Creating Shareholder Value: A Guide for Managers and Investors
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Creating Shareholder Value: A Guide for Managers and Investors
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Overview
The ultimate test of corporate strategy, the only reliable measure, is whether it creates economic value for shareholders.
After a decade of downsizings frequently blamed on shareholder value decision making, this book presents a new and indepth assessment of the rationale for shareholder value. Further, Rappaport presents provocative new insights on shareholder value applications to: (1) business planning, (2) performance evaluation, (3) executive compensation, (4) mergers and acquisitions, (5) interpreting stock market signals, and (6) organizational implementation. Readers will be particularly interested in Rappaport's answers to three management performance evaluation questions: (1) What is the most appropriate measure of performance? (2) What is the most appropriate target level of performance? and (3) How should rewards be linked to performance? Through the lens of high-stakes case studies, like the notable acquisition of Duracell International by Gillette, Rappaport dissects the intricate decisions and risks inherent in the merger and acquisition process.
The shareholder value approach presented here has been widely embraced by publicly traded as well as privately held companies worldwide. Brilliant and incisive, this is the one book that should be required reading for managers and investors who want to stay on the cutting edge of success in a highly competitive global economy.
Product Details
| ISBN-13: | 9780684844107 |
|---|---|
| Publisher: | Free Press |
| Publication date: | 12/01/1997 |
| Edition description: | REVISED |
| Pages: | 224 |
| Product dimensions: | 6.12(w) x 9.25(h) x 0.90(d) |
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Read an Excerpt
Chapter 1
SHAREHOLDER VALUE AND CORPORATE PURPOSE
The idea that management's primary responsibility is to increase value has gained widespread acceptance in the United States since the publication of Creating Shareholder Value in 1986. With the globalization of competition and capital markets and a tidal wave of privatizations, shareholder value rapidly is capturing the attention of executives in the United Kingdom, continental Europe, Australia, and even Japan. Over the next ten years shareholder value will more than likely become the global standard for measuring business performance.
In the early 1980s there were very few companies with an unambiguous commitment to shareholder value. While many companies used piecemeal applications of the shareholder value approach, such as discounted cash-flow analysis for capital budgeting decisions and for merger-and-acquisition pricing, management thinking largely was governed by a short-term earnings orientation. The takeover movement of the latter half of the 1980s provided a powerful incentive for managers to focus on creating value. Many companies, particularly those in mature industries such as oil, allocated their very substantial excess cash flow toward uneconomic reinvestment or ill-advised diversification. Other companies failed to seek the highest valued use for their assets. For example, retailing establishments, particularly large department stores sitting on valuable downtown real estate, missed the opportunity to sell the real estate and redeploy the cash to value-creating growth or, in the absence of profitable investment opportunities, distribute the cash to shareholders. In each of these cases the stock market predictably penalized the companies' shares. This led to the infamous "value gap," i.e., the difference between the value of the company if it were operated to maximize shareholder value and its current market value. A positive "value gap" was an invitation to well-financed corporate raiders to bid for the company and replace incumbent management. The only compelling takeover defense is to close the "value gap" by delivering superior shareholder value. Whatever one thinks of raiders and their tactics, the threats of takeovers did prompt CEOs to give long-overdue focus to delivering value for shareholders.
The excesses of the late-1980s takeover movement — payments of unwarranted acquisition premiums financed by high leverage — led to the demise of "financial" acquisitions. Entering the 1990s CEOs of many public companies were relieved to see Wall Street raiders move backstage. But there was to be no return to business as usual. Over the past few years institutional investors have substantially increased their efforts to gain better returns for the beneficiaries of the funds they manage. Their primary approach has been to shine the spotlight on underperforming companies and promote changes in either corporate strategy or in management itself. For example, the California Public Employees' Retirement System (CalPERS) screens annually for the ten most seriously underperforming stocks in its portfolio. The Council of Institutional Investors, a trade organization for public pension funds, publishes a "bottom 20" list comprised of companies in the Standard & Poor's 500 who most underperformed their industry in total shareholder returns, i.e., dividends plus stock price change. In 1992 Robert Monks and Nell Minow founded LENS, a fund exclusively devoted to investing in "companies with strong underlying values, but whose performance lags due to lack of focus by the management or the board." After four years of constructive involvement with its portfolio companies, $1 invested in 1992 compounded to $2.28 versus $1.69 for the S&P 500. Active institutional investors have helped displace CEOs at such major companies as American Express, Eastman Kodak, General Motors, IBM, K-Mart, Sears, and Westinghouse.
Maximizing shareholder value is now embraced as the "politically correct" stance by corporate board members and top management in the United States. As is the case with other good ideas, shareholder value has moved from being ignored to being rejected to becoming self-evident. It is invariably invoked in annual reports, press releases, meetings with financial analysts, and management speeches. However, the critical role of the shareholder value approach in allocating resources in a market-based economy is far from universally accepted. Years of restructuring and employee layoffs frequently attributed to shareholder value considerations coupled with politicians who charge top management with self-interest and a shortsighted focus on the current stock price have promoted frustration and uncertainty. In other parts of the world, such as the European continent, there is increasing political tension between the shareholder value business practices required in a competitive global market and the long-standing tradition of social welfare. In light of these developments, a reassessment of the fundamental rationale for the shareholder value approach is warranted.
MANAGEMENT VERSUS SHAREHOLDER OBJECTIVES
It is important to recognize that the objectives of management may in some situations differ from those of the company's shareholders. Managers, like other people, act in their self-interest. The theory of a market economy is, after all, based on individuals promoting their self-interests via market transactions to bring about an efficient allocation of resources. In a world in which principals (e.g., stockholders) have imperfect control over their agents (e.g., managers), these agents may not always engage in transactions solely in the best interests of the principals. Agents have their own objectives and it may sometimes pay them to sacrifice the principals' interests. There are, however, a number of factors that induce management to act in the best interests of shareholders. These factors derive from the fundamental premise that the greater the expected unfavorable consequences to the manager who decreases the wealth of shareholders, the less likely it is that the manager will, in fact, act against the interests of shareholders.
Consistent with the above premise, at least four major factors will induce management to adopt a shareholder orientation: (1) a relatively large ownership position, (2) compensation tied to shareholder return performance, (3) threat of takeover by another organization, and (4) competitive labor markets for corporate executives.
Economic rationality dictates that stock ownership by management motivates executives to identify more closely with the shareholders' economic interests. Indeed, we would expect that the greater the proportion of personal wealth invested in company stock or tied to stock options, the greater would be management's shareholder orientation. While the top executives in many companies often have relatively large percentages of their wealth invested in company stock, this is much less often the case for divisional and business unit managers. And it is at the divisional and business unit levels that most resource allocation decisions are made in decentralized organizations.
Even when corporate executives own shares in their company, their viewpoint on the acceptance of risk may differ from that of shareholders. It is reasonable to expect that many corporate executives have a lower tolerance for risk. If the company invests in a risky project, stockholders can always balance this risk against other risks in their presumably diversified portfolios. The manager, however, can balance a project failure only against the other activities of the division or the company. Thus, managers are hurt by the failure more than shareholders.
The second factor likely to influence management to adopt a shareholder orientation is compensation tied to shareholder return performance. The most direct means of linking top management's interests with those of shareholders is to base compensation, and particularly the incentive portion, on market returns realized by shareholders. Exclusive reliance on shareholder returns, however, has its own limitations. First, movements in a company's stock price may well be greatly influenced by factors beyond management control such as the overall state of the economy and stock market. Second, shareholder returns may be materially influenced by what management believes to be unduly optimistic or pessimistic market expectations at the beginning or end of the performance measurement period. And third, divisional and business unit performance cannot be directly linked to stock price.
The third factor affecting management behavior is the threat of takeover by another company. Tender offers have become a commonly employed means of transferring corporate control. Moreover the size of the targets continues to become larger. The threat of takeover is an essential means of constraining corporate managers who might choose to pursue personal goals at the expense of shareholders. Any significant exploitation of shareholders should be reflected in a lower stock price. This lower price, relative to what it might be with more efficient management, offers an attractive takeover opportunity for another company, which in many cases will replace incumbent management. An active market for corporate control places limits on the divergence of interests between management and shareholders.
The fourth and final factor influencing management's shareholder orientation is the labor market for corporate executives. Managerial labor markets are an essential mechanism for motivating management to function in the best interests of shareholders. Managers compete for positions both within and outside of the firm. The increasing number of executive recruiting firms and the length of the "Who's News" column in the Wall Street Journal are evidence that the managerial labor market is very active. What is less obvious is how managers are evaluated in this market. Within the firm, performance evaluation and incentive schemes are the basic mechanisms for monitoring managerial performance. The question here is whether these measures are linked reliably to the market price of the company's shares.
How managers communicate their value to the labor market outside of their individual firms is less apparent. While the performance of top-level corporate officers can be gleaned from annual reports and other publicly available corporate communications, this is not generally the case for divisional managers. For corporate level executives, the question is whether performance for shareholders is the dominant criterion in assessing their value in the executive labor market. The question in the case of division managers is, first, how does the labor market monitor and gain insights about their performance and second, what is the basis for valuing their services.
SHAREHOLDERS AND STAKEHOLDERS
Environmentalists, social activists, and consumer advocates such as Ralph Nader have argued since the 1960s that corporations should be "socially responsible" and serve the broader public interest as well as shareholder interests. In the 1990s corporate governance discussions are replete with references to "balancing the interests of all stakeholders." While corporate social responsibility and stakeholder advocates sometimes embrace different issues, each calls for the corporation to have a purpose beyond maximizing returns to shareholders.
In a market-based economy that recognizes the rights of private property, the only social responsibility of business is to create shareholder value and to do so legally and with integrity. Critical social issues in education, health care, drug abuse, and the environment pose enormous social challenges. Corporate management, however, has neither the political legitimacy nor the expertise to decide what is in the social interest. Our form of government calls for elected legislators and the judicial system to be the mechanisms for collective choice. Ironically, costs that social responsibility advocates would impose on corporations often are costs that voters through the political process would be unwilling to bear. Such imposed costs invariably will be passed on to consumers by way of higher prices, to employees as lower wages, or to shareholders as lower returns. There still is no free lunch.
Fortunately, there are powerful market incentives that lead value-maximizing managements to make decisions with socially desirable outcomes. Workplace safety serves as an excellent example. The passage in 1970 of the Occupational Health and Safety Act apparently did little to reduce job-related accidental deaths, since they declined at about the same rate before and after its passage. The steady improvement in workplace safety over the years is more reasonably explained by the employer's strong economic incentives to avoid accidents. First, there is a significant wage and benefits premium that employees demand for the higher risk associated with a dangerous workplace. When an accident occurs there are additional losses due to lost worker time and increased turnover arising from safety fears of coworkers. Second, there are workers' compensation insurance premiums paid by the employer, which are affected by accident rates. There are significant savings to be realized for relatively small reductions in accident rates. Managements governed by shareholder interests would invest in technology, training, or reengineered workplaces that reduce safety costs.
Because of its ambiguity and lack of enforceability, the corporate social responsibility model gets little support from policymakers and corporate governance activists today. Primarily as a response to significant employee layoffs, "balancing the interests of stakeholders" has commanded increasing attention in the 1990s. This is not a new idea. Chief executives of some of our largest companies have contended that shareholder interests should not be their primary obligation. Hicks B. Waldron, the former chairman of Avon Products, for example, states: "We have 40,000 employees and 1.3 million representatives around the world. We have a number of suppliers, institutions, customers, and communities. None of them have the democratic freedom as shareholders do to buy or sell their shares. They have much deeper and much more important stakes in our company than our shareholders." Critics charge that balancing stakeholder interests is simply rhetoric by entrenched managers who wish to deflect attention away from their poor performance for shareholders.
It is precisely this casualness toward shareholder interests that precipitated the 1980s takeovers with all their unpleasant and largely avoidable consequences to many employees and communities. The takeover movement demonstrated little tolerance for managements not attentive to shareholder value. Takeovers as well as restructurings, which were management's response to the threat of takeover, unlocked billions of dollars of value for shareholders. It would, however, be a profound error to view increases in a company's value as a concern just for shareholders. Most executives and public policymakers recognize that increases in stock price reflects improvements in productivity and competitiveness, which benefit everyone with a stake in the company and the overall economy. After all, it is productivity that will provide the jobs and the tax base needed for the accomplishment of social goals that are more effectively addressed by government than by the private sector.
The stakeholder model that attempts to balance the interests of everyone with a stake in the company makes it easier for corporate managers to justify uneconomic diversification or overinvestment in a declining core business, since these moves are likely to be endorsed by constituencies other than shareholders. For employees it means more jobs — in the short run. Suppliers enjoy the prospect of additional business, and the local community gets a larger tax base resulting from the increased size of the company. Also, business decisions based on social criteria often bring personal praise for the chief executive officer. But it is these decisions that subordinate shareholder interests that trigger the much maligned corrective mechanisms of takeovers and restructuring.
Fortunately there is an alternative approach to stakeholders that is consistent with shareholder interests, competitiveness, and, in the final analysis, socially responsible business behavior. This view recognizes that to continue to serve all stakeholders, companies must be competitive if they are to survive. This view further recognizes that a company's long-term destiny depends on a financial relationship with each stakeholder that has an interest in the company. Employees seek competitive wages and benefits. Customers demand high-quality products and services at competitive prices. Suppliers and bondholders seek payment when their financial claims fall due. To satisfy these claims management must generate cash by operating its businesses efficiently. This emphasis on long-term cash flow is the essence of the shareholder value approach.
In brief, a value-creating company benefits not only its shareholders but the value of all other stakeholder claims, while all stakeholders are vulnerable when management fails to create shareholder value. Enlightened self-interest dictates that shareholders and other stakeholders actively engage in a partnership of value creation.
Customers and Employees
Two stakeholders, customers and employees, merit further examination. First consider the case of customers. Even the most persistent advocate of shareholder value understands that without customer value there can be no shareholder value. The source of a company's long-term cash flow is its satisfied customers. On the other hand, providing customer satisfaction does not automatically translate into shareholder value. Providing a comparable product at a lower cost than competitors, or providing superior value to the customer through higher quality, special features, or postsale services, are not genuine advantages if the total long-term cost, including the cost of capital, is greater than the cash generated by the sale. A business that provides more value than customers are willing to pay for is hardly competitive — and may not even be viable. The euphoria associated with investments in total-quality programs sometimes exempts such major investments from careful shareholder-value scrutiny. Consider, for example, the Wallace Company, a Houston, Texas-based pipe and valve distributor that won the prestigious Malcolm Baldrige National Quality Award in 1990. Wallace's quality program significantly increased on-time deliveries as well as its market share. Customers, however, were unwilling to accept the price increases initiated to offset the costs of the quality program. As a result, the company began to lose money, lay off employees, and, finally, it declared bankruptcy. While shareholders subsidized customers for a time, all stakeholders — including shareholders — became the ultimate losers. The lesson is clear: When confronted with a conflict between customer value and shareholder value, management should resolve it in favor of shareholders and the long-term viability of the business.
While conflicts between customer value and shareholder interests can be quantified and appropriately resolved by sound shareholder value analysis, conflicts between employee and shareholder interests pose a substantially more difficult challenge. A curious coalition of liberal and conservative commentators has laid the blame of employee insecurity on CEOs who downsize their companies to increase stock price. The same commentators that just a few years ago were lambasting CEOs for underperforming against foreign competitors are now criticizing CEOs for downsizing to improve competitiveness. In most cases CEOs are responding to advances brought about by stunning new technology, pressure from more efficient domestic or foreign competitors, opportunities to produce better or less costly products by outsourcing, deregulation, or simply too much capacity chasing too little demand. It is important to distinguish between the causes of layoffs and the CEOs who as agents of change respond to ensure the competitiveness and survival of their companies. Spare the messenger.
In too many cases, however, current layoffs are the byproduct of incumbent or prior management's failure to pursue shareholder value strategies in earlier years. If shareholder value management had been implemented earlier, the level of downsizing in the 1990s would have been considerably less. After all, work force reductions have been largely triggered by structural changes in the economy rather than by transitory business cycles. If management defers a 10 percent reduction in staff that is needed to make the company cost competitive, how long will it take before its industry rivals aggressively lower prices or invest in improved customer satisfaction, thereby threatening the very survival of the company? The tradeoff is a 10 percent reduction now or a possible loss of jobs for many more if not all employees in the near future. Setting aside for the moment shareholder interests, do the 10 percent of employees facing layoffs merit a higher priority than the remaining employees? Layoffs are a very painful short-term price that must be paid for remaining competitive. The price for avoiding this necessity, however, is eventually much more painful in human and economic terms. Experience teaches the bitter lesson that this type of kindness often turns into unintended cruelty. While the corporate downsizing that began in the 1980s continues, there is also an impressive number of jobs being created in the overall economy. Some of these jobs are in fact materializing in the very same companies that had eliminated other jobs during an earlier restructuring.
Government regulation that presumably "helps" companies to act in the social interest invariably leads to even greater employee insecurity. Many European governments and unions try to protect jobs by making it very costly to lay off employees. This interference with market forces has led to less competitive, high-cost companies and unemployment rates more than twice those experienced in this country. In contrast to the significant restructuring undertaken in the United States, overstaffed companies in Japan and Germany are just beginning to acknowledge that global competition will compel them to do the same. Even at extraordinarily low interest rates in Japan, there is virtually no net increase in corporate borrowing because there are so few profitable investment opportunities. To regain its momentum, Japan will have to reestablish itself as an attractive place to invest in by lowering its costs through a combination of corporate restructuring and government deregulation. In the meantime, implementation of shareholder value has helped transform American industry into the most competitive in the world, after a period when all the talk focused on its dismal performance. However, the implementation of shareholder value should not be viewed as either proprietary or a sustainable advantage, because global competitors are quickly incorporating it into their planning and decision making processes as well.
There is unfortunately another side to restructuring and employee layoffs. Not all downsizing is based on long-term shareholder value considerations. Some downsizing decisions are predicated on reporting better short-term earnings rather than focusing on the longer term position of the business. For example, layoffs in companies that depend heavily on personal relationships with customers can adversely affect longer term profitability. Moreover, such downsizing may also adversely affect the morale and productivity of the remaining work force. The source of the problem here is not the use of the shareholder value approach. The problem instead is its misuse or nonuse, which has led to value-destroying downsizings for companies and their shareholders and uncalled-for dislocations and pain for employees.
Innovation and customized products and services developed by highly skilled employees are increasingly a critical source of value creation. In many cases these employees have developed highly specialized, firm-specific skills that have substantial value to their employers but less value to other organizations. These employees are unlikely to find jobs elsewhere that pay as much as their current employment. Some economists argue that employees with firm-specific skills bear the residual risk of the company along with its shareholders and therefore should have rights on par with shareholders. This is not the place to examine the legitimacy of this argument or its implications for corporate governance. It is, however, important to examine briefly the most frequent suggestion on how to align the interests of employees with those of shareholders.
How can employee interests be aligned with shareholder interests in the face of restructuring and layoff announcements that so often trigger increases in the share price? The most frequent suggestion is that employees be granted meaningful stakes in the company's stock. The argument is that because employees are now also shareholders who will benefit from efficiency-enhancing plant closings and layoffs, they would support these value-creating actions. But such support will come only from those whose stock appreciation exceeds their loss from being laid off. The proportion of stock required in compensation packages to align employee interests with those of shareholders is in most instances simply not feasible. Even if it were, employees concentrating their human and financial capital in one company ignores the wisdom of diversification. I believe that the better solution lies in offering employees meaningful incentives for creating value. Recommended measures and their linkage to incentives are detailed in Chapter 7.
The mutual interdependence among shareholders and other stakeholders makes it imperative that they engage in a partnership for value creation. But stakeholders must perceive the value-sharing process to be fair before they can be expected to maximize their commitment to a company. Simply said, I will help grow the pie if you give me my fair share. While most discussions of corporate purpose address the concerns of various stakeholders, comparatively little attention is devoted to who the shareholders of corporate America are today. When we realize that shareholders are not "them" but are "us," the case for shareholder value becomes even more compelling.
SHAREHOLDERS ARE "US"
About 40 percent of U.S. households own individual stocks or mutual funds. Millions of employees have an indirect stake in stock performance by their participation in defined-benefit pension plans sponsored by their employers. Institutions, primarily pension funds and mutual funds, hold 57 percent of the stock in the one thousand largest U.S. corporations and 47.5 percent of the total U.S. equity market. By some estimates, personal stock holdings and retirement plans account for over 75 percent of Fortune 500 company shares. With the phenomenal growth in defined-contribution plans, particularly 401(k) plans, investment decisions along with the associated risk now belong to employees. A substantial majority of retirees and active employees depend on dividends and stock price appreciation for their retirement security. Shareholders are not the frequently demonized wealthy, self-serving Wall Street caricatures, but instead are largely individuals who invest human capital in their place of employment and financial capital across a broad cross section of the economy. Indeed, Main Street is fast replacing Wall Street. Losses, whether taken in the name of social responsibility or due to poor decision making, come out of the pockets of retirees, workers, and other individuals who depend on management to maximize shareholder value. The broader participation of so-called "middle America" also means that security market prices are likely to affect the real economy more than in the past. This is the case because the larger the investment in securities the greater the propensity of market movements to affect consumer spending decisions. Some economists fear that a significant correction in the stock market could induce a "loss-of-wealth effect," reduce consumer spending, and trigger a recession.
What's on the horizon? Perhaps no prospect looms larger than the potential privatization of Social Security. Those favoring privatization argue that allowing people to invest at least a part of their retirement money in an account similar to a 401(k) or an Individual Retirement Account would ensure the long-term viability of the Social Security system without major cuts in benefits or increases in taxes. Privatization advocates argue that forecasted Social Security shortfalls can be offset by the higher returns earned from a diversified portfolio of stocks and bonds versus the returns from Treasury notes, which by law Social Security must now invest in. Privatization of Social Security is a complex and politically sensitive issue that will take some time to resolve. However, if privatization does materialize, the transition from "them" to "us" will be complete. In such a world, fund managers will be monitored as never before and they, in turn, can be expected to push the companies in their portfolios for performance as never before. Funds with large stock holdings have difficulty selling the shares of underperforming companies. Because of limited market liquidity, shares would have to be sold at a discount to their most recent price. In contrast, investors dissatisfied with their fund's performance are free to move their money to another fund for a relatively small fee or in some cases no fee. Fund managers competing for investors' money will be more motivated than ever before to ride herd on underperforming CEOs with disappointing track records.
Copyright © 1986, 1998 by Alfred Rappaport
Table of Contents
List of IllustrationsPreface
CHAPTER 1. SHAREHOLDER VALUE AND CORPORATE PURPOSE
Management Versus Shareholder Objectives
Shareholders and Stakeholders
Shareholders Are "Us"
CHAPTER 2. SHORTCOMINGS OF ACCOUNTING NUMBERS
Earnings—An Unreliable Bottom Line
The Trouble with Accounting Return on Investment (ROI)
ROI Versus DCF Return Illustrated
Additional Shortcomings of ROI
Shortcomings of Return on Equity (ROE)
CHAPTER 3. SHAREHOLDER VALUE APPROACH
Estimating Shareholder Value
Estimating Shareholder Value Added (SVA)
Threshold Margin
The Shareholder Value Network
Appendix: Conventional Versus Shareholder Value Break-Even Analysis
CHAPTER 4. FORMULATING STRATEGIES
Strategy Formulation Process
Competitive Advantage and Shareholder Value
Strategy "Best Sellers"
CHAPTER 5. VALUING STRATEGIES
Strategy Valuation Process
Valuing Alternative Business Opportunities
Valuing Interdivisional Synergies
Choosing Optimal Investment Level for a New Business
Do Stock Repurchases Create Value?
Ten Value-Creation Questions
CHAPTER 6. STOCK MARKET SIGNALS TO MANAGEMENT
Reading the Market
Corporate Versus Shareholder Rate of Return
Management Implications
CHAPTER 7. PERFORMANCE EVALUATION AND EXECUTIVE COMPENSATION
CEOs and Other Corporate-Level Executives
Operating Managers
Performance Evaluation Alternatives—Shareholder Value Added (SVA)
Performance Evaluation Alternatives—Residual Income
Performance Evaluation Alternatives—Economic Value Added (EVA)
Performance Evaluation Alternatives—Change in Residual Income or Change in EVA
Leading Indicators of Value
Target Level of Performance
Linking Rewards to Superior Performance
CHAPTER 8. MERGERS AND ACQUISITIONS
The Acquisition Process
Value Creation Framework
Do Mergers Create Value for the Acquiring Company?
Gillette's Acquisition of Duracell International
Premium Advice for Targets
CHAPTER 9. IMPLEMENTING SHAREHOLDER VALUE
Implementation Objectives
Gaining Commitment
Introducing Shareholder Value
Reinforcing Shareholder Value
CHAPTER 10. THE SHAREHOLDER SCOREBOARD
A Rising Tide Doesn't Lift All Stocks
Investing as a Game of Expectations
Notes
Index
About the Author
Introduction
PREFACE Much has taken place in the broad arena of shareholder value since the 1986 publication of Creating Shareholder Value. The task of monitoring managers of underperforming companies has shifted from corporate raiders in the 1980s to active institutional investors in the 1990s. A dozen years ago there was considerably less knowledge about shareholder value and a great deal more skepticism about its relevance to corporate governance. Now, in direct contrast, corporate boards and CEOs almost universally embrace the idea of maximizing shareholder value. It has become politically correct, though it is not always fully implemented in practice. Where before the 1990s shareholder value applications consisted principally of evaluating capital expenditures and pricing acquisitions with discounted cash-flow models, companies now incorporate shareholder value measurements into planning and evaluating the overall performance of their businesses. What has not changed is the fundamental shareholder value model itself. After all, it continues to reflect the way rational participants in a market-based economy assess the value of an asset -- the cash it can be expected to generate over time, adjusted for the riskiness of that cash stream. OVERVIEW OF THE BOOK This book presents major applications of the shareholder value approach to management planning and performance evaluation. Not only is the rationale for the shareholder value approach presented, but the tools needed to implement it as the standard for business performance are provided as well. The shareholder value approach can be used to analyze publicly traded or privately held corporations, as well as business units, strategies, or product lines. Throughout the book an effort is made to integrate operating and financial analysis. In particular, the direct linkage between competitive strategy and shareholder value analysis is demonstrated by translating business strategies into the dollars of value they create. What is most encouraging is that the shareholder value applications presented here have been introduced and successfully implemented by an ever-increasing number of companies in the United States and other major economies around the world. Chapter 1 assesses the fundamental rationale for the shareholder value approach to managing companies. It examines the sometimes conflicting objectives of management and of shareholders. The pleas for the corporation to subordinate returns to shareholders and become more socially responsible are examined critically. This chapter also addresses how the conflicts that arise between stakeholders, such as customers and employees, and shareholders are resolved properly. Chapter 2 demonstrates the shortcomings of accounting numbers such as earnings per share (EPS), return on investment (ROI), and return on equity (ROE). EPS growth, for example, is not only unreliably related to changes in shareholder value, but is unreliably related to changes in the market value of publicly traded companies. Accounting numbers fail to measure changes in the economic value of companies because alternative accounting methods are employed, investments are not fully incorporated, and the time value of money and risk are ignored. Chapter 3 provides an introduction to the shareholder value approach. Specifically, the estimation of shareholder value and shareholder value added (SVA) is demonstrated. Threshold margin, the minimum operating profit margin a business needs to maintain shareholder value, is developed as a particularly useful concept in value-creation analysis. Chapter 4 presents an overview of the strategy formulation process and its relationship to the shareholder value approach to valuing business strategies. The strategy formulation process assesses industry attractiveness, competitive position within the industry, and sources of competitive advantage of a company. These factors serve as the foundation for estimating the cash flows needed to value alternative strategies. The discussion then goes on to show that gaining competitive advantage and creating shareholder value are equivalent objectives. Chapter 5 applies the concepts developed in Chapter 4. The shareholder value approach to choosing between competing strategies is illustrated in three cases. The first evaluates the relative attractiveness of two alternative retailing strategies. The second case illustrates how value can be created by exploiting intracompany synergies. The last case shows how the shareholder value approach can be employed to find the optimum level of investment for a new business venture. The chapter concludes with a detailed analysis of the stock repurchase decision. In early chapters, value is estimated based on management forecasts. Chapter 6, in contrast, focuses on what the share price tells us about the market's expectations concerning a company's future performance. The analysis in this chapter shows that even if a company creates shareholder value by investing at above the cost of capital rate, shareholders will not necessarily earn a rate of return exceeding the cost of capital. Shareholder returns depend not only on a company's actual performance, but also on the expected level of performance impounded in the current stock price. This chapter explains and illustrates the important distinction between "corporate return," or the rate of return a business earns on its real investments, and "shareholder return," the rate of return shareholders earn on their investments in the company's shares. Chapter 7 reviews some of the major shortcomings of existing performance evaluation and executive compensation plans. Three issues are addressed for CEOs and other corporate-level executives and for division-level managers: What is the most appropriate measure of performance? What is the most appropriate target level of performance? How should rewards be linked to performance? Chapter 8 presents a comprehensive value-creation framework for analyzing mergers and acquisitions. Care is exercised to differentiate between the value created by an acquisition and the value created for the acquiring company's shareholders. The persistently disappointing track record for acquiring companies is examined in detail. Practical analyses to minimize the risk of buying an economically unattractive business or paying too much for an attractive one are presented. The shareholder value approach to merger-and-acquisition analysis is illustrated with the recent acquisition of Duracell International by Gillette. Chapter 9 discusses how shareholder value can be successfully introduced and implemented throughout an organization. The chapter focuses on the essential requirements of a successful implementation -- a broad consensus on the need for a change, an operational understanding of how to implement change, and the development of a shareholder value infrastructure that ensures that change is sustained. Following the rationale for pursuing shareholder value and practical ways of implementing it presented in the first nine chapters, Chapter 10 examines the proper way for shareholders to keep score. Investors, just as managers, will find the market-expectations analysis illustrated in this chapter to be an extraordinarily valuable tool. After all, investing in stocks is fundamentally a game of expectations. Only investors who anticipate a company's changed prospects before they are incorporated in the stock price will earn superior returns. Successful investors do not just look for good companies, they look for good stocks. What's New in the Second Edition? Readers familiar with the first edition of Creating Shareholder Value will find that with the passage of a dozen years much new material and significant changes to earlier material have been incorporated into this edition. Chapter 1 was rewritten because a new assessment of the rationale for shareholder value was needed after a decade of restructurings and employee layoffs frequently blamed on shareholder value decision making. Readers will find a new and detailed assessment of the "social responsibility of business" and "balancing the interests of all stakeholders" schools of thought in Chapter 1. The basic shortcomings of accounting numbers as indicators of change in the economic value of a business remain. As emphasized in Chapter 2, significant changes in accounting standards, multibillion-dollar stock buybacks, and, perhaps most important of all, the movement from industrial to knowledge-based companies have combined to further erode the usefulness of accounting in economic analysis. The estimation of shareholder value and shareholder value added (SVA) is unchanged. In response to many inquiries about the calculation of residual value -- the value of the business at the end of the forecast period -- I have added a detailed comparison between the two most commonly used approaches to estimating residual value: the perpetuity method and the perpetuity with inflation method. Answers are provided to three questions: What are the essential differences in assumptions for the two methods? How significant are the valuation differences? Which of the two is the more reasonable method? Two new sections, Competitive Advantage and Shareholder Value and Strategy Best Sellers, have been added to Chapter 4. The first section demonstrates why competitive advantage and shareholder value should be regarded by managers as equivalent rather than conflicting objectives. In the second I review briefly recent "best-selling" strategy frameworks and show that each recommends an approach to strategy that is expected to generate desirable competitive outcomes. The missing link is to demonstrate how these desirable outcomes actually translate into positive shareholder value results. A new section has also been added to Chapter 5: Do Stock Repurchases Create Value? The repurchase-of-shares decision has proven to be both challenging and contentious in many companies. After reviewing the principal arguments in favor of stock repurchases, I examine the conditions under which a repurchase creates more value than a dividend and when it would be preferred to investment in the business. The illustrations of stock market signals analysis in Chapter 6 have been revised to provide a clearer understanding of how to conduct this analysis. Chapter 7, on performance evaluation and executive compensation, is entirely new. The recent proliferation of executive stock options and performance evaluation models that purport to measure shareholder value results are assessed and compared with the shareholder value framework developed in this book. As many readers already know or will discover in this chapter, linking short-term performance evaluation and executive compensation to the long-term value of a business is no easy task. For some companies it has proven to be the Achilles' heel of shareholder value implementation. A new section, Do Mergers Create Value for the Acquiring Company?, has been added to Chapter 8. The use of market signals analysis to establish the maximum acceptable purchase price is illustrated in this section. The recently completed acquisition of Duracell International by Gillette is presented as a case study for the shareholder value approach to mergers and acquisitions. Finally, the question of when a target company should accept an acquiring company's premium offer is addressed in Premium Advice for Targets. Chapter 9, Implementing Shareholder Value, and Chapter 10, The Shareholder Scoreboard, are new to the Revised and Updated edition. WHO WILL BENEFIT FROM THIS BOOK? This book is directed to a broad audience. Both managers with operating, planning, or financial responsibilities, who seek to develop value-creating business strategies, and security analysts, searching for improved insights into the economic attractiveness of companies and industries, will benefit from the practical and proven applications. The material also provides a useful foundation for management consultants, investment bankers, commercial bankers, public accountants, and others offering professional services to value-seeking companies. Business school graduates and others who need a refresher course that integrates strategic planning concepts with sound and widely used valuation techniques will also benefit from this book. ACKNOWLEDGMENTS I want to express my continuing appreciation to the individuals mentioned in the First Edition for their many thoughtful suggestions. There are a number of people who made special contributions to this edition. Michael Allman, Stuart Jackson, Marc Kozin, and Thomas Nodine, all of The LEK/Alcar Consulting Group, provided extremely valuable comments and suggestions. Robert Agate, Charles E. Fiero (MLR Publishers), Professor Arthur Raviv (Northwestern University), Robert S. Roath, Colin Smith (LEK-Australia), and J. Randall Woolridge (Pennsylvania State University) each provided insightful comments. George S. Priniski, Jr. and Myra B. Wagner, ably assisted by Laura M. Zimmerman, reviewed the entire manuscript and were enormously helpful in developing updated cases for this edition. I want to take this opportunity to thank Christopher Kenney of The LEK/Alcar Consulting Group for developing Chapter 9 on implementing shareholder value and Christine Lawley for her helpful editorial assistance. Finally, my thanks to my two sons, Nort and Mitch, who contributed valuable suggestions on early versions of the manuscript. > As a member of the faculty for twenty-eight years at the J. L. Kellogg Graduate School of Management, Northwestern University, I enjoyed the benefits of an extraordinarily stimulating environment for research and teaching. My association with The Alcar Group, Inc., which I cofounded with Carl M. Noble, Jr., in 1979, was invaluable as we learned to translate shareholder value from theory to organizational reality. In 1993 the consulting and education operations of The Alcar Group became part of The LEK/Alcar Consulting Group, LLC. I have benefited greatly from my association with The LEK/Alcar Consulting Group, LLC since that time. My thanks go to the firm for providing the resources needed to develop new cases and other materials. I am especially grateful to Marc Kozin, Managing Partner, and Leon Schor, who have been unfailingly supportive and enthusiastic throughout the process. Once again, many thanks go to Robert Wallace, my editor at The Free Press, who originally persuaded me to do "the book," and to Julie Black and Celia Knight, who have been instrumental in the timely publication of this edition. Copyright © 1986, 1998 by Alfred Rappaport