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.

RELATED TERMS
  1. Shareholder

    A shareholder is any person, company, or institution that owns ...
  2. Shareholders' Equity (SE)

    Shareholder's equity (SE) is the owner's claim after subtracting ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value ...
  4. Cash Dividend

    Cash dividend is the money paid to stockholders normally as a ...
  5. Homemade Dividends

    Homemade dividends are a form of investment income that comes ...
  6. Capital Dividend

    A capital dividend is a type of payment a firm makes to its investors ...
Related Articles
  1. Investing

    Analyze cash flow the easy way

    Learn the key components of the cash flow statement, how to analyze and interpret changes in cash, and what improved free cash flow means to shareholders.
  2. Investing

    Cash flow statement: Analyzing cash flow from financing activities

    The financing activity in the cash flow statement measures the flow of cash between a firm and its owners and creditors.
  3. Investing

    Asset Turnover Ratio

    Investopedia explains: The asset turnover ratio is a measure of a company's ability to use its assets to generate sales or revenue, and is a calculation of the amount of sales or revenue generated ...
  4. Investing

    What Does Negative Shareholder Equity On A Balance Sheet Mean?

    Negative shareholder equity on a company’s balance sheet is a red flag that should prompt potential investors to take a closer look before committing their money.
  5. Retirement

    Picking Retirement Stocks: Dividends vs. Free Cash Flow

    Instead of focusing on dividend payments, a better metric for choosing stocks for your retirement portfolio could be a company’s free cash flow (FCF).
  6. Investing

    Operating Cash Flow: Better Than Net Income?

    Differences between accrual accounting and cash flows show why net income is easier to manipulate.
  7. Investing

    The Difference Between Enterprise Value and Equity Value

    Enterprise value calculates a business’s current value, while equity value offers a snapshot of that business’s current and potential future value.
  8. Investing

    Cash Flow From Investing

    Cash flow analysis is a critical process for both companies and investors. Find out what you need to know about it.
RELATED FAQS
  1. What does negative shareholders' equity mean?

    A negative balance in shareholders' equity (also called stockholders' equity) means that liabilities exceed assets and can ... Read Answer >>
  2. What does total stockholders equity represent?

    Understand the equation for total stockholders' equity and what it represents. Learn the components of stockholders' equity ... Read Answer >>
  3. Why are efficiency ratios important to investors?

    Learn about efficiency ratios, such as the asset turnover ratio, and why these metrics are important to investors when analyzing ... Read Answer >>
Hot Definitions
  1. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  2. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  3. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  4. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  5. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  6. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
Trading Center