Creating Value

Shareholder value is driven by the following four factors: The amount of capital invested; The actual rate of return on capital invested; The required rate of return on capital invested; The length of time over which the performance spread (see below) will persist to create value. And, essentially, the actual return must be more than the required return for value to be created. That is, there must be a positive performance spread.

The performance spread is the percentage spread of the actual return above or below the required rate of return, given the finance provider’s opportunity cost of capital. To measure annual value created (or projected value yet to be created), multiply the quantity of capital invested by the performance spread.

Annual value creation = Investment x (actual return – required return) = I (r - k)

The point in the future where the required and the actual rates of return become the same is the ‘planning horizon’.

Corporate value = Present value of cash flows within planning horizon + Present value of cash flows after planning horizon

After the planning horizon even if investment levels are increased significantly corporate value will remain constant. This is because the discounted cash inflows (to time zero) associated with that investment exactly equal the discounted cash outflows (to time zero). In other words, after the planning horizon it is not possible to make returns greater than those required by investors.

Good growth and bad growth: Good growth occurs when a business unit or an entire corporation obtains a positive performance spread on new investment capital. Bad growth occurs when investment is made in strategies that produce negative performance spreads.

There are five key actions firms can take in order to increase shareholder value: Increase the return on existing capital; Raise investment in positive spread units; Divest assets from negative spread units to release capital; Extend the planning horizon; and,  Lower the required rate of return.