Shareholder Value Analysis

View Template for: Shareholder Value Analysis

Many corporations announce in their annual reports and in their mission statements that their goal is to maximize shareholder value. But not all executives ever calculate shareholder value, let alone compare alternative strategies based on their different impact on shareholder value.

A simplified format for computing shareholder value is presented on the template web page. The overall concept is that money comes in from one or more sources and money goes out as well. The goal is to identify net cash flows by year. Different industries will use different proxies for cash inflows (such as revenues, sales, or premiums) and for cash outflows (such as expenses). Because of depreciation and other non-cash expense items, the expense total is just a proxy for cash outflow. A pure analysis would trace cash flow into the bank and cash flow out of the bank. But the big picture need is simply to approximate the overall cash flow dynamics of the business.

This shareholder value analysis is suitable for businesses with or without actual shareholders.

In the cash flow analysis presented on the template web page, shareholder value is computed as the sum of:

• the 10-year discounted cash flow from operations; and
• the discounted residual value of the business assuming the business is sold at the end of the 10th year.

If your business has an investment portfolio, this would be a third component to be added to the shareholder value computation (not shown in the template example).

It is critical to note that different competitive strategies imply different financial outcomes, and therefore, different strategies have different implications for shareholder value.

A business should forecast its future cash flows based on a specific strategy. The cash flows then need to be discounted to reflect the time value of money because a dollar received a year from now is worth less than a dollar received today.

A few notes regarding using the shareholder value method:

• The time horizon can be other than ten years - whatever time horizon is appropriate for the industry;
• The discount rate should be a function of the industry, the projected economic environment, and the timing and probability of the cash inflows and outflows;
• In a corporation with many businesses, it is helpful to standardize on the time horizon and the discount rate for political reasons, even though a valid theoretical argument can be made for doing otherwise;
• The higher the discount rate the better. Most business managers are very optimistic and they believe that in three years every problem will be solved and sales will go through the roof. A high discount rate ensures that the forecast for the first few years will be weighted significantly more than the outer years. The valuation will therefore be more reliable. The data for the first few years will be objectively derived because of the business manager's fear of losing face in the organization by not reaching one's own forecast.
• Some industries require tailoring the column headings. For example, a property and casualty's cash flows might include: direct written premiums; reinsurance premium ceded; direct expense outflow; reinsurance ceded commissions; direct new loss payout; ceded new loses recovered; old accident year cash flows; and investment income from surplus. The key goal is to project future cash flows no matter what their name.

This page continues the shareholder value analysis with a listing of notes and assumptions used in conjunction with the shareholder value calculations. This is followed by a brief commentary on the computed shareholder value of the business.

Notes and Assumptions

The notes section should be used to define terms and to state the input values for the tax rate, the discount rate, and other variables. The assumptions help to link the forecasted revenue and expense data to a specific strategy. For example, "Revenues will increase by 10% next year because of a planned price increase and because of the implementation of our new telemarketing system. Revenues will increase by 7% for each year after next year, primarily due to increased exports to Asia."

The forecast may be right or wrong, but at least the financial projections can be related to the business environment.

In practice, business managers should calculate shareholder value based on at least two different strategies. For example, a business might compute the shareholder value for both Strategy X, which includes the development of a new product for current customers; and on Strategy Y, which is based on marketing current products to new customers in new markets. Both strategies should be compared in terms of their impact on shareholder value.

Theoretically, there are an endless number of strategies that could be pursued, each with its own implications for success and shareholder value. Financial analysts with personal computers armed with spreadsheet software are able to 'crunch the numbers' effortlessly. The key, however, is to link the input data fed into the spreadsheet calculations with plausible scenarios which forecast the state of the industry and the competitive position of the business.

Shareholder Value Analysis Summary

To conclude this section on shareholder value, it is appropriate to evaluate the difference between the shareholder value of the business (based on its chosen strategy) and the current sale value of the business. In practice, if this is the first time the business is computing its shareholder value be cautioned, the results could be surprising.

Especially in large corporations, the business units with the greatest revenue are not always the most valuable in terms of shareholder value. In fact, a business unit can even have a negative value. (Special warning to corporate planners: a corporate planner who `helps' a business manger of large business discover this unpleasant surprise may become less popular.)

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Last modified:   Tuesday February 19, 2008