Five simple steps to create and manage shareholder value

Identify what makes your business valuable, then manage to create consistent growth

SARIT CHOKCHAINIRAND

Some great companies are overlooked because analysts don’t understand them.

Ideally, the main objective in managing a public company should be to "maximise shareholder value". I assume most top management of public companies understand and know that in order to "create and/or maximise shareholder value", a company needs to consistently generate return, e.g. TSR, that are greater than company's required rate of return. However, many times and in many cases, top management do not understand that it is within their power to manage this value.

In his article, Alexander Wood has emphasised the importance of Investor Relations -  communicating well with the capital market in order to achieve in "fair value". Apart of this, there are two other components that top management can influence in order to create and manage shareholder value.

First, management should focus on its asset strategy, because the engine of value creation at the company is its asset and investment strategy. Leaders should focus around the company's core skills and competitive advantages and where these can be used in areas with significant value growth potential.

Second, management can manage value through financial strategy. Financial resources should be directed to and aligned with strategic focus of the company. However, in many circumstances, financial resources are directed to a project that does not support company's strategy and/or create value to the firm. Poor financing decisions can hold back shareholder value growth through lack of capital, high transactions costs, etc.

These three components -  asset strategy, financing decision, and investor relations -  are key components to manage and create shareholder value.

How can top management effectively utilise and align these components to maximise shareholder value? I have extracted five simple steps to help management create and manage shareholder value as follows:

1. Identify the value of the firm and understand what drives value for a particular company. Numerous times I have been in discussions with CEOs and CFOs of public companies and have been surprised to find that they are unsure of the truth worth of their company. Many executives simply look at the company's P/E and compare this with peers and in this way ascertain if their company is "fairly valued". However, it is fundamental that to understand and manage a firm's value, management must know the value of the firm and the factors that drive it. Each company should have a simple discounted cash flow model that is regularly updated and analysed by the finance department, and then is reported on a regular basis.

Once the company has a reliable financial model in place, management should conduct a sensitivity analysis to assess the impact on value generated by each item in the cash flow model. Identifying and understanding these items will help management determine value drivers, which should then be prioritised in terms of monitoring and improvement in order to understand and validate the company's share price.

2. Develop a corporate strategy designed to create shareholder value. Once the management is cognisant of the value of the firm and understands from what the value is derived, the next step is to consider ways in which they can enhance the firm's value. Beginning with developing a corporate strategy, management could hire a strategic or management consulting firm to help identify a value creation strategy or it could utilise a variety of management tools to develop strategy internally.

Regardless of the approach used to develop a strategy, it is vital that the new strategy is quantified and incorporated into the financial model in order to determine its impact on the company's value. This will help management anticipate the effect on its share price once the strategy is implemented and aid in making the decision whether or not to introduce this new strategy: i.e., is it essential to the improvement of the company's value or does it help create or conversely, actually harm the firm's value? In many cases, management unintentionally destroys value of a company when it implements a new strategy that does not complement its core competency and existing customer base.

3. Align the strategy with the firm's operations. A great strategy is a flop if it cannot be implemented. It is, therefore, critical that management takes time and makes the effort to translate the new strategy and properly align it at the different levels within the firm's operations. Firstly, the objectives and key performance indicators should be set for each business function based on this new strategy. Then all the projects, funding and resources should be allocated and prioritised accordingly in order to achieve the target. There are various tools, one of which is the "Balanced Scorecard", that can help align and translate the strategy to best mesh with company operations during implementation.

4. Link the value with management's performance and incentive compensation. To motivate management to create shareholder value, it is important to link management's performance and incentives to the firm's value and its drivers. A company's compensation scheme should attract, motivate and retain high-performing personnel. A good compensation scheme is easier said than done, but it should meet at a minimum three objectives:

 - Align interest: give managers an incentive to choose strategies and investments that maximise shareholder value;

 - Leverage commitment: use incentive to foster management commitments e.g. work long hours or take risks;

 - Retention: give sufficient compensation during periods of poor performance arising out of factors that cannot be controlled.

5. Communicate your value to the investment community. Last but not least, to best manage value, management must communicate to the investment community on a regular basis and provide consistent information through all communication channels and to all targets. Many great companies with good performance sometimes are undervalued and under-covered because the financial community does not fully understand them and their strategies. Many also avoid giving out bad news by not communicating at all when things turn down. They fail to realise that the very act of shutting out the market tells the market they are doing poorly -  and may in fact actually magnify the problems in the eyes of the market.

Thus, to grow value, management needs to ensure it has good investor relations and that it always sends out correct and honest messages to the financial community and that it maintains a high standard of corporate governance.

These five simple steps are probably not completely new ideas, as many, if not most manager, are already aware of some if not all of these simple steps that will aid them in creating and managing shareholder value. At the same time, even prestigious companies with good business performance are unable to execute all five steps because some do not understand their firm's value, some have not incorporated a value creation strategy, some fail to align their strategies with function KPIs, some do not have a compensation system that awards or penalises management with respect to the firm's value creation, and some do not sufficiently and consistently communicate their value creation and growth strategies to the financial community.

All of these oversights lead to a gap between a company's fair value and market value. If a company will then adopt these five simple steps, it will be able to embark on the road to creating, managing and sustaining its TSR for the long run.

Sarit Chokchainirand is a Director of two strategy consulting firms: Effinity and Op8. He has consulting experience with public companies and government agencies for more than eight years. He can be contacted at sarit@pyi.co.th and sarit@effinity.co.th