Volume 40

Number 2
June 2013

Sedm e
Small Enterprises Developm ent,
M anagem ent, & Extension
Journal

y t w o td d w id e w indow o n A G IS M S s t u d i e s
S hareholders V alue C reation and
M easurement: A pproaches

A. Vinayagamoorthy*
C. Sankar

A bstract

This paper aims to explain what shareholder value creation means, how the present emphasis
on shareholder value measurement as a strategic initiative has developed in management practice
and the present day tools and techniques of shareholder value creation and measurement. The
shareholder value creation approach helps to strengthen the competitive position o f the firm by
focusing on wealth creation. It provides an objective and consistent framework o f evaluation
and decision-making across all functions, departments and units o f the firm. It can be easily
implemented since cashflow data can be obtained by suitably adapting the firm ’s existing system
o f financial projection and planning. The only additional input needed is the cost o f capital. The
adoption o f the shareholder value creation approach does require a change o f the mind-set, and
educating the managers about the shareholder value approach and its implementation.

* A. Vinayagamoorthy is Professor of Commerce; C. Sankar is Research Scholar, Department of

Commerce, Periyar University, Salem-11, Tamil Nadu; mobile: 09566997631; e-mail:
avmvaishali59@gmail.com; sankarzee.c@gmail.com respectively.

June 2013
 141 Vinayagamoorthy & Sankar

Introduction
Globalisation has increased calls for corporations to use the firm s’ resources to help
alleviate a wide variety o f social problem s. These calls fo r expanded responsibilities for
business are intuitively appealing to those w ho see e x istin g g o v ern m en ts as unable or
unwilling to deal with such problems. Firms may indeed have resources that could be used
to help with issues that are typically dealt with by governm ents or other non-governm ental
organisation. This paper aims to explain what shareholder value creation m eans, and how
the present emphasis on shareholder value m easurem ent as a strategic initiative developed
in the m anagem ent practice and the present day tools a n d tech n iq u es o f shareholder
value creation and measurement.

C reating shareholder value is the key to success in to d a y ’s m arket-place. T here is

increasing pressure on corporate executives to m easure, m anage and report the creation
of shareholder value on a regular basis. In the em erging field o f shareholder value analysis,
various measures have been developed that claim to quantify the creation o f shareholder
value and wealth.

M ore than ever, corporate executives are under increasing pressure to dem onstrate on
a regular basis that they are creating shareholder value. T his pressure has led to the
emergence o f a variety of m easures that claim to quantify value-creating perform ance.

C reating value for shareholders is now a w idely accep ted corporate o b jectiv e. The
interest in value creation has been stim ulated by several developm ents.

• Capital markets are becoming increasingly global. Investors can readily shift investments
to higher yielding, often foreign, opportunities.

. Institutional investors, who were traditionally passive, have begun exerting influence
on corporate m anagements to create value for shareholders.

. Corporate governance is shifting, with owners now d em anding accountability from

corporate executives. M anifestations of the increased assertiveness o f shareholders
include the necessity for executives to justify their co m p en satio n levels, and well-
publicised lists o f under-performing com panies and overpaid executives.

. Business press is em phasising shareholder value c re a tio n in p e rfo rm a n c e rating

exercises.•

• Greater attention is being paid to link top m anagem ent com pensation to shareholder
returns.

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Shareholder value: Meaning

The total economic value o f an entity such as a com pany or business unit is the sum of
the values of its equity. This value of the business is called “corporate value” and the value
of the equity portion is called “shareholder value.”
To sum up,

Corporate value = D ebt + Shareholder value

The debt portion of corporate value includes the m arket value of debt, unfunded portion
o f em ploym ent benefits, if any, and the m arket value o f other claims such as preferred
stock. Shareholder value is reflected in the m arket price o f equity shares o f a company.
Shareholder value can also be understood as the market capitalization of the equity capital
o f the com pany at any point o f time.
Shareholder value: Definition
In the economist’s view-point, value is created when management generates revenues
over and above the econom ic costs to generate these revenues. Costs com e from four
sources: employee wages and benefits; material, supplies, and economic depreciation of
physical assets; taxes; and the opportunity cost of using the capital.

In the value-based view, value is created only when revenues exceed all costs including
a capital charge. This value accrues mostly to shareholders because they are the residual
owners of the firm.

Shareholders expect m anagem ent to generate value over and above the costs of
resources consumed, including the cost of using the capital. If suppliers o f capital do not
receive a fair return to com pensate them for the risk they are taking, they will withdraw
their capital in search o f better returns, since value will be lost. A company that is destroying
value will always struggle to attract further capital to finance the expansion, since it will be
ham strung by a share price that stands at a discount to the underlying value o f its assets
and by higher interest rates on debt or bank loans dem anded by creditors.

W ealth creation refers to changes in the wealth o f shareholders on a periodic (annual)

basis. A pplicable to exchange-listed firms, changes in shareholder w ealth are inferred
mostly from changes in stock prices, dividends paid, and equity raised during the period.
Since stock prices reflect investor expectations about future cash flows, creating wealth
for shareholders requires that the firm undertake investm ent decisions that have a positive
net present value (NPV).

Although used interchangeably, there is a subtle difference between value creation and
wealth creation. The value perspective is based on measuring value directly from accounting-

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based information with some adjustments, while the w ealth perspective relies m ainly on
stock m arket information. For a publicly traded firm th ese tw o concepts are identical
when,
(1) M anagem ent provides all pertinent inform ation to capital m arkets, and

(2) The markets believe and have confidence in m anagem ent.

Shareholder value approaches

McKinsey approach
M cK insey & Company, a leading international co n su ltan cy firm has developed an
approach to value-based m anagem ent w hich has b e e n very w ell articulated by Tom
Copeland, Tim Roller, and Jack M urrian o f M c K in se y & C om pany. A cco rd in g to
them, properly executed, value based m anagem ent is an ap proach to m anagem ent
whereby the com pany’s overall aspirations, analytical tech n iq u es, and m anagem ent
processes are all aligned to help the com pany m axim ise its value by focusing decision
making on the key drivers of value.
The key steps in the M cKinsey approach to value-based m axim isation are as follows:
Ensure the supremacy of value maximisation
Find the value drivers
Establish appropriate m anagerial processes
Implement value-based m anagement philosophy
Alcar approach
The A lcar group, Inc., a m anagem ent and softw are co m pany has d e v e lo p e d an
approach to value-based m anagem ent which is based on discounted cash flow analysis.
In this framework, the emphasis is not on annual perform ance but on valuing the expected
performance. The implied value m easure is akin to valuing the firm based on its future
cash flows, and is the method m ost closely related to the D iscounted Cash F low (D C F )/
Net Present Value framework.

In this approach, one estimates future cash flows of the firm over a reasonable horizon,
assigns a continuing (term inal) value at the end o f the horizon, estim ates the c o st of
capital, and then estimates the value o f the firm by calculating the present value o f these
estim ated cash flow s. This m ethod o f valuing the firm is identical to that fo llo w ed in
calculating N et Present Value (NPV) in a capital-budgeting context. Since the computation
arrives at the value o f the firm, the implied value o f the firm ’s equity can be determ ined by

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subtracting the value o f the current debt from the estim ated value of the firm. This value
is the implied value of the equity of the firm.
To estim ate w hether the firm ’s m anagem ent has created shareholder value, one
subtracts the implied value at the beginning o f the year from the value estim ated at the
end o f the year, adjusting for any dividends paid during the year. If this difference is
positive (i.e., the estimated value of the equity has increased during the year) management
can be said to have created shareholder value.
The Alcar approach has been well received by financial analysts for two main reasons:
1. It is conceptually sound as it employs the discounted cash flow framework.
2. A lcar had m ade available com puter software to popularise their approach.
However, the Alcar approach seems to suffer from two main shortcomings:
1. In the Alcar approach, profitability is m easured in terms of profit m argin on sales.
It is generally recognised that this is not a good index for comparative purposes.
2. Essentially a verbal model, it is needlessly cum bersom e. Hence it requires a fairly
involved computer programme.
Marakon approach
M arakan Associates, an international m anagement-consulting firm founded in i 978,
has done pioneering work in the area of value-based management. This measure considers
the difference betw een the R O E and required return on equity (cost o f equity) as the
source of value creation. This m easure is a variation o f the economic value measures.
Instead o f using capital as the entire base and the cost o f capital for calculating the
capital charge, this m easure uses equity capital and the cost of equity to calculate the
capital (equity) charge. Correspondingly, it uses economic value to equity holders (net of
interest charges) rather than total firm value.
A ccording to M arakan m odel, shareholder w ealth creation is m easured as the
difference betw een the m arket value and the book value o f a firm ’s equity. The book
value o f a firm ’s equity, A, m easures approxim ately the capital contributed by the
shareholders, whereas the m arket value of equity, N, reflects how productively the firm
has em ployed the capital contributed by the shareholders, as assessed by the stock
market. Hence, the m anagem ent creates value for shareholders if N exceeds A, decimates
value if N is less than A, and maintains value if N is equal to A.
A ccording to the M arakon model, the m arket-to-book values ratio is the function of
the return on equity, the grow th rate of dividends, and the cost of equity.

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 18/ Vinayagamoorthy & Sankar

For an all-equity firm, both Economic Value and the equity-spread m ethod will provide
identical values because there are no interest charges and debt capital to consider. Even
for a firm that relies on some debt, the two measures will lead to identical insights provided
there are no extraordinary gains and losses, the capital structure is stable, and a proper
re-estimation of the cost o f equity and debt is conducted.

A m arket is attractive only if the equity spread and e c o n o m ic profit earn ed by the
average competitor is positive. If the average co m p etito r’s equity spread and econom ic
profit are negative, the market is unattractive.

For an all-equity firm, both Econom ic Value and the equity spread m ethod will provide
identical values because there are no interest charges and debt capital to consider. Even
for a firm that relies on some debt, the two measures will lead to identical insights provided
there are no extraordinary gains and losses, the capital structure is stable, and a proper
re-estim ation o f the cost o f equity and debt is conducted.

A m arket is attractive only if the equity spread and e c o n o m ic profit earn ed by the
average com petitor is positive. If the average com petitor’s equity spread and econom ic
profit are negative the m arket is unattractive.

Economic value added

Consulting firm Stem Steward has developed the concept o f Econom ic Value A dded
(EVA). Companies across a broad spectrum of industries and a w ide range o f com panies
have jo in ed the EVA, bandw agon. T he EVA is a usefu l tool to m easure the w ealth
generated by a com pany for its equity shareholders. In o th er w ords, it is a m easure of
residual incom e after meeting the necessary requirem ents for funds.

Computation of EVA

Economic Value Added (EVA) is essentially the surplus left after making an appropriate
charge for capital em ployed in the business. It m ay be calcu lated by using follow ing
equation.

EVA = N et operating profit after tax- Cost charges fo r capital em ployed

Econom ic value added is the net earnings in excess o f the cost o f capital supplied by
lenders and shareholders. It represents the excess return (over and above the m inim um
required return) to shareholders; it is the net value added to shareholders.

In the above form ula net operating profit after tax [NOPAT] is calculated as follows:

NOPAT= P B IT (1 -T)=PA T+IN T (1-T)

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Features of EVA Approach

✓ EVA is a performance measure that ties directly, theoretically as well as empirically,
to shareholder wealth creation.
✓ It converts the accounting information into econom ic reality that is readily grasped
by non-fmancial managers. It is a simple yet effective way of teaching business literacy
to everyone.
v It serves as a guide to every decision from strategic planning to capital budgeting to
acquisitions to operating decisions.
v It is an effective tool for investor communication.
v It is closest in both theory and construct to the net present value o f a project in
capital budgeting, as opposed to the Internal R ate o f Retum(IRR).
v The value of a firm, in Discounted Cash Flows(DCF) teims, can be written in terms
o f the Econom ic Value A dded o f projects in place and the present value of the
Econom ic Value A dded o f future projects.
Discount cash flow approach
The true economic value o f a firm or a business or a project or any strategy depends
on the cash flows and the appropriate discount rate (commensurate with the risk of cash
flow). There are several methods for calculating the present value of a firm or a business/
division or a project. In the following pages three m ain methods will be discussed that
are m ostly used under discount cash flow approach.
T he first m ethod uses the w eighted average cost o f debt and equity (W ACC) to
discount the net operating cash flows. W hen the value o f a project w ith an estim ated
econom ic life or o f a firm or business over a planning horizon is calculated, then an
estimate o f the terminal cash flows or value will also be made. Thus, the economic value
o f a project or business is:
Economic Value=Present Value of Net Operating Cash Flows+ Present
Value of Terminal Value
The second method of calculating the economic value explicitly incorporates the value
created by financial leverage. The steps that are involved in this method o f estimation of
the firm ’s total value are as follows:
1. E stim ate the firm ’s unlevered cash flows and terminal value
2. D eterm ine the unlevered cost of capital

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3. Discount the unlevered cash flows and terminal value by the unlevered cost o f capital
4. Calculate the present value o f the interest tax shield d isco u n tin g at the cost o f debt

5. Add these two values to obtain the levered firm ’s total value
6. Subtract the value of debt from the total value to obtain the value of the firm ’s shares.
7. Divide the value of shares by the number of shares to obtain the economic value per share.

The third m ethod to determ ine the shareholder e c o n o m ic value is to calculate the
value o f equity by discounting the cash flows available to shareholders by the cost of
equity. The present value of equity is given as below:

Economic Value of Equity= Present Value of Equity Cash Flows+ Present

Value of Terminal Investment
Shareholder value management
The criteria for valuation o f equity shares are proposed by B enjam in G raham , hailed
as the father of the subject o f Security Analysis.
Benjamin Graham’s quality and valuation criteria for value stocks are indicated below.
Adequate size
For India let it be specified that it has to be 1 100 crore in sales.
Strong financial condition
Current assets should be at least tw ice the current liabilities.
Long-term debt should not exceed the net current assets.
Or
Total debt-equity ratio is to be less than 1:1.
Earnings stability
Som e earnings for the com m on stock in each o f the past ten years
Dividend record
U ninterrupted dividend paym ents for at least the past 20 years
Earnings growth
A m inim um growth rate equal to grow th in national incom e over the last 7 years

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Moderate price/'earnings ratio

Current price should not be more than 20 times the average earnings o f the past seven
years for the best companies. To give a more specific instruction, set the multiplier equal to
the growth rate in EPS in percentage in the last 7 years subject to a maximum value of 20.
Or

Current price should not be m ore than 15 times the average earnings o f the past three
years for the best companies.
Moderate ratio of price to assets
Current price should not be more than 1.5 times the book value last reported. As a rule
the product o f the multiplier times the ratio of price to book value should not exceed 22.5.
Rules of Graham highlight the importance of earnings per share (EPS) as a determinant
o f s h a re p ric e s a n d v a lu e s . B e n ja m in G ra h a m ta u g h t S e c u rity A n a ly s is
at C olum bia U niversity during 1928 to 1956. Prior to Graham, the book value of the
com pany was the im portant benchm ark for the valuation o f equity shares. Despite the
popularity of Graham ’s classes and books, the valuation principles o f Graham were not
embraced whole-heartedly by the stock market participants. Most of the active investors
preferred P/E ratios based on single year EPS figures. A lso the em phasis was much
m ore on fluctuations. H ence there were no clear guidelines on the ratio to be applied.
One thing became a rule, increases in EPS were generally welcome and w ere likely to
be follow ed by share price increases. Decreases in EPS w ere followed by share price
declines. In this paradigm, companies concentrated on reporting increasing EPS figures.
Evaluation of shareholder value strategy
“Finance theory rests on the premise that the goal o f the firm should be to maximize
the w ealth o f its current shareholders” (Prasanna C handra 2008). C orporate finance
theory w as developed on the above premise. The financial m anagers are supposed to
take decisions which help to create additional value or wealth for current shareholders of
the company. This goal probably remained as the goal of the finance management function
only and rest of the organisation may not be assessing its decisions on the touchstone of
shareholder value or w ealth building. Also, even today shareholders are given accounts
o f past transactions only. They do not know what the m anagem ent is going to do in the
future and how it is going to protect their wealth and increase it. The financial reporting
profession mandated that only audited record of the past transactions are m ade available
to capital m arket participants to make their decisions regarding fair prices to buy and sell
equity shares in the market.

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Creating shareholder value

Creating shareholder value can be the beginning o f the cu rren t m o v em e n t o f
shareholder value management. It has subsequently founded the A lcar group, a com pany
dedicated to the production of software to help com panies achieve som e o f the goals
laid out. The free cash flow (FCF) model of business and equity valuation had show ed
how the normal discounted cash flow techniques used in project evaluation can be put
into use in valuing on-going business firms and com panies (A lfred R appaport 1986)
M anaging for value is linking shareholder value creation (SH V ) to the art o f running
a company. Management consultants took the initiative from there and developed a new
practice area o f shareholder value creation and m anagem ent (Bernard R eim ann 1987).
Valuation is exposition of the issues o f valuing com panies, so that com panies can act
in the direction of increasing the value (Tom C opeland 1990).
The fam ous book entitled The Questfo r Value, w hich introduced the strategy o f
economic value added (EVA). The book focused m ore on the detailed m easurem ent of
a firm ’s balance sheet, and how certain items need to be treated differently from the way
accountants usually handle them (G B ennett Stewart 1991).
The book entitled Search o f Shareholder Value tells that sh a re h o ld er value
m anagem ent is a necessary activity in the era o f shareholder activism (A bdrew Black
1998).
T he b o o k EVA and Value-Based M anagem ent: A P ra ctica l G uide to
Implementation is by Stephen O ’Byrne who was form erly a senior vice-president at
Stem Stewart & Co., and is the president o f S hareholder Value A dvisors, Inc., a firm
specialising in creating shareholder value (S. D avid Y oung and Stephen F. O ’B yrne
2001).
Today, there are a series o f booklets and brochures published by all top m anagem ent
consulting firm s in the area o f shareholder value m anagem ent. This is an area w here
actual practice is being attempted in a large num ber o f com panies in m any countries in
the w orld w here capital m arkets provide bulk o f the resources for corporate sector.
Conclusion
C reating shareholder value is the key to success in to d a y ’s m arket-place. T here is
increasing pressure on corporate executives to m easure, m anage and report the creation
of shareholder value on a regular basis. In the emerging field o f shareholder value analysis,
various measures have been developed that claim to quantify the creation o f shareholder
value and wealth. Globalisation has increased calls for corporations to use firm s’ resources

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 Shareholders Value Creation...123

to help alleviate a wide variety of social problems. These calls forexpanded responsibilities
for business are intuitively appealing to those w ho see existing governments as unable or
unwilling to deal with such problem s. Firm s m ay indeed have resources that could be
used to help with issues that are typically dealt w ith by governm ents or other non­
governmental organisations.
R eferences

1. N.A. (2001). Measuring and Managing Shareholder Value Creation. NJ: Institute of
Management Accountants. 10 Paragon Drive, Montvale, NJ 07645-1760, www.imanet.org.
2. Hillman, Amy J. and Geraldd (N .d). “Shareholder Value. Stakeholder Management, and
Social Issues: What’s The Bottom Line”. Strategic Management. 125-139.
3. Chandra, Prasanna (N.d.). “Financial Management Theory and Practice” New Delhi .
Tata McGraw-Hill, fifth edition.
4. Lefort, Fernando, and Eduardo Walker (2005). The Effect of Corporate Governance Practices
on Company Market Valuation and Payout Policy in Chile. This research project was
supported by the Latin American and Caribbean Research Network at the IADB.
5. Offshore Group of Insurance Supervisors, Principals Paper (N.d.) “Corporate Governance
for Captive Insurance Companies”.
6. Pandey I.M. (N.d.) Financial Management. New Delhi: Vikas.
7. (N.d.) S.N. Maheswari Financial Management Problem and Solution. New Delhi: Sultan
Chand & Sons Publication, fourth edition.

June 2013
ISSN. 0970-8464 Reg. No. 25330/74

About Sedm e

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