Creating Shareholder Value: A Guide for Managers and Investors
Summary
Rappaport wrote the foundational text on shareholder value analysis, arguing that accounting measures including earnings per share and return on equity do not measure value creation, and that the correct measure is discounted future free cash flow. His argument against accounting measures is specific. Earnings can be increased by investments earning below the cost of capital, since earnings do not charge for equity capital. Accounting policies including depreciation methods, inventory valuation and revenue recognition alter reported earnings without changing cash. Earnings ignore the timing of cash flows and the investment required to produce them.
His framework identifies value drivers: sales growth rate, operating profit margin, incremental investment in working capital and fixed capital, the cash tax rate, the cost of capital and the value growth duration, meaning the period over which a company can invest above the cost of capital. Any strategy or decision can be evaluated by its effect on these.
He applies the framework to corporate strategy evaluation, merger and acquisition analysis, performance measurement and executive compensation, arguing that incentive schemes based on accounting measures reward exactly the behaviour that destroys value. The second edition addresses criticisms of shareholder value that emerged in the 1990s.
The framework has been substantially blamed for corporate short-termism, which Rappaport disputes on the grounds that discounted cash flow is inherently long-term and that the failure was in using accounting proxies and stock prices instead. That defence is correct about his method and does not address how the concept was implemented. The value driver framework remains the standard analytical structure for valuation.
Key takeaways 8
- Earnings per share and return on equity do not measure value creation, since earnings do not charge for the equity capital employed.
- Value equals discounted future free cash flow, which means the timing of cash and the investment required to produce it both matter.
- Accounting policies alter reported earnings without changing cash, which makes reported figures unreliable for measuring performance.
- Any decision can be evaluated through its effect on seven value drivers including growth, margin, investment requirements, tax and the cost of capital.
- The period over which a company can invest above its cost of capital determines a large share of its value and is usually the least examined assumption.
- Growth destroys value when the return on incremental investment is below the cost of capital, which accounting measures conceal.
- Compensation schemes based on accounting measures reward the behaviour that destroys value, which makes incentive design a valuation problem.
- Rappaport disputes the blame placed on shareholder value for short-termism, arguing that the failure was in using accounting proxies rather than his method.
Who should read it
Investors and executives who want the original statement of value drivers and the case against accounting measures of performance.
About Alfred Rappaport
Professor emeritus at the Kellogg School of Management, Northwestern University; originated shareholder value analysis.
Creating Shareholder Value demonstrated that reported earnings and accounting growth do not measure value creation, and identified the cash flow drivers that do - a framework corporate finance departments still run on. Expectations Investing, written with Michael Mauboussin, inverts the exercise: read the expectations already priced into a stock, then judge whether the business can beat them.
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