UK: Out with earnings per share, in with shareholder value. (1 of 3)

UK: Out with earnings per share, in with shareholder value. (1 of 3) - Helen Kay looks at the current trend for measuring a company on its assets rather than its earnings.

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Last Updated: 31 Aug 2010

Helen Kay looks at the current trend for measuring a company on its assets rather than its earnings.

Five years ago if you wanted your company to look good to the City you would borrow heavily to fuel corporate growth and drive up earnings per share. Then you would have a rights issue to get more money for more growth, which would in turn hike up the earnings per share previously diluted by the rights issue. It was a simple equation: more borrowing equals more growth equals more earnings. And the City would love you. Or so the theory went.

These days any chief executive would do better to recall the advice of Mark Twain: "There are only two times in a man's life when he should not speculate: when he can't afford it, and when he can." The fallen colossi of Next and Burton, the struggling Saatchis and the death throes of Polly Peck are all evidence of this obsession with EPS. All right, so you may not end up in the Marshalsea, but you will have to part with the period furniture and private art collection. Even this will hardly placate the shareholders who have lost their shirts on your stock.

Given the salutory lessons of the past few years, it is no wonder that the shareholder's voice has gradually been getting louder. Fund managers have started to wield their clout. Indeed, Sir Ralph Halpern's hasty departure from Burton is unofficially attributed to institutional investors' unease. Now the shareholder on the Clapham omnibus has suddenly been elevated to unprecedented heights, for the new news on the corporate circuit is shareholder value.

Actually it is old news. The idea originated with the 19th century stock market, which was set up to pool the risk of many thousands of individual investors. But shareholder value got a major facelift in the early 1980s, when American academic Alfred Rappaport first began to make a splash in the Harvard Business Review. His book "Creating Shareholder Value", published in 1986, is now the acknowledged gospel on shareholder value analysis, or SVA to initiates.

Rappaport argues that a company's "true" value is the discounted value of its future cash flows. A dollar today is worth more than a dollar tomorrow, so future cash flows are discounted to allow for that reduced benefit. In the same vein, a high risk investment offers a more uncertain future cash flow, so the value of that future cash flow is more heavily discounted. The discount rate itself is a complex calculation based on the cost of capital, the level of risk and the interest rate.

Rappaport's approach is significant for shifting the focus from earnings to assets. For a shareholder, created value is thus the increase in shareholder funds between the purchase and sale of his stock, together with the dividends paid in the interim. For the City it is the sum of the dividends and the difference in stock price between those dates (itself a reflection of the increase in assets).

But was EPS growth not supposed to boost share prices? So is this the same old formula dressed in a different wrapping? No, argues Rappaport, EPS has little relation to the market value of a company's shares and is, besides, a dubious financial standard by which to evaluate corporate strategy. In fact a company can increase its earnings at the expense of shareholder value.

Suppose, for example, that in 1981 the White Elephant Group acquired a company in order to reduce dependence on its core business. The total net investment in the subsidiary can be determined by discounting the original investment, together with incremental cash flows, over the appropriate number of years. But unless the net present value of the company (established by discounting future cash flows), together with dividends paid to the parent, matches the total net investment, then the parent has actually destroyed shareholder value. In short, though it has increased earnings, the shareholders would have been better off if they had simply been given the cash.

Contrast this with SVA, which, Rappaport claims, helps to trace which businesses within a group are dragging down its share price, and how to choose between strategies for maximising value. SVA, the argument goes, not only identifies the shortfall between a company's share price and true value; it also enables senior management to close that gap.

In fact SVA is not just a product of the academic stratosphere. Liberating value, it could be said, is the province of the stock market predator. As early as 1985 T Boone Pickens was justifying his role as corporate raider on the ground that "it is the stockholders who own companies, not managements, and the stockholders are just beginning to realise it". So, in recognising, and redressing, the gap between share price and value, Lord Hanson and his ilk have fulfilled a worthy social function - and made their pile.

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