Main Financial Metrics Employed to Measure Shareholder Value Introduction Today, shareholder value has become considerably a significant subject among investors more than ever. The shareholder value is formed when the profitability surpasses the investors’ anticipations as determined by the cost of capital…
Many firms calculate the profitability in their own method of calculation where as investors take a different method to do the same, and it makes a hard time for the management of the firm to coordinate the results. An investor always focuses on the economic profits of the firm as well as looks at the extent of debt and equity that is invested in the business. Some of the important financial metrics employed to measure shareholder value are given below; 1. Shareholder Value Analysis (SVA) The shareholder value analysis (SVA) approach was developed by Alfred Rapport during 1980s and is used to estimate the value of the shareholders’ stake within a company or business unit which can also be adopted as the fundamental measure to formulate and evaluate strategic decisions (CIMA, 2004. p.10). The estimation of the value of a firm’s operations is usually carried out through the process of discounting anticipated future operating “free cash flows” at a suitable cost of capital. Here, the free cash flow shows the cash flow derived from a business for a specified period, i.e. the cash flow before extracting any financial-related cash flows associated with share or debt. For the purpose of calculating the shareholder value, the value of “marketable securities and other investments” must be added to, and the value of debt must be subtracted from the business valuation (CIMA, 2004. p.10). The advantage of shareholder value analysis is that it can be used to value a business, and also to value alternative strategic decisions, by contrasting the pre- and post-strategy positions of the firm. Moreover, it is a simple most common method of calculation by considering the seven key value drivers, which can be broken down into comprehensive practical measures in order to encourage the managers to act on the ultimate objective of generating shareholder wealth. 2. Economic Profit (EV) Economic Profit (EP) is another method for evaluating the shareholder value which is also known as “residual income” as a method of measuring divisional performance. It determines how well a firm is performing. The EP evaluates the surplus return gained by the business in a specific period after deducting all expenses, including the cost of using investor’s capital in the business (Encyclopedia of Business, 2011). The measure of net profit cannot be used for analysis even though the interest charged on debt capital is deducted, as its cost related with using equity funds is omitted. So many opt for the EP, arguing that net profit would be mislead and would erroneously exhibit a firm to be profitable based on net profit, where as the actual economic profit would describe it as economically unprofitable. We can state that economic profit is the variance between the return on capital and the cost of capital which can be computed using the following two methods: EP = Invested capital x (return on capital – WACC) EP = Operating profits after tax less capital charge 3. Economic Value Added (EVA) According to Bennet and Stewart (p.40, 2007), Economic Value Added is the financial performance evaluation method which is able to accurately capture the true economic profit of an organisation, and is the performance measure most directly associated with the creation of shareholder wealth over time. EVA is an evaluation of finding out ...
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