What is shareholder value?

Shareholder value definition is rather straightforward. It is a business term that describes the value enjoyed by shareholders for owning shares in a company. Shareholder value is the financial worth a business owner receives by owning shares in a company. It can be attributed to several factors including the management's ability to increase revenue, or cash flow.

A company's shareholder value is determined by strategic decisions made by its senior management. This includes its ability to make prudent investment decisions and generate sound returns on the invested capital. In contrast, faulty decision-making or inappropriate tactics may damage shareholder value. When a company creates shareholder value in the long term, stock prices rise and shareholders are paid more cash dividends. Notably, mergers result in significant increases in shareholder value.

An increase in shareholder value increases the total amount in the equity section of the company’s balance sheet. The balance sheet formula for shareholders’ equity is assets minus liabilities. Shareholders’ equity includes retained earnings – the company's net income fewer cash dividends since incorporation.

Shareholder value can be a contentious issue for businesses as creating wealth for shareholders does not always mean value for a company's employees or customers.

How to compute Shareholder value

Here's how to compute your portion of shareholder value:

• Step 1: Start by subtracting your company's preferred dividend from its net income. Preferred dividends are dividends paid to preferred stockholders. Net income is the company's total revenue less operating and non-operating expenses, depreciation, interest, and taxes. If a company has a net profit of $1 billion and a preferred dividend of $200 million, shareholders can earn $800 million.
• Step 2: Divide the company's available income by the total number of outstanding shares to calculate the company's earnings after the acquisition of shares. If your company has 400 million shares outstanding, divide $800 million by $400 million to get a profit per share of $2.
• Step 3: Add the stock price to the profit per share. If a company's stock sells for $40 per share, then add $40 and $2 per share to earn $42.
• Step 4: Now multiply the above total by the number of shares held by one shareholder. If a shareholder owns 10 shares, the individual shareholder value is $420.

Basic drivers of shareholder value

Shareholder value is usually broken down into components called value drivers because it's not directly affected by any manager. The widely used model includes seven drivers of shareholder value that guide managers including:

• Revenue
• Operating margin
• Cash tax rate
• Incremental capital expenditure
• Investment in working capital
• Cost of capital
• Competitive advantage period

Considering some of these factors, it's clear that short-term profit maximization does not always increase shareholder value. The period of competitive advantage largely takes care of this – when a company sells inferior products to reduce costs and make quick profits, it damages its reputation and loses its competitive advantage in the future. The same is true for companies that neglect research and don’t invest in trained employees. Therefore, this detailed concept eliminates some (not all) of the issues associated with criticism of the shareholder value model. Based on these seven factors, business functions can be meticulously designed and show how they affect shareholder value.

The shareholder value maximization myth

It is well known that the company's board of directors and management must maximize shareholder value, particularly for listed companies. However, an evaluation of case laws suggests that this general wisdom is a practical myth. There is no legal obligation to maximize profits when running a business.

The idea traces largely back to the exaggerated effects of one outdated and misunderstood ruling in the 1919 Dodge v Ford Motor Company decision of the Michigan Supreme Court. It primarily addressed the legal duty of a controlling majority shareholder for a minority shareholder and certainly not about maximizing shareholder value. Legal and organizational scholars Lynn A. Stout and Jean-Philippe Robé, have studied and reported this myth extensively.

Criticism

The sole focus on shareholder value is often criticized. Focusing on shareholder value can be economically beneficial to corporate owners, but does not provide a clear measure of social issues such as employment, environmental issues, or ethical business practices. Business decisions can maximize shareholder value while reducing the welfare of all other groups involved. Shareholder value associated with short-termism has also been criticized for lowering overall economic growth due to lower capital accumulation.

It can also handicap stakeholders of the company like customers. For instance, in the interest of improving shareholder value, a company may not offer support for old, or maybe even new, products.

The concept of maximizing shareholder value is generally emphasized for possible examples of CEOs and other management behaviors that enrich themselves, at the cost of shareholders. Examples include mergers or acquisitions that weaken shareholders’ positions. However, the legal premise of a public company is that the management is obliged to maximize the company's profits. This does not imply that management has any legal obligation whatsoever, to maximize shareholder value.

In addition, a focus on short-term shareholder value can be detrimental to long-term shareholder value. Tricks that increase stock value in the short term can harm its long-term value. The CEO of Salesforce – Marc Benioff once said “the obsession with maximizing profits for shareholders has brought us: terrible economic, racial, and health inequalities; the catastrophe of climate change.” Critics argue that oversimplifying the role of business overlooks or even disregards, the imperfect world we live in.

Final word

Several factors influence shareholder value, making it difficult to accurately attribute any rise or fall. The primacy of shareholder value can sometimes be called into question because of a host of complications, including executive compensation incentives. External forces constantly influence how a business is run, and thus this differential impact can be challenging to measure