Chapter 13 – Managing for Shareholder Value

Shareholder value is the value delivered to the equity owners of a corporation due to
management's ability to increase sales, earnings, and free cash flow, which leads to an
increase in dividends and capital gains for the shareholders.

A company’s shareholder value depends on strategic decisions made by its board of directors
and senior management, including the ability to make wise investments and generate a healthy
return on invested capital. If this value is created, particularly over the long term, the share price
increases and the company can pay larger cash dividends to shareholders.

Top Creators of Shareholder Value

Boston Consulting Group released its 2019 Value Creators Rankings, an analysis that assess
firms based on their total shareholder returns.

Total shareholder return is different than the annual appreciation of a company's stock price. It's
a long-term metric that takes into account the performance of a business's stock and any
dividends paid out to reflect the total value returned to shareholders over time. Here are the 10
companies that have delivered the best average shareholder return over the past five years,
ranked in increasing order.

10. PJSC Lukoil

Location: Russia
Industry: Oil
Market cap: $50.3 billion
5-year average shareholder return: 27.1%

9. UnitedHealth Group
Location: United States
Industry: Health care services
Market cap: $239.7 billion
5-year average shareholder return: 29%

8. Tencent Holdings
Location: China
Industry: Media and publishing
Market cap: $379.1 billion
5-year average shareholder return: 29.3%

7. Intuitive Surgical
Location: United States
Industry: Medical Technology
Market cap: $54.7 billion
5-year average shareholder return: 30.2%

6. Amazon
Location: United States
Industry: Retail
Market cap: $734.4 billion
5-year average shareholder return: 30.4%

5. Adobe
Location: United States
Industry: Technology
Market cap: $110.4 billion
5-year average shareholder return: 30.5%

4. Netflix
Location: United States
Industry: Media and publishing
Market cap: $116.7 billion
5-year average shareholder return: 38.5%

3. Broadcom
Location: United States
Industry: Technology
Market cap: $103.6 billion
5-year average shareholder return: 39.5%

2. Kweichow Moutai
Location: China
Industry: Consumer nondurables
Market cap: $107.8 billion
5-year average shareholder return: 43.5%

1. Nvidia
Location: United States
Industry: Technology
Market cap: $81.4 billion
5-year average shareholder return: 54.4%

Business Valuation Approaches

The valuation of a business is the process of determining the current worth of a business, using
objective measures, and evaluating all aspects of the business.

The valuation process is intrinsically technical; hence it is vitally important that whoever is
conducting the valuation acquires financial knowledge. The valuator should also be aware of the
company’s business model, its strategy, have a thorough understanding of the market where it
operates, and the value-creating elements it acquires. The tools used for valuation can vary
among evaluators, businesses, and industries. The three primary approaches for valuing a
business are as follows:

 The Income Approach

 The Market Approach
 The Cost Approach

I. Income Approach
The Income Approach is most commonly used for established businesses with profitable – or
nearly-profitable – operations. Why? Because it is entirely oriented around cash flows. The
Income Approach considers three key characteristics of a business: the level of cash flows,
the timing of cash flows, and the risk associated with those cash flows.

If a business is not cash flow positive nor soon-to-be cash flow positive, you can see why the
Income Approach is not an optimal fit.

The Theory Behind It 

The Income Approach is based on the premise that equity holders are investors, and they view
their ownership as they would any other investment. Financial theory holds that an investment is
a current commitment of money to an endeavor that will (hopefully) result in future payments to
the investor that are greater in value. The Income Approach is thus “forward-looking.” Further, it
discounts those future payments back to their present-day value, incorporating the risks and
opportunity costs inherent in any future project into the discount rate. The emphasis on future
cash flows is a unique attribute of this approach that distinguishes it from the other approaches.

When to Use the Income Approach

The Income Approach could be appropriate for a business when the future cash flows have the
following characteristics:

 Future cash flows are positive

 Future cash flows are relatively stable – not highly volatile
 Future cash flows can be reliably forecasted for several years into the future

Pros

 Focused on future cash flows which are of utmost importance to investors

 Unlike the Market Approach, the Income Approach is not as reliant on similar past
transactions or comparable companies which can never truly match the unique
characteristics of the subject company
 Unlike the Cost approach, the Income Approach considers value derived from
both tangible and intangible assets

Cons

 Not as relevant when valuing businesses that are years away from achieving positive
cash flow
 Potential to become highly complex and involve many underlying assumptions

II. Market Approach

The Market Approach establishes a value for a business by comparing it to similar companies
that have a value attached to them that is publicly known. The premise is that an investor (a
willing buyer) would look at the values of what is referred to as the “comparable companies” or
“comps” and would price the subject company according to the values of these similar
companies.
Thus, the Market Approach relies on publicly available data for pricing data which can arise from
three primary sources:

 Sales transactions of similar companies

 Publicly-traded similar companies
 Sales of interests in the subject entity

Notice that the first two sources rely on pricing data for other companies whereas the last
source relies the subject company itself. Neither is a perfect apples-to-apples comparison given
the present-day subject company will have unique qualities that aren’t necessarily replicated in
comparable companies or weren’t present in its prior stages. Moreover, it’s possible that relying
on more than one of these methods within the Market Approach would result in a more accurate
value for the subject company.

The following is an expanded version of the bulleted list that includes the widely accepted
industry names for each of these methodologies:

 Guideline Company Transaction Method – Sales transactions of similar companies

 Guideline Public Company Method – Publicly-traded similar companies
 Guideline Sales of Interests in Subject Company – Sales of interests in the subject entity

The Theory Behind It 

The underlying theory of the Market Approach is that a rational financial buyer will only be
willing to pay the market rate for a company, and this market rate is based on the pricing data of
companies with highly similar qualities to the subject company.

When to Use the Market Approach

The Market Approach could be appropriate for a business when the following characteristics are
present:

 The pricing data for comparables is robust and readily available

 In situations where future cash flows are negative or highly unpredictable

Pros

 The Market Approach is “forward-looking” because market prices reflect investor

expectations about the future
 Assumptions, adjustments, and third-party data are required, but the overall analysis is
typically less complex than the Income Approach
 The value derived considers all of the operating assets, including tangible and intangible

Cons

 Insufficient or low-quality market data can limit the accuracy of the Market Approach or
render it unsuitable
  Key assumptions are often excluded; an example would be the growth expectations for
the comparables which can be available for public companies but rarely for private
comparables

III. Cost Approach

The Cost Approach (also referred to as the Asset Approach) is used to ascertain the value of a
business from a balance sheet perspective. In other words, a valuation expert will determine the
overall enterprise value based on the underlying value of the business’s assets net of its
liabilities.

As you might expect, the Cost Approach is the least reliant on forward-looking projections.
Instead, the Cost Approach typically begins with the book-basis balance sheet and “builds up”
or “restates” the assets and liabilities to fair value (financial reporting) or fair market value (tax
and other purposes). This build up exercise is performed because balance sheet values rarely
reflect market values. Over time, this separation between historical cost and market value tends
to grow wider, particularly for illiquid assets.

The Theory Behind It 

The underlying theory to the Cost Approach is that – despite its historical bias and limitations – it
can be more suitable for certain businesses versus the Income Approach or Market Approach.
For example, when a holding company or asset-intensive business (like a real estate company)
is being appraised, the valuation expert could conclude that the Cost Approach is suitable
because the underlying assets make up most of the value and can be separately appraised. In
this case, a greater weighting is placed on this approach than the others.

When to Use the Cost Approach

As previously discussed, the Cost Approach is typically used only in specific situations.  Those
may include but are not limited to the following:

 For use in valuations for financial and tax reporting purposes when minimal progress has
been made on a company’s business plan
 For tangible asset-intensive businesses
 For investment, holding, and real estate companies where cash-flowing operations tend
to contribute less of the value than the underlying assets
 For small businesses where there is little or no goodwill

Pros

 Does not rely on the challenging process of forecasting future cash flows
 Simple to understand and relatively straightforward to execute

Cons

 Rarely applicable to operating companies because an earnings-based approach is likely

more relevant
  Does not directly value intangible assets so the valuation expert still needs to assess
their value separately or use an additional Cost Approach, such as a cost to recreate, to
value the intangible assets

Drivers to Enhance Company Value

Monitoring value is something that should be done in any economic environment. Ideally,
business owners and their management teams should begin monitoring the value of their
business at least five to seven years before considering an exit.

Most assume valuation is a quantitative science focused solely on financial statements,

forecasts, multiples, and rates of return but it is actually more qualitative in nature.

Valuation is a prophecy of future business expectations. To accurately reflect those

expectations, it is critically important for a business owner to identify and understand what
drives value? What factors increase cash flows and reduce risk? There are, quite frankly,
hundreds of value drivers, some of which are industry-specific. For brevity, focus will be on
these ten universal factors that are considered essential to increasing cash flows and reducing
risk, thereby enhancing overall company value.

1. Capital Access.

The smaller the company, the more limited its access to debt and equity capital. The company
will need to assess the kind of capital needed to achieve its goals.

Questions to ask: How is the company currently leveraged? How do bank covenant restrictions
impact the business and its future plans? Do shareholders have to provide equity or personally
guarantee loans? Is bringing in an outside investor and issuing preferred stock a viable option?

2. Customer Base.

A solid and diversified customer base is essential for the ongoing viability of a business. When
companies grow and prosper by catering only to their largest customers, dependency may
increase to the point where too great a percentage of revenues are concentrated with too few
customers; companies must manage the allocation of customer concentration to reduce the risk
of losing a large source of revenues.

Questions to ask: What percentage do the top five customers contribute to the company’s
revenues? What amount of revenue is recurring? What is the economic useful life of its entire
customer base, as well as its largest customers?

3. Economies of Scale.

As production output increases, businesses typically achieve lower costs per unit. Whether
through quantity discounts or spreading capacity costs over higher volumes, larger companies
possess distinct advantages in certain operations and markets.

Questions to ask: Is the company effectively exploiting its internal economies of scale (i.e., cost
savings that accrue regardless of the economic environment or industry in which it operates)?
What are the company’s growth opportunities to realize additional or larger economies of scale?
Can the company enter into a consortium, joint venture, or outsource to increase buying power
and reduce expenses?

4. Financial Performance.

Financial analysis aids in measuring trends, identifying the assets and liabilities of a company,
and comparing the financial performance and condition of the company to other, similarly-
positioned firms. Internally prepared and compiled financial statements may hamper
management’s assessment of performance, causing potential buyers to possibly question the
quality of this data.

Questions to ask: How does the company compare in terms of liquidity, activity, profitability, and
solvency measures? Are financial controls in place? Are the financials audited or reviewed by
an outside CPA?

6. Market Environment.

Each business is impacted by economic trends and developments in the industry in which it
operates. Management must understand how the industry is impacted by economic factors and
how the industry is structured to minimize the impact of macro trends on the business.

Questions to ask: What is the company’s market share? Where is it positioned in the market?
Does management have an understanding of its niche and unique offering? Does it have
diverse offerings that can modulate the impact of economic swings?

7. Marketing Strategy and Branding.

Marketing is the link between customers’ needs and their response to a company’s
products/services. Strong branding will not only improve company sales by increased market
recognition, but it will also provide a clear direction that will improve operational efficiency when
tied to the company’s mission.

Questions to ask: How does the company market itself? What are its marketing and sales
capabilities and shortcomings? How effective and known is its brand? What is its social media
presence? How effective is its website? Is the brand tied to the company’s mission statement
and its strategic direction?

8. Product/Service Offering.

Specialty companies frequently derive their strength from focusing in niche fields, but
concentration may create risks from lack of diversification and overdependence on limited
markets. Some specialty companies may find their largest customers adopt a policy to deal only
with suppliers who offer a broad range of products, forcing them to either expand product
offerings or sell out to a larger company. Increasing diversification reduces risk, which improves
value.

Questions to ask: What is the company’s mix of offerings? Are any concentrated offerings
subject to economic and industry swings? What products/services can be offered that differ from
existing ones but use similar human capital, production capability, customer base, etc. to
diversify? What opportunities exist for vertical or horizontal integration?

9. Strategic Vision.

Most companies put together a one-year budget, but few attempts to put together a business
plan or a long-term forecast. Valuation is all about future expectations and company
management needs a strategic vision to create value. Management must take a look at all the
information they’ve gathered from reviewing their company to divulge a strategic vision that can
be passed along to the future owner, providing additional support and assurance of continuity,
and even increase, of sales.

Questions to ask: What is management’s long-term outlook? When did the company last write a
formal business plan? Is the company’s strategy in tune with its customers’ demographics,
tenure, needs, and demands?

10. Technology.

Companies with fewer monetary resources often lack adequate research and development
resources, finding it difficult to keep pace with technological changes in their markets. Such
companies often face an inescapable need to incur large amounts of capital expenditures in the
near future or allocate resources to a limited number of product development projects. This
inevitably results in product or service obsolescence, adverse impact on future growth, and loss
of market share. In the meantime, larger companies are in a better position to demonstrate
technological expertise by developing products that address emerging customer needs, leading
customers to choose the state-of-the-art products, despite the eventual availability of lower cost,
lower performance technology.

Questions to ask: How many resources does the company allocate to R&D? Is their use of
technology up-to-date? Are there impending technological changes that could negatively impact
the company’s product/service offering?

Balancing Pay for Performance with Shareholder Alignment

In designing compensation programs, two key objectives that are universally shared among
public companies are:

(1) ensuring that the pay levels of executives move with their performance, and

(2) aligning the interests of executives with those of shareholders.

The general appeal of these objectives is that they both ring true in terms of fairness.

Pay for performance is the mantra of shareholders, activist investors and shareholder advisory
firms and critics of executive compensation practices. A pay for performance compensation
scheme is designed to lay out specific performance targets for an employee to provide an
incentive to the employee. The most effective incentive schemes will select measures of
performance that effectively measure the results that an employee can control versus factors
that are out of the employee’s control.
The challenge is identifying performance measures that are within the employee’s control, but
are also viewed as drivers of the company’s long-term value. One of the challenges for a
publicly-traded company is that the executives that run the company are generally not the
owners of the company. Instead, the executives act as managers of the company on behalf of
shareholders. Economists refer to this situation as the principal–agent problem. There is a
potential that the interests of the agent (the executive management team) may not be the same
as the interests of the principal (the shareholders). Ideally, the shareholders would like the
executive management team to manage the company to promote shareholder interests
exclusively. However, economic theory finds that the executive management team is likely
trying to maximize its compensation and minimize its effort and while this may not be entirely
true at the individual level, there is some truth to it.

Because shareholders’ interests can be defined in different ways, multiple long-term incentive
vehicles, coupled with well thought through annual incentives are used to align management
with shareholders:

1. Restricted stock/stock units: Ensures that executives are focused on the absolute
performance of the stock price and concerned about increases and decreases in the
stock price

2. Stock options: Stock options focus management on increasing the stock price, but
provide limited incentives to protect against downside risk

3. Relative total shareholder return (TSR) performance shares: Reward executives based
on relative outcomes for shareholders