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Giba Proposal
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CAN YOU SPOT SERIOUS SHAREHOLDER VALUE
By Mr Frederick Akalamudo (June 1999)
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Shareholder value has become the main basis on which companies are run today.
It is common to hear all Chief Executive Officers say that the decisions they
are taking in a particular scenario such as in a take over bid, joint-venture
or fusion are in order to create value for their shareholders.
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The need to create value for shareholders is today more exemplified in their
voting rights as they actually put a stamp on top management’s strategy, as we
observe in the BNP, Société Generale and Paribas saga in France.
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Spotting serious shareholder value is not an issue for top management alone,
nor staff of the company or shareholders, but is generally an issue for all
stakeholders. A financier like a banker will be more interested in lending to
an organisation if he or she knows that there is an opportunity to create
shareholder value. Similarly Governments will support businesses in which
shareholder value can be created. But because shareholders take the most brunt
for the failure of a business, senior management focuses on creating value for
this set of risk takers.
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Serious shareholder value can be spotted when an idea, process or an innovation
translates into a competitive edge, enabling a certain service or product to be
made available to consumers at a cheaper, easier and faster rate than an
alternative will normally have taken.
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Such ideas, processes or innovation may be functional as in technology
(engineering and information systems/ telecommunications), finance (cost
control measures, financing and tax management), human resources management
(compensation system linked to performance, sales, profits and stock options),
marketing (advertising, public relations, sales drive), environmental or
internal communications.
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They could also be strategic like in an alliance, acquisition (amicable or
hostile), fusion, joint venture, restructuring, retrenchment or outright
liquidation when the ability to create value and hence the need to remain in
the competition can no longer be sustained or justified.
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Senior management will always be privy to the processes that will eventually
create shareholder value, because it is their duty on a daily basis to fashion
them out. But shareholders and financial analysts in most cases do not have the
information that senior managers have, as a result they must fashion out tools
for measuring the ability of Top management to create shareholder value.
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Because Management has a set of projects to be executed and resources are not
available to finance all of them, they carry out capital allocation or
rationing and execute those projects that have a greater opportunity to
generate cash or create shareholder value by maximising profits.
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This will involve Discounted Cash Flow Analysis to obtain the Net Present Value
and Internal Rates of Return of projects and comparing them with in-house set
internal rates of return which are well above average five year interest rates,
and checking the effects of taxation and inflation on these approaches and also
whether some of the projects are compatible or not.
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Shareholders and financial analysts never get enough details of these projects
and the ensuing analysis unless they are institutional investors or they are on
the Board of Directors and so they have to design or apply methodologies in
which they use company final accounts in an expectation manner that will be
forward looking, in just the same way that a Chief Executive Officer fixes
targets and expectations for individual units of an organisation.
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Since the less informed staking public are not privy to the day to day running
of organisations, I wish to propose the Growth Index Based on Accounts (GIBA)
method of spotting serious shareholder value. It is both forward looking and
backward looking and thus total in approach.
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Basically a number of ratios or indices, seventeen in number are computed in an
expectation manner and thus forward looking, with nine of them being convolved
with one another to obtain the GIBA value. The GIBA value of a share or company
then determines if there is a realisable potential (purchase/ hold strategy)
and thus creation of value or if there is an exhausted or pressurized potential
(sale of shares).
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In the GIBA valuation approach, the following seventeen indices are computed :
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Expected Net Asset Per Share divided by Market Price
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Expected Return on Shareholder Funds (not TSR or Total Shareholder Returns) in
present year related with or divided by the average over the last four years
excluding the present.
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Expected Average Return on Shareholders Funds (not TSR) in the last five years
including the present year.
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Expected Profit/ Turnover in the present year related with or divided by the
average of the last four years before the present.
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Expected Average Profit/ Turnover in the last five years.
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Inflation Rate (hundredths) subtracted from 1.
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Exchange Rate during share sales or present year (ERs) divided by Exchange Rate
during purchase or present year minus five years (ERp).
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5 year average earnings per share divided by market price.
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5 years average dividend per share divided by market price.
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It is these nine indices that are convolved by one another or multiplied to
obtain the GIBA valuation as a measure for spotting serious shareholder value.
The other indices helping in this understanding but not being part of the GIBA
formula are as follows :
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Average 5 years, Fixed Asset divided by Turnover
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Average 5 years, Fixed Asset Per Share divided by Market Price
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Average 5 years, General Reserves Per Share divided by Market Price
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Expected Average, 5 years Turnover divided by Shareholder Funds
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5 years Average, Gross Profit divided by Tax
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5 years Average, Capital divided by Long Term Liability
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Average 5 years, Long Term Debt Per Share divided by Market Price
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Average, Dividend Per Share divided by Earnings Per Share in the last five
years
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The mathematical convolution of GIBA is given below: -
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where NAPS = Net Asset Per Share
Price =
Current Market Price
ROSFn=5
= Present Expected Return on Shareholders Funds ( Capital plus Retained
Earnings)in percent
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ROSF = Return on Shareholder Fund in percent
i = Prevailing Interest
Rate
P/T = Profit divided by Turnover
d = Inflation Rate
ERs = Exchange Rate today, year 5 or during share sale
ERp = Exchange Rate during purchase or five years ago
EPS = Earnings Per Share
DPS = Dividend Per Share
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I also wish to define the GIBA(d) which is the serious shareholder value
cut-off at which a purchase or hold decision changes into a sales decision.
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This is given empirically as :
GIBA(d) = ½ ( Interest Rate(%))4
So that if prevailing interest rate is 5% then
GIBA(d) = ½ ( 5 )4 = 312.5
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This is interpreted to mean when GIBA computed from the nine indices in the
earlier formula is above 312.5 for a particular share or an organisation, then
it has potential for growth and value creation and should be held or purchased.
But if it is below 312.5, then its value potential has been eroded or is being
destroyed and should thus be sold.
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When we look at the nine components of the GIBA formula, we can trace them to
the way a company is being run as follows :-
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NAPS/ Price : In this ratio, it can be identified if
management’s ability to create shareholder value is being rewarded by the share
attracting a favourable price above current interest rates.
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ROSFn=5 / ROSFn=1-4 : Here,
management’s ability to create serious shareholder value at a rate that
surpasses current interest rate is compared with the average of the last four
years.
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ROSF / 5 : This index gives an indication of
management’s ability to create value above current interest rate and sees to it
that for every euro that is retained and not distributed as profit, management
was actually able to generate returns above current interest rates.
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4(P/T)n=5 / (1+ i )(( P/T) n=1-4 ): This
is Profit / Turnover ratio from one year to the last four years. It is also a
check of management’s ability to streamline its costs in such a way as to
improve on yearly basis in a manner that surpasses current interest rate.
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( P/T ) / 5 : In this ratio of average profit / turnover
in the last five years, management’s ability to outperform current interest
rate and thus confirm the need to remain in the competition at all is once
again verified.
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( 1 - d ) : In this index the overwhelming influence of
inflation as a reduction in shareholder value is brought to bear on an
organisation by its inclusion in the GIBA formula.
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ERs / ERp : This index seeks to put exchange rate
difference in check by relating it to shareholder value. In this case,
investments made in euro, pound sterling or swiss francs will be related to the
dollar while those made in dollars will be related to say the euro. For
instance if one buys 20 shares at 20 euro each at a time when the exchange rate
is $1.15 to the euro and eventually sells them at 25 euros each when the
exchange rate was $1.10 to the euro, then, a 25% gain in euro terms has been
made. But it is also true that the gain in dollar terms is just about 19%.
So if an investor has chosen to spot serious shareholder value based on a
particular currency, then this aspect of the GIBA convolution enables him to
measure management’s value creation conformity with exchange rate fluctuations.
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EPS/ Price : This is a classic ratio that immediately
shows if management’s ability to surpass current interest rate translates into
higher price earning ratios. Very low price earnings ratio are usually
indicative of badly managed companies in which shareholder value has been
eroded. Conversely very high ratios are no good either as they indicate that
the market is overrating the company and will need to correct itself before
long, which is common with internet stocks.
In countries where there is instability or infrastructural decay, it is
possible for companies to perform well above current interest rate and still
have very low price earnings ratio, because of outright avoidance of such
markets by foreign investors who could have improved the demand situation in
such markets.
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DPS/ Price : This ratio seeks to examine management’s
dividend policy and it is expected that 50% of earnings should be distributed
as dividends. This is responsible for the half in the GIBA(d) formula where
GIBA(d) equals ½ ( Interest Rate(%))4 .
A company that is not generous in its dividend policy cannot be assured of the
creation of shareholder value as far as Total Shareholder Returns entailing
market price is concerned.
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Once the components of the GIBA formula are known the price( share worth,
present valuation or shareholder value) at which sale or hold decision should
be taken can be calculated independent of current market prices.
Since
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Once this shareholder value or price is known, an investor can sell
courageously when he or she identifies that the market is overrating a
particular stock. In the same vein a short sale is possible if one’s valuation
shows that present worth is less than initial purchase price and shareholder
value has been decreasing steadily.
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An advantage of the GIBA method of spotting serious shareholder value is that
fear and greed or sentiment find no place in the approach. That the crowd acts
in a particular manner will have no effect on this approach. But the investor
will sell once the market attains the GIBA present valuation or shareholder
value not because management is no longer creating additional value, but
because at this point the market begins to pressure the company and is thus the
time to put greed where it belongs.
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Similarly the market price of a share may tumble over a not very tested reason,
usually as a result of crowd pressure or fear and in the confidence of the GIBA
analysis or convolution, if the market prices are below the computed
shareholder value( GIBA price), then an investor can courageously buy into the
market thus also putting fear where it belongs.
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It will be normal to criticise the GIBA valuation technique because it is
dependent on company accounts with its various ways of reporting. But the
analysis is based on five years company statistics which will normally give a
better appreciation of a company’s ability to create shareholder value than one
year accounts and it is possible to discountenance those parts of the account
that seem ambiguous such as a general reserves posting that is negative.
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Again, the fact that the fifth year is treated in an expectation manner makes
the GIBA valuation to be forward looking. Thus in a purchase scenario, a
pessimistic outlook for the fifth year will require that purchase be made at
lower prices and if the company exceeds this outlook, then it will translate
into value creation and returns on the purchase. But company accounts are
available as information to all members of the market while analysis of the
future cash generation of the company based on projects is available to only a
few people and we know that markets are information driven and so implies that
a greater proportion of the market will be using company accounts.
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This leads us to the premise of information available to only a few people may
well not create shareholder value and in just the same way, good company
performance without the payment of dividend may not translate into the creation
of value or share price appreciation.
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As new information becomes available to the market, it gets factored into the
fifth year or present year computations even before the company’s quarterly or
semester results are published. For instance a change in the price of the
barrel of crude oil from $9 to $20 can be factored into expected profit and
turnover for the year in relation to the results arising from the $9 era even
before present year end accounts will be published. Therefore the GIBA
valuation is based not only on company accounts but puts all arising
information into perspective to generate expectation indices.
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Based on the kind of information, the fifth year or present year computations
may be an increase in performance or a reduction in performance expectations.
It could be the awarding of new contracts in previously closed markets and thus
possibility of increasing shareholder value or it could be that a competitor
has just developed an innovative breakthrough which demands that the
expectation for value creation in the company in question be reduced
accordingly.
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The functional ones were described as in technology, finance, human resources,
marketing, environment and communications while the strategic ones were as in
an alliance, acquisition, fusion, joint venture, restructuring, retrenchment or
outright liquidation.
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Technology : This is a rapidly developing area for ideas, processes and
innovation and is probably the largest and fastest contributor to value
creation. New discoveries imply risk of obsolescence as older technologies are
replaced and thus competitors must be on the look out for what others are
doing.
Information systems and telecommunications are known to have changed the way
business is done as supercomputers are used today in manufacturing, producing
and service companies. The internet remains one of the most recent and
outstanding innovations in the technology sphere and will change the way
businesses are done in the next ten years and how shareholders themselves will
decide on spotting serious shareholder value through internet trading.
Sometimes technological innovation will conflict with cultural values like is
possible with genetic engineering which could lead to increased shareholder
value in some cultures or countries but not in others.
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Finance : Because the bottom line in every business as a going concern
is to make profit, the finance function may well be described as the real
engine of any organisation because the plans are first made here. Companies
that are prudent in their budgetary and cost controls show ability to create
shareholder value.
Outside funds in appropriate ratio combined with capital will often give better
results than sourcing all funds from shareholders. Very aggressive expansion
with excess debt profile could spell doom and reduction in shareholder value if
the sales side does not click.
Proper tax management is important in spotting serious shareholder value as use
of long term debt will sometimes mean less tax been paid and organisations may
register businesses in offshore locations where tax is low to increase
shareholder value. Finance reporting( accounting) has come to focus recently as
companies who cook their books can be sure that when found out, the shareholder
value will plunge accordingly.
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Human Resources : Companies that have designed mechanisms to retain
staff will always have an edge in knowledge management and since humans are the
most important asset in any organisation, such companies are bound to create
shareholder value.
Companies that can pay for the best talents in the market and constantly
retrain their staff improve on knowledge management and thus easily generate
the ideas, processes and innovations that guarantee improved shareholder value.
Where rewards ( promotion, advancement, stock options) are linked with results,
such as performance, production, profit, sales and return on capital employed,
motivation of employees and management will translate into improved shareholder
value.
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Marketing : A good product like a franchise easily markets itself and
quickly creates shareholder value. Products which are available from other
competitors will need to be properly differentiated by branding and made aware
to consumers through advertising, for their organisations to attract serious
shareholder value.
Goods and services need to be realistically priced as a function of the
elasticity of their demand, and distribution networks should be extensive to
reach as many consumers as possible. When there are shortfalls in sales
prediction, promotional techniques will be applied to increase demand. But in
monopolies or regulated businesses where price is fixed, creation of
shareholder value is never maximised because of the absence of competition.
In competitions however, organisations can reduce their shareholder value by
putting up anti - competitive behaviour like differential price fixing and
forced distribution.
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Environment : When looked at globally, environment does not only concern
environmental issues such as pollution and restoration of the natural habitat
but will include political and economic stability, security of personnel,
installations and citizens of a country at large, safety, and corruption as an
impediment to business.
State of infrastructure like in electricity, water, roads, transport and
providing telecommunication services is important in developing countries and
could be considered as part of the business environment.
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Communication : Organisations need to communicate with all publics,
employees and shareholders. Flat and horizontal structures enable more internal
and vertical communication and could be helpful in systems where decisions need
to be taken quickly.
Organisations wishing to bridge the communications gap in their system have
email services provided for all employees and an internal networking or
website. Very innovative companies require that new ideas from employees be
emailed directly to the CEO.
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Alliance : Organisations in the same business will sometimes form an
alliance to reduce cost in areas of duplicating operations such as research and
development. It can be formed also to compete against other alliances in order
to increase joint market share. This is common in the airline business and in
defence manufacturing systems.
Bottom line, if forming an alliance will enable you to reduce cost or increase
market share then it will increase shareholder value.
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Acquisition/ Fusion : Companies with excess cash need to justify why it
is not been distributed as profits and can acquire other companies in far flung
geographic areas in an expansionist bid, if the potential for shareholder value
creation has been identified in such firms. This could be friendly as in a
fusion or hostile as in an unsolicited bid. Low cost per barrel of oil at $9
prompted some fusions as a means to reducing duplicating costs.
In the telecommunications/ cable sector acquisitions have had more to do with
increasing market share and geographic spread than reducing costs.
An organisation with cash may acquire another as a diversification strategy if
it observes that growth in its traditional line of business has flattened out
and is beginning to decline.
Mergers and acquisitions will still need to be approved by State controls in
order to avoid anti - thrust laws.
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Joint Venture : Companies will form a joint venture when as distinct
units they have to share expenses and revenue. This is common in cases where
the technical expertise is coming mostly from one partner.
This ability to penetrate a new country or market in the form of a joint
venture is indicative of the possibility of increasing shareholder value.
A state monopoly performing below expectation can improve on its value by
opening up its market through joint ventures.
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Restructuring : To improve the functional aspects of the processes,
ideas and innovations that translate into spotting serious shareholder value,
Senior Management or the CEO can reorganise or restructure the different
functional units so that they may be more effective.
This could involve decentralisation, flat structures, horizontal integration,
matrix systems, project or asset based management or outright spin - off of an
arm of the business through sale or granting it autonomy.
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Retrenchment : People remain the most important asset of an
organisation, but when things get really difficult and the numbers are in bad
shape, management will shed weight as a means of still staying above water.
Sometimes it could be because they recognised that the system is bloated, if a
competitor shows or posts higher turnover or profit per employee figures.
State monopolies after privatising their businesses are usually obliged to
retrench to remain competitive.
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Outright Liquidation : Companies escape outright liquidation by
innovating continuously. Products with declining sales profile are removed from
the production lines and replaced by newer ones. Companies in mining and
petroleum businesses continue to explore for new reserves to remain afloat.
But badly managed companies, where all the figures and plans do not add up,
especially in aggressive expansion, when the sales aspect does not click and
long term debt has to be repaid, usually have only liquidation as the way out.
Sometimes a buyer might be found but the original company will cease anyway.
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Closing Comments : It is not possible to list the ideas, processes and
innovations that help in spotting serious shareholder value in an essay, let
alone expound them. They have always been there on the Great Dinning Table of
Creation and humanity only receives them as a function of their intelligence
and their openness to the Laws of Nature or Creation.
They have been received in steps, just as the lower steps must be climbed first
before having access to the upper ones in a staircase, and from time to time
there is a tremendous innovation with the effect of a lift, enabling one to
cover so many floors in one go. This will sometimes lead to the obsolescence of
a technology.
Some consumers will be able to pay immediately for the new innovation while
others will wait and continue to use the older one until it becomes cheaper to
provide the newer one.
Some cultures will still be cut off from most of what is going on because they
refused to open themselves to equality, freedom and love.
You will spot sustained serious shareholder value in organisations that operate
in cultures where equality, freedom, love and the understanding of the Law of
Balance have been accepted.
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