Introduction
Within the first blog, we looked at shareholder wealth
maximization (SWM) and the feasibility of this goal being used as a main
corporate objective. We concluded that a conflict of interest between
maximizing shareholder wealth in the long term and maximizing profits in the
short term could distort the long-term value of a company. In order to
implement SWM as an objective, managers must measure SWM effectively (Arnold,
2013). Within this blog, we consider the most common and increasingly
old-fashioned measures of SWM and
evaluate the success and implications of each.
EPS
and ROCE
It is commonly stated that earnings per share
(EPS), is a managers most preferred measure for business performance (Cheng et.
al., 2011; Financial Times, 1996; Dodge, 1991) and similarly, return on capital
employed (ROCE) is a major financial ratio used by financial analysts (Robin,
2010). According to Watson & Head
(2013), an increase in EPS typically refers to an increase in share price
in addition to ROCE being renowned as one of the most important measures for in
investment decision-making.
However, there are explanations to why some
investors find both measures misleading:
Firstly, both measures can be easily manipulated
(Arnold, 2013; Watson & Head, 2010; Koller et.al., 2005). Evidence
of this derives from Kim & Yang
(2010) study where 50% of S&P 500 firms use EPS to correspond
with incentive schemes. Within my previous blog, we discussed profit
maximization as a corporate objective and how managers manipulate figures to
enhance financial performance. Likewise, to improve earnings performance,
self-interest managers may manipulate the accounts for short-term gains. A
classic example of this again stems from the company Enron, where the board of
directors stated in their 2000 annual report that “growth in earnings and
earnings-per-share was to be the firm's paramount goal” (Stewart, 2006).
Relating back to my first blog, Do Corporate Objectives Conflict? we
can argue that EPS as a measure links to Agency theory and coincides with the
clash between short term profit maximization and SWM.
Case
Study: Tesco
A second topical example relates to the
supermarket chain Tesco. In order to maximize short-term profit it is alleged
that £250m of supplier rebates were included in the accounts, which technically
were inadmissible.
(Figure
1)
Note: Image from Google Finance (2014). Retrieved Jan 2015 from http://www.google.co.uk/finance
The consequences have been dire with a major
downward realignment of the Tesco share price (Figure 1) and in this extreme example, the Serious Fraud Office
have become involved (BBC, 2014). It is fair to say that ROCE also has its
critics as like EPS, the usage of accountancy data rather than cash flows
exposes both metrics to manipulation.
Secondly, EPS fails to take investment and
risk into consideration. To consider this, it is best shown in an example.
Company X and Y have the same EPS value, but X has invested more money in
P&E in order to deliver the profit gained, whereas Y did not need to embark
on the additional investment (Arnold, 2013). Obviously, if we were to pick a
company, Y would win, as more cash will be generated to its shareholders.
However, at a high-end view, we would not be able to determine who the better
company would be. Here we can criticize EPS. As an investor, we need to ask
ourselves: Is the risk and return from the investment sufficient enough for me
to hold on to my shares? Unfortunately, we can’t answer that question whilst
only considering EPS as a measurement tool. This therefore jeopardizes SWM as a
result.
While we can argue that ROCE provides us with
useful information regarding an investment, it ignores the timing of cash flows within a project (Watson & Head, 2010).
Lets ask the question: Company X offers a steady return annually over a 5 year
project; whereas Company Y offers a large return with the final year of the
project. Which is more favorable? Again, investors cannot answer this question
by considering ROCE. Additionally, ROCE cannot determine the return on an
investment considered (Watson & Head, 2010). If the timing of cash flows is
unknown then ROCE could potentially have a negative effect on SWM.
Discounted
Cash Flows
Unlike EPS and ROCE, Net present value (NPV)
offers a method of valuing an investment by taking the concept of time value
of money into consideration (Liesen et.
al., 2013; Lumby & Jones, 2011). This concept is best explained by Arnold (2013) who describes it
as sacrificing the money you have now for investment with hope that the money
invested will gain a higher level of return in the future.
Why is NPV good for SWM? NPV has the
straightforward approach of accepting a project with positive NPV and rejecting
those that show a negative value (Liesen et.
al., 2013; Lumby & Jones, 2011). NPV uses cash flows rather than
accounting profit over the life of a
project (Watson & Head, 2010). It is therefore easier to favor this as a
method. Within my last blog, I mentioned the concept of manipulating accounts
in order to enhance short-term profits. NPV cannot be manipulated unlike EPS
and ROCE. It gives an absolute measure of
project desirability. Therefore, we can argue that if a manager bases their
investment decision on NPV, the project as a result, is successful in producing
long-term value for the company. Hence, we can state that NPV is a SWM metric.
However, NPV is primarily based on estimation
(Connor, 2006). We can argue that there is an opportunity cost for investments and risk associated from choosing
one project over the alternative (Arnold, 2013). We can therefore criticize NPV
for over/under rating the returns on particular investments, and, as a result,
damaging SWM as a consequence.
What
metrics are investors looking for?
All financial
measures considered show their own advantages and disadvantages in their own
right. But which metric is most desired by investors? We can argue that it
solely depends on the company’s aims and objectives. Though as mentioned in the
opening of this blog and in my previous blog, SWM is a common objective used.
As financial
measures have only been considered within this blog, academic literature has
also recently highlighted the concept of measuring non-financial factors for
overall business value (Asaf, 2004; Financial Times, 1999; Parmenter, 2010). In
Asaf (2004) Executive Corporate Finance: the business of enhancing
shareholder value, the author describes that business performance “cannot
be found in financial data alone.”
Therefore, to
conclude my evaluation, this blog considers Kaplan and Norton (1992) theory of
a balance scorecard that ponders both financial and non-financial metrics. The
balance scorecard is an integrated performance measurement that allows
executives to measure and manage objectives clearly and effectively (Asaf,
2004). Hence, the introduction of a balance scorecard, including KPIs on
customer satisfaction e.g. OTIF, employee satisfaction measures e.g. H&S
and the company’s contribution to the local community and environment i.e. CSR
(Arnold, 2013) can assist on the evaluation of a company’s performance by
potential shareholders.
Though we have
solely criticized the financial metrics in this blog, we cannot completely
ignore these in our managerial decisions. Looking at historical data to provide
accounting ratios does question the relevance for long-term company value.
However, so does discounted cash flow metrics. How can we realistically predict
the return on an investment? Therefore, using financial metrics as
guidance, coinciding with non-financial indicators should enhance overall SWM
in an organisation.
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Fraud Office starts Tesco criminal investigation. BBC News. Retrieved 29th
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