HOW TO FIND A COMPANY THAT HAS THE HIGHEST SHAREHOLDER VALUE?
What is shareholder value?
Shareholder value is the value delivered to the shareholders of a company by way of increase in dividends and capital gains for the shareholders due to the management’s ability to increase sales, earnings and free cash flow.
In simple layman’s terms, shareholder value is the return of investment to the shareholders for buying stocks or shares of a particular company.
This is an important aspect that the investors need to look for while investing in shares/stocks as this plays a vital role in shaping their investing decision.
The ultimate measure of a company’s success is the extent to which it provides value in terms of returns to its investors.
It is very essential for a company to increase its shareholder value to attract more investors in its stocks. The company’s management should keep in mind the interest of the shareholders when making key decisions.
There are a few basic parameters that will help the investors to determine a company’s shareholder value.
1. Earnings per share (EPS): Earnings per share is one of the most important tools that investors use to gauge the profitability of a company before buying its shares. This can be calculated by dividing the company’s profit by the number of common shares it has outstanding. A higher EPS indicates greater profitability from the company.
How is EPS calculated?
In a nutshell, EPS formula is:
|EPS = (Net Income − Preferred Dividends) / End-of-Period Common Shares Outstanding|
To illustrate this, let’s take a company ABC, which is left with a net income of Rs. 20 lakhs. It must also pay Rs. 8 lakhs as preferred dividends to its preferred shareholders. It has Rs.4 lakhs as common shares outstanding (weighted average) at the current period.
Therefore, the EPS of ABC Company as per earnings per share formula would be:
EPS = Rs. (20,00,000 – 8,00,000)/ 4,00,000
= Rs. 3 per share
Generally, the company’s balance sheet and its income statement need to be looked for in order to calculate EPS. Also, it is often recommended to consider the weighted average number of common shares as the number of shares may vary over a given period.
Also Read: Reading a Balance Sheet
Importance of Earnings Per Share (EPS):
- EPS helps gauge the shareholder value of a company, in the sense, it will give an idea to the investors if investing in a particular company would generate more income for them. To elaborate, a higher EPS indicates a higher profitability, which in turn, suggests that the company may increase dividend payout over time. So, the shareholder value formula is EPS * NUMBER OF SHARES THAT SHAREHOLDER HOLDS. For example, if a XYZ person holds 1000 shares of ABC company then SHAREHOLDER VALUE = 1000×3 = Rs. 3000
- Also, it helps in comparing the performance of companies in terms of favourable performance, which ultimately aids in choosing the most suitable investment option.
- EPS not only helps to measure a company’s current financial position but also helps track its past performances. For instance, a company with a steadily increasing EPS is often considered to be a reliable investment option. Whereas, companies with decreasing or irregular EPS are usually not preferred by experienced investors.
2. Free cash flow (FCF): Another important parameter determining shareholder value is Free Cash Flow, which is a measure of how much cash a company generates after accounting for capital expenditures. If a company has more cash at its disposal, then it can lead to the pursuit of new opportunities by the company that lead to greater profitability. It can also use that spare cash to boost its dividend.
In other words, free cash flow is the cash that is remaining after a company pays for its operating expenses such as salary, rent, taxes, other overheads, etc. and capital expenditures such as land, equipment, furniture and fixtures, etc. and a company can use it at its discretion.
Free Cash Flow will provide an insight for the investors into the financial status of a company and help them to make informed investment decisions. It will provide them an idea of how much money could possibly be distributed in the form of dividend payments. Free cash flow is best used to analyze non-financial companies with distinct capital expenditures such as warehouses, inventory and manufacturing equipment.
An investor should look for companies that have increasing free cash flows because it is an indicator that such companies have excellent prospects. If investors find a company with rising cash flow and an undervalued share price, it is a good investment.
How can an investor calculate Free Cash Flow (FCF)?
The most common and simplest way to calculate free cash flow is using the operating cash flow. The formula is:
|Free Cash Flow = Operating Cash Flow – Capital Expenditures|
Where to locate the above items in the financial statements of the company?
One needs to look for the item, “Cash flow from operations” also referred to as “operating cash or “net cash from operating activities” from the cash flow statement. The item, “Capital Expenditures” will be available on the balance sheet of the companies.
3. Dividend policy: A company’s dividend policy affects shareholder value. Dividend is the share of the company’s profits that is paid out to its shareholders. It is a token reward paid to them for investment in a company’s equity. Dividends communicate the financial well-being of a company to the shareholders. A company that pays a decent dividend has a high shareholder value when compared to the company that does not pay dividends.
A dividend payout of about 35% to 55% is considered as a healthy or optimum payout. From a shareholders’ point of view, a company that is likely to distribute roughly half of its earnings as dividend, can be gauged as a company that is well established and a leader in the industry and has a high shareholder value because it gives good returns to the shareholders in the form of dividends.
4. Mergers and Acquisitions: Merger refers to the acquisition of the entire company by another company, whereas acquisition refers to purchase of a part of a company by another, which could be purchase of assets or purchase of the company’s subsidiaries.
The results of the studies on whether mergers and acquisitions undertaken by a company would increase the shareholder value of that company are mixed. Some studies show that they increase the shareholder value, but some studies show that they do not lead to an increase in shareholder value. Hence, there is no strong conclusive evidence on this.
In simple terms, shareholder value is the returns that the shareholders receive for investing in the stock of a particular company.
Higher the shareholder value, the greater number of investors will a company attract to invest in its stocks/shares.
Earnings Per Share (EPS), Free Cash Flow (FCF) and the Dividend policy of a company are important parameters that one should look for to compare the shareholder value of companies.