Shareholder value is the financial value investors receive from owning shares of a company’s stock.
Increasing shareholder value over the long term typically leads to a higher stock price and potentially higher dividends.
Shareholders can experience value from owning shares of a business in two ways: through income or asset appreciation, says Zach Weiss, a research analyst at FBB Capital Partners in Bethesda, Maryland.
“As a shareholder, you own rights to a company’s earnings,” he says. “Companies can cycle earnings back into the business to juice up future profits, or firms can pay out some portion of profits to investors as dividends, generating current income.”
Shareholder value can also be measured in the appreciation of a company’s stock price. “Over the long term, stocks usually chase profits, and many corporate managers will claim they are increasing shareholder value by boosting corporate profits as a way of driving the share price higher,” Weiss says.
Investors care about shareholder value because when you invest your money in a company, you expect the value of your investment to grow over time. “Actions speak louder than words, and while most companies say they intend to maximize shareholder value, few do so successfully,” Weiss says. “Accordingly, it is important to evaluate the value creation or destruction potential from management’s actions and if their incentives are aligned with shareholders.”
With this fundamental understanding of shareholder value in mind, here are a few points for investors to consider:
— The main drivers of shareholder value.
— How to measure shareholder value.
— Should companies prioritize shareholder value?
The Main Drivers of Shareholder Value
“Shareholder value creation generally occurs when a company can generate a return on investment that exceeds the investment’s cost,” Weiss says.
Just like how moving your money from a checking account earning a 1% annual return into an investment earning a 2% annual return creates value, companies can allocate their resources in ways that either increase or decrease value.
“Management’s ability to allocate resources, or capital, is the primary driver of shareholder value creation or destruction,” Weiss says. “For example, the management team of an automobile company may face decisions around building a new plant, ordering a new piece of equipment, investing in technology, shutting down a business line, acquiring a company or buying back stock.”
Shareholder value increases when a company earns a higher return in its invested capital than the capital’s cost, creating profit. To do this, a company can find ways to increase revenue, operating margin (by reducing expenses) and/or capital efficiency.
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How to Measure Shareholder Value
To measure shareholder value, many investors look at a company’s fundamentals such as return on equity (ROE), which measures the return a company generates on its net assets, or return on invested capital (ROIC), which measures a company’s return on invested capital. A stable or growing ROE suggests a company that knows how to reinvest its assets to grow shareholder value. Similarly, companies with positive ROIC are better at creating value.
Measures of shareholder value are particularly important to value investors, who believe that “the price of a stock does not necessarily reflect its true value but merely the price that the market is willing to pay at the given time,” says John Mantia, co-founder and director of finance at PARCO, headquartered in Washington, D.C. Value investors try to evaluate a company’s “intrinsic” value by determining if a company has a high ROE, growing free cash flow, expanding operating profit and growing book value — all of which would indicate growing shareholder value.
Mantia says investors can also evaluate shareholder value through softer measures such as innovation and competitive dynamics, “which are harder to measure but can be just as important.”
Since management’s ability to allocate resources is the primary driver of shareholder value creation or destruction, looking at management’s past decisions can be another useful gauge of their ability to increase shareholder value, Weiss says. For example, “patterns of growing through acquisitions or deviating from a source of competitive advantage” can be red flags for investors.
You might also investigate management’s compensation structure to determine if their incentives align with your own as a shareholder. “We believe people act on incentives, and we prefer management teams that have compensation structures aligned with creating shareholder value,” Weiss says. “For example, we like to see management teams that only get paid if return on invested capital over a multiyear period is in the top quartile relative to an industry peer group.”
Proxy statements, which public companies file each year, provide details on the management compensation structure.
Another shareholder valuation metric is relative total returns. “We look for companies generating long-term total returns above a broad market index or above peers,” Weiss says. “These successful companies are likely creating shareholder value, or at least creating more than their rivals.”
M.J. Nodilo, regional director and partner at EP Wealth Advisors in Phoenix, adds “factors such as scalability, market share, discipline, adherence to a philosophy, (and) care for your employees and the community” to the list of measures investors can use to determine a company’s shareholder value. That said, “from an investor’s point of view, what really matters is the direction and trajectory of shareholder value and what is being done to drive it over the long term,” he says.
[See: 6 Companies That Announced Big Executive Payouts During the Pandemic.]
Should Maximizing Shareholder Value Be a Priority for Companies?
While maximizing shareholder value is a chief concern for investors, there is considerable debate about whether it should also be a priority for companies.
“In our opinion, the No. 1 job of corporate management teams is to allocate shareholders’ capital to create value,” Weiss says. “Because shareholders are owners of the business, management teams, in theory, should work for the best interest of shareholders.”
Some experts contend that a “tunnel vision” focus on increasing shareholder value can cause managers to prioritize the short term over the long term.
“A focus on short-term value, of which there are countless examples, is typically a recipe for disaster as it often marginalizes culture employees by placing near-term results over long-term benefits,” Nodilo says. “Longer-term shareholder value is typically a result rather than a strategy.”
Mantia says shareholder maximization should “be heavily contingent on the time frame, where corporate leaders plan on maximizing shareholder value for the long term — at least a decade out.” This longer-term view can mitigate the incentive for managers to take short-term actions that will make their results look temporarily better but have disastrous long-term results.
“For example, failing to invest in property plants and equipment, physical capital or research and development could cause a company to show increased profits or cash flow in a given quarter or year,” Mantia says. “But over the long run, failure to make these investments will sharply erode a firm’s competitiveness in the market and long-term viability.”
[READ: ESG Investing Focus: Big Banks’ Money Laundering Problem.]
There is also growing debate around whether a broader metric than shareholder value should be used. “The advent of ESG-focused investing has expanded the definition of shareholder value to include factors beyond financial returns, reflecting other stakeholders in a company,” such as employees, customers, suppliers, the environment and local governments, Weiss says. “Adding value to stakeholders, if done right, can feed back into favorable publicity, market share gains, earnings growth and improving shareholder value.”
So investors may do better to pursue companies with a focus on increasing value for all stakeholders, rather than just shareholder value.
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What Is Shareholder Value? originally appeared on usnews.com
