Human Resource Knowledge

Value creation

Frequently, profit maximization is offered as the proper objectives of the firm. However, under this goal a manager could continue to show profit increases by merely issuing stock and using the proceeds to invest in Treasury bills. For most firms, this would result in a decrease in each owner’s share of profits—that is, earnings per share would fall. Maximizing earnings per share, therefore, is often advocated as an improved version of profit maximization.

However, maximization of earnings per share is not a fully appropriate goal because it does not specify the timing or duration of expected returns. Is the investment project that will produce a $100,000 return five years from now more valuable than the project that will produce annual returns of $15,000 in each of the next five years? An answer to this question depends on the time value of money to the firm and to investors at the margin. Few existing stockholders would think favorably of a project that promised its first return in 100 years, no matter how large this return. Therefore, our analysis must take into account the time pattern of returns.

Another shortcoming of the objective of maximizing earnings per share—shortcoming shared by other traditional return measures, such as return on investment—is that risk is not considered. Some investment projects are far more risky than others. As a result, the prospective stream of earnings per share would be more risky if these projects were undertaken. In addition, a company will be more or less risky depending on the amount of debt in relation to equity in its capital structure. This financial risk also contributes to the overall risk to the investor. Two companies may have the same expected earnings per share, but if the earnings stream of one is subject to considerably more risk than the earnings stream of the other, the market price per share of its stock may well be less.

Finally, this objective does not allow for the effect of dividend policy on the market price of the stock. If the only objective were to maximize earnings per share, the firm would never pay a dividend. It could always improve earnings per share by retaining earnings and investing them at any positive rate of return, however small. To the extent that the payment of dividends can affect the value of the stock, the maximization of earnings per share will not be a satisfactory objective by itself.

For the reasons just given, an objective of maximizing earnings per share may not be the same as maximizing market price per share. The market price of a firm’s stock represents the focal judgment of all market participants as to the value of the particular firm. It takes into account present and expected future earnings per share; the timing durations, and risk of these earnings; the dividend policy of the firm; and other factors that bear on the market price of the stock. The market price serves as a barometer for business performance; it indicates how well management is doing on behalf of its shareholders.

Management is under continuous review. Shareholders who are dissatisfied with management performance may sell their shares and invest in another company. The action, if taken by other shareholders (who are not satisfied with the returns from the company on their investments), will put downward pressure on market price per share. Thus, management must focus on creating value for share-holders. This requires management to judge alternative investment, financing, and asset management strategies in terms of their effect on shareholder value (share price). In addition, management should pursue product-market strategies, such as building market share or increasing customer satisfaction only if they too will increase shareholder value.

Labels: Marketing

posted by Paresh @ 6:19 PM