What Drives Shareholder Value?

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LAURENCE BOOTH
ROTMAN SCHOOL OF MANAGEMENT
PROFESSOR OF FINANCE
UNIVERSITY OF TORONTO
PHONE:
(416) 978-6311
105 ST. GEORGE ST.
FAX:
(416) 971-3048
TORONTO, ONT.
INTERNET:
[email protected]
CANADA M5S 3E6
What Drives Shareholder Value?
Presented at the Federated Press “Creating Shareholder Value” conference, October 28,
1998

What Drives Shareholder Value?
Many corporate executives still focus on quarterly earnings figures as a key driver of
stock market values. Although no-one can discount the importance of quarterly
earnings numbers or the impact on the stock market of earnings surprises, they are not
the fundamental driver. Stock market values are driven by real corporate performance,
as compared to market benchmarks. The key relationship is whether the money
entrusted to corporate management earns a higher return than the owners can get
elsewhere. Focussing on this key relationship differentiates the value manager from
other managerial styles. Implementing a “value managerial” system can be
accomplished by two main metrics: a sales, operating margin, turnover metric and a
more traditional return on investment, reinvestment rate metric. Both metrics are
simply ways of expressing the underlying determinants of market value. The most
critical decision facing a firm is whether to adopt a value based managerial system
rather than a particular set of decision tools.

What Drives Shareholder Value?
Discussion of finance topics involves both normative and positive statements, and it is
important to be aware of their distinction. ”Normative“statements refer to what
“ought” to be and are usually derived from an assumption about how the world
behaves. This is most evident in standard economics topics, where assumptions about
human and corporate behaviour are made to derive supply and demand curves, which
are then used to explain how prices are determined. Financial theory is an application
of these standard economic models to explain how prices in the capital market are
determined. As such, financial economists use essentially the same tools as their
colleagues in other areas of economics to predict how, for example, equity prices
“ought” to be determined, and how as a result corporate management “ought” to
behave. In contrast, “positive” statements refer to “what is, was or will be,” it is
commonly referred to as an appeal to the facts.1
The above distinction between positive and normative statements is important, since it
turns out that many heated arguments in finance, as in many areas of business, are in
reality arguments over assumptions, not facts, that is, they are arguments over what
“ought” to be. This is as true of shareholder value analysis, as it is of any other area of
finance. In this paper, I will discuss the normative principles that underlie shareholder
value analysis, as well as some of the positive evidence in its support.
The Normative Justification for Creating Shareholder value.
It is a normative statement that creating shareholder value (CSV) is the correct goal of
the firm. Douglas Frost will be discussing in more detail the conflicts between different
stakeholders in the firm, but I always use Figure 1 to demonstrate the dynamics. The
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firm is the rectangular box with the managers “inside the box” in control of the firm’s
operations. The firm buys labour, capital (both debt and equity) from investors,
intermediate goods from suppliers and uses up what we commonly refer to as “free”
goods, such as the right to emit pollutants and use social services provided by the state.
The firm then creates its product, which it sells to consumers and in the process creates
free goods, such as, for example, by increasing the level of education in the community
by retraining its workforce. All of this production, in turn, occurs under the watchful
eye of governments (all levels) and subject to societal pressure from other members of
the community.
All of these stakeholders have some claim on the firm. How this tangle of claims on the
firm subsequently gets resolved in terms of the firm’s objectives depends on both the
legal structure of the country and the state of the markets in which the firm operates.
Finance, as we understand it, has largely developed in countries with a common
Anglo-Saxon legal heritage that places the ownership of the firm’s common equity as
the primary determinant of elections to the board of directors, who then have a
fiduciary responsibility to act in their interests. The corollary of this legal principal is
that the stockholders are primarily interested in the maximisation of their wealth and
ergo the market value of the firm’s common stock price. Hence, the focus of this
conference on creating shareholder value.
The economic justification for creating shareholder value (CSV) as the over-riding
objective of the firm primarily comes from an assumption implicit in most of the
finance literature that all the markets in which the firm operates are perfectly
competitive. This means that if the firm’s employment is increased or decreased, that
the employees in figure 1 are indifferent. If they are hired, they are just getting market
wages, and if they are laid, off they can immediately get equivalent jobs elsewhere.
Similarly, suppliers and consumers can switch to other firms, and taxes to all layers of
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government will be the same regardless of the firm’s operations. As a result, the
welfare of all other stakeholders in the firm is unaffected by the firm’s operations, so
that maximising the welfare of the stockholders causes no welfare losses to these other
stakeholders. The implicit assumption underlying most of the shareholder value
literature is, therefore, that there are no other stakeholders in the firm, except the
stockholders! Or put another way, the normative statement that creating shareholder
value should be the objective of the firm is based on the assumption that all markets are
perfectly competitive.
The perfect market assumption is valid for small businesses in practically every country
around the world, since they do not affect the functioning of other markets. However,
for large businesses it is more questionable. In many of the less diversified European
economies, the impact of certain large firms is critical for the functioning of their
economies. As result, there is “worker” representation on the board of directors and the
legal responsibility of the board is to take into account factors other than the interests of
the stockholders.2 At the other extreme, creating shareholder value has become the
mantra of corporate USA, since the USA has by far and away the most diversified
economy and the most competitive markets.3
Canada has historically sat in between these two extremes. The large number of
interlocking ownership structures has made hostile takeovers scarcer than in the US,
while governance structures have generally resulted in more captive, less active,
boards. Additionally, the fact that Canadian equity has largely been trapped in Canada
due to foreign ownership restrictions in tax sheltered plans, as well as the dividend tax
credit, has meant that Canadian firms could pay less attention to their shareholders. Of
interest is that the overall Canadian equity market has consistently underperformed
that of the US.
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In Tables 1 & 2 are average rates of return earned in the US and Canadian markets on
equities, Government bonds and Treasury bills, as well as the consumer price index.
Although Canadian fixed income returns have been higher than those in the US, equity
rates of return have lagged those in the US. There are a variety of potential reasons for
the poorer performance of the Canadian equity market, but the greater emphasis in the
US on creating shareholder value is certainly a potential factor. As the North American
Free Trade Agreement (NAFTA) has opened up the market for goods and services we
are seeing more competition among firms. Consequently, Canadian market structure is
moving closer to the US model. Similarly, as the international capital market becomes
more integrated, it will intensify the pressure on Canadian firms to pay more attention
to creating shareholder value.
However, before discussing how to create shareholder value, it is important to point
out how not to create shareholder value. From figure 1, there are many ways in which
the overall value of the firm’s operations (largely the firm’s revenues) can be allocated.
This means that one way to create shareholder value is simply to transfer existing value
to the shareholders, at the expense of these other claimants. For example, the firm can
skimp on pollution controls and increase contamination of the environment, leaving
others to clean up its mess. The equity holders can also engage in activities that shift
wealth from the bond holders to the equity holders, as often occurs during times of
financial distress. Finally, I hate to say it, but many corporate financing strategies are
tax motivated and merely transfer wealth from all tax payers to the firm’s shareholders.
There is no theoretical justification in economics to support creating shareholder value,
when it is simply a transfer of wealth from other claimants on the firm to the common
shareholders. The reason for this is simply that “society” as a whole is no better off.
The economic justification for creating shareholder value is based on the efficiency
gains of more productive operations and a better reallocation of resources.4 This result
stems from having managers become “value” managers, where they treat corporate
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resources as they would if they were the owners.5
Problems with Accounting Earnings
It may surprise some, but stock market value is not created by accounting games to
dress up the financial statements. This is not to deny that accounting statements are
important, they obviously are, but the fact is that the stock market looks far into the
future when assessing value. Consider the stock prices in Table 3 taken at random from
quotes from the Financial Post on August 1, 1998. The quotes are for the first ten
common equity issues for each letter from A to J. The first column is the stock price, the
second the dividend yield and the third the implied annual dividend. The fourth
column then values this dividend assuming that it goes on forever with a 5% discount
rate. That is, the stock is treated as if it were a perpetuity preferred share. The final
column gives that part of the share price that is not accounted for by the perpetuity
values of the current dividend.
The final column of Table 3 makes for interesting reading. For BC Gas and Hammersen
the growth components of the current stock price is relatively low at 26% and 16%
respectively, which is what you would expect given their operations. However, for the
other eight firms future growth accounts for 36-96% of the share price. This implies
that shareholders are looking well beyond the company’s current performance in
valuing their shares. This in turn raises problems as well as opportunities.
BC Gas is primarily a regulated gas distributor and oil pipeline in British Columbia,
where the bulk of its operations are regulated by the BC Utilities Commission to ensure
a fair return to the common shareholders. This means that there are few surprises in its
quarterly financial statements and any that there are, are likely to result in changes by
the BCUC, so as not to have a significant long term effect on the shareholders. This is
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the main reason why “growth” accounts for such a small part of BC Gas’s stock price. It
also means that the market does not react very much to BC Gas’ quarterly results: there
simply is not much “news” in them.
In contrast, for the other firms a large amount of the stock price comes from future
growth prospects, which are very hard to predict. It is inevitable when valuing these
“growth” companies that every piece of information is scrutinised in some detail to see
whether the firm’s performance is still “on target.” In this state of scarce and limited
information, one of the most “reliable” sources is obviously the firm itself through its
quarterly statements. If these results are below market expectations, without any
accompanying information to explain the discrepancy, investors will extrapolate the
impact into the future. The result will be an immediate impact on the stock price, with a
greater effect felt for those firms with a greater “growth” component in their stock
price. It is one of the ironies of finance that it is the fact that the market values
operations very far into the future, that causes it to react violently to short term
results.
This result has strong implications for corporate finance. First, there is no doubt that
earnings management pays off. The market does not like surprises and the
management of quarterly earnings can prevent dramatic market revaluations in
response to what the firm may correctly estimate to be temporary phenomena.6 On the
other hand, it does not mean that the market is dumb and can be permanently fooled
by the manipulation of financial statements. What the market is interested in is the
underlying ability of the firm to generate real, not accounting earnings. This is a
normative statement, however, a large amount of research over the last thirty years has
gone into determining whether it is also a positive statement.
I do not have time to review all the evidence on how the market reacts to accounting
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versus real decisions. Instead, I will discuss the two classic accounting issues that have
been examined extensively: the use of FIFO/LIFO inventory valuation and purchase
versus pooling accounting for mergers and takeovers, and how the market values
research and development (R&D) expenditures.
Inventory valuation is a classic test of whether the market values accounting earnings
or cash, since in the US whichever inventory method is used for the financial
statements also has to be used for tax purposes. During the inflationary 1970's using
first in first out (FIFO) for valuing inventory persistently underpriced the cost of goods
sold, since the last items produced invariably cost more. This resulted in not only
higher accounting earnings, but also higher taxes and consequently less cash.7 In
contrast, last in first out (LIFO) inventory valuation, priced cost of good sold with the
last units produced, which although it reduced accounting earnings, also reduced taxes
leading to stronger cash flow. Biddle and Lindahl8 found that US firms switching to
LIFO saw their stock price increase, despite lower accounting earnings, with the
magnitude of the price gains increasing with the size of the tax gains. Several other US
studies have found similar effects, that the market looks through cosmetic accounting
issues to focus on underlying cash.
Accounting for mergers is a similar test of whether the market values a particular
accounting method, when in this case the choice should have no real effect at all. If one
firm “buys” another, the difference between the purchase price and the (revalued)
assets of the purchased company is called “goodwill.” In purchase accounting, this
goodwill is recorded as an asset and written off against future income, usually over the
next forty years, thereby reducing accounting earnings. Moreover, until 1993 in the US,
as is still the case in most countries, writing off goodwill had no tax implications.
Even though writing off goodwill is a classic “non-cash” charge in the income
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statement, firms in the US frequently paid extra just to be able to get the transaction
classified as a pooling of interests. In AT&T’s acquisition of NCR, Davis9 points out that
AT&T incurred extra costs of almost $500 million to ensure that the takeover could be
treated as a pooling. Similarly in Canada, where it is harder to avoid purchase
accounting, Royal Bank’s proposed takeover of the Bank of Montreal, as well as the
share exchange ratio, seems to have been heavily influenced by the desire to account for
the transaction as a pooling of interests.
However, contrary to the predictions of the “accounting earnings model,” Davis shows
that the market does not reward firms for using pooling rather than purchase
accounting and that “there is no evidence that paying to pool is a justifiable or
profitable use of firm resources.” Quite the contrary, Davis concludes that “purchased
goodwill” is valued in the market and that the extensive US practises that he discloses,
whereby goodwill is buried with other assets in defiance of SEC guidelines, does not
help stock prices.
While a critical assessment of how the market values what are primarily financial
statement issues shows that the market can “see through” some major accounting
changes, what about real cash effects in the financial statements? A classic case here is
how to treat research and development expenditures. Clearly, R&D is an investment, it
is undertaken to produce new investments and products and to generate future cash.
However, in almost all cases, R&D expenditures are immediately written off, rather
than capitalised. The result, is that a reduction in “worthwhile” R&D helps immediate
accounting earnings, at the expense of the firm’s future prospects. If the market is
indeed fixated on accounting earnings, we would expect to see high R&D firms with
depressed earnings and stock prices.
Testing the impact of R&D on market values is difficult, since R&D expenditures are
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