latter two are finite.

Merryn also quotes Montier on the evolution of the IBM Roadmap. In its early days the core principles were:

  1. respect for individual employees
  2. a commitment to customer service and
  3. achieving excellence

The principles that made IBM a giant in the first place are a lot nicer than the recovery plan.

Management incentives

Merryn Somerset Webb

Merryn’s big issue with SV is that it leads to treating executives as short-term shareholders, and to incentivising them with shares and share options. This is likely to lead to short-term thinking and under-investment.

Options in particular are a bad idea since they give executives upside with no downside and encourage risk-taking. Also, as we saw in the candle task incentives reduce performance since people focus on the money rather than the task, especially where life-changing amounts of money are involved.

Merryn notes that before SV took hold, firms returns around 20% of their cashflow to shareholders. By 2007 this had risen to 50%.7

The solution

So what should a company do instead? For me, the real issue – as so often – is short-termism.

Long-term SV is a good thing – that’s why people invest their capital in firms. That means sticking to the knitting – re-investing in those activities which generate the above-cost returns. Short-term manipulation of a couple of numbers to make things look good, with no regard to the future health has nothing to do with this.

As far as firms go, the key is to focus on the customer. While I am no fan of Apple, and lack the disposable income to become part of their customer base, they do give their fans what they want.8

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In terms of reshaping capitalism (a modest proposal), we need to do several things:

  1. give employees a stake in their company, which grows with their tenure and contribution to the firm (John Lewis would be the local poster child here)
  2. link corporation tax to long-term measures of shareholder value, so that well-behave companies get better treatment
  3. re-vamp long-term incentive programmes for executives to match those of their shareholders; this can only mean lifetime release (and/or clawback) of benefits accrued is post – executives need to see their bonuses as something more like a pension than a leprechaun’s pot of gold
  4. link executive remuneration to average worker pay, with allowance for differing industry sector profiles of pay
  5. include workers and private investors on company remuneration committees, to veto the escalating deals waved through by the current old boys club9
  6. find positive10 incentives for (all kinds of) people to hold shares for the long-term, and therefore choose them on that basis; this can only mean incrementally favourable tax treatment

I’ll be back next week with more on shareholder activism.

Until next time.

Sources
  1. What exactly do we mean by “shareholder value” – Terry Smith, FT
  2. Shareholder value is an outcome, not an objective – Terry Smith, FT
  3. Shareholder value maximisation: a dumb idea that we really have to dump – Merryn Somerset Webb, Money Week
  1. like “fairness” or “equality”, or Mom and apple pie []
  2. a third definition of shareholder value – one popular with activist investors – is simply making the share price go up []
  3. to which we will return in a later post []
  4. and, depending on how it’s done, can lead to relationship issues – witness the Tesco example of badly treated suppliers becoming unreliable []
  5. In reality this behaviour is driven by the growing use of EPS as a shorthand for ROCE, but the effect on ROCE remains the same []
  6. IBM had made only $11 in the first three quarters of the year []
  7. This has also contributed to the reducing labour share of GDP – higher wages reduce EPS, and hence perceived SV []
  8. Over-priced adult comforters, in my opinion []
  9. this proposal and three one before it would need global co-operation on implementation in order to work properly, so we can add them to world trade, climate change, arms limitation and the Tobin tax on the “pigs might fly” pile []
  10. Here I am deliberately excluding negative measures like the Tobin Tax []

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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Shareholder Value

by Mike Rawson time to read: 5 min