To quote Larry the Liquidator, played by Danny DeVito, addressing the annual general meeting of his takeover target, in the movie “Other People’s Money”:
“Lest we forget, the reason you became a stockholder in the first place was to make money.”
Managing for shareholder value is the fundamental principle that has underpinned most of my comments throughout the finance modules. I am, of course, I am speaking from a narrow financial perspective when I say this. There are other stakeholders whose interests need to be considered.
Modigliani, one of the Nobel Laureates mentioned above in relation to the pizza theory of the cost of capital, said:
“The view which existed until the time our paper came out was that management was supposed to maximize profits. We replaced that concept with another one, maximizing the market value of the firm – you should do those things that the market likes. This concept has been very broadly used, and there is now a broad discussion that the goal of management is the maximization of market value.”
The maximisation of market value requires a longer term perspective. This is because in calculating the value of a share, analysts broadly use the same principles that we have used in evaluating projects; a company may be viewed as a large project. To reiterate, NPV is dependent on:
When presented with a company’s financial projections, an analyst will use their own knowledge and expertise to adjust these and develop their own cash flow forecast for the company. The cash flows will then be discounted to arrive at an NPV for the company. Add the NPV to the value of the company’s assets, divide by the number of shares and we have the share price. If this is higher than the current share price the analyst may consider buying the company’s shares.
This is a simplification but for our purposes it is sufficient. There are two elements I would like to highlight:
Although it can seem as if the market is short-sighted when a share price plunges in response to a poor quarter’s results from a company, this is rarely the case. (The reason for the apparent overreaction will become clear shortly.) Since the share price is a function of NPV, investors are just as concerned with potential future profits. Shareholders want to see investment in the drivers of business performance: brand, skills, culture, relationships, R and D. Although these are generally ‘expensed’ in the accounts they create intangible assets that can be leveraged. These assets enable a company to sell at higher margins, introduce products more quickly and adapt to changing conditions.
“How can so many managers continue to believe that stock prices are driven by short-term accounting numbers?”
Alfred Rappaport, ‘Creating Shareholder Value’
Understanding that shareholders are interested in longer-term performance, captured in a higher NPV, should free managers from the pressure to achieve short-term results at the expense of the future. This does not mean that investors are not concerned with short-term performance – they are, and in fact view it as a good indicator of management’s ability to deliver results in the long-term. But it is not simply accounting performance that interests them.
The accounts tell them what happened: they are a lag indicator. Of greater interest are the lead indicators: customer satisfaction, churn rates, new product pipeline, brand awareness, employee satisfaction and so on. These determine where the company is going and investors are interested in how they are being managed. NPV is forward-looking.
The discount rate incorporates a premium for risk. There are risks which could have an impact on all companies: political, economic, natural disasters and so on. Some companies may be seen as more vulnerable to such risks and this will be reflected in the discount rate used by analysts in their calculations. Other elements of risk are more specific to the company and include two that we have already discussed: financial risk from being highly geared (high proportion of debt financing) and operating risk resulting from high fixed costs. There are also risks associated with competitor activity, security of the customer base (are they tied in by contracts, their financial status etc), the supply chain (are there dependencies on a single source or threats of shortage) and infrastructure (which covers everything from the flexibility of assets through to robust IT systems). Whilst these are important I would suggest that they are overridden by what I term management risk.
This may be summarised as:
Does the management team have the capability to deliver shareholder value?
This may not seem tremendously scientific but it is the question that all other analysis ultimately leads to. It encompasses decision-making related to, inter alia, strategic and marketing choices, operational efficiency, investment, and, critically, the management team’s understanding of the business as reflected in its ability to forecast accurately. It is for this reason that a share price will often tumble following quarterly results which are not in line with management’s previous projections. Two thoughts are likely to run through an analyst’s mind:
The result is that the NPV is slashed and the share price falls. It is not the market being short-sighted, it is a response to management risk. If you work or have worked in a large organisation you may occasionally have been mystified by the sudden rush to get orders entered before a month-end. You can now see why. I can remember working with a group of engineers who were aghast at a product full of bugs being launched. But a commitment had been made and a failure to launch would have affected market confidence. Senior management took a calculated gamble – launch the product and fix the bugs before the next investor briefings. A risky approach to managing the perception of management risk.
One way to reduce the perceived management risk is to be transparent in explaining your business approach, including identifying the drivers of business performance and how they will be measured.
Investors will be more trusting (and so lower the discount rate) if management can connect the dots between performance drivers, non-financial measures and financial performance. Here is a very simple illustration:
If churn is reduced by 10% and there is a $10 million improvement in profits then management has demonstrated that it not only understands the drivers of business performance but is capable of effective execution.
There is support for this approach in the research by Ittner & Larcker, summarized in an article in the Harvard Business Review, “Coming up Short on Non-financial Performance Measurement”. They comment:
“The companies in our study that adopted nonfinancial measures and then established a causal link between those measures and financial outcomes produced significantly higher returns on assets and equity over a 5-year period than those that did not.”
It takes time for many initiatives to be reflected in financial performance. A cause-and-effect model, supported by appropriate measures, is therefore an essential accompaniment to the financial statements. Many organisations capture and summarise this cause-and-effect model in a Balanced Scorecard. In the words of its developers, Harvard professors Robert Kaplan and David Norton:
“Briefly summarized, balanced scorecards tell you the knowledge, skills and systems that your employees will need (their learning and growth) to innovate and build the right strategic capabilities and efficiencies (the internal processes) that deliver specific value to the market (the customers), which will eventually lead to higher shareholder value (the financials).”
The Balanced Scorecard was developed to provide a more balanced framework for measuring performance. Rather than emphasising traditional ratios, which are historic lag indicators, the Balanced Scorecard identifies the real performance drivers in the business and measures these:
“for example, how faster process-cycle times and enhanced employee capabilities will increase the retention of customers and thus increase company revenues.”
The generic scorecard has four dimensions: finance, customers, processes and learning (or people), although many organisations create their own scorecard structure. Within each dimension targets are set and the performance drivers and their measures are identified. Linkages between the drivers are indicated using lines. The scorecard thus becomes a map to achieving strategy and the firm’s financial objectives. It is alternatively referred to as a Strategy Map.
The scorecard for the firm can be cascaded down through the organisation; ultimately every person in the organisation can have their own scorecard. This cascade of scorecards ensures consistency and integration and makes strategy – and value creation – part of everyones’ everyday job. The best scorecards become predictors of value.
The Balanced Scorecard is not without its critics and implementation can be challenging, not least because in many organisations it is administered by the finance department which is often unable to escape from its preference for hard, financial-based numbers. It is though a step in the right direction.
This broader, integrated approach does not reduce the significance of financial performance, rather it helps managers to focus on the real measure of financial performance – value creation.