Alfred Rappaport Shareholder Value Pdf

The Idea in Brief

Many firms sacrifice sustained growth for short-term financial gain. For example, a whopping 80% of executives would intentionally limit critical R&D spending just to meet quarterly earnings benchmarks. Result? They miss opportunities to create enduring value for their companies and their shareholders.

  • Make strategic decisions that maximize expected future value — even at the expense of lower near-term earnings. In comparing strategic options, ask: Which operating units’ potential to create long-term growth warrants additional capital investments? 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. Consider Dell Computer’s well-chronicled direct-to-consumer custom PC assembly business model. 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. You’ll give shareholders a chance to earn better returns elsewhere — and prevent management from using the cash to make misguided value-destroying investments.
  • Reward senior executives for delivering superior long-term returns. Standard stock options diminish long-term motivation, since many executives cash out early. Instead, use . These options reward executives only if shares outperform a stock index of the company’s peers, not simply because the market as a whole is rising.
  • 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. Prepare a corporate performance statement that allows analysts and shareholders to readily understand the key performance indicators that drive your company’s long-term value.

Do not manage earnings or provide earnings guidance.

Hercus 260 metal lathe manual. 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. A 2006 National Investor Relations Institute study found that 66% of 654 surveyed companies provide regular profit guidance to Wall Street analysts. A 2005 survey of 401 financial executives by Duke University’s John Graham and Campbell R. Harvey, and University of Washington’s Shivaram Rajgopal, reveals that companies manage earnings with more than just accounting gimmicks: A startling 80% of respondents said they would decrease value-creating spending on research and development, advertising, maintenance, and hiring in order to meet earnings benchmarks. More than half the executives would delay a new project even if it entailed sacrificing value.

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.) A sound strategic analysis by a company’s operating units should produce informed responses to three questions: First, how do alternative strategies affect value? 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?

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. With record levels of cash and relatively low debt levels, companies increasingly use mergers and acquisitions to improve their competitive positions: M&A announcements worldwide exceeded $2.7 trillion in 2005.

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.

Return cash to shareholders when there are no credible value-creating opportunities to invest in the business.

Even companies that base their strategic decision making on sound value-creation principles can slip up when it comes to decisions about cash distribution. The importance of adhering to the fifth principle has never been greater: As of the first quarter of 2006, industrial companies in the S&P 500 were sitting on more than $643 billion in cash — an amount that is likely to grow as companies continue to generate positive free cash flows at record levels.

Reward CEOs and other senior executives for delivering superior long-term returns.

Companies need effective pay incentives at every level to maximize the potential for superior returns. Principles 6, 7, and 8 set out appropriate guidelines for top, middle, and lower management compensation. I’ll begin with senior executives. As I’ve already observed, stock options were once widely touted as evidence of a healthy value ethos. The standard option, however, is an imperfect vehicle for motivating long-term, value-maximizing behavior. First, standard stock options reward performance well below superior-return levels. As became painfully evident in the 1990s, in a rising market, executives realize gains from any increase in share price — even one substantially below gains reaped by their competitors or the broad market. Second, the typical vesting period of three or four years, coupled with executives’ propensity to cash out early, significantly diminishes the long-term motivation that options are intended to provide. Finally, when options are hopelessly underwater, they lose their ability to motivate at all. And that happens more frequently than is generally believed. For example, about one-third of all options held by U. S. executives were below strike prices in 1999 at the height of the bull market. But the supposed remedies — increasing cash compensation, granting restricted stock or more options, or lowering the exercise price of existing options — are shareholder-unfriendly responses that rewrite the rules in midstream.

Reward operating-unit executives for adding superior multiyear value.

While properly structured stock options are useful for corporate executives, whose mandate is to raise the performance of the company as a whole — and thus, ultimately, the stock price — such options are usually inappropriate for rewarding operating-unit executives, who have a limited impact on overall performance. A stock price that declines because of disappointing performance in other parts of the company may unfairly penalize the executives of the operating units that are doing exceptionally well. Alternatively, if an operating unit does poorly but the company’s shares rise because of superior performance by other units, the executives of that unit will enjoy an unearned windfall. In neither case do option grants motivate executives to create long-term value. Only when a company’s operating units are truly interdependent can the share price serve as a fair and useful indicator of operating performance.

Reward middle managers and frontline employees for delivering superior performance on the key value drivers that they influence directly.

Although sales growth, operating margins, and capital expenditures are useful financial indicators for tracking operating-unit SVA, they are too broad to provide much day-to-day guidance for middle managers and frontline employees, who need to know what specific actions they should take to increase SVA. For more specific measures, companies can develop leading indicators of value, which are quantifiable, easily communicated current accomplishments that frontline employees can influence directly and that significantly affect the long-term value of the business in a positive way. Examples might include time to market for new product launches, employee turnover rate, customer retention rate, and the timely opening of new stores or manufacturing facilities.

Require senior executives to bear the risks of ownership just as shareholders do.

For the most part, option grants have not successfully aligned the long-term interests of senior executives and shareholders because the former routinely cash out vested options. The ability to sell shares early may in fact motivate them to focus on near-term earnings results rather than on long-term value in order to boost the current stock price.

Provide investors with value-relevant information.

The final principle governs investor communications, such as a company’s financial reports. Better disclosure not only offers an antidote to short-term earnings obsession but also serves to lessen investor uncertainty and so potentially reduce the cost of capital and increase the share price.

  • separates out cash flows and accruals, providing a historical baseline for estimating a company’s cash flow prospects and enabling analysts to evaluate how reasonable accrual estimates are;
  • classifies accruals with long cash-conversion cycles into medium and high levels of uncertainty;
  • provides a range and the most likely estimate for each accrual rather than traditional single-point estimates that ignore the wide variability of possible outcomes;
  • excludes arbitrary, value-irrelevant accruals, such as depreciation and amortization; and
  • details assumptions and risks for each line item while presenting key performance indicators that drive the company’s value.

The Rewards — and the Risks

The crucial question, of course, is whether following these ten principles serves the long-term interests of shareholders. For most companies, the answer is a resounding yes. Just eliminating the practice of delaying or forgoing value-creating investments to meet quarterly earnings targets can make a significant difference. Further, exiting the earnings-management game of accelerating revenues into the current period and deferring expenses to future periods reduces the risk that, over time, a company will be unable to meet market expectations and trigger a meltdown in its stock. But the real payoff comes in the difference that a true shareholder-value orientation makes to a company’s long-term growth strategy.

  • Despite a slowdown in growth and margin erosion in the company’s maturing core business, management continues to focus on developing it at the expense of launching new growth businesses.
  • Eventually, investments in the core can no longer produce the growth that investors expect, and the stock price takes a hit.
  • To revitalize the stock price, management announces a targeted growth rate that is well beyond what the core can deliver, thus introducing a larger growth gap.
  • Confronted with this gap, the company limits funding to projects that promise very large, very fast growth. Accordingly, the company refuses to fund new growth businesses that could ultimately fuel the company’s expansion but couldn’t get big enough fast enough.
  • Managers then respond with overly optimistic projections to gain funding for initiatives in large existing markets that are potentially capable of generating sufficient revenue quickly enough to satisfy investor expectations.

Alfred Rappaport Creating Shareholder Value Pdf

  • To meet the planned timetable for rollout, the company puts a sizable cost structure in place before realizing any revenues.
  • As revenue increases fall short and losses persist, the market again hammers the stock price and a new CEO is brought in to shore it up.
  • Seeing that the new growth business pipeline is virtually empty, the incoming CEO tries to quickly stem losses by approving only expenditures that bolster the mature core.

Estate Of Alfred Rappaport

  • The company has now come full circle and has lost substantial shareholder value.

Stake Holder Value Definition

Clearly, if a company is vulnerable in these respects, then responsible managers cannot afford to ignore market pressures for short-term performance, and adoption of the ten principles needs to be somewhat tempered. But the reality is that these extreme conditions do not apply to most established, publicly traded companies. Few rely on equity issues to finance growth. Most generate enough cash to pay their top employees well without resorting to equity incentives. Most also have a large universe of customers and suppliers to deal with, and there are plenty of banks after their business.

Shareholder Value Definition

A version of this article appeared in the September 2006 issue of Harvard Business Review.



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