Value-Based Management

The focus of value-based management is on the capital market driven returns earned by the shareholders of the company over the long term. The literature contains frequent references to the fact that before satisfying shareholders’ demands for profit, you first have to satisfy the contractual claims of other groups. Criticism of the classic profit figures stemming from the annual financial statement, such as sales or return on investment (ROI), is the source of another prime motivation for value-based management. Perceived problems with these figures include their orientation toward the past and the potential for manipulation. The value-based approach gained particular popularity though the book Creating Shareholder Value by Alfred Rappaport (Rappaport 1999).

Since then, “shareholder value” has become a term that is often interpreted differently by different groups in actual practice, and which has come to contain certain fashionable aspects. In recent years, managers and financial analysts have been confronted with a veritable flood of new concepts, figures, and terms related to value-based management. Management consultancies in particular developed a

series of procedures for measuring added value. Rappaport himself focused on discounted cash flow (DCF); economic value added (EVA®) originates from the consulting firm of Stern Stewart; economic profit (EP) comes from McKinsey; the Boston Consulting Group (BCG) propagated the term cash value added (CVA) and the related cash flow return on investment (CFROI) (Ballwieser 2000, pp. 160-161). The origins of these models, as well as their relationships to each other, are frequently unclear. For the sake of clarity, two dimensions should be clearly delineated from each other: shareholder value as a financial figure on the one hand, and as a maxim for action on the other hand (Hostettler 2000, pp. 22-31).

As a financial measurement figure, shareholder value describes the benefits the shareholder enjoys, and is defined as the present value of all of the investor’s future net income. From the point of view of the shareholder, economic profit (as opposed to accounting profit) is not attained until a certain minimum interest is earned on the invested capital (in the sense of opportunity costs). The situation can thereby arise that, despite accounting profits, the investor nonetheless experiences a loss as seen from this viewpoint (Bühner/Weinberger 1991).

Capital is seen as a constraining factor. It is essential to consider the timing of payments and the resulting effects of inflation, along with the cost of capital. The difference between the actual and the approximately determined fair share price (target share price) is referred to as the value gap. This makes it possible to determine whether the corporation is overvalued or undervalued. These estimates form an important parameter during strategy formulation. The calculation can be made in one of the following ways:

 Number of shares multiplied by the market price (market capitalization)

Calculation based on the discounted payment surplus according to the DCF method (see Rappaport’s approach)

Calculation as excess operating profit (residual net profit) (see approaches of Stewart (EVA), Copeland et al. (EP) and Lewis (CVA/ CFROI))

Using the third option, excess operating profit is the amount in excess of the cost of capital. The following elements are needed to calculate this figure:

Amount of profit

Amount of capital

Capital cost rate

Profit is normally the operating profit from the income statement, excluding nonoperational elements. Capital is determined from assets shown in the balance sheet. The capital cost rate reflects the weighted, average earnings owed to outside investors (creditors) and providers of equity (taking opportunity costs into account) (Hostettler 2000, pp. 45-46).

According to Rappaport, shareholder value can be influenced in three areas with When the shareholder value approach is taken as a maxim for actions, the intention is to align the objectives of the firm with the interests of the shareholders. Measures for increasing corporate value, beyond the level of simple growth in sales or profits, become of central importance. 

lasting effect:

Operational decisions that influence operational performance. Examples are pricing or the scope of customer services.

 Investment or disinvestment decisions that are reflected on the assets side of the balance sheet. These affect both fixed and current assets. Along with purchases of machinery, this also includes increases in inventory turnover or a reduction in time allowed for customers to pay.

Financing decisions that influence the liabilities side of the balance sheet, that is, the relationship between external capital and equity. This primarily involves the sources of capital or the financing instruments used, as well as the shaping of the legal structure of the company.

Each of these decision categories has its affect on various financial figures that can be summarized in value-based key figures. Problems are caused not so much by the calculations as by the different, to some extent subjective, definitions of the basic elements: profit, capital, and capital cost rate (Hostettler 2000, pp. 23-30).

An additional parameter that intermittently has a very strong influence on shareholder value is the volatility of share prices. It is included in the calculation of capital costs in form of the beta  factor (comparison of the fluctuation of a share in relation to the market as a whole). As  decreases, capital costs are reduced and the corporate value rises. Measures that can reduce the volatility of the share include:

Continuous growth in profit

Early and extensive information for stakeholders (see section 2.3)

Efficient risk management, also communicated externally

In the following, we briefly explain some of the best-known concepts related to shareholder value and compare them with one another.