What is Shareholder Value
Shareholder value is that delivered to shareholders of a corporation because of management's ability to increase sales, earnings and free cash flow over time, leading to the ability for companies to increase dividends and encourage capital gains for its equity owners. A company’s shareholder value depends on strategic decisions made by its board of directors and senior management, including the ability to make wise investments and generate a healthy return on invested capital. If this value is created over the long term, the share price increases and the company can pay larger cash dividends to shareholders.
Often, market participants and investors assume that corporations exist to maximize shareholder value, first and foremost. However, the legal requirement to do so may actually be a persistent myth.
BREAKING DOWN Shareholder Value
Increasing shareholder value increases the total amount in the stockholders' equity section of the balance sheet. The balance sheet formula is assets less liabilities equals stockholders' equity, and stockholders' equity includes retained earnings, or the sum of a company's net income less cash dividends since inception.
Factoring in Earnings Per Share
If management makes decisions that increase net income each year, the company can either pay a larger cash dividend or retain earnings for use in the business. A company’s earnings per share (EPS) is defined as earnings available to common shareholders divided by common stock shares outstanding, and the ratio is a key indicator of a firm’s shareholder value. When a company can increase earnings, the ratio increases and investors view the company as more valuable.
How Asset Use Drives Value
Companies raise capital to buy assets and use those assets to generate sales or invest in new projects with a positive expected return. A well-managed company maximizes the use of its assets so the firm can operate with a smaller investment in assets. Assume, for example, a plumbing company uses a truck and equipment to complete residential work, and the total cost of these assets is $50,000. The more sales the plumbing firm can generate using the truck and the equipment, the more shareholder value the business creates. Valuable companies are those that can increase earnings with the same dollar amount of assets.
Instances Where Cash Flow Increases Value
Generating sufficient cash inflows to operate the business is also an important indicator of shareholder value, because the company can operate and increase sales without the need to borrow money or issue more stock. Firms can increase cash flow by quickly converting inventory and accounts receivable into cash collections. The rate of cash collection is measured by turnover ratios, and companies attempt to increase sales without the need to carry more inventory or increase the average dollar amount of receivables. A high rate of both inventory turnover and accounts-receivable turnover increases shareholder value.
The Shareholder Value Maximization Myth?
It is commonly understood that corporate directors and management have a duty to maximize shareholder value, especially for publicly traded companies. However, legal rulings suggest that this common wisdom is, in fact, a practical myth - there is actually no legal duty to maximize profits in the management of a corporation. The idea can be traced in large part to the oversize effects of a single outdated and widely misunderstood ruling by the Michigan Supreme Court's 1919 decision in Dodge v. Ford Motor Co., which was about the legal duty of a controlling majority shareholder with respect to a minority shareholder and not about maximizing shareholder value. Legal and organizational scholars such as Lynn Stout and Jean-Philippe Robé have elaborated on this myth at length.