With companies showing a growing tendency to blame stock market pressures for management failures, Shamin A. Sookia of Perigeum Capital Ltd explains the principles that vindicate the creation of shareholder value for the long term, and set companies on the path to sustainable success.
Shareholder value can be simply defined as creating as much wealth as possible for shareholders and generating returns for shareholders in a tangible form. For listed companies, shareholder value creation comes from a rise in share price rather than from dividends.
As such, shareholder value is not about profit, although current and anticipated profits are part of the picture. It is commonly thought that if a public company makes a profit, it will have a healthy share price. The converse is also believed, that is, if the company makes a loss the share price will go down.
While the above will hold true in many instances, it is far too simplistic to infer that all companies who make profits in the short term are creating shareholder value and that those who make losses are not doing so.
Why Profits and Shareholder Value Only Share a Tenuous Connection at Best
There are quite a few instances where public companies have consistently made losses and yet their share prices continue to rise. It is presumed that investors are confident, which might be for a number of reasons, such as, for example, the company’s customer base has expanded, its brand has become stronger, and thus the company is expected to generate profits in the long term.
Another instance worth mentioning regards pharmaceutical companies which have not cut back on research and development and have seen their short-term results suffer – while their long-term competitiveness is being retained or even enhanced. Had they adopted a stance whereby investments in research would not have been made, then their long-term outlook vis-a-vis the market and their competitors would have been negatively impacted.
There are multiple ways by which the share price of a company may be raised, leading to the creation of long-term shareholder value. Usually, the greater the confidence that investors place in the capacity of a company to generate profit and cash in the long term, the more likely a company’s share price will rise, thus leading to creation of shareholder value.
What companies normally do is convey to the market their current strategy in creating the necessary conditions that will lead to profit and cash generation in the future. They would expect the market and investors to gauge their current levels of profits along with the progress being made in creating profit potential for the long term.
Growing Tendency to Blame Stock Market Pressure for Management Failures
It is all too easy to blame the pursuit of shareholder value for the problems encountered in the corporate world which hamper growth and development. When company executives destroy the value they are supposed to be creating, they almost always claim that stock market pressure made them do so.
The reasons underlying such behaviour often have to do with managers and investors being obsessed with next quarterly/half-yearly results, failure to invest in long-term growth, and even the accounting scandals that have shaken businesses worldwide and made the headlines on so many occasions.
The reality is that the shareholder value principle has not failed management; rather, it is the converse which is true, that is, management has betrayed the principle. In the 1990s, for example, many companies introduced stock options as a major component of executive compensation. While the idea was to align the interests of management with those of shareholders, the generous distribution of options largely failed to motivate value-friendly behaviour because their design almost guaranteed that they would produce the opposite result.
Principles Vindicating Creation of Long-Term Shareholder Value
There are certain principles which have been put forward that vindicate the creation of shareholder value for the long term based on the premise that these principles are scrupulously abided by.
- Focus on Strategic Decisions, Not Short-Term Earnings:
The first principle is about not managing earnings or providing earnings’ guidance as such. This almost runs contrary to what all public companies generally do, which is to play the earnings expectations game. The question now is why this focus on earnings could effectively impact long-term shareholder value. Reasons include the fact that the accountant’s bottom line does not approximate a company’s value or factor in its change in value over the reporting period. Also, corporations compromise value when they invest at rates below the cost of capital or forego investment in value-creating opportunities to boost short-term earnings. Rather, companies should focus on making strategic decisions that maximise expected value, even at the expense of lowering near-term earnings. - Carry Assets that Maximise Value:
Another important principle is to carry assets that maximise value, implying that companies must always be conscious of the business model they need to adopt. Value-minded companies would regularly monitor whether there are buyers willing to pay a meaningful premium over the estimated cash flow value for their business units, brands, real estate, and other assets. Another way to ensure that shareholder value is sustained for the long term is to consider returning excess cash to shareholders whenever there are no credible value-creating opportunities to invest in the business through dividend distribution and share buybacks. This not only gives shareholders the opportunity to look for better returns elsewhere but also reduces the risk that management might use the excess cash to make value-destroying investment decisions. - Reward CEOs and Senior Executives for Creating Shareholder Value:
Rewards for CEOs and senior executives of corporations should be for delivering superior long-term returns. Properly structured stock options are useful for corporate executives responsible for overall performance, yet such options are usually inappropriate for rewarding operating-unit executives, who have a limited impact on overall performance. The reward for operating-unit executives should be directed toward performance in adding superior multiyear value. - Provide Investors with Relevant, Reliable, and Timely Information:
The final principle for ensuring long-term shareholder value creation involves providing investors with information that is relevant, reliable, accurate, and timely. This governs investor communications, such as financial reports, as well as ad-hoc disclosures. This obligation to disclose relevant information can serve to alleviate investor uncertainty, potentially reducing the cost of capital and increasing the share price.
Working Towards Value Creation That Stands the Test of Time
Ultimately, the crucial question is whether these principles, if properly followed by companies, would effectively serve the long-term interests of shareholders.
For most companies, the answer is a resounding yes. Eliminating practices that delay or forego value-creating investments to meet quarterly/half-yearly earnings targets can make a significant difference. Furthermore, abandoning a short-term earnings focus and avoiding practices that defer current expenses to future periods may reduce the risk of failing to meet market expectations, preventing a potential meltdown in share price.
Finally, the true test lies in the difference that a shareholder-value orientation can make to a company’s long-term growth strategy.
By Shamin A. Sookia,
Managing Director,
Perigeum Capital Ltd
