14.1 Creating value

It is now almost universally recognized in business literature that the ultimate objective of all financial decisions – and indeed, of all strategic management decisions – is to create value. In the English-speaking countries this is explicitly seen as value for the common shareholders. In legal terms, this was never in doubt. The shareholders are the legal owners of the company. They provide its permanent capital funds. In a liquidation they have only a residual claim on assets, and they have a claim on the company’s earnings only after all other claimants have been satisfied.

Other providers of funds are lenders, who take a limited risk for a limited return. The shareholders take an unlimited risk and commit their funds without safeguards. In return they have the right to nominate a board of directors to supervise the company’s operation, and to ensure that it is managed in their interest. Dissenting voices are suggesting that equal weight should be given to the claims of other stakeholders – employees, suppliers, customers, lenders, the local community and even society at large. In practice, the two approaches can be harmonized. Paying due consideration to other stakeholders’ needs and interests is both a moral responsibility and good business sense and it is unlikely that value can be maximized in the long run if such considerations are ignored (see Chapter 23 for a detailed discussion of corporate social responsibility). But the shareholders are the ultimate claimants to the residual incremental value created after all the other claims have had due consideration, and maximization of shareholder value will be the underlying philosophy in this chapter.

Despite the clear ownership position of the common shareholders, it is only in recent years that shareholder value has come to be used as the basis for management decision-making. A first step in making the concept operational was to understand how value is created. In fact, three different concepts are in common use – though fortunately they lead to similar courses of action. One approach, pioneered and promoted by the consultants Stern, Stewart and Company, is market value added (MVA), which regards value as the difference between the market value and the book value of a company’s equity. Another view is the “free cash flow” approach, which takes the view that value is created only when the cash produced by a company’s operations exceeds the incremental investments required in fixed assets and working capital, and sees the value of a company as the present value of those future free cash flows. The simplest approach, however, and the one that will be used in this chapter, is that value is created only by making investments in which the return on invested capital (ROIC) exceeds the weighted average cost of capital (WACC).

The importance of a clear concept of value is that it provides the basis for developing a set of financial strategies and actions – value drivers – aimed at maximizing value. This is an area where finance and strategy come very close. Strategy is usually thought to be about developing a competitive advantage. The reason for a competitive advantage, though, is simply that it makes it possible