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How top companies create shareholder value.

How top companies create shareholder value

A survey of senior financial people at some of the nation's largest corporations reveals the most popular strategies for boosting a firm's share value. The 1980s ushered in the widespread resurrection of a founding corporate objective: to increase shareholder value. This basic guiding principle, upon which every business entity initially is established, seeks to provide investors with returns to compensate for the risks they assume through their investment.

The factors contributing to this renewed focus on enhancing owner's worth reflect a variety of influences. Firms exist with the support of and attention to several constituencies: customers, suppliers, employees, communities, shareholders, and other stakeholders. Although complacency in addressing any of these groups can lead to dire consequences, corporate managements must adjust priorities to respond to changing pressures.

One of the most significant areas of concern to corporate management, one that erupted and gained accelerating momentum during the 1980s, is the wave of takeovers, mergers, and restructurings. The potential threat of losing control over the activities of a business has prompted managers to keep a keen eye on how their performance impacts the rather elusive target of enhancing shareholder value.

It's true that market prices for publicly traded equity securities are subject to macroeconomic fluctuations, takeover speculation, and specific industry or company developments that can lead to significant volatility, as evidenced most recently by the October 13, 1989, stock market tumble. But ample evidence exists to support the long-term rationale of prices based on prior achievements and, more important, expected future performance levels.

Since the conclusion of the 1981-82 recession, corporate after-tax profits, adjusted for inventory valuation and capital consumption, have grown slightly more than twofold to $195 billion. During this same eight-year time span, the Dow Jones Industrial Average has leaped from 1,000 to 2,700. Given that performance does drive shareholder values, then the real issues facing an organization are the appropriate selection and successful execution of those strategies that will contribute to the performance required for the maximization of shareholder worth.

There are several schools of thought on how performance should be evaluated and linked to the creation of shareholder value. One school holds that achievements are adequately measured and communicated in the context of the classic accrual-based accounting model. The keys to prompting an upward appraisal of value are growing earnings per share and returns on assets and capital employed.

Another school of thought that has recently gained attention focuses on cash-generating capacity as the fuel that drives value creation. This school has numerous champions, including investment bankers, LBO specialists, and several academic and financial theoreticians. Here, the key to enhancing value lies in growing cash-based returns.

Although there are clearly differing views on how to best equate short-term performance with a prospective investor's appraisal of value, there is a strong consensus that long-term economic/market value can be enhanced only through achieving and maintaining a competitive advantage that will produce a consistent positive spread between returns and the risk-adjusted cost of capital. Interestingly, the significance of the differences between accounting numbers and cash flows does tend to dissipate over time.

With the continuing theoretical debate over the most appropriate way to maximize the creation of shareholder value, an intriguing but unanswered question remains: how are corporate managements actually pursuing this objective? What strategies are being selected and employed to enrich the worth of the firm's owners? Despite the unique challenges faced by each organization, is there a right versus a wrong direction to take?

To gain insight into how Corporate America is striving to respond to the focus on shareholder returns, a poll was conducted in June of 1989 of the senior financial executives from 411 firms with revenues exceeding one billion dollars, as presented in the 1989 Fortune 500 industrial and Fortune 100 diversified service listings. The 118 respondents indicated which of 21 listed strategies (segmented into three categories--operating, investment, and capital) they have pursued in the last three years or are currently contemplating implementing over the next three years. They also provided a rating of the relative effectiveness of the strategies.

What the survey revealed

The 118 survey participants operate within a broad cross section of industries that provide products and services to consumer, industrial, and governmental markets. With a few exceptions, the responding firms have performed rather well in generating increases in shareholder value. During the 10-year period from 1979 through 1988, the mean average annual return (both dividend yield and price appreciation) to the shareholders of these firms was 17.8 percent. The range of average annual shareholder returns for the participating firms ran from a low of 4.5 percent to a high of 35.6 percent, as calculated and presented in the Fortune listings.

Attention to increasing returns on operating capital/equity and cash flow are the fundamental objectives that executives pursue as the key linking contributors to generating higher shareholder returns. Also, the underlying and paralleling strategies of asset redeployment, cost reduction/margin enhancement, and growth are the courses of action they take to close the gap between current and perceived value.

Surprisingly, interest in reducing the cost of capital through expanding the use of leverage is waning. And less reliance is being placed on stock repurchase programs as a future avenue to enhance value.

The debate over whether the value creation process should be measured from an accounting or a cash perspective still is being waged. Although this study did reveal growing support for the discounted cash flow approach to measure value, the more conventional and ingrained focus on accounting-based returns still exists and continues to be used as a basis to communicate performance.

A look at operating strategies...

Of the 21 strategies listed in the poll, the seven grouped within the operating category received the most attention. A total of 2,324 individual strategy selections were made by the responding firms, and 41 percent, or 959, fell within the operating category as opposed to the investment or capital category. Look at Figure 1 for a graphic summary of the use of each operating strategy and its mean effectiveness rating (1 being the least effective and 5 being the most effective) in increasing shareholder returns.

The two most effective strategies cited received mean ratings of 3.8, for increasing the ROA/ROE, and 3.7, for maximizing the operating/discretionary cash flow. Both of these objectives also are slated to receive increased attention in the future. Surprisingly, the corollary strategy of accelerating asset turnover generated only a 3.2 rating and a significantly lower utilization frequency.

High priority has also been given to achieving a competitive advantage by lowering costs. The most frequently cited strategies in this area, both receiving a mean rating of 3.5, were the return-magnifying objectives of growing the level of sales and earnings and enhancing operating margins. The competitive advantage of attaining market leadership, which was only the sixth in terms of frequency, earned a 3.4 rating.

Looking deeper into the strategy selection process, those respondents that generated shareholder returns above the mean demonstrated a slight preference for the growth strategy. These firms, given their outstanding performance, see further shareholder gains coming from increasing size as opposed to increasing ROA/ROE. The latter strategy received a lower effectiveness rating amongst this select group of corporations.

Then investment strategies...

The strategies listed in the investment category captured 38 percent of the attention of the responding organizations. Figure 2 presents a frequency distribution of the selections made and the mean effectiveness rating for each strategy surveyed.

The two courses of action used most in the past three years relate to internally developing new or enhanced products and disposing of those assets, products, or businesses yielding low returns. Interestingly, the latter approach, which had the highest effectiveness rating--3.8, will be pursued substantially less in the next three years. Apparently, the major housecleaning activities of the respondents have been largely completed.

Adding complementary product lines through the acquisition route is the only listed strategy that will receive slightly increased impetus going forward. Excluding this selection, the use of the other strategies in the poll is declining by an average of 15 percent.

Relatively high marks were given to adjusting capacity levels (3.2), increasing operational efficiencies (3.2), and departing from markets that offer low-growth potential (3.3), which is very compatible with the actions being taken to lower costs and increase margins. But purchasing businesses to gain entry into new markets received the lowest rating (2.9), reflecting the general market aversion to diversification beyond core activities.

The top-performing firms, those that have provided their shareholders with 10-year average annual returns that exceed 17.8 percent, clearly demonstrated a higher incidence of growing through purchasing businesses with complementary products. The expansion of product lines through internal development takes a second-place finish, apparently reflecting the typically longer timeframes and higher risks associated with successfully introducing new products.

... and, finally, capital strategies

This group of seven strategies secured only 482 responses, or 21 percent, of the total received. The capital strategies category also showed a rather steep (22 percent) decline in the future versus the past rates of use. Additionally, with two exceptions, the courses of action in the poll generated lower ratings as effective means of increasing shareholder value.

A maximum effectiveness rating of 5.0 was indicated for the decision to accept an offer to sell the firm. Instituting a leveraged buyout generated a similarly high rating of 4.4. Although empirical evidence does strongly support these strategies as excellent means to maximize the short-term returns to shareholders, they are clearly not the favored choices of the predominantly public, independent firms included in the population surveyed.

Somewhat surprisingly, the tactic of expanding financial leverage received a low rating. In fact, a number of respondents actually noted that they are making a concerted effort to reduce their debt levels and financial risks, as is graphically portrayed in Figure 3. A comparable utilization pattern can be seen in the reduced future frequency of share repurchase programs (rated 3.3 on the effectiveness scale), which have been largely financed through expanding debt levels.

Issuing new equity securities, other than to an employee stock ownership plan, to maximize shareholder value generated the lowest rating (2.8) of any of the 21 strategies in the poll. This assessment is consistent with previous studies that have found that share prices decline after new offerings are placed in the market.

The two distinguishing characteristics of the top-performing firms were their attention to increasing the level of dividends paid to shareholders and adopting or expanding an ESOP. The survey participants are acutely aware that dividends are a component of the returns that investors are seeking, and they place a high priority on satisfying this requirement. These organizations also have recently recognized the defensive, financing, productivity, and tax benefits of ESOPs as a tool to enhance shareholder value.

Shareholder value has been rekindled from the status of a mere concept that is fashionably extolled to one of being the prime motivator of corporate action. There is a new sense of urgency to satisfy shareholder demands for a return on their investment. And it is highly doubtful that the preoccupation with this corporate constituent will ebb in the near future as the wave of mergers and acquisitions continues into the 1990s.

The only available means that corporate management has to address this issue is through the implementation of those strategies that will achieve gains in shareholder worth. However, optimizing strategies is complex.

Corporate managers must carefully evaluate their competitive strengths and weaknesses and then select and successfully execute those strategies that are linked to the creation of value. The objective of this study has been to shed some light on the current thinking of financial executives and to determine the specific strategies they're using to maximize shareholder value. [Figures 1 to 3 Omitted]

Mr. Schneider also is a corporate manager with CBI Industries, Inc.
COPYRIGHT 1990 Financial Executives International
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Copyright 1990, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Schneider, Alan J.
Publication:Financial Executive
Date:May 1, 1990
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