Shareholder value might, on first glance, seem a rather abstract notion but measuring the returns of a business and assessing the risk undertaken by shareholders is anything but notional. The concept is one that encapsulates a number of ideas but from an investment perspective, all ultimately coalesce around the need to ensure that the business can generate a return on invested capital (ROIC) in excess of its weigh-adjusted cost of capital (WACC).
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In his book Making the Right Investment Decisions: Analysing Companies and Valuing Shares, Michael Cahill cites a Duke University study from 2004 which suggests that ‘78% of senior financial executives in the US said they would sacrifice shareholder value to hit an earnings target.’
This kind of short-termism has sadly become an endemic feature of the contemporary corporate landscape and all the more so with many executive teams being set what are ultimately short-term earnings targets. The business of management has latterly become a matter not of running a firm to maximise value but rather to hit targets which in effect have little intrinsic economic value.
This short-termism has a distorting effect which can ultimately lead to decisions to the company’s long-term detriment. A chief executive officer for example, under pressure to find the money to hit a short-term earnings target, may decide to cut the company’s research and development budget or to fund earnings expectations by reducing marketing spend.
There is however another potential red flag in that management may decide to deploy rather more dark arts. It’s no secret that a company’s balance sheet is capable of hiding a multitude of sins and while corporate governance struggles to deal with this, a culture that remunerates for short-term earnings growth all but ensures the temptation to doctor remains strong. With such an unhealthy emphasis on growth, all too often the accounting illusion of growth is offered in place of longer term strategies that drive the company’s performance and create ROIC in excess of WACC on a sustainable basis.
Of course this short-termism is nothing new and is not confined to the boardrooms of listed companies. Peter F. Drucker, a writer, professor and management consultant in 1986 warned of a severe threat to our ‘long-term economic future’. ‘Corporate managements’, he wrote, ‘are being pushed into subordinating everything (even such long-range considerations as a company’s market standing, its technology, indeed its basic wealth-producing capacity) to immediate earnings and next week’s stock price.’
The reality is that companies with a longer strategic horizon tend to perform better in the long run. Presented to the Canadian Institute of Corporate Directors in May this year by the Canadian Pension Plan Investment Board and McKinsey Consultants, the paper Focusing Capital on the Long Term advises that there are clear lessons to learned from the Asian experience where there is much less opposition to decision-making on a five to ten-year horizon. It’s worth bearing in mind for example that companies like Procter & Gamble (PG:NYSE), Coca Cola (CCH) and Wal-Mart Stores (WMT:NYSE) in some cases took more than a decade to become profitable in China.
The main priority in looking under the bonnet of a business is whether or not it has a strong competitive position and whether or not it has the potential to generate sustained returns over time. Ultimately, this means calculating whether ROIC consistently exceeds a firm’s WACC. ROIC is calculated as:
Operating profit after tax
(Shareholders’ funds + debt + write-downs)
Having established ROIC, the investor must now assess whether this is high enough to justify the risk of giving his cash to the company to put into its business. This is risk is quantified by the WACC, which from the perspective of the company is the price it needs to pay investors to access their capital. Calculating the WACC is a three-step process. The first step is to establish the cost of equity:
Risk-free rate + (beta × equity-risk premium)
The best proxy for the risk-free rate (RFR) is the yield on 10-year Gilts, 2.6% at the time of writing. The equity-risk premium (ERP) is the excess return required by shareholders to justify investing in stocks rather than safe Government bonds. Since its inception in 1962, the FTSE All-Share has advanced at a compound annual rate of 7.1% and in addition paid an average yield of 3.8% making for a total return of 10.9%. By subtracting the RFR from this long-term average annual gain on equities you arrive at the ERP. Discounting for quantitative easing (QE), which has artificially depressed Gilt yields, and assuming a historical 4% to 5% return from Gilts, the ERP would be in the region of 5% to 6%.
Beta measures how much a stock moves by when the overall market rises or falls by 1%. If a company has a beta of 1.5, the share price will, on average, move by 1.5% for every 1% change in the FTSE All-Share. In essence beta converts the market’s ERP into the ERP for the specific equity in question, and when you add this number to the RFR you arrive at its historic return for equity investors, or put another way the cost the company has had to pay to attract its equity investments.
The second step in arriving at the WACC is to calculate the cost of debt, which is taken to be the RFR, being the benchmark rate off which all corporate lending is priced. Blending the cost of equity and cost of debt, depending on the percentage of capital employed that each accounts for, is the third step when you arrive at the full WACC formulae:
(% equity × cost of equity) + (% debt × cost of debt)
Referring back to the ROIC formulae above it is clear that a company can enhance shareholder value by either driving up profits or reducing the amount of capital employed but there is a third way and that is by reducing the WACC by loading a company’s balance sheet up with debt which is generally cheaper than equity although riskier. The carnage which followed the private equity (PE) buy-out boom of the mid to late noughties, when many PE-backed companies came close to or breached their banking covenants, revealed that excessive debt can severely crimp long-term sustainable shareholder value. The same issue is presenting itself now as a result of QE which, by creating a distorted picture of the true cost of debt (Gilt yields at 2.6% will have to revert to mean at some point) is justifying acquisitions which might not otherwise make economic sense as seen with Severn Trent (SVT).
Perhaps the most assured means of creating long-term shareholder value is to focus on operating margins and profits. The ability of a company to increase its prices is crucial here, as any gains will drop straight though to the bottom line. This is why master investors like Warren Buffett put so much store by the concept of ‘pricing power’. To enjoy pricing power a company needs to produce a product people desire but can’t get anywhere else and this essentially reverts back to competitive advantage. A high-ROIC business is likely to prompt competition as new market entrants jostle for share and how well a company can protect its position is key.
Investors should be wary whenever a company appears to have missed the key concept of shareholder value. At a MRQ event in October 2013 the CEO of mining firm Charaat Gold (CGH:AIM) Dekel Golan told the audience: ‘I don’t necessarily want to mine, I want to make money and create value for shareholders.’ Though it should be pointed out he was responding to a question on whether he would consider an outright sale of the company, it is important not to confuse a rising share price with the trickier feat of creating shareholder value, achieved by managing a company’s assets so ROIC exceeds WACC.
This is an edited version of an article first published by Shares in October 2013.