About The Book Economist, consultant, and Wall Street Journal contributor Alfred Rappaport provides managers and investors with the practical tools and tests for a corporate strategy that creates shareholder value. The ultimate test of corporate strategy, the only reliable measure, is whether it creates economic value for shareholders. After a decade of downsizings frequently blamed on shareholder value decision making, this book presents a new and indepth assessment of the rationale for shareholder value. Further, Rappaport presents provocative new insights on shareholder value applications to: 1 business planning, 2 performance evaluation, 3 executive compensation, 4 mergers and acquisitions, 5 interpreting stock market signals, and 6 organizational implementation.
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The Idea in Brief Many firms sacrifice sustained growth for short-term financial gain. They miss opportunities to create enduring value for their companies and their shareholders.
How to cultivate the future growth your firm needs to succeed? Rappaport identifies 10 powerful practices. Another practice: Ensure that executives bear the same risks of ownership that shareholders do—by requiring them to own stock in the firm.
At eBay, for example, executives have to own company shares equivalent to three times their annual base salary. When executives have significant skin in the game, they tend to make decisions with long-term value in mind. The Idea in Practice Rappaport recommends these additional practices to create long-term growth for your company: Make strategic decisions that maximize expected future value—even at the expense of lower near-term earnings. Which have limited potential and therefore should be restructured or divested?
What mix of investments across operating units should produce the most long-term value? Carry assets only if they maximize the long-term value of your firm. Focus on activities that contribute most to long-term value, such as research and strategic hiring. Outsource lower value activities such as manufacturing.
Dell invests extensively in marketing and telephone sales while minimizing its investments in distribution, manufacturing, and inventory-carrying facilities. Return excess cash to shareholders when there are no value-creating opportunities in which to invest. Disburse excess cash reserves to shareholders through dividends and share buybacks. Reward senior executives for delivering superior long-term returns. Standard stock options diminish long-term motivation, since many executives cash out early.
Instead, use. Reward operating-unit executives for adding superior multiyear value. Instead of linking bonuses to budgets a practice that induces managers to lowball performance possibilities , develop metrics that capture the shareholder value created by the operating unit.
And extend the performance evaluation period to at least a rolling three-year cycle. Reward middle managers and frontline employees for delivering superior performance on key value drivers they influence directly. Focus on three to five leading value-based metrics, such as time to market for new product launches, employee turnover, customer retention, and timely opening of new stores. Provide investors with value-relevant information.
Counter short-term earnings obsession and investor uncertainty by improving the form and content of financial reports. When executives destroy the value they are supposed to be creating, they almost always claim that stock market pressure made them do it.
The reality is that the shareholder value principle has not failed management; rather, it is management that has betrayed the principle. In the s, for example, many companies introduced stock options as a major component of executive compensation.
The idea was to align the interests of management with those of shareholders. But the generous distribution of options largely failed to motivate value-friendly behavior because their design almost guaranteed that they would produce the opposite result. To start with, relatively short vesting periods, combined with a belief that short-term earnings fuel stock prices, encouraged executives to manage earnings, exercise their options early, and cash out opportunistically.
Of course, these shortcomings were obscured during much of that decade, and corporate governance took a backseat as investors watched stock prices rise at a double-digit clip. The climate changed dramatically in the new millennium, however, as accounting scandals and a steep stock market decline triggered a rash of corporate collapses.
The ensuing erosion of public trust prompted a swift regulatory response—most notably, the passage of the Sarbanes-Oxley Act SOX , which requires companies to institute elaborate internal controls and makes corporate executives directly accountable for the accuracy of financial statements.
Nonetheless, despite SOX and other measures, the focus on short-term performance persists. In their defense, some executives contend that they have no choice but to adopt a short-term orientation, given that the average holding period for stocks in professionally managed funds has dropped from about seven years in the s to less than one year today. Why consider the interests of long-term shareholders when there are none?
This reasoning is deeply flawed. Studies suggest that it takes more than ten years of value-creating cash flows to justify the stock prices of most companies. The competitive landscape, not the shareholder list, should shape business strategies.
What do companies have to do if they are to be serious about creating value? In this article, I draw on my research and several decades of consulting experience to set out ten basic governance principles for value creation that collectively will help any company with a sound, well-executed business model to better realize its potential for creating shareholder value. Though the principles will not surprise readers, applying some of them calls for practices that run deeply counter to prevailing norms.
I should point out that no company—with the possible exception of Berkshire Hathaway—gets anywhere near to implementing all these principles. Mauboussin Do any companies in America make decisions consistent with all ten shareholder value principles? Berkshire Hathaway, controlled by the legendary Warren Buffett, may come the closest. If you have the mentality of both, it aids you in each field. Our guideline is to tell you the business facts that we would want to know if our positions were reversed.
Shareholder-value companies recognize the importance of generating long-term cash flows and hence avoid actions designed to boost short-term performance at the expense of the long view. But we can guarantee that your financial fortunes will move in lockstep with ours for whatever period of time you elect to be our partner. Further, Berkshire is the rare company that does not grant any employee stock options or restricted stock. Buffett is not against equity-based pay per se, but he does argue that too few companies properly link pay and performance Principle 6.
So far, Berkshire looks like a complete level 10 value-creation company—one that applies all ten principles. Principle 4 advises selling operations if a buyer offers a meaningful premium to estimated value.
Consistent with Principle 5, Buffett is clear about the consequence of failing this test. For example, the Washington Post and Coca-Cola were among the first companies to voluntarily expense employee stock options in Companies with which Buffett has been involved also have a history of repurchasing stock.
Michael J. He is a shareholder in Berkshire Hathaway. Principle 1 Do not manage earnings or provide earnings guidance. Companies that fail to embrace this first principle of shareholder value will almost certainly be unable to follow the rest.
Unfortunately, that rules out most corporations because virtually all public companies play the earnings expectations game. More than half the executives would delay a new project even if it entailed sacrificing value.
Second, organizations compromise value when they invest at rates below the cost of capital overinvestment or forgo investment in value-creating opportunities underinvestment in an attempt to boost short-term earnings. Third, the practice of reporting rosy earnings via value-destroying operating decisions or by stretching permissible accounting to the limit eventually catches up with companies.
Those that can no longer meet investor expectations end up destroying a substantial portion, if not all, of their market value. WorldCom, Enron, and Nortel Networks are notable examples. Principle 2 Make strategic decisions that maximize expected value, even at the expense of lowering near-term earnings. Companies that manage earnings are almost bound to break this second cardinal principle. Indeed, most companies evaluate and compare strategic decisions in terms of the estimated impact on reported earnings when they should be measuring against the expected incremental value of future cash flows instead.
Expected value is the weighted average value for a range of plausible scenarios. To calculate it, multiply the value added for each scenario by the probability that that scenario will materialize, then sum up the results. Second, which strategy is most likely to create the greatest value? Third, for the selected strategy, how sensitive is the value of the most likely scenario to potential shifts in competitive dynamics and assumptions about technology life cycles, the regulatory environment, and other relevant variables?
At the corporate level, executives must also address three questions: Do any of the operating units have sufficient value-creation potential to warrant additional capital? Which units have limited potential and therefore should be candidates for restructuring or divestiture?
And what mix of investments in operating units is likely to produce the most overall value? Principle 3 Make acquisitions that maximize expected value, even at the expense of lowering near-term earnings. Companies typically create most of their value through day-to-day operations, but a major acquisition can create or destroy value faster than any other corporate activity.
They view EPS accretion as good news and its dilution as bad news. When it comes to exchange-of-shares mergers, a narrow focus on EPS poses an additional problem on top of the normal shortcomings of earnings. The inverse is also true.
Management needs to identify clearly where, when, and how it can accomplish real performance gains by estimating the present value of the resulting incremental cash flows and then subtracting the acquisition premium.
Value-oriented managements and boards also carefully evaluate the risk that anticipated synergies may not materialize. They recognize the challenge of postmerger integration and the likelihood that competitors will not stand idly by while the acquiring company attempts to generate synergies at their expense. If management is uncertain whether the deal will generate synergies, it can hedge its bets by offering stock.
Principle 4 Carry only assets that maximize value. The fourth principle takes value creation to a new level because it guides the choice of business model that value-conscious companies will adopt. There are two parts to this principle. First, value-oriented companies regularly monitor whether there are buyers willing to pay a meaningful premium over the estimated cash flow value to the company for its business units, brands, real estate, and other detachable assets.
Such an analysis is clearly a political minefield for businesses that are performing relatively well against projections or competitors but are clearly more valuable in the hands of others. Yet failure to exploit such opportunities can seriously compromise shareholder value.
A recent example is Kmart. Lampert was able to recoup almost his entire investment by selling stores to Home Depot and Sears, Roebuck. Former shareholders of Kmart are justifiably asking why the previous management was unable to similarly reinvigorate the company and why they had to liquidate their shares at distressed prices. Second, companies can reduce the capital they employ and increase value in two ways: by focusing on high value-added activities such as research, design, and marketing where they enjoy a comparative advantage and by outsourcing low value-added activities like manufacturing when these activities can be reliably performed by others at lower cost.
Examples that come to mind include Apple Computer, whose iPod is designed in Cupertino, California, and manufactured in Taiwan, and hotel companies such as Hilton Hospitality and Marriott International, which manage hotels without owning them. Principle 5 Return cash to shareholders when there are no credible value-creating opportunities to invest in the business.
Ten Ways to Create Shareholder Value
The ultimate test of corporate strategy, the only reliable measure, is whether it creates economic value for shareholders. After a decade of downsizings frequently blamed on shareholder value decision making, this book presents a new and indepth assessment of the rationale for shareholder value. Further, Rappaport presents provocative new insights on shareholder value applications to: 1 business planning, 2 performance evaluation, 3 executive compensation, 4 mergers and acquisitions, 5 interpreting stock market signals, and 6 organizational implementation. The recent acquisition of Duracell International by Gillette is analyzed in detail, enabling the reader to understand the critical information needed when assessing the risks and rewards of a merger from both sides of the negotiating table. The shareholder value approach presented here has been widely embraced by publicly traded as well as privately held companies worldwide.
Alfred Rappaport (economist)
The Idea in Brief Many firms sacrifice sustained growth for short-term financial gain. They miss opportunities to create enduring value for their companies and their shareholders. How to cultivate the future growth your firm needs to succeed? Rappaport identifies 10 powerful practices. Another practice: Ensure that executives bear the same risks of ownership that shareholders do—by requiring them to own stock in the firm. At eBay, for example, executives have to own company shares equivalent to three times their annual base salary.