Question

As hired by a company’s owners, or stockholders, managers are supposed to work for the best interests of stockholders. Explain how stockholders’ wealth can be measured or quantified on an annual basis. In addition, discuss about some actions that a company's stockholders can take to ensure that management's and stockholders' interests are aligned.

Answer 1

The iiaverage iishareholder, iiwho iiis iitypically iinot iiinvolved iiin iithe iiday-to-day iioperations iiof iithe iicompany, iirelies iion iiseveral iiparties iito iiprotect iiand iifurther iihis iior iiher iiinterests. iiThese iiparties iiinclude iithe iicompany's iiemployees, iiexecutives, iiand iiboard iiof iidirectors. iiHowever, iieach iione iiof iithese iiparties iihas iiits iiown iiinterests, iiwhich iimay iiconflict iiwith iithose iiof iithe iishareholder.

1. Shareholders' iiinterests iiare iiprotected iiby iiseveral iiparties iiboth iiwithin iiand iioutside iithe iicorporation.

2. The iiboard iiof iidirectors iiis iielected iiby iithe iishareholders iito iigovern iithe iimanagement iiteam iiand iito iimake iicorporate iidecisions iion iitheir iibehalf.

3. The iiboard iiis iidirectly iiresponsible iifor iiprotecting iiand iimanaging iishareholders' iiinterests iiin iithe iicompany.

4. Proper iicompensation iipackages iifor iiemployees iiand iiboard iimembers iican iihelp iialign iitheir iiinterests iiwith iithe iicompany's iishareholders.

Shareholder iivalue iiis iithe iivalue iidelivered iito iithe iiequity iiowners iiof iia iicorporation iidue iito iimanagement's iiability iito iiincrease iisales, iiearnings, iiand iifree iicash iiflow, iiwhich iileads iito iian iiincrease iiin iidividends iiand iicapital iigains iifor iithe iishareholders. iiA iicompany’s iishareholder iivalue iidepends iion iistrategic iidecisions iimade iiby iiits iiboard iiof iidirectors iiand iisenior iimanagement, iiincluding iithe iiability iito iimake iiwise iiinvestments iiand iigenerate iia iihealthy iireturn iion iiinvested iicapital. iiIf iithis iivalue iiis iicreated, iiparticularly iiover iithe iilong iiterm, iithe iishare iiprice iiincreases iiand iithe iicompany iican iipay iilarger iicash iidividends iito iishareholders. iiMergers, iiin iiparticular, iitend iito iicause iia iiheavy iiincrease iiin iishareholder iivalue.

Measuring iiShareholders iiValue

Economic iiValue iiAdded ii(Eva):

Economic iivalue iiadded iiis iia iimeasure iiof iiperformance iievaluation iithat iiwas iioriginally iiemployed iiby iiStern iiStewart ii& iiCo. iiIt iiis iivery iipopular iimeasure iitoday iiwhich iiis iiused iito iimeasure iithe iisurplus iivalue iicreated iiby iian iiinvestment iior iia iiportfolio iiof iiinvestments. iiEVA iihas iibeen iiconsidered iias iia iibetter iimeasure iiof iidivisional iiperformance iias iicompared iito iithe iiReturn iion iiAssets iiROA iior iiROI.

It iiis iialso iibeing iiused iito iidetermine iiwhether iiand iiinvestment iipositively iicontributes iito iithe iishareholders iiwealth. iiThe iieconomic iivalue iiadded iiof iian iiinvestment iiis iisimply iiequal iito iithe iiafter iitax iioperating iiprofits iigenerated iiby iithe iiinvestment iiminus iithe iicost iiof iifunds iiused iito iifinance iithe iiinvestment.

Market iiValue iiAdded ii(MVA):

The iimarket iivalued iiadded ii(MVA) iiis iithe iisum iitotal iiof iiall iithe iipresent iivalues iiof iifuture iiEVAs. iiThe iimarket iivalue iiadded ii(MVA) iican iialso iibe iidefined iias iithe iidifference iibetween iithe iicurrent iimarket iivalue iiof iithe iifirm iiand iithe iibook iivalue iiof iicapital iiemployed iiby iithe iifirm. iiThe iimarket iivalue iiof iithe iifirm iiis iisimply iithe iisum iiof iimarket iivalue iiof iiits iiequity iiand iidebt. iiIn iicase, iithe iimarket iivalue iiof iia iifirm iiexceeds iithe iibook iivalue iiof iicapital iiemployed, iiit iiis iisaid iito iihave iia iipositive iiMVA.

In iithe iisame iimanner, iiif iithe iivalue iiof iicapital iiemployed iiexceeds iithe iimarket iivalue iiof iithe iifirm, iiit iiis iisaid iito iihave iia iinegative iiMVA.

ii ii ii ii ii ii ii ii ii ii ii ii ii iiEffective iifinancial iidecision iimaking iirequires iian iiunderstanding iiof iithe iigoal(s) iiof iithe iifirm. iiWhat iiobjective(s) iishould iiguide iibusiness iidecision iimaking iithat iiis, iiwhat iishould iimanagement iitry iito iiachieve iifor iithe iiowners iiof iithe iifirm? iiThe iimost iiwidely iiaccepted iiobjective iiof iithe iifirm iiis iito iimaximize iithe iivalue iiof iithe iifirm iifor iiits iiowners, iithat iiis, iito iimaximize iishareholder iiwealth. iiShareholder iiwealth iiis iirepresented iiby iithe iimarket iiprice iiof iia iifirm’s iicommon iistock.

The iishareholder iiwealth iimaximization iigoal iistates iithat iimanagement iishould iiseek iito iimaximize iithe iipresent iivalue iiof iithe iiexpected iifuture iireturns iito iithe iiowners ii(that iiis, iishareholders) iiof iithe iifirm. iiThese iireturns iican iitake iithe iiform iiof iiperiodic iidividend iipayments iior iiproceeds iifrom iithe iisale iiof iithe iicommon iistock. iiPresent iivalue iiis iidefined iias iithe iivalue iitoday iiof iisome iifuture iipayment iior iistream iiof iipayments, iievaluated iiat iian iiappropriate iidiscount iirate. iiThe iidiscount iirate iitakes iiinto iiaccount iithe iireturns iithat iiare iiavailable iifrom iialternative iiinvestment iiopportunities iiduring iia iispecific ii(future) iitime iiperiod.

The iiobjective iiof iishareholder iiwealth iimaximization iihas iia iinumber iiof iidistinct iiadvantages. iiFirst, iithis iiobjective iiexplicitly iiconsiders iithe iitiming iiand iithe iirisk iiof iithe iibenefits iiexpected iito iibe iireceived iifrom iistock iiownership. iiSimilarly, iimanagers iimust iiconsider iithe iielements iiof iitiming iiand iirisk iias iithey iimake iiimportant iifinancial iidecisions, iisuch iias iicapital iiexpenditures. iiIn iithis iiway, iimanagers iican iimake iidecisions iithat iiwill iicontribute iito iiincreasing iishareholder iiwealth.

Second, iiit iiis iiconceptually iipossible iito iidetermine iiwhether iia iiparticular iifinancial iidecision iiis iiconsistent iiwith iithis iiobjective. iiIf iia iidecision iimade iiby iia iifirm iihas iithe iieffect iiof iiincreasing iithe iimarket iiprice iiof iithe iifirm’s iistock, iiit iiis iia iigood iidecision. iiIf iiit iiappears iithat iian iiaction iiwill iinot iiachieve iithis iiresult, iithe iiaction iishould iinot iibe iitaken ii(at iileast iinot iivoluntarily).

Third, iishareholder iiwealth iimaximization iiis iian iiimpersonal iiobjective. iiStockholders iiwho iiobject iito iia iifirm’s iipolicies iiare iifree iito iisell iitheir iishares iiunder iimore iifavorable iiterms ii(that iiis, iiat iia iihigher iiprice) iithan iiare iiavailable iiunder iiany iiother iistrategy iiand iiinvest iitheir iifunds iielsewhere. iiIf iian iiinvestor iihas iia iiconsumption iipattern iior iirisk iipreference iithat iiis iinot iiaccommodated iiby iithe iiinvestment, iifinancing, iiand iidividend iidecisions iiof iithat iifirm, iithe iiinvestor iiwill iibe iiable iito iisell iihis iior iiher iishares iiin iithat iifirm iiat iithe iibest iiprice, iiand iipurchase iishares iiin iicompanies iithat iimore iiclosely iimeet iithe iiinvestor’s iineeds.

Inefficiencies iithat iiarise iibecause iiof iiagency iirelationships iihave iibeen iicalled iiagency iiproblems. iiThese iiproblems iioccur iibecause iieach iiparty iito iia iitransaction iiis iiassumed iito iiact iiin iia iimanner iiconsistent iiwith iimaximizing iihis iior iiher iiown iiutility ii(welfare). iiThe iiexample iicited iiearlier iithe iiconcern iiby iimanagement iifor iilong-run iisurvival ii(job iisecurity) iirather iithan iishareholder iiwealth iimaximization iiis iian iiagency iiproblem. iiAnother iiexample iiis iithe iiconsumption iiof iion ii-the ii-job iiperquisites ii(such iias iithe iiuse iiof iicompany iiairplanes, iilimousines, iiand iiluxurious iioffices) iiby iimanagers iiwho iihave iino ii(or iionly iia iipartial) iiownership iiinterest iiin iithe iifirm. iiShirking iiby iimanagers iiis iialso iian iiagency-related iiproblem

Useful iimotivational iitools iithat iiwill iiaid iiin iialigning iistockholders' iiand iimanagement's iiinterests iiinclude:

1. reasonable iicompensation iipackages, ii

Executive iicompensation iiis iia iisignificant iithing iito iiconsider iiwhen iievaluating iian iiinvestment iiopportunity. iiExecutives iiwho iiare iiimproperly iicompensated iimay iinot iihave iithe iiincentive iito iiperform iiin iithe iibest iiinterest iiof iishareholders, iiwhich iican iibe iicostly iifor iithose iishareholders.

While iinew iilaws iiand iiregulations iihave iimade iiexecutive iicompensation iimuch iiclearer iiin iicompany iifilings, iimany iiinvestors iiremain iiclueless iias iito iihow iito iifind iiand iiread iithese iicritical iireports. iiThis iiarticle iiwill iitake iia iilook iiat iithe iidifferent iitypes iiof iiexecutive iicompensation iiand iihow iiinvestors iican iifind iiand iievaluate iicompensation iiinformation.

2. direct iiintervention iiby iishareholders, iiincluding iifiring iimanagers iiwho iidon't iiperform iiwell

A iifirm’s iiintrinsic iivalue iiis iian iiestimate iiof iia iistock’s ii“true” iivalue iibased iion iiaccurate iirisk iiand iireturn iidata. iiIt iican iibe iiestimated iibut iinot iimeasured iiprecisely. iiA iistock’s iicurrent iiprice iiis iiits iimarket iiprice—the iivalue iibased iion iiperceived iibut iipossibly iiincorrect iiinformation iias iiseen iiby iithe iimarginal iiinvestor. iiFrom iithese iidefinitions, iiyou iican iisee iithat iia iistock’s ii“true” iilong-run iivalue iiis iimore iiclosely iirelated iito iiits iiintrinsic iivalue iirather iithan iiits iicurrent iiprice.

Equilibrium iiis iithe iisituation iiwhere iithe iiactual iimarket iiprice iiequals iithe iiintrinsic iivalue, iiso iiinvestors iiare iiindifferent iibetween iibuying iior iiselling iia iistock. iiIf iia iistock iiis iiin iiequilibrium iithen iithere iiis iino iifundamental iiimbalance, iihence iino iipressure iifor iia iichange iiin iithe iistock’s iiprice. iiAt iiany iigiven iitime, iimost iistocks iiare iireasonably iiclose iito iitheir iiintrinsic iivalues iiand iithus iiare iiat iior iiclose iito iiequilibrium. iiHowever, iiat iitimes iistock iiprices iiand iiequilibrium iivalues iiare iidifferent, iiso iistocks iican iibe iitemporarily iiundervalued iior iiovervalued.

3. The iithreat iiof iitakeover. iiThe iithreat iiof iitakeover iiacts iito iidiscipline iimanagers iiand iiso iireduces iithe iiagency iiproblems iibetween iimanagers iiand iishareholders. iiBut iiit iialso iimakes iishareholder iiassurances iito iimanagers iiless iireliable iiand iiso iiinterfered iiwith iicontracting iibetween iithem. iiThese iitwo iieffects iihave iiopposing iiimplications iiabout iithe iilevel iiof iiexecutive iicompensation: iithe iidisciplinary iieffect iiimplies iia iireduction iiin iicompensation; iithe iicontracting iieffect iiimplies iian iiincrease. iiWhich iiof iithe iitwo iieffects iidominates iiis iian iiempirical iiissue. iiWe iiexamine iithe iirelation iibetween iimanagerial iicompensation iiand iithe ii(industry-wide) iithreat iiof iitakeover iito iiaddress iithis iiissue.