What is shareholder value?
Shareholder value is the value delivered to a company’s shareholders due to management’s ability to increase sales, profits, and free cash flow, resulting in an increase in dividends and capital gains for shareholders.
A company’s shareholder value depends on strategic decisions made by its board of directors and senior management, including the ability to make smart investments and generate a healthy return on capital invested. If this value is created especially in the long term, the share price rises and the company can distribute higher cash dividends to the shareholders. Mergers in particular tend to lead to a strong increase in shareholder value.
Shareholder value can become a hot topic for companies because creating wealth for shareholders does not always or equally translate into value for employees or customers of the company.
The central theses
- Shareholder value is the value given to a company’s shareholders based on the company’s ability to make and grow profits over time.
- An increase in shareholder value increases the total amount in the equity portion of the balance sheet.
- The maxim of increasing shareholder value is indeed a practical myth – there is no legal obligation for management to maximize business profits.
Understand shareholder value
An increase in shareholder value increases the total amount in the equity portion of the balance sheet. The balance sheet formula is: assets minus liabilities equals shareholders’ equity, and equity includes retained earnings or the sum of a company’s net income minus cash dividends since inception.
How the use of assets increases value
Companies raise capital to buy assets and use those assets to generate sales or invest in new projects with a positive expected return. A well-run company will maximize the use of its assets so that the company can operate with a lower investment in assets.
For example, let’s say a plumbing company uses a truck and equipment to do residential work, and the total cost of those assets is $ 50,000. The more sales the plumbing company can generate with the truck and the equipment, the more shareholder value the company creates. Valuable companies are those that can grow their bottom line on the same dollar amount of assets.
Cases where cash flow increases value
Generating sufficient cash inflows to run the business is also an important indicator of shareholder value as the business can operate and grow sales without borrowing money or issuing more shares. Businesses can increase cash flow by quickly converting inventory and receivables into cash collections.
The cash collection rate is measured by inventory turnover, and companies seek to increase sales without increasing inventory or increasing the average dollar amount on accounts receivable. A high inventory turnover and customer turnover rate increases shareholder value.
Taking into account the earnings per share
If management makes decisions that increase net income each year, the company can either pay a higher cash dividend or withhold profits for use in business. A company’s earnings per share (EPS) is defined as the earnings available to its common stockholders divided by the number of common shares outstanding, and the ratio is an important indicator of a company’s shareholder value. If a company can increase its bottom line, the rate increases and investors see the company as more valuable.
The myth of maximizing shareholder value?
It is well known that corporate directors and management have a duty to maximize shareholder value, especially in publicly traded companies. However, legal judgments suggest that this common wisdom is actually a practical myth – there is actually no legal requirement to maximize profits when running a business.
Much of the idea can be traced back to the oversized impact of a single outdated and widely misunderstood decision of the 1919 Michigan Supreme Court decision Dodge versus Ford Motor Co., which was about the legal obligation of a controlling majority shareholder towards a minority shareholder and not about maximizing shareholder value. Legal and organizational scholars such as Lynn Stout and Jean-Philippe Robé have elaborated on this myth.