Every Manager's Guide to Business Processes:

Extract (12): Shareholder Value

Shareholder value is the total return on invested capital that accrues to the owners of a company's stock. "Shareholder" here does not refer to Wall Street traders but to the wide range of investors who provide the long-term capital that is the entire basis for building and sustaining a successful firm; these include most employees in pension funds (55% of all large companies' stock is invested here), mutual funds, and many other forms of saving.

Shareholder value is increasingly recognized in both financial theory and successful management practice as the most meaningful target for and measure of business performance. Regardless of apparent profitability, reported earnings per share, and income statement, a firm that generates an after-tax cash flow that exceeds its cost of capital will thrive and one that does not will falter.

Many successful firms lose their competitive position by unwittingly wasting capital. They raise capital easily, invest it in profitable projects, and report growing earnings. But savvy investors, who in the longer term set the market, are not fooled by the earnings picture. They know, and studies corroborate, that there is no correlation between earnings and stock price but that there is a very strong correlation between economic value-added and market value-added. Economic value-added is the after-tax cashflow generated by the company's operations minus the cost of all the capital the company has used to generate that cash flow. Cost of capital is the weighted average of interest on loans plus the cost of equity. The riskier or weaker the company, the higher its cost of capital; banks charge higher interest on its loans, bond holders require a higher rate of return, and shareholders are unwilling to pay a premium for its stock.

Economic value-added determines the increase in shareholder value generated by the firm; this market value-added is the increase in the market value of the firm, that is, the premium investors will pay for the stock. If investors see economic value-added growing, they bid the stock up. If not, they bid it down. The correlation, shown below, along with a comparable graph plotting the lack of relationship between earnings per share and stock price, is very strong.

It is easy to explain in commonsense terms why shareholder value carries more significance than earnings per share. We handle (or should) our personal affairs with shareholder value in mind. For ourselves, shareholder value is directly equivalent to net worth, and economic value-added to after-tax cash flow. We don't try to maximize the equivalent of profit. To do so would mean trying to state as high a gross taxable income on our federal and state tax statements as we could. Instead, we try to reduce tax, maximizing deductions and pushing income into next year, rather than taking it now, thereby increasing our after-tax cash flow. We also pay attention to the cost of borrowing. If we rent out an $80,000 house, we calculate the after-tax return. Our gross profit is the rent minus operating costs. From that profit we deduct the mortgage interest, which is our cost of capital for the $80,000 asset that generates the income. That cost is tax deductible, so even if the rental shows a loss the deduction adds after-tax cash flow to our savings, which represents the equivalent of economic value-added and increase in net worth.

Cost of capital and after-tax cash flow are the main elements of net worth, as they are of shareholder value. Imagine a situation in which certificates of deposit are earning 5.5 percent interest. A friend boasts to you that he is getting a guaranteed return of 11.8 percent and has deposited $28,000 in this instrument. Are you impressed? Probably so, until you casually ask your friend how he got the $28,000 to invest. "Oh, I borrowed on all my credit cards."

Fifty-five percent of large companies' stock is invested in pension funds. Add to this individuals' holding in mutual funds, employee stock options, and universities' endowments that fund a large fraction of tuition costs, and it becomes clear that "shareholders" are not just anonymous Wall Street money managers. Shareholders are most of us.

Given that the interest rate on his cards runs at 15 to 18 percent, the 11.8 percent return is not at all the deal it appears to be. Your friend is outperforming the market but draining his net worth. Companies make the equivalent of this mistake. Here are just a few representative examples. 

• In 1992, Spiegel, the catalog retailer, reported a net profit of $119 million. Its total capital was $1.6 billion, and the cost of capital was 11.1 percent (a weighted average of debt at 6.8% and equity at 18.3%). The carrying cost of this capital was thus $1.6 billion x 11.1 percent: $178 million. Even though it is profitable, the firm is actually draining shareholder value. With ten years of such profits, a firm will go broke.
  
  
• In the late 1980s, the managers of RJR, the tobacco company, underwent what one commentator calls an "earnings addiction." For example, at the end of 1988, RJR offered its distributors incentives to stock up on inventory, thereby greatly increasing sales and reported profits. The stocking up, however, produced overstock; the distributors had accumulated close to 20 billion unsold cigarettes when RJR announced its next semiannual price increase. It had sold the cigarettes at a lower price and had paid excise duty earlier than it needed to. Shipments dropped 29 percent and 17 percent in the next quarters. Yet the stock price went up. The smart investors who drive the market saw management at last facing up to the situation and taking action to restore the firm's economic health. The stock price of the "profitable" RJR had been $55; the less profitable firm was taken private at $110 a share. Bennett Stewart, whose book The Quest for Value is a superb analysis of economic value-added and its direct link to shareholder value, comments on RJR, "Kick the earnings habit. Join the cash-flow generation."
  
  
• In the 1960s, W.T. Grant grew its earnings into bankruptcy. It implemented an aggressive sales policy and a strategy of store expansion. Sales and profits grew at an impressive rate, but inventories and credit card receivables grew much faster. From 1968 to 1975, its most profitable years, Grant's economic value-added was negative, despite the earnings growth. W.T. Grant is no longer in business. 

Cash flow generated by the efficient use of capital is now the mainstream of corporate financial strategy and investment strategy. Legendary maestro investor Warren Buffett speaks of  "owners' earnings" and the finance theorists focus on "free cash flow"; the many companies that have adopted this perspective generally use economic value-added as the new management metric. Firms such as CSX, PepsiCo, AT&T, and Quaker report that it provides a discipline for planning and a measure of management performance that has significantly improved corporate performance, mainly because it focuses management's attention on the use of all capital.

Processes are capital, not just workflows, so all decisions about them must be based on increasing shareholder value as the investment metric. The process paradox-that substantial benefits from process improvement so often do not lead to improved business performance-reflects the widespread lack of attention in the process movements to the capital nature of processes.

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