HOW PRIVATE FIRMS CAN MAXIMIZE SHAREHOLDER VALUE

Much has been written recently about publicly traded companies maximizing shareholder value. This concept is described by a variety of terms such as "creating shareholder value," "value opportunity analysis" and "economic value added." The idea behind these concepts is the conventional accounting-based measures such as net profit, return on equity and earnings per share may not tell the complete story of corporate performance.

These concepts can be used to develop value-added strategies by privately held companies to create and maximize wealth for their investors. The analysis can also be used to develop management-compensation systems to focus and creating value. It can also be used to measure the true profitability of divisions or business units of a company.

How to calculate shareholder value
Maximizing shareholder value is a relatively easy concept to measure. Instead of stopping at the conventional accounting measure of profit, Subtract one additional expense - the company's cost of capital. If the return after the cost of capital is subtracted is positive, the company is creating value, for its shareholders. If the return is negative, the company is destroying value.

The difficulty in applying shareholder value analysis is that it requires a measurement of both a company's true cost of capital and its total capital employed. Most managers understand the cost of debt capital, which is the interest that they have to pay on borrowings. However, a key factor is the measurement of the cost of equity capital employed in the company - a cost which is difficult to measure in a public company and is more subjectively measured in a privately held company.

However, proxies exist which provide a close estimate of a privately held company's cost of equity. A company's total cost of capital is then the marginal borrowing cost on an after-tax basis (since interest expense is tax deductible) weighted with the company's cost of capital.

A second necessary measurement is the amount of capital tied up in the company. This level may be more than what appears on the balance sheet. For example, research and development costs and employee training costs may benefit a corporation for years following an expenditure, but accounting principles usually require these items to be expensed. Existing balance sheets and income statements may have to be adjusted to reflect these and other similar items to provide a strict measure of total capital employed in a company.

Once these items are calculated it is a few simple steps to measure value creation. The easiest method is to take operating profit and deduct taxes. Then subtract the company's cost of capital (the product of weighted average cost of capital and the capital employed in the company). The remainder after capital costs are deducted from net operating profit after taxes is the amount of value that is being created.

The accompanying table illustrates how conventional accounting measures may distort the true operating performance of a company. In this example we compare two hypothetical companies, Valstar and Addog. Both companies appear to be extremely profitable using traditional accounting measures. However, when the cost of capital is analyzed, only Valstar is creating value for its shareholders. Addog is actually destroying value. (See chart.)

Three ways for a company to increase its value added capabilities are:

1. Earn more profit without using more capital. An example would be a company that is creating efficiencies and lowering its operating costs.

2. Use less capital. Many companies use this method to create value. For example, a company can create a production schedule that would require lower levels of inventory and its associated fixed asset costs.

3. Invest capital in high return projects. A company can focus on business lines that generate the highest return after deducting their total capital costs.