Shareholder value

Today’s ‘Strategy and Financial Policy’ class raised an interesting point regarding strategy and shareholder value creation. Over the 2000-2005 period while the world economy grew at about 3%, shareholders had set unrealistically high targets of, on average, 6% revenues growth and 12% earnings growth for their companies. Empirically, a study conducted by Bain & Co looking at 1,854 companies over the last 10 years finds that only 240 of them (13%!) actually managed to earn their cost of capital. Does this mean that the shareholders were over-demanding, or simply that the companies were bad?...

To answer this question, I would analyze the reasons that make us believe that shareholders might be asking too much of these companies. This issue is especially important nowadays, in a period of crisis, where shareholder demands put more pressure on companies to seek short-term, external growth through M&A rather than sustainable organic growth. At first glance, what strikes me is that shareholders set a target of 12% increase in earnings whereas they only demand a 6% increase in sales. This would mean that about half of the growth in profits should come from cost reductions and improved efficiency! This is obviously not sustainable over the longer term, especially if we look at the fact that the 6% growth target for sales is very ambitious as well (double that of the market).

However, this is not the main problem. The biggest question here is whether the shareholders are entitled to ask for a 12% return given the riskiness of the company’s activity or they are just setting an unrealistically high target. As we know, shareholders have the right to ask for the CAPM rate of return, which is basically the risk-free rate + the market risk premium adjusted for the riskiness of the company. Now, when we calculate the risk premium we basically look at the average return on the S&P over a very long period of time (ex 1926-2006) but in this way we dilute the impact of economic shocks, such as periods of crisis… whereas now we are precisely in such a period. Thus it becomes questionable whether the risk premium we should use during crisis should be the same, because when all markets collapse, demand falls and uncertainty rises we cannot expect the companies to earn the same returns as they did two or three years ago. If indeed the shareholders set their expectations according to the CAPM rate of return, then these might indeed be unrealistic and become a too high target for the company in the current conditions. It is very likely that this is what was also happening in the 2000/2001 crisis… and this is perhaps why many companies did not manage to meet their targets and earn the required return on equity capital after servicing their debt. This is in fact saying that the companies are not bad, but that, indeed, shareholders probably asked for a too high rate of return. How the shareholders should react is by adjusting their demands to more reasonable levels: seeing that only 13% of the companies were able to earn their cost of capital should send a clear signal to investors that they should lower their targets. All companies cannot be bad performers, and it is more likely that shareholder expectations lag behind new market developments.
I would say this situation is reinforced by the company’s managers as well. Even though it’s the shareholders, through their power to change the CEO, that decide on the revenue and earnings targets that the company should achieve, managers have an incentive to show a growth in earnings and profits as well. This is mainly because analysts and investors tend to look less at the company’s performance in that year in isolation or as compared to the competitors, than they do as a comparison to the previous years’ performance. Thus managers have a pressure to provide every year higher earnings (or at the very least, show no losses), be it through M&A or simply through questionable accounting practices such as earnings management.

However, what should be the appropriate return for the risk incurred in this case by the shareholders, and how the market risk premium should be assessed during a crisis period, remains an open question…