First of all, I will focus on the shareholder value topic before I proceed to the cost of equity topic.
What shareholder value is really about?
This blog post is part of the HBR Online Forum The CEO’s Role in Fixing the System.
Most CEOs, as well as some of the other contributors to this forum, appear to have a false sense of what creating shareholder value means. CEOs need to understand the principles of shareholder value and why they are so important in judging difficult trade-offs, learn about the relationship between the financial performance of the company and the company’s stock, and communicate clearly and act appropriately when expectations gaps open.
It is now in vogue to dismiss the idea that creating shareholder value should be a CEO’s guiding objective. Concepts like “societal value,” “shared value,” and “customer capitalism” are offered as desirable and more enlightened substitutes. This is muddled thinking. CEOs who understand the principles of shareholder value and execute effectively will satisfy most, if not all, of the objectives of those who call for a new way of thinking. The problem is that the true definition of creating shareholder value seems to have gotten lost.
A CEO must understand three issues to be effective. First, he or she needs to internalize the true meaning of creating shareholder value. This amounts to a collection of principles that guide strategic, financial, and organizational issues. Second, he or she needs to understand how capital markets work. Finally, he or she must communicate effectively to shareholders, as well as to other stakeholders.
Creating Shareholder Value
Critics imply that managing for shareholder value is all about maximizing the short-term stock price. Companies that manage for shareholder value, the thinking goes, do whatever it takes to engineer an ever-higher market price. That is a profound misunderstanding. The premise of shareholder value, properly understood, is that if a company builds value, the stock price will eventually follow. The objective is to build value and then let the price reflect that value.
While some executives allow that they should not manage to increase the short-term stock price, they remain reluctant to embrace the concept of managing for shareholder value. It is worth explaining why this is the right objective, and how other stakeholders — including employees, customers, and suppliers — fit into the picture.
A CEO’s job is about resource allocation with a goal of earning a return in excess of the opportunity cost of capital. This requires difficult trade-offs. The challenge is figuring out how to allocate human and financial capital to its best and highest use for the long term. Value creation, by means of maximizing long-term free cash flow, provides the appropriate approach to judge alternative strategies and subsequent performance.
Here’s where other stakeholders come in. To maximize long-term free cash flow, a company must properly manage its relationships with all of its stakeholders. For instance, companies that charge too much for their goods or services will lose customers to the competition. Companies that charge too little may have happy customers but will be unable to meet their other financial obligations or offer new and improved products and services to customers. So a successful shareholder value-oriented company must find the price that adds value for both customers and shareholders.
Similarly, paying employees too little ensures a substandard workforce in a competitive world. Paying employees too much, as the U.S. auto companies discovered, hampers a company’s ability to remain competitive. The same logic extends to suppliers and the government.
The shareholder value approach acknowledges the tough choices that corporate executives face, and gives them a means to decide between them. But one point should be abundantly clear: A company cannot maximize shareholder value through systematic exploitation of its stakeholders.
Understanding Capital Markets
Almost without fail, individuals who get promoted to the position of CEO have been highly successful in some part of the corporation. They may have effectively run a large division or devised a winning marketing strategy. But the fact is, most CEOs have a poor understanding of how the stock market works. The skills and effort that catapulted them to the top spot typically do not prepare them to deal with markets and investors.
An enlightened CEO learns how the stock market sets prices. The research in this area points to three salient points:
First, the value of the business is the present value of future cash flows. In the very long haul, earnings and cash flow converge. But in the short run, cash flows and earnings can be very different. Notwithstanding a nearly ubiquitous focus on earnings and earnings per share, the informed CEO will focus on long-term cash flow.
Second, the stock market reflects cash flows many years into the future — it is long-term oriented. Let me say that again: No matter what you hear about short-term focused investors, values in the stock market are driven by long-term cash flows. Essentially, investors make short-term bets on long-term outcomes. The way to convince yourself of this is to build a spreadsheet and see for yourself. It is not uncommon for it to take 10 or more years of value-creating cash flows to justify a company’s stock price.
Third, the market pays for value creation. Take M&A as an example. Most deals are additive to earnings but destroy value. But research shows that if the synergies of combining businesses exceed the premium the acquirer pays, the stock of the acquiring company goes up irrespective of the immediate earnings impact — and the reverse is true as well.
CEOs often pay attention to analysts, investment bankers, or the media to try to understand the market. None of these are good sources because they represent a small percentage of the collective information that prices capture. A CEO who doesn’t take the time to understand markets is at risk of being influenced by individuals who have incentives that are not aligned with the goals of the company.
Communication
A company’s stock price conveys useful information about the expectations for future financial performance. Executives can reverse engineer those expectations, generally expressed through value drivers, and compare them to the company’s internal forecasts. (Value drivers include sales growth, operating profit margin, and investment requirements.) Large gaps between what the market believes and what the company believes represent an opportunity for communication or action.
If a company perceives that the market has the expectations wrong, the CEO can discuss the key value drivers of the business with the financial community in order to narrow the gap. If the market doesn’t respond, management can take action to benefit from the value gap. For example, if the shares are undervalued, management can buy back shares. If the shares are overvalued, management can issue them as currency for an acquisition.
There is no reason to scrap the notion of creating shareholder value. If anything, it is more important now than ever. The problem is that the concept is broadly misunderstood. CEOs need to grasp what creating shareholder value is really about and to have the fortitude to implement strategies to create long-term value.
Michael Mauboussin is an investment strategist and an adjunct professor at Columbia Business School. His latest book is The Success Equation.
And..... this is a debate. Something to look on. Watch and I need your views on this.
No comments:
Post a Comment