Shareholder Value: What It Means and How It Is Measured

Shareholder value is what the residual claim on a business is worth to whoever holds it. A year adds to it only when the business earns more on the capital it uses than that capital costs. Sankalp Industrial Systems Limited, invented, earned 15.00 per cent on invested capital in Year 0 against a 12.00 per cent cost of capital, and the economic profit recorded for that year is Rs 36,00,00,000.

Shareholder value rests on one fact about accounting that almost nobody says out loud. Capital is not free, and a profit and loss account charges for only some of it. The money borrowed from lenders shows up as interest and is deducted in full. The money shareholders put in and left in is deducted nowhere at all. The shareholders' capital can earn less than it costs for ten years running, and the company will report a profit in every one of those years and have added nothing whatever. Every measure of shareholder value that works is a way of putting that missing charge back. Every measure that fails is a measure that leaves it out and hopes nobody checks.

What exactly is being measured when somebody says shareholder value?

The phrase is built on what a shareholder actually holds, so start there. A lender to Sankalp Industrial Systems Limited holds a contract: a fixed amount, a fixed rate, a fixed date. Whatever the business earns, the lender is entitled to that and no more, and is entitled to it before anybody else. A shareholder holds the opposite kind of thing. There is no amount, no rate and no date. A shareholder is entitled to whatever is left after everyone with a contract has been satisfied. In a good year the leftover is a great deal, and in a bad year it is nothing at all.

A claim with no amount, no rate and no date is what residual means, and the residual claim is the whole of why the phrase exists. Shareholder value is the worth of that leftover position. No line in a set of accounts reports it, so the worth is a worth and not a figure. The accounts report what happened last year. The worth of a residual position depends on what the business will do for the rest of its life. An accountant is not asked to write that down.

Think about a household that has put Rs 5,00,000 of its savings into a small shop and has also borrowed Rs 3,00,000 from a cooperative bank to fit it out. At the end of the year, the bank is paid its interest whatever the shop did. The household is paid whatever survives, and if the shop had a poor year the household is paid nothing while the bank is still paid in full. Ask the household what its stake in that shop is worth and it will not answer with last year's takings. The household will answer with something about how the shop is likely to do. The instinct is exactly right, and shareholder value is that same instinct scaled up.

Why does one phrase end up meaning two different things?

Because two quite different objects are both available and both get called by the same name. The first is a market quotation. Sankalp Industrial Systems Limited has 20,00,00,000 shares and each trades at Rs 90.00, so its market capitalisationThe whole share count multiplied by the last traded price, which describes what the market is currently charging rather than what the business is worth. is Rs 18,00,00,00,000. The market capitalisation is public, it changes every day, and it is very easy to point at. The second is a measure of what a year actually added after every provider of capital has been paid for. The second measure is not public, it takes a paragraph to explain, and it changes once a year.

Guess which one gets quoted. The phrase gets attached to the number that is easiest to reach rather than to the number that answers the question, and almost every argument conducted under the banner of shareholder value is an argument about a share price over a few months. The second object is the harder one, and it is the one the phrase was invented to name.

What does a profit and loss account charge for, and what does it quietly leave out?

Take Sankalp Industrial Systems Limited at Year 0 and walk down the reported column. Operating profit after taxEarnings from trading, taxed as though the company had borrowed nothing whatever, so the figure is unaffected by how the business is funded. for the year is Rs 1,80,00,00,000. Out of that comes the interest bill on the borrowings. After the tax relief on it, the interest costs Rs 36,00,00,000. Out of that also comes the slice of the consolidated subsidiary belonging to minority interestThe share of a fully consolidated subsidiary held by people outside the group, whose claim on that subsidiary's earnings is not the group's to keep.. The outside slice is Rs 6,00,00,000. The remainder is profit attributable to owners of Rs 1,38,00,00,000. Spread across 20,00,00,000 shares, that comes to Rs 6.90 each.

Read that walk again and notice what is missing. Interest appears because a lender sends an invoice and the law makes the company pay it. Tax appears for the same reason. The outside share of the subsidiary appears because it belongs to somebody else. The shareholders' capital appears nowhere, for the single reason that shareholders do not send an invoice. Shareholders have handed over money that could have been earning something elsewhere, they expect to be compensated for the risk of standing last in the queue, and the accounting system has no line to record either fact.

Both figures are honest and neither is a mistake. The two figures answer different questions, and the trouble starts only when one is offered as an answer to the other's question. Rs 1,38,00,00,000 answers the question a tax authority and a lender care about: what was left for the owners under the rules of accounting. Rs 36,00,00,000 answers the question the phrase was invented to ask: after every rupee of capital had been paid for at what it costs, how much did the year add.

So what is the measure for one year, and what does it say here?

The year measure has a name and it is economic profit: the earnings still standing once every source of capital has been paid the price that source demands. On Sankalp Industrial Systems Limited at Year 0, that figure is Rs 36,00,00,000. The figure is taken as a given. How it is arrived at, and the two separate routes that both land on it, are covered separately.

The one relationship a reader would want to move is the gap between what the capital earns and what it costs, and the arithmetic that converts that gap into the Rs 36,00,00,000 is covered separately, along with both of its routes.

The meaning of the figure matters as much as its size. Economic profit of Rs 36,00,00,000 means that in that year, on that capital base, the business covered the full cost of every rupee it was using and had Rs 36,00,00,000 over. The figure does not mean the shares are worth more than they were. Nor does it mean the year was a success by any other standard. And it emphatically does not mean the number will repeat. Economic profit measures one lap and nothing else.

Is there a shorter way of saying the same thing?

There is, and it fits on one line. Compare what the capital earned with what the capital cost. Sankalp earned 15.00 per cent and paid 12.00 per cent, so the gap is exactly 3.00 percentage points in its favour. The gap is what practitioners call the spread, and the spread carries the entire verdict in a single figure. Positive means the business is covering the cost of the money it uses. Zero means it is exactly breaking even against that cost. Breaking even sounds respectable and is in fact the point where growth stops being worth anything. Negative means the money is being fed into something that returns less than the money costs.

The spread and the rupee figure say the same thing at two magnifications, and each is useful for a different purpose. The spread compares businesses of wildly different sizes on one scale. The rupee figure shows how much the gap is actually worth on this particular capital base. A small spread on an enormous base can be worth far more than a wide spread on a tiny one. Neither figure retires the other.

When does growing the business create value, and when does it destroy it?

Here is the condition, stated exactly, and it is shorter than most people expect. Growth creates value when the return on the capital being put in exceeds the cost of that capital, and only then. Nothing else in the sentence matters. Not the growth rate, not the market, not how impressive the expansion looks in a results announcement. Only the sign of that one gap. Why does a condition this large compress into one line? Because three quantities that look separate turn out to be a single relationship, and Koller, Goedhart and Wessels are the ones who tied them into it.

Run it on the case. Every forecast year for Sankalp Industrial Systems Limited carries the same reinvestment, being Rs 1,00,00,00,000 of capital added on top of whatever is already there. Fresh capital is credited with an 18.00 per cent return, against the 12.00 per cent that capital costs, so each year's new money adds Rs 6,00,00,000 of value in the year it lands, and a programme twice the size would add Rs 12,00,00,000. Now imagine an otherwise identical company where new capital earns 12.00 per cent. The same Rs 1,00,00,00,000 goes in, the same revenue growth is announced, and the value added is exactly zero. Now imagine one where fresh capital earns 9.00 per cent. The same investment now subtracts Rs 3,00,00,000 a year. Three companies, one investment programme, three different answers, and the only thing that changed is a rate of return.

What is the uncomfortable part of that condition?

The uncomfortable part is that growth is not automatically good, and this is the reason the whole measure is worth the trouble of learning. Every set of results ever published presents revenue growth as an achievement. A company that grew 20 per cent puts it in the first line of the announcement. A company that grew 4 per cent explains why the market was difficult. Nobody ever leads with the return on the capital that bought the growth.

Yet a company earning less on its capital than that capital costs destroys value faster the more it grows, and the growth is the mechanism of the destruction rather than a consolation for it. Picture a household running a wedding catering business that borrows at 11 per cent to add a second kitchen, and the second kitchen turns out to earn 8 per cent. Adding one kitchen loses a little. Adding four kitchens loses four times as much, and every one of those four openings can be announced as expansion. The announcements are true. The announcements are simply not evidence of value creation, and value creation is what they are offered as evidence of.

What is the assumption holding all of this up?

Every worked case has one input doing more work than the rest, and in this one it is easy to name. In the forecast for Sankalp Industrial Systems Limited, freshly installed capital is credited with an 18.00 per cent return. Capital that has been in place for years is credited with 15.00 per cent. The three point difference is an assumption. Nothing in the record establishes it, no evidence anywhere shows the new capacity to be better than the old, and an account that quotes the 18.00 per cent without saying so has turned somebody's choice into a fact.

Stated properly, the claim becomes far easier to argue with, so it is worth seeing precisely what is being claimed. Start from a fact that closes off one explanation straight away: the operating profit margin in this forecast never moves. The margin sits at 15.00 per cent of revenue for the base that is already there and for every rupee added afterwards. Whatever the three point difference is, a margin story is not available. Set the two side by side and what is left is arithmetic about the workload each rupee of capital is being asked to carry.

Read that way, the difference says nothing about profitability at all: it says every new rupee is expected to be worked a fifth harder than the rupees already there. The base supports revenue rupee for rupee. Fresh capital is asked to support a fifth more than it costs to install, and the flat margin then does the rest of the arithmetic on its own.

Say it that way and a reader has something they can actually argue with. Asking whether new capacity will be more profitable is a vague question nobody can settle. Asking whether a fresh Rs 1,00,00,00,000 of plant and working cycle will really carry Rs 1,20,00,00,000 of sales, when what is already installed carries only rupee for rupee, is a concrete question an operations manager could answer in an afternoon. The assumption also does visible work over the forecast: by Year 5 invested capital has risen to Rs 17,00,00,00,000 and operating profit after tax to Rs 2,70,00,00,000, so the return on invested capital has drifted up to 15.88 per cent purely because the newer, faster capital is a larger share of the mix.

How is any of this measured over a stretch of time rather than one year?

Now change the question. Instead of asking what a year added, ask what a holder of the residual claim actually received over some longer stretch. The period measure is a different object with a different construction, and confusing the two is responsible for a large share of the muddle around this phrase.

Over a period, what a shareholder received has two parts and only two. The first is the cash that was handed over, the dividends. The second is the change in what the claim itself is worth between the start of the period and the end of it. Added together, they are the full account of the position. The year measure asks what the business added; the period measure asks what the holder got, and a business can do well in a year during which a holder received nothing whatever.

Only the first of those two parts is on the record here. Sankalp Industrial Systems Limited declared Rs 3.60 a share in Year 0. Across 20,00,00,000 shares, that is Rs 72,00,00,000 handed over. The second part is not recorded anywhere in this case. Pricing a claim at the opening of a stretch and again at the close of it needs machinery covered separately, and the distance between what something is worth and what it last changed hands for is a subject in its own right.

Which dividend does a yield use, and does the choice matter?

The choice matters more than most people expect, and on this company the size of the difference is easy to see. The Rs 3.60 a share paid in Year 0 was not one payment but two, together worth Rs 72,00,00,000, of which Rs 52,00,00,000 was the repeating part and Rs 20,00,00,000 was not. The repeating part was a regular dividendA payment the board sets expecting to repeat, and expecting to be asked about it if it ever falls. of Rs 2.60, the continuation of a run that has risen every year. The rest was a special dividendDeclared on its own, and labelled that way precisely so that nobody reads a promise into next year. of Rs 1.00, which arrived once and carries no commitment to anything.

At the Rs 90.00 share price, the regular dividend alone is a yield of 2.89 per cent. The total including the special one is a yield of exactly 4.00 per cent. Both are arithmetically correct and they are more than a full percentage point apart. A yield quoted without saying which dividend it used is not a comparable figure, and on this company the choice moves the answer by more than a point. The same split runs through the payout ratio, meaning the dividend measured against the profit attributable to owners for the same year: the regular dividend is 37.68 per cent of the profit attributable to owners and the total is 52.17 per cent, which are two very different pictures of the same board's policy.

Which three figures get offered as shareholder value and are not?

Three measures do most of the damage, and each is offered in good faith by people who would be embarrassed to be told what it leaves out. Each fails for its own reason, and the reasons are not interchangeable, so the three are worth taking one at a time.

One, earnings per share

Earnings per share carries a denominator, and a denominator can be changed without anybody touching the business. Sankalp Industrial Systems Limited did exactly that once. At the end of an earlier year it ran a buybackA company spending cash to take its own shares off the market and cancel them, leaving fewer behind., spending Rs 60,00,00,000 to buy 75,00,000 shares at Rs 80.00 and taking the count from 20,75,00,000 down to 20,00,00,000. Set Year 0 profit of Rs 1,38,00,00,000 against the two share counts and the earnings per share is Rs 6.90 rather than Rs 6.6506. The rise is exactly 3.75 per cent, because the share counts are in exactly that ratio.

But the Rs 60,00,00,000 did not evaporate. The cash was spent, and before it was spent it was earning something. Put that back and the honest comparison is against Rs 6.7807 rather than Rs 6.6506, and the rise is 1.76 per cent rather than 3.75 per cent. The figure a company would print is more than double the figure that survives the obvious correction, and neither figure is a measure of value in any case. The full arithmetic behind that pair, and where the break-even sits, is set out elsewhere; what belongs here is only the principle that a company can lift earnings per share while destroying value, and that the lift is arithmetic about a denominator.

Two, accretion in a transaction

Accretion is worse. The figure can change sign without anything at all changing about the business. Mahasagar Industrial Group Limited, invented, is a possible buyer of Sankalp Industrial Systems Limited at Rs 115.00 a share. Funded entirely with new shares, that deal is 3.74 per cent accretiveA rise in earnings per share that a deal produces, set against what the buyer would have reported on its own.. Funded entirely with borrowing, for the identical company at the identical price on one day, it is 1.73 per cent dilutive. The two figures are locked in the case record and the arithmetic producing them is set out elsewhere; what matters here is that they exist as a pair.

Two identical businesses, one identical price, opposite verdicts. Nothing about what the combined company would earn from customers differs between the two versions. The only thing that differs is how the cheque was funded, and a measure that reverses on the funding of a cheque is not measuring the worth of a deal.

Three, a rising share price over a few months

The third is the most used and the easiest to dispose of. A share price records what somebody was willing to pay on a particular afternoon. A traded price is a real and useful fact, and it is a different object from the worth of the residual claim. The distinction between the two is important enough to be a subject of its own and is set out separately. Here it is enough to say that a price over a few months is a record of transactions and not a measurement of a business.

Who decides whether value was created, and over what stretch of time?

The choice of period is the part that turns a decent measure into a phrase capable of meaning almost anything, and the arithmetic plays no part in it whatever. Value created is always measured across some period. Somebody has to choose that period. Whoever chooses it has already gone a long way towards choosing the answer.

A year in which Rs 36,00,00,000 of economic profit was earned can sit comfortably inside a decade in which almost none was. A decade of steady value creation can contain three miserable years, and a critic who selects those three has said nothing false. Neither selection is a lie and both are useless on their own. The measure is not wrong; it is incomplete until the period travels in the same sentence, every single time.

Naming the measure and naming the period are therefore the entire defence. A measure without a period is unfalsifiable. Any inconvenient result can be answered by moving the window. A measure with a period stated is something two people can disagree about productively. At least the two are arguing about the same thing.

How does a lender, an analyst or a household actually use this?

The measure earns its keep in different ways depending on who is holding it, and none of those ways involves quoting the phrase at anybody.

A lender uses it as an early warning about the drift that eventually threatens repayment. A lender is not paid out of value creation, and a company earning below its cost of capital can service a loan perfectly well for years. But a business persistently earning less on its capital than the capital costs is a business that will keep needing money, and a borrower that keeps needing money is a borrower whose capital structure is drifting in one direction. Sankalp Industrial Systems Limited has a 3.00 point positive gap and a growth plan funded partly by borrowing, and the useful question for a lender is not whether the gap is positive today but whether the 18.00 per cent assumption on new capital is one the borrower can stand behind.

An analyst uses it to decide which parts of a growth story deserve credit. When a company announces an expansion, the announcement is about revenue. The measure converts that into a question about capital: how much is going in, what is it expected to return, and how does that compare with the cost. On this company the answer is checkable in a line. Rs 1,00,00,00,000 a year goes in, it is assumed to return 18.00 per cent, capital costs 12.00 per cent, so the programme adds Rs 6,00,00,000 a year on the forecast's own assumptions. Change that 18.00 to 9.00 and the same announcement is describing a programme that subtracts Rs 3,00,00,000 a year.

A household with a stake in a small business uses the same test without any of the vocabulary. Somebody weighing whether to put another Rs 2,00,000 into a shop asks two questions: what will the extra money bring in, and what is the money costing, whether that is loan interest or the deposit return being given up. If the first is bigger, the expansion is worth doing. If not, the shop can double its takings and the household will still be worse off. The comparison is the entire idea, and shareholder value is that comparison scaled up and given a vocabulary.

One thing none of these three does is use the measure to reach a verdict on a company. The gap says what a year did against what capital cost. The gap does not say whether the shares are worth holding, whether the price is sensible, or what anybody should do. Each of those is a separate question with separate machinery, and the measure is silent on all of them.

Sankalp Industrial Systems Limited and Mahasagar Industrial Group Limited are invented.
Educational material. Not advice on any investment, tax, budget or market position.