Measuring Shareholder Value

During the 1980s and 1990s growing concerns on traditional accounting measures have emerged, especially on the scope of subjectivity that most accounting standards allow (Starovic et al., 2004). Alternatively, a number of value-based measures or value-metrics based on the concept of shareholder value are proposed by a number of consultants, such as Rappaport (1986) and Stewart (1991). These measures have in common the basic premise that profit needs to be measured in a way that takes into account the cost of the capital employed to generate it (Bromwich, 1998; Starovic et al., 2004).

These measures include Shareholder Value Added (SVA), Economic Profit (EP) or Residual Income (RI), Economic Value Added (EVA), Cash Flow Return on Investment (CFROI) and Total Business Return (TBR) (Starovic et al., 2004).

2.5.2.1 Shareholder Value Added (SVA)

Rappaport (1986) developed SVA to estimate the value of the shareholders’ stake in a company and evaluate strategic decisions (Rappaport, 1986; Starovic et al., 2004).

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SVA can be estimated through discounting the expected future operating free cash flows using a certain cost of capital, as follows:

SVA = (Present Value of Cash flow from Operations during the Forecast Period + Residual Value + Marketable Securities) - Debt

The most important problem with SVA is predicting the variables required to estimate it (Starovic et al., 2004). Therefore, it is not commonly used by companies and, arguably, is less popular than its founder (Copeland, 1994). For instance, an international survey by the European Institute of Business Administration (INSEAD) for VBM practices reported that only 8% of respondents used SVA (Boulos et al., 2001).

2.5.2.2 Economic Profit (EP) or Residual Income (RI)

According to Bromwich and Walker (1998), EP or RI has a long history at both the theory level (e.g. Solomons, 1965) and the practice level (e.g. GM co. since 1920s). EP is the excess of earnings (revenues) over expenses, including cost of capital. It can be calculated as annual accounting profits minus an interest charge on the book value of assets (cost of capital) (Bromwich and Walker, 1998):

EP = Accounting Profit after Tax – Cost of Capital

EP can be used in measuring performance, evaluating businesses and strategic decsion making. However, one of the important problems with this approach is based on the accounting profit, which is based on traditional accounting conventions and rules (Starovic et al., 2004).

2.5.2.3 Economic Value Added (EVA)

EVA is the most popular variant of EP approaches, which was founded by Stern Stewart and Co. (Bromwich and Walker, 1998). In the INSEAD survey, more than 47% of the respondents claimed to use EVA as the EP measure (Boulos et al., 2001). Although EVA is a variant of EP, Stewart (1991) points that at least three problems threaten the calculation of EP, including the use of accruals-based bookkeeping; the bias resulting from applying the prudence concept and the understated capital as a result of using “successful efforts accounting” (Stewart, 1991; Starovic et al., 2004).

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To address the measurement problems in EP, Stewart (1991) suggests up to 164 adjustments to accounting profits and capital, on which EVA is already based (Stewart, 1991; Starovic et al., 2004). EVA can be calculated as follows:

EVA = Adjusted Operating Profits after Tax - (Adjusted Invested Capital * Weighted Average Cost of Capital)

Arguably, EVA grasps all the advantages of the EP approach and the argued improvements in accounting profit after being adjusted (Stewart, 1991; Starovic et al., 2004). However, it is rather complicated, time consuming in implementation and lacks the theoretical foundations of the suggested adjustments (Zimmerman, 1997; Starovic et al., 2004).

2.5.2.4 Cash Flow Return on Investment (CFROI)

CFROI was developed by HOLT Value Associates in collaboration with Boston Consulting Group (Ameels et al., 2002). According to the INSEAD survey, CFROI was very popular as 23% of the respondents argued to use CFROI as a measure of shareholder value creation (Boulos et al., 2001). CFROI can be considered a real measure of rate of return, as it relates the cash generated by a business to the cash invested (Starovic et al., 2004). CFROI is defined as the annual gross cash flow relative to the invested capital of a business unit (Ameels et al., 2002).

CFROI is calculated by converting the accounting profit into real cash flow and converting capital invested in the business into an inflation adjusted measure of investment in business and, finally, the annual cash performance to be converted into a measure of economic performance over the average life of company’s assets using the principles of IRR to find the r value, which approximates the value of CFROI (Starovic et al., 2004) in the following equation (Ameels et al., 2002):

Gross Operating Asset Investment

= ∑

+

Where:

CF Gross cash flow

W Expected residual value of non depreciating assets

Arguably, CFROI is an accurate and advanced measure of economic performance as it is not misshapen by the effect of inflation and depreciation as other approaches,

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such as EP and EVA. In addition, it incorporates the internal rate of return (IRR) concept used in evaluating capital investments and reflects the way in which the stock market judges a company performance (Starovic et al., 2004). However, calculating CFROI is rather complicated, time consuming and costly to implement (Starovic et al., 2004).

2.5.2.5 Total Business Return (TBR)

Total business return (TBR) is the internal equivalent of the external total shareholder return (TSR) measure, which considers capital gains and dividends received by shareholders (Starovic et al., 2004). TSR represents the change in capital value of a company over a one-year period, plus dividends, expressed as a plus or minus percentage of the opening value (Ameels et al., 2002).

Total Shareholder Return = [(Pt+1 - Pt) + D t+1] ÷ Pt

Where:

P share price D paid dividends

t beginning of the period t+1 end of the year

According to the INSEAD survey, 7.4% of the respondent companies were using TSR (Boulos et al. 2001). It has been argued that TBR addresses the problems of short term performance measures such as EVA® and CFROI, as it incorporates the long- term effect of decisions taken in a particular period on the value of the business. This is because TBR combines both the cash flow performance of a business with the change in value that occurs during a certain period (Starovic et al., 2004).

However, using the TSR measure is not without problems, as it can only be calculated for companies that are quoted on the stock exchange. Moreover, it cannot be used to calculate shareholder return at business unit level or for specific product market combinations. In addition, because it is driven by many factors beyond the control of the firm’s executives, it is an inefficient measure in evaluating performance (Bannister and Jusuthasan, 1997; Ameels et al., 2002).

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