Shareholder value added

From CEOpedia | Management online

Shareholder Value Added (SVA) is a value based management performance measure of a company's worth to shareholders compared to the weighted average cost of capital invested (WACC). It started to become popular in the 1980s mainly thanks to Jack Welch, former CEO of General Electric, and Alfred Rappaport.

Sources of shareholder's value

In its essence, the idea is that shareholders' money should give a higher return than could be earned by investing in other assets at the same level of risk. In other words, value is added when the overall net economic cash flow of the business exceeds the economic cost of all the capital employed to produce the operating profit. Value creation is virtually guaranteed when a company's return on capital exceeds its cost of capital. In sharp contrast, accounting profitability does not necessarily lead to value creation. In fact, in many cases, profitable projects actually destroy the value of the company.

Fig.1. Shareholder value sources

The Shareholder Value Added method has rooted from experiences connected with using the discounted cash flow model (DCF). The mathematical model behind it is based on the thought that the value of the company is comparable with the belief of its future generation of cash or dividends and not historical earnings. To put it in a simple thinking framework for example, if a US$100 investment in an enterprise is made, that has a 20 percent risk factor, the expected average return could be US$20.

If the investment provided more than US$20, it had positive value added - the result was more than the money invested. If it yielded less than US$20, it proved to have negative value added. Even if there would be a return, but less than US$20 the value added would be negative if it was less than the expected return based on the amount of investment and the risk factor (or cost of capital).

SVA = Net Operating Profit After Taxes (NOPAT) - (Capital x WACC)

Advantages of shareholder value added

Traditionally accounting measures focus on sore profits after tax equivalents measured as a percentage of the total asset base, the value based management approach, like SVA, concentrates mainly on the operating performance of the firm by adjusting net operating revenue (NOPAT) by the allocation of a capital charge along with the economic operations of the business. SVA itself takes into consideration one hugely important variable that most traditional accounting measures do not - how much capital is being employed in the business. SVA combines income statement and balance sheet data to determine the excess returns available to all capital holders.

Criticism of shareholder value added method

The sole concentration on shareholder value has been widely criticized. While shareholder value benefits the owners of a corporation financially, it does not provide a clear measure of corporate social responsibility and environmental issues like employment, ethical business practices. A management decision can maximize shareholder value while lowering the welfare of the local communities, the workers employed and the environment.

Additionally, short term focus on shareholder value can be harmful to long term shareholder value; the expense of tricks that briefly boost a stocks value can have negative impacts on its long term value.

Even one of its earliest users, mentioned before, Jack Welch, has widely criticized the SVA model - "On the face of it, shareholder value is the dumbest idea in the world," he said. "Shareholder value is a result, not a strategy. Your main constituencies are your employees, your customers and your products.".

See also:

Examples of Shareholder value added

  • Earnings per Share (EPS): This measure shows how much profit the company has earned for each share of its stock. It is calculated by dividing the company's net income by its total number of shares outstanding.
  • Return on Equity (ROE): This measure indicates how much profit the company makes relative to the amount of equity invested in the business. It is calculated by dividing the company's net income by its shareholders' equity.
  • Shareholder Value Added (SVA): This measure evaluates the performance of a company from the perspective of its shareholders. It is calculated by subtracting the company's weighted average cost of capital from its return on equity.
  • Market Value Added (MVA): This measure evaluates a company's performance from the perspective of its investors. It is calculated by subtracting the market value of the company's equity from the total amount of capital invested in the business.

Limitations of Shareholder value added

  • Shareholder Value Added (SVA) does not account for intangible assets and non-financial factors, such as customer loyalty, brand equity, and employee engagement, which may have a significant impact on a company's value.
  • SVA is also limited by the fact that it is based on historical data and does not take into account future expected performance.
  • SVA is based on the assumption that all cash flows generated by a company are reinvested, which is not always the case.
  • SVA is also heavily reliant on the accuracy of the inputs that are used, such as the weighted average cost of capital and the assumptions used to calculate the discount rate. If the inputs are incorrect, then the SVA calculation will be inaccurate.
  • SVA does not take into account the impact of macroeconomic variables or other external factors, such as changes in the market, which may have a significant impact on a company's performance.
  • SVA does not provide stakeholders with an understanding of the strategic decisions taken by the company or the underlying reasons for the performance of the company.

Other approaches related to Shareholder value added

Shareholder Value Added (SVA) is a performance measure focused on creating value for shareholders, relative to the cost of capital invested. Other approaches that focus on creating value for shareholders include:

  • Economic Value Added (EVA) - a measure of a company’s financial performance, based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes.
  • Cash Flow Return on Investment (CFROI) - an analytical technique used to measure the performance of a company by calculating the amount of cash flow generated in relation to the invested capital.
  • Quality of Earnings (QOE) - a measure of the effectiveness of management in generating value for shareholders, by analyzing the quality of reported earnings and the sustainability of those earnings.
  • Residual Income (RI) - a measure of a company’s financial performance based on the amount of income left over after deducting the cost of capital from the operating profits.

In sum, Shareholder Value Added (SVA) is one of several approaches aimed at creating value for shareholders. Other approaches include Economic Value Added (EVA), Cash Flow Return on Investment (CFROI), Quality of Earnings (QOE) and Residual Income (RI).

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Author: Łukasz Skarka