The business of creating shareholder value

A new technical report from CIMA entitled Maximising shareholder value: achieving clarity in decision making focuses on ways of defining, measuring and pursuing shareholder value in listed companies. It discusses a management approach commonly known as value-based management (VBM).

CIMA's Official Terminology defines VBM as "a management process which effectively links strategy, measurement and operational processes to the end of creating shareholder value." It consists of three key elements:

• Creating value – i.e. ways to actually increase or generate maximum future value
• Measuring value
• Managing for value – i.e. governance, management, organisation, culture, communication.

The report is not an attempt to endorse a particular VBM approach. Instead, it acknowledges both research and anecdotal evidence that shows that companies today tend to use a more pick-and-mix approach to manage and measure performance. It draws attention to the basics of value creation and questions some of the most common assumptions about performance, strategy and decision-making.

Most listed companies would say they are in the business of creating value for their shareholders. Yet the accounting scandals of recent years have shown the extent to which some companies fail to take their investors' perspective on value. Managers at Enron or Parmalat managed to wipe out shareholder value on a monumental scale, destroying their companies in the process.

Value destruction
There are less spectacular though equally shocking examples of value destruction. For example, a study from the University of Washington reveals that some 78 per cent of companies surveyed admitted to artificially smoothing earnings and sacrificing shareholder value in order to meet or beat Wall Street expectations. The managers' key concern seems to be the share price rather than the long-term sustainability and success of the business.

A recent survey carried out on behalf of the Institute of Chartered Accountants England and Wales of audit partners, finance directors and audit committee directors found that the so-called aggressive earnings management is still a regular occurrence despite the regulators' attempts to stamp it out post-Enron. Although it has decreased in the last two years, the need to exceed market expectations and hit remuneration-linked targets was still driving many companies to disguise their true position to a greater or lesser extent.

Those surveyed had little doubt that aggressive earnings management would always be there and that those involved in ensuring the integrity of financial reporting must never lose sight of this fact. Indeed, a common warning amongst the interviewees was that the incidence of aggressive earnings management may well increase when the post-Enron reporting climate changes or if recession returns.

It is not just the intentional gaming behind the earnings management (with varying degrees of aggressiveness) that shareholders should be worried about. Some cases of value destruction are driven by well-meaning but wholly misguided attempts to improve performance. The recent case of the Compass Group shows how the wrong choice of measures used in executives' incentive plans can lead to shareholder value destruction and a profit warning that wiped out some US$3 billion off its value.

Moving away from incentives
A comment from one support services analyst summarised the situation: ‘Incentivising the management on earnings growth was like saying, ‘you may use our balance sheet capacity to increase your bonus''. The company has had to restructure its incentives plan and move away from schemes that were heavily weighted towards increasing earnings per share and underlying profits. Now, two-thirds of all executive bonuses depend on whether the company ‘breaks the cost of capital'.

All of this shows why value-based management matters – it serves to remind companies that the aim of maximising shareholder value is more than just ‘a corporate rallying cry' – instead, it is ‘a goal of serious strategic planning'. It is about focusing on what matters to those who invest money in their companies – an acceptable return on capital.

Despite the lack of universal definitions, VBM is essentially about measuring profit in a way that takes into account the cost of capital employed to generate it. But it is also about more than that – one of the hallmarks of successful VBM programmes has been a dedicated focus not on measurement but on strategic decision making.

If there is one thing companies can learn from VBM success – such as Lloyds TSB which manage to increase its market capitalisation 40-fold between 1983 and 2001 – it is that successful strategies don't just happen, they are the result of a structured and disciplined decision-making process.

Talking the talk
Despite the obvious fact that competitive advantage can only be the end result of a superior strategy, the amount of time boards spend discussing strategy is surprisingly small. According to Economist Intelligence Unit research into 187 global companies with market caps of at least $1bn, of the average 21 hours a month top executives spend together, less than three hours are devoted to strategy. Some 80 per cent of time is taken up by issues that account for less than 20 per cent of a company's long term value: operations, tactics, information-sharing and roving discussion. Only 5 per cent of companies said they had a disciplined process for focusing attention on matters of potentially high value.

VBM is about companies being ‘decision-focused'. It is not that VBM will remove the uncertainty around strategy – the future is never predictable – but it makes the actual process of decision-making more explicit.

When Sir Brian Pitman was at the helm of Lloyds TSB, he used to tell managers that there is always a better strategy – they just haven't come up with it yet. Companies often treat strategic decisions and strategy implementation as a simple choice between doing something and not doing it – they forget that it is about choosing between more than just those two options. Finally, value-based management is a way of ensuring that the aims of corporate governance – protecting the owners from the possible conflicts of interest arising from the split between them and the managers appointment to run the companies on their behalf – is not an add-on but an integral part of how a company conducts its business.

This is because VBM places their interests right in the heart of decision making by choosing strategies that won't destroy shareholder value and measuring performance in a way that takes into account shareholders' expected returns.