Strategy 1: This is expected to result in a market price of $100 per share of common stock and a price of $120 five years from now.
Introduction
Most organizations often need help to link the statistics used in strategic shareholder value to the most innovative and rigorous strategic planning within the organization. These issues with placing strategic shareholder value are reasonable given the fact that strategy formulation and strategic shareholder value are carried out by individuals in various departments of the company and that executives are prone to human weaknesses like overconfidence and constrictive thinking (Mielcarz & Paszczyk, 2010). Reasonable enough, but not suitable strategy formulation. As a result, managers need to figure out how to avoid frequent risks if they hope to replicate the strategic shareholder value that certain businesses have attained and guarantee that the company increases shareholder satisfaction and makes its stock more attractive to investors. The strategy scenario “Is expected to result in a market price of $100 per share of common stock at present and a price of $120 five years from now” is the strategy that will be taken into consideration.
Shareholder Value and Competitive Advantage
Understanding the relationship between competitive advantage, value creation, and corporate strategy is essential for managers to fully appreciate why strategic shareholder value can often go wrong and how crucial strategic planning is connected to it. Each manager has a basic understanding of those particulars. Developing a competitive edge entails beating rivals in cost, technological expertise, obtaining raw materials, and consumer value. Increasing shareholder value, or value creation, necessitates the business generate profits above its cost of capital. However, not all managers know the relationship between shareholder value and the company’s competitive edge. A well-crafted strategy produces both: a plan can only provide prolonged shareholder value if it creates sustainable benefits, a prerequisite for winning in the business world (Whitwell & Doyle, 2005).
However, while determining the optimal strategy alternatives is the apparent goal of strategy analysis (the study of competitive advantage) and strategic shareholder value, the two are neither different. They employ various value conceptions, pay attention to various constituencies, deal with various marketplaces, employ various degrees of analysis, deal with various variables that influence decisions, and emphasize various metrics. To put it briefly, they have fundamentally divergent perspectives on the goal of strategy. The goal of the strategy, based on strategy assessment, is to attain the lowest deliverable cost or to create more excellent value in the minds of the customer; by strategic shareholder value, the strategy ought to yield the most significant returns to shareholders.
As an executive leader for ABC Company, the two financial strategies for the company to increase shareholder satisfaction and make ABC stock more attractive to investors, will have to take into consideration two strategies;
- Strategy 1: This is expected to result in a market price of $100 per share of common stock and a price of $120 five years from now.
- Strategy 2: This is expected to result in a market price of $80 at present and a price of $140 five years from now.
Computing the dividend paid out for each stock would be as follows;
Strategy 1:
Market Price per Share of Common Stock = $100
Price of Stock = $120
Period = 5yrs
The required rate of return on equity investments is 10%
The dividend paid out for the stock will be given by;
(120 x (5 + (10/100)) – 100 = $5.12
From the above calculations and based on the one-period valuation model of stock prices, stock one will pay out $5.12 in dividends if it is sold five years later for $120, and the needed rate of return on equity investments is 10%.
Strategy 2:
Market Price per Share of Common Stock = $80
Price of Stock = $140
Period = 5yrs
The required rate of return on equity investments is 10%
The dividend paid out for the stock will be given by;
(140 x (5 + (10/100)) – 80 = $6.34
From the above calculations and based on the one-period valuation model of stock prices, stock two will pay out $6.34 in dividends if it is sold five years later for $140, and the needed rate of return on equity investments is 10%.
Computing the NPV for each strategy:
Strategy 1:
NPV = Cash flow / (1 + i)^t – initial investment.
NPV = 120/(1+10/100) ^5 – 100
NPV = 20.01
Strategy 2:
NPV = Cash flow / (1 + i)^t – initial investment.
NPV = 140/(1+10/100) ^5 – 80
NPV = 40.01
Given that the stock price for Strategy 1 equals the net present value (NPV) of all future dividends, it is evident from the calculations that this is the ideal/optimal option. It is evident that the price at which the stock is trading is equal to its discounted value after five years and the net present value (NPV) of the dividends paid out during the other five years.
Recommendations
Increasing Shareholder’s Value through NPV Projects
Based on the widely recognized principle of corporate finance, it is believed that if the investment proposal has a positive Net Present Value (NPV), it will increase shareholder value in the long run. Typically, projects involving a negative net present value (NPV) are financially illogical from the shareholders’ point of view because they decrease their financial security. However, the rule does not apply to everyone.
When choosing an NPV-negative investment, three scenarios are the best way to maximize shareholder return. It may additionally be assumed, though, that in these circumstances, managers consider the project’s expected net present value (NPV) about the likelihood that the project will be implemented. In other words, their actions are consistent with the residual dividend concept. In order to distribute any free cash to them—it is called into question by examining the residual dividends hypothesis’s fundamental assumptions and the concept of shareholder value optimization.
Placing the Net Present Value, Fair Value, and Risk Perception
The rate of return that shareholders anticipate from a project largely determines how much it generates positive shareholder value. Because the projected return parameter appears arbitrary, investors may determine that a project has a different net present value (NPV) depending on how they evaluate the risks associated with the project. Nonetheless, the concept of finance offers some guidance on calculating a minimal expected return, which is reasonable given the risk presumed from the shareholders’ point of view. Establishing such a rate ought to result in calculating the project’s “objective,” or fair, value.
More in-depth analysis of the Fair Value Concept, Investment Concept, and Capital Asset Pricing Model assumptions is needed to ascertain its degree. Determining the level that defines the “objective” expected rate of return will make it possible to support the thesis—which holds that, when considering the monetary needs of shareholders, executing projects with a lower projected rate of return may be a logical decision.
Determining the anticipated rate of return, or the rate of discount, that may be applied to the fair value standards valuation of securities that have not been listed in an active market requires the assumption that there are infinite potential buyers and sellers. The shareholders’ expected rate of return on investment would go down to a level that considers their risk profile, a premium for making investments in equity securities, with a risk-free rate if the specific risk is reduced. The Capital Asset Pricing Model (CAPM) entirely aligns with the assumptions made regarding the existence of a volatile market, the ability to mitigate specific risks through diversifying your portfolio, and the rationale for an additional return on capital at a certain level of systematic risk associated with a particular asset exclusively (Day & Fahey, 2012).
Consequently, evidence supports the notion that the CAPM is a valuable tool for determining the desired rate of return that shareholders anticipate. This enables estimates of fair value for investment initiatives in an environment that is no longer active and the valuation of equity instruments. A corporation’s stock price in an appropriately informed and active marketplace would automatically decline due to the project’s negative net present value (NPV) if its managers approved a project with a rate of return lower than what the CAPM predicted. Because of this, a business that upholds the value for shareholders maximization idea and has a diverse shareholder base ought to turn down projects whose rate of return is less than the return calculated using the CAPM.
Suppose investors need to include the theory of diversification in their portfolios of investments. In that case, they find it more challenging to decide whether carrying out a project is worthwhile and how it will affect shareholder value. This occurs, for instance, when an investor owns all of the stocks of a particular company and possesses no other substantial assets except those shares. In this case, the business serves as the shareholders’ investment platform for portfolio diversification and value management. It might make sense to implement a strategy whereby the business takes on projects that do not produce the “objective” fair rate of returns but lower the amount of risk associated with the proprietor’s financial position and level of risk (Hillman & Keim, 2011).
The Relationship between Shareholder Value Analysis and Strategy Analysis
There exist distinct relationships between shareholder value analysis and strategy analysis. Because of these distinctions, achieving one type of value at the price of another is conceivable. For instance, one manufacturing material company improved its competitive position at the expense of shareholder value. It decided to significantly enhance its after-sale support, providing clients with more excellent value while maintaining competitive pricing. Customer satisfaction and shareholder value eventually converge.
Good strategy analysis is characterized by a tough-minded examination of competition and market realities, which should also be present in strategy shareholder value. Investing in future alternatives and investment in retaining consumers are two investment techniques that are crucial for creating and maintaining competitive advantage. However, SVA is infamous for failing to value them. Occasionally, a business will make a first investment in a newly emerging technology or market to expand if the technology or market continues to be successful.
References
Day, G. S., & Fahey, L. (2012). Putting strategy into shareholder value analysis. Harvard Business Review, 68(2), 156-162.
Hillman, A. J., & Keim, G. D. (2001). Shareholder value, stakeholder management, and social issues: What is the bottom line? Strategic Management Journal, 22(2), 125-139.
Lukas, B. A., Whitwell, G. J., & Doyle, P. (2005). How can a shareholder value approach improve marketing’s strategic influence? Journal of Business Research, 58(4), 414-422.
Mielcarz, P., & Paszczyk, P. (2010). Increasing shareholder’s value through NPV-negative projects. Contemporary Economics, 4(3), 119-130.
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