What Is Shareholder Value?

Shareholder value is the value delivered to the equity owners of a corporation, thanks to management’s ability to increase sales, earnings, and free cash flow, which leads to an increase in dividends and capital gains for shareholders.

A company’s shareholder value depends on strategic decisions that its board of directors and senior management make, including the ability to make wise investments and generate a healthy return on invested capital. If this value is created, particularly over the long term, then the share price increases and the company can pay larger cash dividends to shareholders. Mergers, in particular, tend to cause a large increase in shareholder value.

Understanding Shareholder Value

Increasing shareholder value also increases the total amount in the stockholders’ equity section of the balance sheet. The balance sheet formula is:

• Assets, minus liabilities, equal stockholders’ equity.
• Stockholders’ equity includes retained earnings, or the sum of a company’s net income, minus cash dividends since inception.

How Asset Use Drives Value

Companies raise capital to buy assets and use those assets to generate sales or invest in new projects while expecting a positive return. A well-managed company maximizes the use of its assets so that the firm can operate with a smaller investment in assets.

Assume, for example, that a plumbing company uses a truck and equipment to complete residential work, and the total cost of these assets is $50,000. The more sales the plumbing firm can generate using the truck and the equipment, the more shareholder value the business creates. Valuable companies are those that can increase earnings with the same dollar amount of assets.

Instances When Cash Flow Raises Value

Generating sufficient cash inflows to operate the business is also an important indicator of shareholder value, because the company can operate and increase sales without the need to borrow money or issue more stock. Firms can increase cash flow by quickly converting inventory and accounts receivable into cash collections.

The rate of cash collection is measured by turnover ratios; companies attempt to increase sales without the need to carry more inventory or increase the average dollar amount of receivables. A high rate of both inventory turnover and accounts-receivable turnover increases shareholder value.

Factoring in Earnings Per Share

If management makes decisions that increase net income each year, the company can either pay a larger cash dividend or retain earnings for use in the business. A company’s earnings per share (EPS) is defined as earnings available to common shareholders, divided by common stock shares outstanding; the ratio is a key indicator of a firm’s shareholder value. When a company can increase earnings, the ratio increases and investors view the company as more valuable.

What Is the Shareholder Value Maximization Myth?

It is commonly understood that corporate directors and management have a duty to maximize shareholder value, especially for publicly traded companies. However, legal rulings suggest that this commonly held belief is, in fact, a myth: There is actually no legal duty to maximize profits while managing a corporation.

The idea can be traced in large part to the oversize effects of a single outdated and widely misunderstood ruling by the Michigan Supreme Court in its 1919 decision in Dodge v. Ford Motor Co., which was about the legal duty of a controlling majority shareholder with respect to a minority shareholder and not about maximizing shareholder value. Legal and organizational scholars, such as Cornell University law professor Lynn A. Stout and Paris’ Sciences Po Law School professor Jean-Philippe Robé, who is a member of the bar in Paris and New York, have elaborated on this misconception.

The Bottom Line

A company’s shareholder value depends on strategic decisions made by its board of directors and senior management, including the ability to make sound investments and generate a robust return on invested capital. If this value is created, particularly over the long term, then the share price increases and the company can pay larger cash dividends to shareholders. Mergers, in particular, tend to cause a substantial increase in shareholder value.

Shareholder value can become a hot-button issue for corporations, as the creation of wealth for shareholders does not always or equally translate to value for the corporation’s employees or customers.