Valuation
Measuring and managing the value of companies – 3rd edition
McKinsey & Company Inc. - Tom Copeland, Tim Koller and Jack Murrin
Chapter 1: Why value value?
Managers who focus on building shareholder value will create healthier companies, which
will in turn lead to stronger economies, higher living standards, and more career and business
opportunities for individuals.
Shareholders vs. Stakeholders
Monetary value for shareholders vs. Employment, social responsibility, environment
1.1 Acceptance of shareholder value
Four major factors in the acceptance of the shareholder value model:
1. The emerge of an active market for corporate control
2. The growing importance of equity-based features in the pay packages of managers
3. The increased penetration of equity holdings in household assets
4. The recognition that many social security systems are heading for insolvency.
1.1.1 The market for corporate control
When companies are not dealing with major changes in their industry and do not have the
creation of value for shareholders as their major goal, they become subject to a leveraged
buyout (LBO), friendly or hostile.
How do LBO’s create value?
Many mature, established industries that have been subject to hostile takeovers
generate high levels of free cash flows. Some companies in this situation often do not
have sufficient attractive investment opportunities. Nevertheless, the natural
inclination of an enterprise is to reinvest its cash, rather than give it back to
shareholders. Such an approach can result in bad investments that reduce shareholder
value. Outside intervention is an instrument through which this economically
suboptimal allocation of cash resources can be stopped. In the case of an LBO, this
occurs through substituting equity with debt, forcing much of the free cash flow out of
the enterprise and back into the capital markets in the form of interest and principal
payments. This can also be accomplished voluntarily, without an LBO, by leveraged
recapitalization. Both situations lead to significant increases in value for shareholders.
The basic premise of the market for corporate control is that managers have the right to
manage the corporation as long as its market value cannot be significantly enhanced by an
alternate group of managers with an alternate strategy.
, 1.1.2 The increased role of stock options
Management’s decisions should be in line with the interests of shareholders.
Research from the past showed that corporate management tends to pursue strategies which
are not likely to optimize resources from a shareholder’s perspective. So the incentives for the
management team needs to be redesigned. By including stock options into the pay
packages of management, the managers become shareholders themselves. Which brings
their interests in line with the rest of the shareholders. The will pursue shareholder value.
1.1.3 The popularization of equity
The remarkable performance of equity markets has contributed to the popularization of stock
options in households. Many people become shareholders through mutual funds and
retirement programs. Because the people become shareholders, the debate between striving
for shareholder value or stakeholder value is diminished.
1.1.4 Pension insolvency
Mandatory public pensions represent the largest part of income of retirees. Most of these
public plans are set up as pay-as-you-go systems, where contributions by workers today are
used to pay the retirements of current retirees. This system works fine as long as there are
more workers than retirees, but this is changing.
The system needs to be converted to a funded pension system, where at least a part of the
premiums that workers pay are actually set aside for their retirement. These funded pension
systems need to generate attractive returns to make it through the transition. The money
needs to be invested in the private sector where companies are pressured to generate
shareholder value.
1.2 Shareholder –oriented economies perform better
A company that focuses on building shareholder value is being a good corporate citizen.
Simply because such a company will create more value for its shareholders. If a company
tries to increase profits by treating their employees badly, the company will have trouble
attracting and retaining high quality employees, and thus be less profitable.
The creation of shareholder wealth does not come to the expense of other stakeholders.
Companies with higher labor productivity are more likely to create more value, and these
gains do not come at the expense of employees in general. Companies that are able to create
more value also create more jobs.
Measuring and managing the value of companies – 3rd edition
McKinsey & Company Inc. - Tom Copeland, Tim Koller and Jack Murrin
Chapter 1: Why value value?
Managers who focus on building shareholder value will create healthier companies, which
will in turn lead to stronger economies, higher living standards, and more career and business
opportunities for individuals.
Shareholders vs. Stakeholders
Monetary value for shareholders vs. Employment, social responsibility, environment
1.1 Acceptance of shareholder value
Four major factors in the acceptance of the shareholder value model:
1. The emerge of an active market for corporate control
2. The growing importance of equity-based features in the pay packages of managers
3. The increased penetration of equity holdings in household assets
4. The recognition that many social security systems are heading for insolvency.
1.1.1 The market for corporate control
When companies are not dealing with major changes in their industry and do not have the
creation of value for shareholders as their major goal, they become subject to a leveraged
buyout (LBO), friendly or hostile.
How do LBO’s create value?
Many mature, established industries that have been subject to hostile takeovers
generate high levels of free cash flows. Some companies in this situation often do not
have sufficient attractive investment opportunities. Nevertheless, the natural
inclination of an enterprise is to reinvest its cash, rather than give it back to
shareholders. Such an approach can result in bad investments that reduce shareholder
value. Outside intervention is an instrument through which this economically
suboptimal allocation of cash resources can be stopped. In the case of an LBO, this
occurs through substituting equity with debt, forcing much of the free cash flow out of
the enterprise and back into the capital markets in the form of interest and principal
payments. This can also be accomplished voluntarily, without an LBO, by leveraged
recapitalization. Both situations lead to significant increases in value for shareholders.
The basic premise of the market for corporate control is that managers have the right to
manage the corporation as long as its market value cannot be significantly enhanced by an
alternate group of managers with an alternate strategy.
, 1.1.2 The increased role of stock options
Management’s decisions should be in line with the interests of shareholders.
Research from the past showed that corporate management tends to pursue strategies which
are not likely to optimize resources from a shareholder’s perspective. So the incentives for the
management team needs to be redesigned. By including stock options into the pay
packages of management, the managers become shareholders themselves. Which brings
their interests in line with the rest of the shareholders. The will pursue shareholder value.
1.1.3 The popularization of equity
The remarkable performance of equity markets has contributed to the popularization of stock
options in households. Many people become shareholders through mutual funds and
retirement programs. Because the people become shareholders, the debate between striving
for shareholder value or stakeholder value is diminished.
1.1.4 Pension insolvency
Mandatory public pensions represent the largest part of income of retirees. Most of these
public plans are set up as pay-as-you-go systems, where contributions by workers today are
used to pay the retirements of current retirees. This system works fine as long as there are
more workers than retirees, but this is changing.
The system needs to be converted to a funded pension system, where at least a part of the
premiums that workers pay are actually set aside for their retirement. These funded pension
systems need to generate attractive returns to make it through the transition. The money
needs to be invested in the private sector where companies are pressured to generate
shareholder value.
1.2 Shareholder –oriented economies perform better
A company that focuses on building shareholder value is being a good corporate citizen.
Simply because such a company will create more value for its shareholders. If a company
tries to increase profits by treating their employees badly, the company will have trouble
attracting and retaining high quality employees, and thus be less profitable.
The creation of shareholder wealth does not come to the expense of other stakeholders.
Companies with higher labor productivity are more likely to create more value, and these
gains do not come at the expense of employees in general. Companies that are able to create
more value also create more jobs.
