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…
Hello world!
Acum 3 săptămâni
Postări
2 comentarii:
I think shareholders can ask for whatever return they want. It's business, not ethics. Is it sustainable to ask for a 10% ROE? As Bokros would put it, the answer is "It depends". Assuming we are calculating the cost of equity through the CAPM method, the formula is: Ke = Rf + Beta x Market Risk Premium (or Equity Risk Premium). To this formula you can add a company size premium and a country risk premium. And here begins the it depends part. It depends on how you choose the risk free rate and here you have to choose a bond with AAA rating and after you choose the bond (Germany, US, Japan, etc) which have different yields and depend also on the maturity period you also have to choose (e.g. 3,5,10,20,30 years, etc). When you're done you go to the Beta, which is very volatile, can change from one day to another and depends on the stock market index against which it is calculated. This Beta is ok for a listed company, but if you want to calculate the Ke for a non listed company you have to choose the average Beta of peers that are listed, then apply the Blume adjustment to unleverage this Beta. The Beta resulted, or the Asset Beta can now be used to determine Ke for a non listed company. Now, the MRP. The easiest way to calculate the MRP is to get it from Ibbotson yearbook, then apply a 1.5 adjustment and voila. However, as you said this is more like an "average" MRP that does not take into consideration the current economic climate. That's why, from a theoretical point of view the Ke is an estimation and the "correct" Ke value is more like an art than a fixed science looking just on how many choices you have to make.
From a practical point of view, it depends on the company, on the country, on the industry, on the economic climate. If a company has the potential to increase it's sales by 20% it is fair to ask for a 10% ROE. If the industry the company operates in can rise by 10% and 30% of that rise will go to the company I'm investing in, I am "entitled" to ask for 10% ROE. However, this cannot happen each year. Sometimes the growth slows down or the company goes in reverse. The problem is that stakeholders want to get their money as soon as possible and much as possible. The notion of "tomorrow" in this context is rather unknown.
The discussion can be developed in a countless number of ways (add for example the financing options for a company, as in - if you can't afford financing through equity, finance yourself through debt) and that's why I'm not going to continue, as I cannot cover all there is to it.
I must say I'm surprised to read your post. I never imagined you like such intricate economic details. :D
Hi Alex!
Indeed, shareholders can ask for whatever return they want – I do not question that. They can ask for a 200% return on their investment… but which company would be able to pay so much? And for a higher return they will need to bear a higher risk otherwise they would be cashing in on “free” returns (a situation which, as we know does not last long on the market). Therefore “asking” for a rate of return is merely assessing the expected payoff and the risks involved in the investment and deciding whether, for you, it is worth it or not. Now, I know the CAPM offers a vague benchmark, but it seems to be the best we have so far…and even if we change the beta, or we adjust for other risks, we should end up with a value which is in the same range as the approximation we would get without refining CAPM. What I mean by this is that you would clearly not invest in a project/company that earns around 10% if your required return is closer to 20%... that is enough for you to know and you won’t investigate more to see if it should earn 9% or 11% according to its riskiness.
The question that I wanted to raise in my post is basically what you said as well: “is it sustainable”? Because apparently, the result of such seemingly high ROE targets leads the companies to undertake acquisitions to artificially increase the level of their revenues without actually adding value on the long term. You end up with conglomerates and a diversification which eats up into the core business’ profits – which is in fact worse for shareholders on the long term. Especially since it is increasingly difficult for companies to alter their capital structure in times of crisis, when leverage becomes dangerous and access to credit is limited and more expensive. As a result, many companies are forced to fund most of their project through equity or to forego some growth opportunities and focus only on the ones which have the higher returns.
Thank you for your extensive reply. I think you do have a point, that there is no cap on the return that shareholders can ask… but capital market is still a market and demand must meet supply. Shareholders can ask for 200% returns but if there are no projects/companies out there that can offer that return, they will have to adapt to what is offered on the market. So does this mean that we can say shareholders ask too much? I honestly don’t know, but I think it is an interesting question…
Also, when the market performance of companies is shifting up/down during a period, let’s say 1 year, the expectations of all shareholders on the market will also shift, requiring a higher/lower return compared to previous years. Then, shouldn’t a benchmark for the required return on equity take this fluctuating factor into consideration as well? Just some questions which will probably remain unanswered.
PS. I became much more interested in all these things since I study corporate finance.. I must say I think it’s a very challenging and interesting field, at the core of everything that is business and strategy. I’m glad you liked the post :)
Trimiteți un comentariu