《金融时报》：我们究竟何为股东价值

As an investor you will probably have encountered two terms which have the word “shareholder” in common: shareholder value and activist shareholder.

Just before the end of last year we were contacted by an activist investor who has a stake in one of our portfolio companies to discuss a set of proposals. They basically amounted to a demand that the company should seek to sell itself to one of its competitors to “create additional shareholder value”.

This set me thinking again about the nature of shareholder value, and indeed activism. In this and a subsequent article, I’ll attempt to explain what I think these terms really mean and how they fit into the world of investment.

Company managers, fund managers and activists investors often say they are committed to generating or releasing shareholder value without ever spelling out precisely what that means. For me, it is simply determining whether or not a company is creating additional wealth for its ultimate owners, and whether its managers are acting appropriately to achieve this. I’m not sure this is everyone’s definition, though. Latterly I have come to wonder whether this concept has come to be misused, like so many others in finance.

Put simply, my definition of value creation is when a company delivers returns that are above the cost of the capital used to generate them. Companies are in essence just like us. If you borrow money at a cost of 10 per cent a year and invest it at a return of 5 per cent a year you will become poorer. If you invest it at a return of 20 per cent a year you will become richer.

Similarly, companies which consistently make returns above their cost of capital become more valuable and vice versa. A company that can sustain a return on capital above its cost of capital creates value for its shareholders, who should want it to retain at least part of its profits to reinvest at these attractive rates of return rather than handing them all over as dividends or using them to buy back shares.

Determining what the cost of capital is for a company is rather more difficult. If you borrow money at a cost of 10 per cent in order to invest, then your cost of capital is fairly clear. A company’s cost of debt capital is equally clear and can often be found in, or calculated from, the notes to its accounts. But what about the cost of its equity?

The commonest way of estimating this uses the so-called capital asset pricing model, often snappily known as “Cap-M” after its acronym. This defines the cost of equity capital as a risk-free rate, usually taken as the yield on government bonds in the same currency as the company, plus a risk premium. This premium is observed over time from the actual return that equities deliver relative to the bonds that form the risk-free rate.

If I haven’t lost your attention with that last paragraph, I’d be amazed. And therein lies one of the problems: a company’s cost of capital is not easy to define and can only ever be an estimate. These problems have been compounded more recently because of the financial crisis. This has led some investors to query whether government bonds are truly risk-free, while ultra-low official interest rates, quantitative easing and a lack of inflation have sent bond yields down to record lows and even into negative territory.

Perhaps because cost of capital is not straightforward to define or compute, the most commonly accepted means of measuring value creation is growth in earnings per share (EPS), which is just the profits net of tax divided by the number of shares in issue. What could be simpler to calculate? Not much — which is probably why so much importance is attached to this simplistic measure of performance and its related valuation metric, the price/earnings ratio. Look through any analyst’s research and you’ll find dozens of references to them, often on the front page.

Simple they may be, but EPS and p/e ratios suffer from some serious flaws. The most important is that they take no account of the capital employed or the returns made on it. As the Tesco example shows, it is perfectly possible for a company to generate rising EPS at the same time as it is employing increasing amounts of capital at falling and inadequate rates of return. In other words a company can be busy destroying shareholder value even as it increases its earnings.

So I’m sticking with Roce as my preferred measure of value creation. But of course neither Roce nor EPS is the same as making the share price go up. This, I suspect, is an even more common definition of shareholder value creation, especially among activist investors — of which more in the next column.

Terry Smith

Financial Times