Shareholder value means what? It is the value delivered to the long term shareholders of the company during the course of their holding period.
How to ensure delivery of value? By taking such decisions which eventually translates into increased shareholder value.
When companies make decisions that enable their shareholders to earn more by way of dividends and price appreciation, it can be called a shareholder-friendly decision.
Such companies can be said to be ensuring shareholder value while they run their business operations. It is companies like that which often see phenomenal future growth in their price. Why? Because stocks of such companies are always in demand. They always have more buyers than sellers.
How To Creare Shareholder Value?
When people buy shares of a business (company), they expect something in return for the risk they are taking. What are their expectations? Some dividends in the short-term and at least decent capital appreciation in the long-term.
The expectation of shareholders is what builds the cost of equity. Though the company is not obliged to meet the expectations, they do it anyway. Why? If shareholders are not obliged with at least decent returns, they will start selling shares. That may cause panic and trigger a steep price fall.
Companies also borrow money from banks, called loans. The interest paid by the company on their bank loans is also called the cost of debt.
The sum-total of the cost of equity and cost of debt is the cost of capital. We can also express the ‘cost of equity’ as the Weighted Average Cost of Capital (WACC).
For a company to be profitable, its management must use the total capital efficiently so that it generates maximum Return on Invested Capital (ROIC). How to do it? By minimizing non-essential and wasteful expenses.
For any company, its ROIC must always be higher than WACC. It is only then a company becomes capable of ensuring its shareholder’s value.
Companies that can keep their RoIC higher than WACC for a prolonged time will find more buyers for their stocks. FII’s, mutual funds, retail investors flock to buy their shares and often hold them for the long term. As a result, the market price of such stock grows at a faster pace.
What is ROIC?
The formula for ROIC is shown below:
This ratio is like a litmus test for the profitability measurement of a company. It measures the percentage profit that a company can generate for itself (net of dividend) per unit invested capital. The higher is the ROIC number, the better.
Comparison of ROIC with WACC is one of the essential profitability criteria for any business. Higher ROIC and lower WACC (as must as practically possible) is the target for good companies.
How High ROIC and Low WACC impacts Shareholder’s Value?
Both ROIC and WACC affects the intrinsic value of a company (stock). How? To answer this, let’s first know a basic about the ‘intrinsic value.’
The present value (PV) of all future free cash flows (FCF) that a company will generate in its lifetime will give us its intrinsic value.
A company that has a higher ROIC has more capital that can be reinvested back into the business (Net profit minus dividend). This helps the company to expand and modernize its facility more efficiently (at a low cost). Such businesses tend to produce more future free cash flows.
WACC is a product of the cost of capital and the cost of debt. Keeping WACC low is not easy for companies. Companies have the least control over their cost of debt. Why? Because banks and lending institutions decide the interest rates on loans.
Even less can be done by the company to lower its cost of equity. Why? Because shareholder’s expectations decide the cost of equity. What the company can do best is to keep its ROIC as high as possible. That itself will take care of the shareholder’s expectations.
High FCF and a reasonable WACC will result in a high present value of future cash flows. This eventually means a high intrinsic value. A company whose intrinsic value is ever-increasing, preferably beating inflation, becomes an automatic value creator for the shareholders.
How a company can improve its ROIC?
From what we have read till now, it is clear that ROIC is a thing that a company needs to work-on to ensure an improving shareholder value. What companies can do to increase their ROIC?
Several things can be done. All can be clubbed into three broad categories:
- Increase Income: Companies can increase income in two ways: (a) they can increase the price of products or services, or (b) increase sales. Companies that have the pricing power, only they can tweak price to improve income. Else, they must focus on customer retention, marketing, and product upgrades. Read about blue-chip companies. Read Understanding P&L account of a company.
- Increase Profitability: This will only happen by cost-cutting. Automation and modernization is the way to increase profitability. Read a detailed analysis of the profit margin of companies.
- Increase Asset Efficiency: It is important for the company to invest in new assets. But care must be taken to ensure that the Return on Asset (ROA) of the company stays high (above the competitors).
All of the above three factors together will work to improve ROIC of a business. Though I’ve generalised the steps too much, but I hope you are getting the point. Income, profitability and asset’s efficiency are three areas of focus which top managers of a company cannot ignore.
What is the easiest way to check if a company in consideration has a focus on shareholder value or not? There will be two steps to it:
- First: Check if the company’s ROIC and ROCE are higher than WACC. For companies that do not have this, are actually value destroyers. I would personally stay away from them till they’ve amended their profitability numbers. See this video for details.
- Second: Check the company’s Return on Equity (ROE). But we must not stop with only one year ROE. It is important to understand the trend. Calculate Return on Equity (ROE) of the last 10 years. If the trend in last 10 years is increasing, it is a clear hint of improving shareholders value.
This is also true, a company that focuses only on shareholder value might not do well. The focus of good companies is on all stakeholders. Who are the stakeholders? Customers, employees, suppliers, and investors. In fact, a company whose customers, employees, and suppliers are satisfied, that itself will take care of the investors’ expectations (shareholder’s value).