This paper gives a critical analysis of the article “Putting Strategy into Shareholder Analysis”, by George S. Day and Liam Fahey, published in the Harvard Business Review in March, 1990. The article talks primarily about the strengths and weaknesses of the Shareholder Value Analysis method of analyzing alternate strategy options for the organization. It focuses on the conflict between two measures used by organizations to evaluate different strategy alternatives; Shareholder Value Analysis and competitive advantage analysis. Also, it explores potential problems in SVA, and how these problems can be resolved to accurately analyze proposed business strategies.
Shareholder Value Analysis (SVA)
SVA analyzes the potential success of a proposed strategy based on how much return it will give to the shareholder. It is based on the belief that basic accounting methods are insufficient to measure the true value of a proposed strategy, as these methods are firstly based on a historical perspective, and secondly, produce only short term benefits. For example, if we are to use basic accounting methods such as growth in profits or price to earnings ratios, it can be argued that it is possible to boost these figures in the short term, but have little, or negative growth in the long run. (Bnet)
SVA overcomes these shortcomings by giving a more long-term perspective, and is strongly rooted in the belief that the strategy’s true value can only be gauged by how much value will be given to the shareholders.
There are, however, several criticisms against this technique of valuing alternative strategies. For example, some say that the figures used in calculations can easily be manipulated according to the preferences of the managers. This is possible because the analysis is based on elements such as future cash flows, which have to be forecasted by the managers. Thus, managers use their own judgments, and unless these judgments are based on hard facts, the end figures calculated can easily be manipulated.
Another related argument is that managers will hardly ever agree on the elements which the analysis is based on. For example, the most important aspect of the analysis is the terminal value of the proposed project; one which will be gained at the end of the concerned period. This value is the most difficult to forecast, and managers will hardly ever agree on one value, simply because of the inherent uncertainty that revolves around it.
Other arguments are that this analysis engages the managers in excessive number crunching and sensitivity analysis, and the result is that the creative or strategic thinking of the manager gets suppressed.
However, the article states, and rightly so, that the fault lies not in the technique, but how it is utilized. The analysis should be carried out in such a way that it complements the strategic thinking of the manager in his decision making. Only then will it yield effective and accurate results.
Conflict between Shareholder Value and Competitive Advantage
To measure the success of any project, the management can take two approaches. One is to consider the competitive advantage gained. This focus is all about the customer and the competitors. The management sees how well the customers have been satisfied, and how much better performance has been in comparison to competitors. The second approach is to see how much wealth or value has been created for the shareholders of the company.
Organizations will often take either one of the two approaches when deciding which alternative action is best. However, both approaches consider the long term success rather than short term. (Crowther, 2004)
Since the two approaches have entirely different points of focus, the advantages gained from one can be offset by resulting damage done to the other. For example, the company can cut back on resources to reduce costs, and shareholders will enjoy the resulting higher profits. However, if the reduced costs result in lower quality products, customers will be dissatisfied, and competition will win them over with better, higher quality products.
However, it is possible for this conflict to be resolved. The key is to find ways which will enhance both competitive advantage and shareholder value. To achieve this, it is sometimes important to keep focus on the long run. For example, there are IT applications which make it easy for organizations to enhance customer care, and organizations which opt for shifts in such technology may incur high capital costs, but in the long run their costs will be minimized. Thus, in the long run, shareholders will benefit from higher profits, and at the same time, customers will enjoy higher quality of service and care.
Where Shareholder Value Analysis Fails
The management can go wrong in three ways when using this approach for valuing alternative courses of action. The first way has to do with tendency of the SVA to undervalue projects which have considerable potential. The most common cases in which this tends to happen is underestimating the importance of future options and of retaining customers. It is these two cases in which this technique tends to undermine the importance of investment.
For example, future options are to do with investing in growth ventures, e.g. investing in technology, or acquiring a business which is thought to yield profitable results in the future. The discounted cash flow method, which is the basis of the SVA, tends to undermine the value of some of these future options. In reality, the investment might be a lot more profitable than reflected in the discounted cash flows. This is why most managers tend to believe that their own intuition or judgment is more reliable than the mathematical calculations required for SVA.
The second way in which SVA can go wrong is when the management overvalues a particular proposed course of action. This happens when the management does not question the assumptions which form the basis of their decision. For example, sometimes managers overlook the possibility of competitors being able to replicate a new idea, or the possibility of consumers resisting a new product innovation. Thus, future cash flows can show a highly optimistic and unrealistic picture of what the proposed strategy will yield in the future.
The third way in which this method can go wrong is when management simply overlooks a possible alternative. All options are not explored, and thus, one or two profitable alternatives could be completely left out in the analysis. If this happens, the analysis would obviously not be able to accurately guide the management on what the optimal course of action is.
Effectively Implementing SVA
It is evident that all the faults which lie in SVA are not inherent in the technique itself, but arise when the technique is not utilized properly. Thus, to effectively use this method it is important to train the people who will be conducting the analysis. This training should encompass how to question all assumptions which one makes to determine things like future cash flows on terminal value of a project. These assumptions should also be subjected to intense sensitivity analysis to see what the worst case scenarios are. Also, the management should be encouraged to continuously explore their minds as well as all information sources for more options and alternatives, to ensure that no option is overlooked.
Conclusion
The article gives an accurate analysis of the SVA technique, by correctly stating its weaknesses, and then showing how these weaknesses can be resolved. The Shareholder Value Analysis is an effective way of analyzing proposed strategies, when used in a way which complements other tools such as competitive advantage analysis, and managers’ knowledge base and experience. It is an effective tool because it focuses on long term results and is a method which can be universally applied, as opposed to accounting techniques which may differ from organization to organization and from country to country. (Entrepreneur.com)
The technique also carries certain disadvantages, such as complex calculations, and the fact that forecasting future cash flows carry a certain degree of uncertainty. This is why I have proposed that to effectively utilize this method, employees and managers need to be trained; not only with regards to mathematical computations, but also on how to make realistic forecasts which are free from bias and based on accurate foresight and knowledge. Managers must also bear in mind the importance of balancing shareholder value with giving value to the customers. Once these conditions are met, SVA will give a more optimal analysis of proposed strategies than other accounting techniques.
References
Bnet. Implementing Shareholder Value Analysis. Web.
Crowther, D. (2004). Managing finance: a socially responsible approach. Butterworth Heinemann.
Entrepreneur.com. (1999). Shareholder Value Analysis (Chechlist 160). Web.