Maximizing Shareholder Wealth
The basic premise underlying the study of modern corporate finance is that the objective of the firm is to Maximize Shareholder Wealth (SWM). Most individuals seek to maximize their personal well being which is partially defined, from an economic perspective, as the consumption of goods and services. While there certainly are other motivations and rewards in living a good life, most of us desire to achieve a certain level of material comfort which requires an appropriate level of wealth or ability to consume. Achieving this goal requires foregoing current consumption in order to free up funds for investment in either equity or debt securities issued by corporate or governmental agencies with the expectation that it will increase our future ability to consume. While higher rewards are more desirable, this is tempered by the reality that the risk of losing all or part of our investment keeps most long term investors from operating in a risk-prone manner.
There is a severe measurement problem with SWM in that we do not all agree on the appropriate definitions to be employed. For example, "wealth" is typically measured in terms of a firm's share price which makes it difficult for the majority of firms in our country since they are not publicly held nor is the equity traded. The larger publicly held firms contain the bulk of corporate assets in the United States, but pale in comparison to the number of small to medium sized businesses in our economy. It would be easy to say that we should estimate the market value of those business activities if they were to be sold, but many of the owner/managers would not sell for a fair price. Their definition of wealth includes considerations such as: independence, community standing, enjoying their work and those with whom they work or making succession plans for children. If the business is sold, they simply become an anonymous person with a bank account whereas there are a great many non-monetary benefits to being a successful practicing business owner. It is unlikely that all of these people would agree that wealth can only be measured in terms of the market price of the equity!
In addition, the term "maximize" is a very demanding taskmaster since it implies that only operating at the outer limit or maximum is appropriate behavior. The reality is that there is a greater chance of losing than winning when operating on the knife edge of maximizing and it is difficult to imagine most of us being comfortable with the high probability of failure. As investors, we urge firms in which we invest to 'maximize', but then become outraged when the strategy fails or management takes steps to conceal losses or mis-state gains in hopes of sustaining or raising the stock price. At its core, the Enron debacle is all about a strategy of maximizing results being adopted in lieu of ethical practices.
When we vacation in Las Vegas or a similar locale, we know the odds offered by the gaming tables and machines must favor the casino operator. We usually have a certain sum of money that we are willing to lose, and consider to be part of our entertainment budget , in hopes of beating the odds. In contrast, most stock and bond investors view the role of firm management as that of taking prudent risks that will offer higher returns to the investor. Shareholders are the legal owners of the firm and have elected the Board of Directors to manage that investment on their behalf. The Board, in turn, hires senior management to put into practice long run objectives for the wealth enhancing management of shareholder resources. While every organization has numerous 'stakeholders' in the form of lenders, employees, customers and suppliers, with interests other than maximizing shareholder wealth, they generally gain when the shareholder gains. Equity shareholders bear the final responsibility in the sense that they are last in the bankruptcy food chain and stand to lose all of their investment if things go badly. So long as the shareholder is "taken care of" in the sense of gaining value from their investment, other stakeholders should also benefit. The difficulty occurs when management loses its focus on its role as an "agent" employed to act in the shareholder's best interest. Agents are those whom we empower to act on our behalf and in our self interest.
The difference between the large, publicly held firm and the local small business is in the nature of the owner-manager agency relationship. A locally owned and managed firm is well aware of the equity investor since it is identical to the management. There is no difficulty keeping track of whose interests they are pursuing nor who will bear the consequences of erroneous decisions. They have invested their own money and seek to earn a daily living as well as to create longer term value which they can leave to their children or to provide a form of retirement fund. They view SWM in a different manner than the CEO of a publicly traded corporation since they have their own views on defining "wealth" and the time frame over which they will "maximize" their investment of time, effort and money.
A senior manager in a publicly traded corporation, on the other hand, is separated from the pleasure and pain of owning the entire equity funded portion of the firm and it is not their own money at risk. They are typically employed via a contract which specifies remuneration and responsibilities, but they do not personally bear the entire financial consequences of decisions made. As shareholders, we ask the Board of Directors and the senior management to act in our own selfish interest as equity holders. We structure the contracts in a manner we hope will be sufficient to both reward them for outstanding decision making and we reserve the right to remove them when things are not performing up to expectations. Like everyone, management is self interest motivated and can easily forget or ignore shareholder interests in hopes of personal gain. The business news of the past 3-5 years has been full of such events including Enron, Tyco, World Com and others. It is unlikely that any former shareholder or employee of Enron would view the senior management as acting in an appropriate manner as an agent working on their behalf! In the short run, share prices were higher and wealth was increased, but the longer term consequences were devastating to any investor who was not sufficiently diversified to avoid the full brunt of the collapse.
A second important agency relationship is that between the equity owners of the firm and any creditors including short term trade credit and longer term bondholders or bank lenders. Creditors base their lending and pricing decisions on expectations regarding the riskiness of existing assets and financing strategies as well as potential future asset acquisitions and financing decisions. However, the equity owners, acting through management, control those decisions and the riskiness of the ensuing cash flows. Equity owners potentially benefit from making decisions that result in greater risk since the risk/return relationship tells us that higher risk offers higher returns. Creditors do not share in these potential higher rewards, but they do bear the potential consequences. Thus, creditors are likely to place restrictive covenants on lending agreements which, in turn, may be seen by equity owners as wealth reducing since it limits the ability to take risks.
The same would be true in a less obvious manner for other stakeholders of the firm such as employees, customers, suppliers and the communities in which they operate. In the long run, shareholders gain by being cognizant and respectful of these other interests since each could take actions that would reduce the value of the owner's wealth. For example, short run wealth maximization would encourage minimal spending on product qualtiy and support for customer complaints which may lead to dramatic reductions in sales over time and a corresponding reduction in longer run shareholder wealth. The critical factor is the time frame over which shareholder wealth maximization is measured!
Economic Value Added (EVA):
Economic Value Added as a product is the enhancement and promotion of a long recognized economic concept called "residual income" or "economic profit". EVA as a branded product was developed and popularized by Stern Stewart Associates (Web Site) and is sometimes called SVA or Shareholder Value Added by those firms who do not employ the services of Stern Stewart and cannot use the copyrighted EVA label. The economic principle is that the firm must earn more on its funds than the cost of those funds or it is not creating value. The formula, from their website, is:
EVA = Net Operating Profit After Taxes (NOPAT) - [Capital * Cost of Capital]
The primary benefit of EVA/SVA is to encourage managers throughout the firm to acknowledge that shareholder value is not being created without a positive economic profit. The firm must earn an amount sufficient to pay for its capital and have some left over to "add value" over and beyond the returns available to the shareholder from investing in other opportunities of similar risk. The premise of EVA is that senior management may recognize this obvious truism, but has difficulty communicating it throughout the organization. Middle and lower level management may see funds received from the corporation as "free" in the sense that you put forward your request for new assets and, if approved, the funding just magically appears. It is one thing to send out memos or have meetings encouraging managers to be prudent with their funding requests on the basis of shareholder wealth maximization. It is something entirely different when you let managers know that they will be evaluated on the basis of EVA/SVA which means that any assets acquired must earn more than the cost of funds employed in those assets!
For example, a department manager proposes the acquisition of a $100,000 piece of equipment which will provide a NOPAT of $10,000 (we address NOPAT calculation in the "Analysis" section but a simple definition is an increased operating cash flow after tax without deducting financing charges or depreciation). The firm employs a 12% cost of capital in its EVA calculation which requires a capital charge of $12,000 ($100,000 * 12%) and results in a negative EVA of $2,000. Even though the project provides a higher NOPAT and presumably a higher net income, the negative EVA would indicate that the proposal does not enhance shareholder wealth.
One criticism of EVA is that it encourages short term wealth enhancement, but does not address longer term value creation. In the above example, the new equipment might provide a capacity to be more flexible in providing customer service or in making product enhancements over time. In the short run, the estimated NOPAT relates only to existing or forecasted activities and does not account for currently unforeseen benefits. This observation leads to the second measure which is MVA or Market Value Added.
Market Value Added (MVA):
MVA is simply the difference between the book value of assets employed and the market value attached by a self interest motivated market. The principal difference lies in the comparison of equity book value and market equity values. If the market value of the stock is higher than its book value, the firm has "created value" for its owners. The basic premise is that the market is long term in its orientation and considers expected future cash flows from current decisions which may result in a higher stock price and greater MVA. A good example would be R&D expenditures which, by definition, would have a negative EVA since the firm is investing shareholder money with no immediate expectation of a greater NOPAT. However, the stock market typically views R&D investments in a positive manner and may feel this expenditure indicates the firm is creating possibilities for greater future cash flows and an increase in shareholder value. If that results, as it often does, in an improved stock price then one could observe that MVA increased even though the EVA was negative and therefore the expenditure should be made. The market is, however, extremely self interest motivated and will expect to observe positive performance in the form of greater cash flows that meet or exceed their expectations and it can be extremely punishing of those firms that do not meet those enhanced expectations.
EVA Links Useful access to sites relevant to EVA
An Alternative Viewpoint/ Goal of Firm