A Study on the Integrated Approach of Shareholder Value Analysis

Table of Contents

Acknowledgement

Abstract

Table of Figures

List of Appendices

List of Abbreviations

Chapter 1
Introduction

Chapter 2
2.0 Methodology
2.1. Definition
2.2 Approaches
2.3 Applied Approach
2.4 Time Horizons
2.5 Research Techniques
2.6 Research Limitations

Chapter 3
3.0 Literature Review
3.1 Thefinancialmarket
3.1.1 Providers of Finance - an international mapping
3.1.2 Thefinancialmarket
3.2 CorporateObjectives
Maximization of profits:
Maximization of sales:
Survival
Social responsibility
Prospects:
Risk:
Communication
3.3 Shareholdervaluetheory
3.3.1 General Information - Introduction
3.4 Financial Ratios
3.4.1 Price-Earnings Ratio (P/E - Ratio)
3.4.2 Discounted Cash Flow Model
3.4.3 Dividend Valuation Model
3.4.4 Economic Value Added (EVA Model)
3.4.5 Market Capitalization
3.4.6 Capital Asset Pricing Model
3.4.7 Shareholder Value Approach - A. Rappaport

Chapter 4
4.0 Analysis
4.1 Price/Earnings Ratio
4.2 Discounted Cash Flow Model
4.3 Dividend Valuation Model
4.4 Economic Value Added
4.5 Beta Ratio
4.6 Cost of Equity Capital (ke)
4.7 Market Capitalization

Chapter 5
5.0 Findings
5.1 Short-term shareholdervalue
5.2 Long-term shareholdervalue

Chapter 6
Conclusion

Chapter 7
References

Chapter 8
Appendices

Acknowledgement

I would like to thank my dissertation supervisor Siobhan Goggin at the University of Lincoln who has guided and assisted me with her expertise from the beginning up to the final completion of my dissertation.

Abstract

The theory of shareholder value is an issue that has to comprise a dichotomy in terms of the standpoint from which it is looked at. Shareholders and the management of a company in many cases still represent counterparts whereas interests do not continuously align.

In this study shareholder value theory is approached by investigating the shareholder perspective in correspondence to shareholder wealth gains in the UK market environment through the implementation of six major financial performance measurement methods including: the Price/ Earnings ratio, the Discounted Cash Flow Model, the Dividend Valuation Model, the Economic Value Added, the Market Capitalization, the Capital asset Pricing Model and the shareholder value approach as suggest by Alfred Rappaport. Having applied them to six selected stock listed companies enabled the author to develop a shareholder value ranking according to their financial performance and the deriving shareholder value dedication.

Table ofFigures

Figure 1: The Strength ofequity markets

Figure 2: CAPM Model

Figure 3: The Shareholder Value Network

Figure 4: P/E Ratio IT Communication Industry

Figure 5: P/E Ratio Oil Industry

Figure 6: P/E Ratio Banking Sector

Figure 7: Discounted Cash Flow Model

Figure 8: Dividend Growth Model

Figure 9: Constant Dividend Model

Figure 10: Economic ValueAdded

Figure 11: Beta Ratio

Figure 12: Cost ofEquity Capital

Figure 13: Market Capitalization Vodafone

Figure 14: Share Price Trend Vodafone

Figure 15: Market Capitalization British Telecom

Figure 16: Share Price Trend British Telecom

Figure 17: Market Capitalization British Telecom

Figure 18: Market Capitalization Royal Dutch Shell

Figure 19: Market Capitalization Royal Bank ofScotland

Figure 20: Share Price Trend Royal Bank ofScotland

Figure 21: Market Capitalization Barclays

Figure 22: Share Price Trend Barclays

Figure 23: short term shareholder value

Figure 24: Short-term Shareholder Value Ranking

Figure 25: Long-term Shareholder value

Figure 26: Long-term Shareholder Value Ranking

List of Appendices

Appendix 1: P/E Ratio
Appendix 1.1 P/E - Vodafone
Appendix 1.2 P/E - British Telecom
Appendix 1.3 P/E - British Petroleum
Appendix 1.4 P/E - Royal Dutch Shell
Appendix 1.5 P/E - Royal Bank of Scotland
Appendix 1.6 P/E - Barclays

Appendix 2: Discounted Cash Flow Model
Appendix 2.1. DCF - Vodafone
Appendix 2.2 DCF - British Telecom
Appendix 2.3 DCF - British Petroleum
Appendix 2.4 DCF - Royal Dutch Shell
Appendix 2.5 DCF - Royal Bank of Scotland
Appendix 2.6 DCF - Barclays

Appendix 3: Dividend Valuation
Appendix 3.1 DVM - Vodafone
Appendix 3.2 DVM - British Telecom
Appendix 3.3 DVM - British Petroleum
Appendix 3.4 DVM - Royal Dutch Shell
Appendix 3.5 DVM - Royal Bank of Scotland
Appendix 3.6 DVM - Barclays

Appendix 4: Economic Value Added
Appendix 4.1 EVA - Vodafone
Appendix 4.2 EVA - British Telecom
Appendix 4.3 EVA - British Petroleum
Appendix 4.4 EVA - Royal Dutch Shell
Appendix 4.5 EVA - Royal Bank of Scotland
Appendix 4.6 EVA - Barclays

Appendix 5: Capital Asset Pricing Model
Appendix 5.1 Average market return rate (rm)
Appendix 5.2 Market risk free rate of return (rf)
Appendix 5.3.1 Beta Calculation - Vodafone
Appendix 5.3.2 ke calculation - Vodafone
Appendix 5.4.1 Beta calculation - British Telecom
Appendix 5.4.2 ke calculation - British Telecom
Appendix 5.5.1 Beta Calculation - British Petroleum
Appendix 5.5.2 ke calculation - British Petroleum
Appendix 5.6.1 Beta calculation - Royal Dutch Shell
Appendix 5.6.2 ke calculation - Royal Dutch Shell
Appendix 5.7.1 Beta calculation - Royal Bank of Scotland
Appendix 5.7.2 ke calculation - Royal Bank of Scotland
Appendix 5.8.1 Beta calculation - Barclays
Appendix 5.8.2 ke calculation - Barclays

Appendix 6: Market Capitalization
Appendix 6.1 Market Capitalization - Vodafone
Appendix 6.2 Market Capitalization - British Telecom
Appendix 6.3 Market Capitalization - British Petroleum
Appendix 6.4 Market Capitalization - Royal Dutch Shell
Appendix 6.5 Market Capitalization - Royal Bank of Scotland
Appendix 6.6 Market Capitalization - Barclays

Appendix 7 Short Term Shareholder value

Appendix 8 Long-term Shareholder Value

List of Abbreviations

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Chapter 1 Introduction

The credit crunch and the subsequent global financial crisis in 2007 shattered the trust among private as well as corporate investors.

Keeping in mind that the majority of corporate capital in the UK is raised through equity provided by private as well as institutional shareholders, even the whole national economy began to tumble.

How long will the recession last, what impact will it have on the real economy and is there a chance for businesses to recover and most importantly rebuilt trust among the banking sector were the questions that not only managers and chief executive officers but especially shareholders had to face.

Now, four years after the genesis of the financial crisis, the trust in the markets has not been completely re-established. The question arises what shareholder wealth dedication can expect from a company in the UK market environment.

This study focuses on corporate performance and the deriving degree of shareholder value by analysing three business sectors whereby for each industry sector two representative stock listed companies for a shareholder value analysis were selected:

1) ThelTandCommunicationsector

Represented by: Vodafone Group Plc and British Telecom Group Plc

2) The Oil industry

Represented by: Royal Dutch Shell Plc and British Petroleum Plc

3) The Banking sector

Represented by: Royal Bank ofScotland Plc and Barclays Plc

The author applied the following six financial models as indicators of a shareholder value orientated business-running including:

1) Price/ Earnings Ratio
2) Discounted Cash Flow Model
3) DividendValuationModel
4) EconomicValueAdded
5) MarketCapitalization
6) Capital Asset Pricing Model

Those models have been evaluated in accordance to their practical relevance in the real world and in respect to their informative value when it comes to estimating financial performance under the premise of shareholder value creation.

Chapter 2 2.0 Methodology

2.1. Definition

A methodology as being the theoretical research approach for a scientific study can be defined as:

"The theory of how research should be undertaken, including the theoretical and philosophical assumptions upon which research is based and the implications of these for the method or methods adopted" (Saunders et al, 2007:602).

2.2 Approaches

Recent literature suggests two major approaches as being appropriate to underpinning a profound scientific research (Saunders et al., 2009, Maylor and Blackmon, 2005):

1. The inductive approach
2. The deductive approach

The distinction between both techniques was clarified by Saunders et al. (2007) stating that the inductive assessment develops "[...] a theory as a result of the observed empirical data" (Saunders et al. 2007:599), whereas the deductive approach examines a theoretical framework by explaining "[...] casual relationships between variables" (Saunders et al. 2007:117).

2.3 Applied Approach

The author of this research employed the deductive research approach whereby the findings ofthis piece ofwork are based on the application ofvarious theoretical financial models.

2.4 Time Horizons

The outcome of this study provides an analysis of the status quo and therefore is limited to a snap-short time period. However in order to derive sufficient statements about the current potential for shareholder wealth gains for each considered company, historic data was used as indicators for future prospects.

2.5 Research Techniques

The author applied six models of finance theory to analyse the degree of shareholder value. Hence, these models as well as necessary input data are based secondary literature such as journal articles, books, websites, newspapers, annual reports and web databases.

Obviously the researcher can benefit from certain advantages when applying secondary data as the underpinning information in a study. More specifically, owing to the fact that data does not have to be gathered by using primary research techniques, a study based on secondary data by far is more time efficient and creates low costs (Saunders et al., 2009).

Nonetheless data might be restricted, misinterpreted or influenced by the author delivering the secondary information (Saunders et al., 2009). As a consequence a deficiency of control ofthe respective content evolves (Saunders et al., 2009).

2.6 Research Limitations

The researcher had to encounter various anomalies of current financial performance due to procrastinatory impacts of the financial crisis in 2007. Additionally due to limited accessibility to historic data as evidence in the appendix section, the author analysed the considered companies under the given limitations of data validity, a narrow time horizon as well as the bias of misinterpretation.

Chapter 3 . Literature Review

In Chapter 3 relevant financial theories underpinning the shareholder value approach will be controversely discussed to provide the necessary information for the analysis and findings section.

3.1 The financial market

3.1.1 Providers ofFinance - an international mapping

In this first part of the literature review the researcher will focus on relevant data by the World Bank to explore to what extent patterns of capital funding differentiate in respect of various countries. An appropriate indicator to draw a distinction is to evaluate whether businesses rely on capital provided by banks or on equity generated by issuing shares. Generally speaking it can be stated that in countries like Germany, France and Italy firms are highly dependent on capital made accessible through bank loans due to a relatively high share of small family owned businesses. A contrary situation can be observed in the United States and the United Kingdom where traditionally a lower level of prudence in accounting principles coherent with a strong correlation of equity-based capital, is most common. Nobes, C. & Parker, R.B. (2006) suggest that substantiated evidence to support these statements can be found by looking at the number of listed companies divided by the number of population in million, the equity market capitalization divided by the country's gross domestic product and the gearing ratio.

Figure 1: The Strength ofequity markets

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Source: World Bank (2009a-c), Nobes and Parker (2006)

When comparing those four countries it is instructive to particularly point out the gearing ratio since it is fairly easy to grasp. By definition the gearing ratio implies how a company raises capital while reflecting the relation between equity and debt funding. A company or in this case the country that is looked at, is considered to be highly geared if the ratio is greater than 100, Watson, D. & Head, T. (2007). As deriving from figure 1, Germany and Italy have a significantly greater debt/common equity ratio compared to the UK and the United States. Therefore it leads the researcher to the conclusion of a two-group categorization concerning capital funding patterns.

Additionally authors like La Porta et al (1997) argue that there is a "statistical connection between common law countries and strong equity markets". Furthermore in his later work La Porta et al (1998) specified the statement through emphasizing, "common law countries have stronger legal protection of investors than Roman law countries do". John Zysman, who is a professor at the University of California, set the foundation for modern age classification of countries according to their financial system. Zysman, J.(1983) formalized three groups:

1 Capital market systems (e.g. United Kingdom, United States)
2 Credit-based governmental systems (e.g. France, Japan)
3 Credit-based financial institution systems (e.g. Germany)

3.1.2 The financial market

In economic terminology, a market is defined as: "...any place where the sellers of a particulargood or service can meet with the buyers of that goods and service where there is a potential for a transaction to take place. The buyers must have something they can offer in exchange for there to be a potential transaction."

SourceMoffatt (2011)

Hence, the financial market being an instrument of the financial system, it operates as a forum to facilitate the exchange of goods in the form of assets such as equities, bonds, currencies and derivatives (Commonwealth Bank of Australia, 2001). Financial markets are essentially characterized by having a transparent pricing according to the efficient market hypothesis as well as prices of traded securities being determined by costs, fees and market forces. Equally important for the proper functioning is the presence of basic regulations on trade, which are enforced by statutory, co-regulatory and self-regulatory bodies (Yulo, 1999).

3.2 Corporate Objectives

The overriding corporate objective of stock listed companies is to align the interest of the management in respect to the economic business operation with the objective of maximizing shareholder value accompanied by the shareholder wealth maximization principle (Watson and Head, 1998).

Shareholders are able to obtain wealth through dividend payouts and capital gains.

Due to the fact that the concept of shareholder wealth maximization is highly complex, literature suggests other corporate objectives as possible substitutes:

1. Maximizationofprofits
2. Maximizationofsales
3. Survival
4. Social responsibility

Nevertheless Watson and Head (1998) stress that these short-term objectives should have a supporting function subordinated to the prevailing long-term objective of shareholder wealth maximization.

The reason for the co-existence of such is inherent in the degree of differentiation considering the number of interest groups (internal as well as external) with stakes in the company including employees, the local community and creditors. Correspondingly, demands of the various stakeholder groups diverge on the subject of what the company should achieve.

Maximization of profits:

This classical economic approach substantiated by Hayek (1969) and Friedman (1970) goes back to the suggestion of running a firm with the paramount purpose of maximizing its profits. Specifically, the operational point of view states that the profit peak is realized whenever the marginal revenue equals the marginal cost.

The following aspects are suggested as limitations of profit maximization as a corporate objective:

a) Pursuing short term profit maximization might lead to a deficiency in the future investment capability of a company owing to the fact that too much liquidity is tied to current operations. As a result, long-term survival of the business is put at risk. Hence, the timescale for profit maximization is difficult to delimitate - a trade-off between short-term profit gains and potential future income opportunities has to be counterbalanced.
b) Qualitative as well as quantitative difficulties concerning the identification, measurement and the obtainment of data required to develop a precise profit ratio evolve due to the high complexity of the profit controlling process. As a result, all factors that contribute to it have to be identified and taken into consideration. However Watson and Head (1998) disbelieve that this is realistic to be achieved on a consistent basis.
c) Disregards risk

A dividend distribution as being a part of shareholder wealth augmentation is paid through cash rather than profit. The factors that are inevitably tied to the determination of shareholder wealth are timing and risk.

As the outlined points suggest, profit maximization is not a sufficient alternative corporate objective in respect to shareholder wealth maximization.

Maximization of sales:

If the mere long-term objective is to maximize the company's sales, there is a high probability of initiating a tendency towards overtrading which could eventually result in liquidation.

Nevertheless, considering the scenario of a company penetrating a new market it might as well be a valuable tool to function as a supporting short-term objective.

Survival

This objective cannot be regarded as to meet the requirements of a sustainable running of a business to the extent that shareholder wealth is maximized. The vast majority of potential shareholders expect the survival of the company in which they invest in to be rudimental and liquidation to be beyond discussion.

One premise to ensure success as well as sheer survival on a larger timescale; however is to attract new capital via providing an investment opportunity with a prospective return on investment (ROI) as high as an equivalent alternative investment.

Regarding recent developments in the economic environment with aggravated capital procurement for businesses, especially after the breakdown of the global finance sector in 2007, survival has proven to be a reasonable short-term objective in times of an economic recession. Furthermore if liquidation is considered to be a likely risk, short-term survival can be defined as being consistent with the principle of shareholder wealth maximization.

A possible scenario for managers to set the highest priority on short-term survival is a market shock.

As outlined above, a market shock can put managers into the position of merely focusing on short-term survival instead of pursuing the premise of long-term capital growth and return prospects for the shareholders. From a manager's perspective, survival is regarded as being the risk avoidance of threats that might jeopardize the company's future.

The attitude of risk aversion however, can cause a divergence between shareholder interests and the management's operational decisions. Even though both parties have stakes in the company, they have a contrasting position to risk in terms of setting different priorities when it comes to risk handling. Whereas private shareholders usually have a relatively small amount of their capital invested in one single company. The possibility of capital diversification allows shareholders to have a relatively moderate risk tolerance whereas managers have the bulk of their income (including share options), prestige and security interrelated to the survival of the company. As a result a tendency towards the avoidance of high-risk and therefore high-return investments can be observed in management decisions. Hence shareholders are deprived of the possibility to gain large capital growth if this theory applies (Arnold, 2007).

Social responsibility

This particular objective has gained an increasing importance during recent years. Good working conditions represent an underpinning requirement for an excellent corporate culture as being a part of the contribution to a company's goodwill. Possible examples to be named are an employees' council, a cafeteria or discounts in local shops and sport facilities offered to employees. Additionally anti-social actions such as environmental pollution are to be avoided in order not to upset the local community and maintain a good reputation among potential customers. Again, the objective of running the business in a way that social responsibility is guaranteed is crucial but should represent a rather supportive function to the overriding goal of shareholder wealth maximization.

Profit maximization vs. shareholder wealth maximization Reasons why profit maximization is not the same as shareholder wealth maximization (Arnold, 2007):

Prospects:

Future prospects including the company's growth potential are disregarded. In addition, the corporate strategy as being the main driver of whether capital gains can be realized or not, is not taken into account when it comes to pursuing the objective of profit maximization.

Risk:

The process of profit maximization may cause a volatility of equity due to certain risks that have to be put up with, whereas shareholders are likely to consider a firm with constant income flows to be a better investment than one with high risk.

In other words, profit maximization does not take risk as a variable into account, which inevitably causes a trade-off phenomenon between the cash flows and risk. Specifically, the prospect of greater anticipated returns is associated with larger risk. Evolving from that coherence, higher cash flows lead to an increase of the share price whereas a higher risk has a negative impact on it (Gitman (1998).

Communication

Even though shareholders are aware of the risk associated with an investment in shares, they seek to minimize it through gathering as much information as possible about the company to mitigate their level of uncertainty. So, a good communication between the firm and its shareholders through the implementation of a sustainable investor relation strategy is of great benefit to both parties. Since especially institutional shareholders that have a comparatively high amount of money invested in the company want to be up to date about the current strategies, future investment plans and the sources of income, large firms have a team of senior executives who spend a lot of time on getting this information delivered (Gitman, 2007). Ignoring the significance of communicating with investors along with the impact of the perceived corporate among the investment community might cause the share price to drop and consequently represents a threat for current shareholders.

3.3 Shareholder value theory

3.3.1 General Information

Shareholder value or shareholder wealth as it is often referred to, can be regarded as being equivalent to maximizing the purchasing power of current shareholders which is derived through capital gains (an increasing share price) and dividend payouts. Variables that have a direct effect on shareholder wealth developments include the magnitude of cash flows derived from business activities, the timing of such as well as the risk linked to them. The main indicator of shareholder wealth is represented by the ordinary share price. In accordance with the efficient market hypothesis the price for which the share is traded on the stock exchange is to reflect the financial community's expectations about potential dividend payments as well as investor perceptions concerning the long term forecast of the company's development in the competitive environment. Consequently, maximizing the share price can be used as a suitable proxy for shareholder wealth maximization since it correlates to the augmentation of the firm's value in terms of its market capitalization (Watson and Head, 2007).

Gitman (2007) stresses that financial managers ought to act in the interest of the shareholders by only accepting actions that will potentially have a positive effect on the company's share price.

The premise for shareholders to invest in shares closely correlates to the agency theory, which will be dealt with in more detail later on. Arnold (2007) approaches the problem by examining the basic incentive of return on investment (the flow of cash in terms of dividends payments through time and an increasing share price) as the main driver encouraging shareholders to postpone immediate consumption and put the management in charge of their capital. However the outlook of the average returns has to be higher than the one that could be achieved by putting money into a bank account with capital gains at the risk free rate (prime rate), for this theory to apply.

3.4 Financial Ratios

3.4.1 Price-Earnings Ratio (P/E - Ratio)

The PE ratio gives the analyst an insight of how valuable a firm is regarded by investors as a multiple of the previous year's income. There is a dichotomy in the implications for either a high or a low PE ratio. The scenario of a company with a great PE ratio in comparison to other companies that operate in the identical business sector reflects the fact that the company is highly regarded by the market rooted in motives excluding its present earnings as Pilbeam (2005) stresses. Subsequently there is high probability of having a significant future earnings augmentation. The opposing case of a remarkably small PE ratio corresponds to the market perception for the firm to be rather low-priced, which inevitably leads to a rising risk of a takeover. Resulting from the correlation between the PE ratio and the anticipated earnings performance, a low PE ratio suggests the company's potential performance to be beyond the market average. Despite the fact of the Price Earnings analysis being a commonly used method to value a firm's performance, there are three limitations that constrain the application of it in order to get reasonable results, Harrison (2005).

1) Only firms that use the same accounting methods can be effectively compared, for instance the way depreciation on capital assets is handled.
2) Reporting dates have to be conforming when comparing companies. Due to volatile economic conditions, the reported earnings per share ratio can fluctuate throughout the fiscal year.
3) The PE ratio analysis is merely useful to evaluate firms that operate in the same industrysector, Harrison (2005).

Computing the Price - Earnings ratio according to Pilbeam (2005):

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The earnings per share (EPS) can either be obtained from online resources or be calculated as follows:

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According to Rice (2003) the following P/E ratio benchmarks should be considered when comparing companies:

1) A company that people believe tob e in danger of being bankrupt will be on a PE of less than 5
2) A company performing poorly would be on a PE between 5-10
3) A company which is doing satisfactorily will be on a PE of between 10 and 15
4) A company with extremely good prospects will be on a PE greater than 15

3.4.2 Discounted Cash Flow Model

The Discounted cash flow model (DCF model) is the most frequently used technique to determine a firm's investment potential, Barker (2001). He stresses that in order to apply this method; however it is crucial to examine the market setting in which the company operates rather than regarding the company as an individual entity. Due to the fact that the DCF valuation is highly sensitive to the quality of involved information (assumed future cash flows, discount rate) it is common to estimate cash flows for diverse potential scenarios (base case, an optimistic case and a pessimistic case) to get the result as accurate as possible, Macabus (2010). In the decision making process whether or not to an investment is beneficial to the company's wealth, each investment is assessed based on its expected cash flows by computing the net present value of all anticipated cash flows, Burksaitiene (2009). If an investment (a project) has a positive NPV, it creates value for the company as wells as for its shareholders. The main driver determining the amount of value creation is the cost of capital which in correspondence with the DCF formula is applied as the discount rate for cash flows to compute the present value of such (Burksaitiene, 2009).

The DCF formula:

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As illustrated in the formula above, the weighted average cost of capital (WACC) is employed as the discount factor to take claims of both shareholders (cost of equity) and debt holders (cost of debt) into account when calculating the present value of future cash flows, Barker (2001). For this reason, the DCF model regards the whole of the company's financial assets, allowing the comparison of companies with dissimilar capital structures on a profound basis. The value a project generates can be increased through decreasing the discount rate by either changing the operating risk, reducing the operating leverage, change the financing mix (ke and kd) or changing the financing type.

Contemporary finance theory sees managers obliged to allocate company resources in a way that a company's value as well the wealth of its shareholders is maximized. Furthermore Damodaran (1999) argues that management compensation systems can barely be linked to the DCF model as a reason of the management being able to manipulate the inputs needed to compute an investment's worthiness. A major advantage of estimating a company's financial performance by using the discounted cash flow model is the fact that it is not affected by inconsistent accounting methods (IFRS, US GAAP) since the generated cash flows used to compute the present value are not subject to disclosure rules. Furthermore unlike the PE ratio method, the more inward-looking point of view mitigates the DCF's exposure to unstable external factors that could possibly bias the financial performance.

3.4.3 Dividend Valuation Model

The decision of shareholders to buy shares of a company through the investment of private capital is driven by the return on investment potential and the coherent risk associated with it. Hence, there is a strong correlation between the volatility of the share price and the uncertainty about future capital gains for shareholders. In other words shareholder value is created when the return on investment exceeds share price fluctuation and therefore compensates the higher risk of capital losses for investors. Return on investment from the shareholder perspective derives from the annual payout of dividends. Resulting from the fact that the dividend valuation model (DVM) is based upon the premise of future cash flow streams being partially returned to its shareholders, it is possible to estimate the theoretical value of a share, Barker (2001). The foundation of the dividend valuation model derives from the assumption that the present market value of ordinary shares reflects accumulated future dividend flows, Arnold (2007). However, changes in the input (the discount rate and the dividend growth rate) used to apply the DVM as a tool of measuring financial performance have a major impact on the firm's valuation owing to the fact that those variables are assumed to be valid to infinity.

There are two most commonly used types ofthe DVM, Eakins (2002):

1) The constant dividend valuation model

Formula:

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This is a simplified application ofthe dividend valuation model with the underpinning criteria of dividends being constant at an annual interest whereby the dividend in year one corresponds to all future dividends until infinity.

2) The dividend growth model

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Average compounded growth rate:

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This more sophisticated approach of valuing a firm by looking at the dividend flows to its shareholders is often referred to as Gordon growth model. The variable that differentiates this method from the constant dividend valuation model is a growth rate (g) which is based upon dividend growth potential whereby the cost of equity (ke) has to be larger than g for the formula to be valid.

The Dividend valuation model is characterized by putting emphasis on maximizing shareholder value. Consequently as deriving from the DVM formula, the model merely regards the equity-financed part of the company whereas stakes of debt-holders are not taken into account. Thus the DVM is not capable of capturing how well a company operates in terms of investment performance. Furthermore, the most significant criticism of the DVM is stated by Miller and Modigliani (1961) who stress that as long as investment plans are maintained, the dividend policy of a company is irrelevant to valuation.

3.4.4 Economic Value Added (EVA Model)

The Stern Stewart consulting organization modified and renamed the idea of residual income (Rl) during the 1990s. Despite the fact that Stern Stewart & Co initially applied the EVA model in that time, economists already considered an analogous notion prior to that. Among them was Alfred Marshall who in 1890 already did research on the concept of economic profit regarding the real profit of a company while considering the coherent operating costs. The EVA was developed by Stern Stewart & Co. under the premise to develop a financial measure that is in correspondence with an incentive system for the management to focus on shareholder wealth maximization (Burksaitiene, 2009). In other words, creating shareholder value particularly should be the overriding objective according to Stern Stewart. With the adjustments by Stewart & Co. made to the Rl model, the EVA valuation facilitates monitoring and controlling invested capital for the management. The role of the EVA as being a performance measure has been extended to the point that it can contribute to an integrated financial management system and subsequently promote decision making to be decentralized (Stern et al., 1997). So the EVA introduces the opportunity to enhance the overall company value by indirect changes in the decision making process (management).

The EVA is calculated by deducting all operational expenses, taxes and cost of capital from the net sales. Therefore this technique of evaluating a company is considered to measure the real profitability of a company. As deriving from the EVA calculation, there are three variables that have to be known in order to compute it: capital invested, return on capital and the cost of capital (ke). Evolving from the EVA evaluation, the maximum dividend per share that a firm is capable of paying to its shareholders can be revealed by dividing the EVA by the outstanding number of shares. In terms of interpreting the EVA, this ratio exposes whether or not a company creates value. Specifically this is the case when the EVA is positive. This method of company valuation is characterized by being a historic measure documenting the realized performance throughout a distinct calendar period, Burksaitiene (2009). This particularly considers the period of time during which the added economic value occurred and is not concerned with estimating performance prospects, Barker (2001). The strong link to shareholder wealth maximization as well as the fact that the EVA model is a technique which enables the analyst to value a company with a relatively simple algorithm contributed a distinctive share to the EVA's recently gained popularity. On the whole, firms, which align their strategy with focusing on the economic value added approach, strive for enhancing the net cash return on invested capital. Explicitly according to Tully (1998) there are three strategies companies can pursue with the intention of increasing their EVA:

1) Earn more profits without using more capital
2) Uselesscapital
3) Invest capital in high return projects

Hence, these alternatives suggest that the management can entirely control the amount of added value. An additional benefit of the EVA method is the inherent incentive system that corresponds to the fact that it can be applied to any department, division or strategic business unit of a corporate organization, which is to produce a separate financial statement, Eakins (2002). This artificial internal competition among the corporate units allows the EVA to operate as a motivation tool especially for the lower management in order to overcome the agency problem of asymmetric allocation of information by means of aligning the management's interest with shareholders through the implementation of a bonus system. When a company's strategy is focused on shareholder value maximization, the EVA can perform well as a tool to assess the management performance as the study by Peixoto (2002) suggests.

Linkage between EVA and NPV

The net present value of a project is an indicator for the accumulated value a project creates over time. Damadoran (1999) argues that the EVA method evolved from the NPV concept with the present value (PV) of the EVA by a project over its lifetime being the NPV of a project. Thus the connection between the EVA and the NPV model is pursuant to the valuation of the firm by the EVA. Damodaran (1999) stressed that in order to give a profound statement about a firm's actual value, cash flows from investments made in earlier periods as well as the anticipated value augmentation have to be taken into consideration.

Resulting from that, there are three components contributing to the value of a company:

1) Capital invested in assets
2) Present value of the EVA by these assets
3) PV of the anticipated EVA

Dury (2004) concludes that the EVA is the long-term equivalent to the DCF model. So assuming that the maximization of the NPV in congruent with shareholder value maximization, then in return maximizing the PV of the EVA as wells is conform to maximizing shareholdervalue.

Further Formula consideration (Sharma and Kumar, 2010):

"The EVA of the company is just a measure of the incremental return that the investment earns over the market rate of return" (Sharma and Kumar, 2010).

Coherently the EVA can be regarded as an estimate of the economic profit shareholders can gain compared to their opportunity costs of investing their money in securities with an equivalent risk.

Calculation:

EVA = NOPAT - (TCExWACC) Where,

NOPAT = Net operating profit after tax

TCE = Total capital employed

WACC = Weighted average cost of capital

Descriptively this formula expresses the EVA concept as the surplus after deducting an appropriate charge for the capital employed.

Non-operating items (e.g. dividends, interests on external investments) as well as non­operating expenses are not taken into account when calculating the NOPAT figure.

The TCE is computed by accumulating the shareholder funds and loan funds. Again, investments outside the business are not considered.

The WACC considers cost of debt after taxes while the cost of equity (ke) is computed by utilizing the capital asset pricing approach.

It is calculated as follows:

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R_f = Risk free return

R_m = Expected market rate of return

B_i = Risk coefficient of particular investment

3.4.5 Market Capitalization

The market capitalization figure illustrates the value of a company by looking at its value according to the stock market. It can be computed by multiplying the current share price with the total number of shares. Deriving from this algorithm, the market capitalization approach measures the value on a particular date (due to volatile share prices) rather than estimating economic performance, Arnold (2007). However, since the share price is one of the factors contributing to shareholder wealth through capital gains, a correlation between shareholder wealth and the market capitalization model can be observed. Typically there is a classification of stock listed companies according to their capitalization: small cap, mid cap and large cap. The main characteristic of large cap firms is that they have a tendency to be moderately constant and established in respect of having only little fluctuation in their market value.

A constraint in respect of addressing potential shareholders is embodied by the mobility barrier between different stock indices (FTSE 100, FTSE 150) that companies have to cope with. Correspondingly, Valdez (1997) stressed the high degree of volatility concerning the market capitalization that fluctuates coherently to a share's selling's or buying's behaviour on the stock market. Therefore utilizing this valuating method enables the analyst to derive the present investing climate on the stock market. In terms of reflecting the true share price of a company, the market cap can be assessed more accurately if the shareholder structure is rather diversified. Additionally, major limitations of the market cap approach derive from the sensitivity to speculative investors as well as the asymmetric allocation of information (agency theory issue) in terms of managers using insider information to manipulate the share price.

3.4.6 Capital Asset Pricing Model

Bill Sharpe (University of Stanford), John Lintner (Harvard University) and Jan Mossin (University of Bergen) developed the Capital Asset Pricing Model (CAPM) both simultaneously and autonomously in the year 1965. The work as well as innovative findings of those researchers benefited from the earlier work of Harry Markowitz, who together with B. Sharpe was awarded the Nobel Price in economics for their outstanding contribution to the theory of finance in 1990 (Eakins, 2002).

The concept of the CAPM approach was embraced by Pike and Neale (1999) as follows:

"The CAPM explains how individual securities are valued, or priced, in efficient capital markets. Essentially, this involves discounting the future expected returns from holding a security at a rate that adequately reflects the degree ofrisk incurred in holding that security"

As every theoretical financial model, the Capital Asset Pricing Model also is subject to various assumptions. Lumby and Jones (1999) summarized them by means of classifying them into two categories:

Assumptions about investors:

- They are rational, risk averse, utility maximizers
- They perceive utility in terms of return
- They measure risk by the standard deviation of returns
- They have a single period investment horizon
- They all have the same expectations about what the uncertain future holds

Assumptions about the financial market:
- Therearenotaxes
- Therearenotransactioncosts

Investors can both lend and borrow at the risk-free rate of return

When applying the CAPM to the real world, inputs that have to be taken into account can be simplified in accordance to the CAPM-formula (Mukherji, 2011).

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Where,

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As formulated by Mukherji (2011), the cost of equity (ke) a company has to expend is described by a linear correlation of its market risk.

The following figure summarizes this complex interrelationship in a graphic manner:

Figure 2: CAPM Model

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Source: Brealeyand Myers (2001, p. 297)

As illustrated above in Figure 2, in accordance to the CAPM, the beta coefficient is linearly correlated to the anticipated risk premium on each investment. Hence, each investment ought to plot along the security market line linking Treasury bills and the market portfolio (Brealeyand Myers, 2000).

Theoretic Fundamentals

The Capital Asset Pricing Model reveals the correlation of the decision making process of stock exchange related investments and investments in shares in respect of individual companies instead of portfolios (Lumby and Jones, 1999). Coherently it is of direct relevance to the management. Equally important is its usefulness in terms of providing substantial information about key factors contributing to the share price evaluation. Nevertheless Lumby and Jones (1999) suggest that the CAPM neither provides a perfect nor an entire portrayal of the real world but argue that it is the most accurate model available. As such, it illustrates the linkage of the systematic risk and the expected return ofan investment.

The scale of the systematic risk is represented by the risk that a sole asset adds to a moderately diversified portfolio of stocks. The beta factor quantifies this magnitude whereas the systematic risk augments in coherence with the beta (R) factor (Hubbard, 2000). Both the covariance and the standard deviation of returns are taken into account when computing the beta coefficient (Howells and Bain, 1998). Furthermore the beta of a security can be seen as being representative for its degree of volatility. In other words, if R < 1 it means that the share progresses slower than the marker whereas a R > 1 has the opposite effect (Foley, 1994). Hence, the return that investors expect of an asset increases and decreases in accordance to R (Hubbard, 2000).

Generally, there are two components that contribute to the expected return of such:

- The default risk free rate
- Theriskpremium

Where, the risk premium (rm-rf) functions as a compensation for investors in the event that the asset does not generate the return that had been expected (Hubbard, 2000).

Impact on Portfolio theory

The theory of finance postulates that portfolio diversification allows stable returns while taking relatively low risk. Thus, Eakins (2002) suggests that investor prefer a diversified portfolio to a non-diversified one. Hence the CAPM assumes a superior portfolio what is known as efficient portfolio, which obtains the highest possible return for the risk. Therefore only the correlation between a particular asset and the efficient portfolio has to be evaluated in order to determine its risk and return.

As suggested by Eakins (2002) the specific case of R being equal to 1, would tell the analyst that the risk of the security aligns with the average market risk, whereas a beta factor of 2 reveals that the risk of the security is twice as high as the market average.

According to Pilbeam (2010) a portfolio's risk consists oftwo factors:

1) Systematic risk
2) Unsystematic risk

The specific or so-called unsystematic risk can be mitigated or eventually diminished through increasing the number of shares that a portfolio comprises (diversification strategy). The market risk, which is often referred to as systematic risk, corresponds to the portfolio beta factor. It is subject to the weighted average of the beta of each single asset the portfolio carries (Pilbeam, 2010).

This circumstance enables the fund manager or alternatively the investor to assemble either aggressive (ß > 1) or defensive (ß < 1) portfolios through the selection of assets with the appropriate risk (in correspondence to R).

Limitations of the CAPM

Fama and French(1992) disclosed a study that had a devastating impact on the CAPM. More specifically they revealed that the CAPM is not completely capable of explain stock returns over time. Furthermore this study suggest that firm size as well as the book-to-value ratio forecast returns betterthan the beta coefficient.

Other limitations that Foley (1994) refers to, include:

- ß uses past data input to estimate anticipated returns

- The ß coefficient is affected by divestment, mergers and acquisitions

3.4.7 Shareholder Value Approach - A. Rappaport

The early work of Alfred Rappaport " Creating Shareholder Value" is considered to be the avant-garde of shareholder value driven management. Specifically he argues that this concept " must emerge as the new standard for business performance" (Rappaport, 1986, p. 13). Furthermore, as discussed by Bierman (1990, p. 145), Rappaport stresses to use the shareholder value approach "...in making capital budgeting decisions over traditional accounting measures such as EPS and ROI".

Rappaport (1986) aims to express the role of planning, controlling and valuation of corporate growth strategies. Cash flows from operations are the underpinning variables that determine the corporate value according to this approach. Hence, as future cash flows are discounted to their present value (PV) by using the weighted average cost of capital of the costs of debt and equity, whereas the latter is computed on the basis of the capital asset pricing model, shareholder value is created whenever the sum of cash flows and the residual value is positive. As a proxy, Rappaport introduced a "threshold margin" to represent a break-even- value which illustrates the point when a company contributes value to its shareholders.

However, Rappaport (1986, p.65) differentiates distinctly between shareholder value and shareholder value creation, stating that "... shareholder value characterizes the absolute economic value resulting from the forecasted scenario, [while] value creation addresses the change in value over theforecast period."

The ShareholderValue approach published by Rappaport (1986) is summarized in the Shareholder Value Network - Diagram.

Figure 3: The Shareholder Value Network

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Source: Rappaport (1986, p. 76)

The Shareholder Value Network as illustrated above shows how Management Decisions, as being the essential parameters influencing a company's value, affect the value creation chain including value drivers, valuation components and in the end result in the formulation of corporate objectives.

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