Companies to pursue shareholder value

"Some commentators argue that during the 1990s, institutional investors operated a 'dual standard' which required old economy companies to pursue 'shareholder value' while they speculated with investments in the new economy. Use examples to discuss the extent investor behaviour affected corporate performance. " Introduction This essay broaches the issue of institutional investor's impact on corporate performance of certain corporations during the 1990s, by requesting old economy companies to pursue 'shareholder value' and invest in the new economy.

In order to illustrate this state of affairs precisely, this essay will explain selected theories and outcomes of pursued shareholder value or Value-Based Management (-VBM ) in context with the operated 'dual standard' by institutional investors. What is 'Shareholder Value' and why do businesses practise it? The shareholder value is defined as the market value of the ownership equity and complies with the company value, depending on the value of shares.

VBM is a concept developed by Alfred Rappaport, regarding business processes as a row of cash-flows, analogue to a series of payments resulting from capital investments of fixed assets. The financial evaluation of a company will be done on the basis of free cash-flows. A company policy which is based on shareholder value, which means that it conducts VBM, will therefore try to maximise the price for its shares leading to an increase in market value ( Gri?? tker, p. 73-79 ).

The aim is not solely to increase the stock-market price in the short-term, but furthermore the long-term improvement of competitiveness and profitability (Li?? hr, p. 20). Graph a: Creation of Shareholder Value The difficulties resulting from the use of VBM are very complex. Institutional investors often have a stark influence on a companies' performance, especially if there is the case of a few investors holding a majority of a companies' shares, allowing them to have substantial influence in decision-making.

They are entitled to play an active role in corporate governance. Moreover since institutional investors have the prerogative to buy and sell shares, they have a large influence on which companies stay solvent and which go insolvent. Therefore it became increasingly important for asset managers to perform in line with shareholder value be it through the growing threat of hostile takeovers in the case of low performance, or through direct pressure from shareholders ( Dr. Blomert, journascience. org ).

Another problematic situation that emerged out of the application of VBM is mentioned in the short-terminist hypothesis, which indicates that equity markets dominated by institutional investors tend to undervalue firms with good earnings prospects in the long term but low current profitability ( Davis 2002 ). Based on the hypothesis that institutional investors are willing to sell shares in takeover battles, in combination with regular performance evaluation of asset managers by trustees, managers are put in a position where they are pressured to generate returns. The logic is simple.

What may be in the best interest of shareholders might not be in the best interest of the business ( Robert, p 7 ). In consequence this might lead to the discouragement of long-term investment or R&D as opposed to the distribution of dividends, since firms that apply long-term strategies run the risk of being undervalued or taken over ( Davis, 2002 ). The logical result is oftentimes that companies deviate from their intrinsic strategic focus and fail to invest enough into the development of products and services, leaving their customers, their main stakeholders dissatisfied.

Moreover if concepts such as business process reengineering and restructuring are applied poorly, leading to the redundancies of skilled employees, a possible decrease in quality of products and operations, as well as a loss in corporate image, negative implications on corporate performance is likely. What are the implications of applied 'Shareholder Value' respectively VBM? Generally it is difficult to declare where investor behaviour affects corporate performance positively or not.

For example if one considers the debt/asset ratio, it was found out that institutional investor have a positive effect on it, suggesting firms to lever up which has an potential positive effect on performance ( Firth, 1995 ). However in times in which the pressure from leverage is less intense this effect can also be regarded as negative ( Grier et al. , 1994 ). A research found some positive returns in short term but no statistically significant positive returns over the long term, leading the researchers to question the overall effectiveness of shareholder activism ( Gillan et al.

1995 ). However if one was looking at firms targeted by CALPERS it was found that shareholder activism again led to no statistically significant improvement in performance of the companies concerned ( Smith, 1996 ). Other studies support that shareholder initiatives were well targeted on firms with atypically poor performance, but had little effect on company share, operating returns, values and top management turnover. The only exception was a significant improvement in returns on assets for the targets relative to a control group ( Karpoff et al. , 1996 ).

The era of the new economy – a short review The Boom: During the 1990, many new technologies were developed such as the personal digital assistant ( PDA ), the mobile phone became part of people's everyday life and the use of the internet became progressively more accepted and applied in the industrial nations. This was the cause for the boom of the new economy, based on high profit expectations. After the Netscape initial public offering in 1995 it was the start-up for many companies relating to new technologies and due to the great interest of shareholders many IPOs followed ( onpulson article ).

Many shareholders believed that the companies operating in those markets would have great future prospects and therefore benefit from the alleged future success by buying shares of those companies. Particularly in the phase from 1995-2000 institutional investors operated a peculiar double standard: On the one hand, old economy firms with low return of capital employed ( ROCE ) or cyclically problems were viewed negatively and their shares were valued low by investors because of the complications they had recovering costs from the product market.

On the other hand, for new-economy firms, the enthusiastic expectation of future earnings, encouraged by a belief in a digital future and supported by growing sales revenue, which represented a proxy for success justified a boom in new issues and very high price/earnings (P/E) ratios in the media, telecoms and technology sector. In many cases such new-economy firms had no profits because of high costs associated with set-up, marketing and so forth. Thus ROCE had little relevance as a performance measure because, in effect, they were recovering their costs unsustainably from the capital ( Froud, p.

44 ). This effect was pushed even further by the expansion of many companies. The liquidity which has been achieved by the IPOs, was invested in the acquisition of further listed companies. Also investment funds amplified the economic bubble, by announcing the prospects of increasing profits to their customers. The shareholders had foremost inflated expectations of profit, ignoring business appraisals as well as financial statements of the companies. Even high cash-burn-rates were regarded as positive features of a company.

The media piqued this euphoria, especially towards the emission of new economy firms, alluring inexperienced shareholders to make risky investments ( von Frenz, 2003 ). The Crash: Graph b: An economic bubble adapted from Dr. Jean-Paul Rodriguez The end of the boom became apparent when the highly evaluated companies were not able to fulfil the high expectations of profit in foreseeable time. The market value of new economy firms was often not covered by fixed assets, since their capital is rather manifested in the skills of the employees.

Quite often the net book values of these companies consisted out of not much more than a few premises and their IT-infrastructure. Eventually, investors were starting to doubt when a few companies started to become insolvent and moreover many companies were feigning their profits. From this it followed that many experienced investors withdrew from the market, leading small investors to panic selling all their shares which led to a total collapse of the market in 2000.