A large number of UK and Irish companies are failing to deliver the cash returns needed to fulfil the expectations created by rising share prices, according to a recent survey conducted by management consulting firm, PA Consulting Group. The analysis revealed, however, that shares in many of these 'low-return' companies continue for a while to trade on the stockmarket at a significant premium to book value, disguising their poor performance to investors, riding on the expectation that their return on equity will improve dramatically.
"If companies continue to fail to deliver returns, investors will become increasingly vocal, which will become a major concern to the management of these low-return companies," warned PA’s Steve Frobisher. According to PA, these dangers can be avoided - a large number of organisations are simply not realising their potential. "By focusing on the activities required for managing shareholder value, these companies can substantially improve their performance," said Mr Frobisher.
PA’s analysis shows a striking correlation between share-price performance and adopting an approach aimed specifically at improving shareholder value (Managing for Shareholder Value, or MSV). The survey shows a remarkable difference in performance between companies which adopt the MSV approach and those which told PA they disagreed with the approach. Over ten years, £100 invested in a company which disagreed would be worth £339; in an MSV company, it would be worth £673 - almost twice as much.
A difference of this scale will be clearly visible to investors and competitors of these companies, so there is a clear risk of shareholder pressure (or even revolt), or hostile takeover - in either case leading to changes in management. For these reasons, senior managers cannot afford to ignore these findings.
The contentious issue of executive remuneration also provides striking evidence for the power of MSV. PA’s analysis linked executive compensation to share-price performance and showed that those organisations who paid bonuses based on the delivery of shareholder value performed dramatically better than those who did not. "Companies must consider what they require from their senior executives in terms of returns and gear their compensation to reflect this," said Mr Frobisher
However, although the approach has its admirers, PA’s experience with MSV initiatives is that delivery is the real challenge. "Despite the fact that 95% of those who participated in the research agreed with the statement ‘The key objective of our senior management is to manage for shareholder value’, many organisations are too busy working out how to measure shareholder value rather than focusing on delivering it," said Mr Frobisher.
The survey report draws on the findings and PA’s experience in designing and implementing MSV initiatives to recommend a three-stage approach:
- Commit to MSV - don’t just talk about it. The vast majority of firms subscribe to the MSV philosophy, but a smaller number had put it into practice, installing the appropriate business processes. Those that used the approach in its entirety have on average enjoyed returns 27% higher over three years than those only paying the approach lip-service.
- Go for the 'quick-hit' areas first. By reviewing companies’ responses - and comparing those responses to levels of shareholder return achieved - PA has identified two quick-hit areas. First, compensation, where PA recommends that organisations create a compensation scheme specifically structured to give strong incentives to managers to create shareholder value. Second, business planning, where firms install a business planning process based on the concept of optimising the allocation of capital to different business units (and allocating strategic missions to each unit based on its ability to deliver sustainable returns above the cost of capital).
The report also identifies a third area - financial policies and processes - although the evidence from companies that have focused on it is conflicting. PA recommends adopting financial policies designed to maximise shareholder value. In particular, targeting an optimum debt-to-equity ratio; using excess cash to repurchase shares; and where that is not possible, paying out any cash which cannot be reinvested at the cost of equity to investors.
- Implement a systematic roll-out of MSV in its entirety. The results of the survey imply that companies need to have their MSV principles agreed; management processes embedded; and all actions and decisions monitored to ensure they are consistent with the original aims. The firm would begin by agreeing on its principles, asking such questions as: "What’s our cost of equity?" and "How do we allocate equity to Divisions or SBUs?"
PA believes that this approach will combat the dangers of poor shareholder returns - turmoil, hostile raiders or displeased shareholders, and management turnover. "Companies can avoid these situations if they take the steps to reorientate their company to shareholder value," said Mr Frobisher.
The MSV survey was issued to the Chairmen, Chief Executives and Finance Directors of the FTSE 500 and ISEQ Top 40. For each responding company, the shareholder returns that the company had achieved in the past three years were compared against the company’s responses.
