What Is Shareholder Value?
Shareholder value is the value delivered to the equity owners of a corporation, thanks to management’s ability to increase sales, earnings, and free cash flow, which leads to an increase in dividends and capital gains for shareholders.
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, particularly over the long term, then the share price increases and the company can pay larger cash dividends to shareholders. Mergers, in particular, tend to cause a large increase in shareholder value.
Shareholder value can become a hot-button issue for corporations, as the creation of wealth for shareholders does not always or equally translate to value for the corporation’s employees or customers.
Key Takeaways
- Shareholder value is the value given to stockholders in a company based on the firm’s ability to sustain and grow profits over time.
- Increasing shareholder value also increases the total amount in the stockholders’ equity section of the balance sheet.
- A well-managed firm maximizes the use of its assets.
- The notion of increasing shareholder value is arguably a misconception; there is no legal duty for management to maximize corporate profits.
Understanding Shareholder Value
Increasing shareholder value also increases the total amount in the stockholders’ equity section of the balance sheet. The balance sheet formula is: Assets, minus liabilities, equal stockholders’ equity. Stockholders’ equity includes retained earnings, or the sum of a company’s net income, minus cash dividends since inception.
How Asset Use Drives Value
Companies raise capital to buy assets and use those assets to generate sales or invest in new projects while expecting a positive return. A well-managed company maximizes the use of its assets so that the firm can operate with a smaller investment in assets.
Assume, for example, that 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 When Cash Flow Raises 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 needing 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; companies attempt to increase sales without needing 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.
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; 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.
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 commonly held belief is, in fact, a myth: There is actually no legal duty to maximize profits while managing 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 in its 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.
Related Glossary
Balance Sheet
A balance sheet refers to a financial statement that reports a company’s assets, liabilities, and shareholder equity at a specific time. Balance sheets provide the basis for computing rates of return for investors and evaluating a company’s capital structure.
Capital Gain
Capital gain refers to the increase in the value of a capital asset when it is sold. Put simply, a capital gain occurs when you sell an asset for more than what you originally paid for it.
Tangible vs Intangible Assets
- Tangible assets are typically physical assets or property owned by a company, such as computer equipment. They are the main type of assets that companies use to produce their product and service.
- Intangible assets don’t physically exist, yet they have a monetary value since they represent potential revenue. An example would be a copyright to a song. The record company that owns the copyright gets paid a royalty each time the song is played.
The Bottom Line
A company’s shareholder value depends on strategic decisions made by its board of directors and senior management, including the ability to make sound investments and generate a robust return on invested capital. If this value is created, particularly over the long term, then the share price increases and the company can pay larger cash dividends to shareholders. Mergers, in particular, tend to cause a substantial increase in shareholder value.
Shareholder value can become a hot-button issue for corporations, as the creation of wealth for shareholders does not always or equally translate to value for the corporation’s employees or customers.
Related Terms: balance sheet, capital gain, tangible assets, intangible assets.
References
- Harvard Law School Forum on Corporate Governance. "Dodge v. Ford: What Happened and Why?"
- Scholarship@Cornell Law: A Digital Repository, Cornell Law School. “New Thinking on ‘Shareholder Primacy’”.
