Treasury Today Country Profiles in association with Citi

Shareholder value

Every for-profit organisation has the objective of generating a consistent, profitable growth and providing its investors with a return. This return should be at least equal to what investors would receive if funds were invested into alternative investments with similar risk features. Management must therefore choose those strategic and investment decisions which increase shareholder returns. Shareholder value or value based management, as it is also called, puts the creation of value at the centre of management’s strategy.

A value based management approach requires that not only the overall investment into a company – but also any individual investment made by the company – should promise a return that exceeds the cost of capital – otherwise the investment should be made elsewhere. Value based management focuses a company’s strategy and operational activities on value creation and means that only those measures that are actually creating value will be pursued.


It is not easy to define value based management (VBM) and there are different opinions as to how to define value, as well as how to measure it and how to generate it. The most common definition is that VBM is a systematic management approach with the objective of maximising the creation of a company’s intrinsic value, as well as the shareholder value, by focusing the decision-making on key value drivers.

Shareholder value and the cost of capital

While there are many measures for accounting profit, the shareholder value concept emphasises that a focus on the creation of value is more important than the generation of profits. A company will only create value, irrespective of its accounting profit, if the return on equity exceeds the opportunity costs of equity capital. Or put differently, a company will only make real profit after it has repaid its cost of capital.

Many difficulties with measuring shareholder value arise from the false notion that equity capital is a free resource. Every shareholder expects a return on the investment made. As equity investments are a relatively risky form of investment, an investor will want to be compensated with comparatively high returns. The return that is expected by the shareholder represents a cost to the company in the sense that shareholders will move their funds into other investments, should the returns prove unsatisfactory.

In contrast to debt financing, where the obvious costs of interest expenses are usually part of management’s calculations, a similar cost for equity financing is sometimes not taken into consideration. If this is the case, it is quite possible to calculate an operating profit for a company that is actually destroying shareholder value.

All value based management concepts share the idea that value can only be measured by considering the cost of the capital employed to generate it. They also accentuate the idea that the primary objective for management should be to generate an acceptable return on the equity investments made by shareholders.

Value based management

VBM aims to align corporate strategy, corporate mission, corporate governance decision processes, performance management and remuneration and reward systems with the overall goal of maximising shareholder value. In this context, shareholder value addresses three basic questions:

  1. How can value be measured?

    The different metrics used to calculate shareholder value.

  2. How is value created?

    The strategy of generating the maximum future value.

  3. How can value creation be managed?

    The implementation of this strategy and its management through change management, corporate governance, communication and leadership.

Measuring shareholder value

One problem with the shareholder value concept is that there is no single metric on the operational level with which to measure shareholder value. As a result, various combinations of different metrics (net income, cash flow etc.) are used to illustrate shareholder value. Each of the measurement methods can be used for different purposes such as valuation, as a strategic tool, performance measurement and monitoring. The most important methods are:

  • Shareholder Value Analysis (SVA)

  • Economic Profit (EP) and Economic Value Added (EVA®)

  • Cash Flow Return on Investment (CFROI)

Shareholder value analysis (SVA)

Shareholder Value Analysis (SVA), as described by Alfred Rappaport (Professor Emeritus at Kellogg Graduate School of Management, Northwestern University in the US), is the process of analysing how decisions affect the net present value of cash to shareholders. It is a variation of the discounted cash flow methodology, which in this method is applied to the company as a whole.

SVA determines the value of a company’s operations by discounting the expected future operating ‘free cash flows’ at an appropriate cost of capital. Free cash flow is a measure that deducts capital expenditures from operating cash flows and represents the cash flow that can be generated by a company after the costs of maintaining the company’s assets have been deducted. The creation of value, for example through the development of new products, acquisitions, the reduction of debt etc. is strongly dependent on a company’s free cash flow.

In theory, free cash flows from operations should be estimated for each future year. However, SVA uses a simplified approach by adding the present value of free cash flows during a specific planning period to the present value of free cash flows after the planning period, known as the ‘residual’ or ‘continuing’ value. The SVA approach is based on seven value drivers:

  1. Sales growth.

  2. Operating profit margin.

  3. Cash tax rate.

  4. Incremental fixed capital investment.

  5. Investment in working capital rate.

  6. Cost of capital.

  7. Planning horizon, during which the company is expected to generate returns exceeding the cost of capital.

At first, an estimation of free cash flows during the planning period is derived from the value drivers. The free cash flows are then discounted to present value by using either a company-wide WACC (see box for definition) or a specific discount rate for each business unit. Then, the present value of the firm after the planning horizon is added to the result. This is calculated by discounting simplified cash flows (eg based on the assumption of constant or zero growth beyond the planning period). The market value of non-trade or non-operational assets is added to the result to arrive at the corporate company value belonging to all investors. Finally, the value of equity is determined by deducting the amount of debt.

Uses and benefits

SVA allows the comparison of alternative strategic options for improving shareholder value by determining which strategy, for example reinvesting into existing businesses, investing into new businesses or returning cash to stockholders, will enhance shareholder value most. The value drivers enable management to pinpoint exactly what drives the value of a company. On the business unit level, the value drivers can be broken down into smaller components, that management is familiar with, to set targets and measure performance. Investment and cash flow forecasts, as well as the prediction of the development of potentially conflicting value drivers, make an in-depth knowledge of the operating business indispensable if this methodology is used.

Economic Profit

The Economic Profit (EP) approach calculates the profit earned by a company after all expenses, including capital costs, have been deducted. Unlike net profit, economic profit takes the opportunity costs of equity capital into account. As a result, it is possible to have a significant accounting profit with little or no economic profit.

EP represents the difference between the return on capital and the cost of capital. There are two ways of calculating it:

  1. EP = invested capital × return on capital  –  WACC
  2. EP = operating profits after tax invested capital  ×  WACC

The first calculation multiplies the invested capital by the ‘performance spread’, which consists of the difference between return on invested capital and the weighted average cost of capital.

The second approach deducts a capital charge (invested capital multiplied by WACC) from operating profits after tax, but before the deduction of non-operating income, such as investment income and interest receivable.

Adjusting the tax charge

The way in which a company is financed, the share of its debt and equity, can have an impact on the way it is being taxed. Under many taxation regimes, interest payable is a tax-deductible expense, whereas interest receivable or investment income is taxable income. A company with high debt and a net interest expense will therefore pay less taxes on its profits than a company with net interest income.

To avoid a distortion of the calculation by the way in which a company is financed, economic profit should therefore be adjusted for tax effects, by multiplying the net interest payable figure by the tax rate, and effectively arriving at a tax charge that would apply if the company was entirely equity financed.

Uses of EP

Like SVA, EP can be used for valuation, performance measurement or as a strategic tool. It is also comparatively easy to implement as it requires only two simple adjustments (tax charge and WACC) on the reported operating profit. The visibility of the cost of capital will support management in their investment decisions and is an incentive to exercise greater control over the cost-effectiveness of investments.

It is also possible to identify a number of value drivers with EP in order to develop more precise targets on the operating level. For example, return on capital is influenced by both a company’s ability to generate turnover from the invested capital and the profit margins the company can achieve relative to the turnover. Return on capital employed can then be further broken down into the constituent parts of capital turnover and operating margin (ROCE tree).

ROCE tree
Diagram 1: ROCE tree

The disadvantage of the EP calculation is that it uses traditional accounting figures, which in turn may be subject to a number of distortions.

Economic value added (EVA®)

Consultants Stearn Stewart have refined the basic EP by making a number of adjustments to it in their EVA® approach. Like economic profit, EVA® is the residual income which remains after net operating profits after tax (NOPAT) has been reduced by the capital costs.

EVA ® = NOPAT capital  ×  cost of capital

In this form, EVA® is a performance measure rather than a value metric, but it makes immediately clear whether profits have exceeded the capital costs incurred to generate them. The shareholder value can be generated by calculating the net present value of future EVAs®, resulting in the market value added (MVA), and then making the same adjustments as for SVA by adding the capital invested and deducting nonoperating assets and debt.

EVA® differs from EP in the way that the components of the formula are calculated. The EVA® approach aims to address a number of potential accounting distortions in the calculation of profits. To correctly measure value creation, the EVA® method provides for up to 164 adjustments, which can be made to both profits and capital where appropriate.

The use of a single performance measure is seen by some as a major advantage of EVA®. However, the method is very complex and some argue that this may make it difficult to conclude how specific management decisions have influenced EVA®.

Cash flow return on investment (CFROI)

CFROI is calculated on an annual basis. It measures the ability of a company to generate cash flow and compares this to an inflation-adjusted cost of capital, in order to determine whether the company has created value superior to the cost of capital. This is another concept that has been developed by management consultants – in this case by CSFB Holt (formerly HOLT) and Boston Consulting Group. As a concept, it assumes that the prices set by stock market are based on cash flows rather than profits and its proponents argue that it mirrors the valuation of a company’s share by the stock market more accurately than profit based metrics.

CFROI aggregates projected average rates of return from a company’s investments and thereby measures its cash profitability for a specific period, usually one year. The calculation of CFROI is quite complex and beyond the scope of this article. It entails an approximation of the average real internal rate of return that is earned by the company on all its depreciating and non-depreciating operating assets. To derive a current value for a company, CFROI discounts future annual cash flows that are generated by the company’s asset base back to their current inflation-adjusted cash value.

CFROI has the benefit that in contrast to EP or EVA® its results are not distorted by inflation or depreciation. The main disadvantage of this concept is its complexity and cost of application. Several aspects of the formula are also open to subjectivity and difficult to estimate.

Benefits of shareholder value measures

All of the described shareholder value metrics have the benefit of applying a common standard or language to all the parts of a company. Performance measurement and target setting can be expressed in one single figure. This makes different business units comparable on a group level, holds them more accountable and provides management with a powerful strategic tool.

Value creating and value destroying investments are highlighted by the shareholder value measures, and the true value drivers within a company can be readily identified.

Future projects and undertakings can be tested by comparing pre- and post-strategy shareholder values. Therefore the shareholder value approach lends itself to developing many alternative strategies and testing them for their potential for creating value.

As a process, strategic decision-making is facilitated by following one single primary objective: the creation of value.

Potential issues with shareholder value

Measure of success

The introduction of shareholder value as a measure for management performance can lead to the problem that shareholder value does not necessarily correspond to management’s traditional measures of success. For example, a loss in market share may still drive shareholder value (for example if business units that destroy shareholder value are sold or shut down), but would generally be regarded as a sign of failure.

Long-term and short-term

All value based metrics are long-term measures. There is a danger that managers with a short-term horizon will reject projects or investments that will create value in the long-term, but do not have this effect in the short-term. In turn, a focus on projects that create value in the long-term, but yield lower short-term returns, can lead to underinvestment of core parts of the business that have a lower NPV.

On the other hand, initial successes can be difficult to maintain. If equity analysts expect similar superior performance for the future, many companies might refocus on the short-term performance of the share price rather than the long-term creation of value.

Shareholder value vs. stakeholder value?

Shareholder value puts a very strong emphasis on the shareholder and the creation of value as a return on their investment. It has been argued that this may run the risk of overemphasising shareholders as opposed to stakeholders such as employees, communities around the company etc. In fact, the concept of shareholder value management is the expression of a particular idea of what role companies and the economy play in society. The shareholder value approach regards companies first and foremost as instruments of their owners and sees stakeholders as a means to achieve profits. It believes in the effectiveness of markets and that by maintaining market-based relationships between a company and its stakeholders, not only the wealth of shareholders will be increased, but also that of society as a whole.

In contrast, proponents of the stakeholder value concept believe that social responsibility is not only a matter for individuals and governments, but also for companies. In addition it is argued that, of all the resources that a company requires, finance should not be considered more important than labour. Stakeholder value advocates believe in a co-operative relationship between the company and its stakeholders and believe that active stakeholder management by the company’s management will result in a more motivated and productive workforce, which in turn results in value creation for both the company and society.

In the past, a pure shareholder value approach has therefore been questioned, particularly in non-Anglo- Saxon economies – for example France or Germany – which traditionally have a different economic perspective and societal model. But also in the Anglo-Saxon world, the view that companies should increase shareholder wealth to a maximum – within the limits of what is legally permissible and without regard for wider stakeholder concerns – has become less common.

In reality, shareholder value concepts will have to take stakeholder concerns into account, if only to prevent the loss of value from reputational damage to their brand.


Value based management methods are difficult concepts that are even more difficult to implement. In order to be truly successful, value based management needs to become part of the corporate culture. This implementation takes time, may come at relatively high cost if consultants are involved and might encounter an adverse reaction by staff. The value based management will also create an environment of competition between different business units of the same company as they compete for future funding and are compared based on shareholder value metrics. Highlighting parts of the company that do not create sufficient value and restructuring the company accordingly will create friction.

Even if a programme does not initially highlight areas that underperform, it is therefore crucial to manage all potential cultural issues.