Checklist Description
This checklist outlines how shareholder value analysis (SVA) is used.
Definition
Shareholder value is a term that suggests that the decisive measure of a company’s success is how well it enriches its shareholders. Shareholder Value Analysis (SVA) is one of a number of techniques used as substitutes for traditional business measurements. It became fashionable in the 1980s, when it was linked to Jack Welch, then CEO of General Electric.
Essentially, the idea is that shareholders’ money should be used to earn a higher return than it could by investing in other assets with the same amount of risk. To calculate shareholder value, you estimate the total net worth of a company, i.e. total assets minus total liabilities, and divide this figure by the value of its shares. The result gives you the shareholder value of the company. The basic rule of SVA is that a company adds value for its shareholders only when equity returns exceed equity costs. When that value has been calculated, the company can take steps to improve its performance and also use SVA to measure the success of those actions.
Although there are some complex formulae for working out shareholder value, it can also be determined using three simpler approaches:
-
Discount the expected cash flows to the present to reach an estimated economic value for the business.
-
Use the appropriate cost of capital for the business to find the actual cost of investment discounted to the present.
-
Work out the economic value of the business by calculating the difference between the results of the above analyses.
SVA is also known as value-based management. The principle is that the management of any company should first and foremost consider how the interests of its shareholders will be affected by any decisions it takes. This is not a new management theory; it is the legal premise upon which any publicly traded company is set up.
Advantages
-
SVA holds that management should first and foremost consider the interests of shareholders in its business decisions.
-
SVA takes a long-term view and is about measuring and managing cash flows over time. It provides the user with a clear understanding of value creation or degradation over time within each business unit.
-
SVA offers a common approach, which is not subject to the particular accounting policies that are adopted. It is therefore globally applicable and can be used across most sectors.
-
SVA forces companies to focus on the future and their customers, with specific attention to the value of future cash flows.
Disadvantages
-
The concentration on shareholder value does not take into account societal needs. Shareholder value financially benefits only the owners of a corporation; it does not provide a clear measure of social factors such as employment, environmental issues, or ethical business practices. Therefore, a management decision can maximize shareholder value while adversely affecting third parties, including other companies.
-
It can be extremely difficult to estimate future cash flows accurately—a key component of SVA. This can lead to the use of faulty or ambiguous figures as the basis for strategic decisions.
-
The development and implementation of an SVA system can be long and complex.
-
Management of shareholder value requires more complete information than traditional measures and can therefore take up management time.
Action Checklist
-
Before adopting SVA, it is important to understand the implications it will have for your business.
-
You should consult professional advisers, such as accountants or consultants who specialize in this area and who can inform you of what the ramifications may be.
-
SVA is based on the principle that creation and maximization of shareholder value is the most important measure of a business’s performance.
-
All members of the organization must be committed to the principle for it to work effectively.
Dos and Don’ts
Do
-
Consult professional advisers, such as accountants or consultants who specialize in this area. The changes required to implement SVA could be costly—even more so if you find you need to reverse them.
Don’t
-
Don’t take on board SVA as a system unless you are positive that your overriding concern is shareholder value.
www.qfinance.com