Period Profit and Shareholder Value
According to at least some people, the objective of a capitalist business is taken to be the maximization of the wealth of its owners, of course within legal, ethical, political, and maybe more boundaries.
The wealth of its owners can be measured in terms of the period profits i.e. the maximum dividends paid and/or shareholder value i.e. the market value of the company’s shares. Profit (the measured profit figure) and shareholder value: are two different phenomena, each having its own merits.
Also, cash flow and profit are two different phenomena. No cash flow is able to make up for what is wrong concerning the profit figure. What has been argued by so many people e.g. Pablo Fernandez (re SSRN_ID330540: the adage ‘profit is an opinion, cash is a fact), is not true. It is the other way round. Period profit can be measured exactly by means of The Profit Formula®.
About what ‘cash flow’ is, various writers advocate different opinions. Profit is not so important according to some people, more important they say, is the creation of shareholder value. Both conceptions, ‘period profit’ and ‘shareholder value, are not conflicting views but mostly in a direct line with one another. Shareholder value is based on cash flows related to selling prices and these cash flows do not tell the whole story.
Period profit is the realised surplus value; it is the extra there is at the end of a period over and above that which was there at the beginning. Shareholder value, the worth of an enterprise, is at any moment the present value (PV-value) of all future proceeds minus loans and current liabilities; it is the price people are prepared to pay at a point in time for the whole company, looking at promising profits to come. To create more shareholder value indeed is very important too, but it is something other than period profit.
The PV-value will be constant through time, in a stable situation naturally, when replacement will always take place of exactly those items that have been used up. Made profits – above a certain level – are not to be despised. Dull business, yes indeed. The cow is not growing but giving all the time a bucket full up with milk.
The quote of an old banker: “good business is dull business.” Maybe a fund for widows and orphans but such a fund still has a prominent place on the official list of the Stock Exchange. Speculators go in search of bulls and bears, those companies whose PV-values are changing rapidly. Imagine, a fast growing calve, no milk yet, promises only for the time being. Something of such a growing cow in calf-company may become a write-off or otherwise get lost, but that same something can be replaced immediately (at the actual replacement cost) and henceforth nobody will see any difference.
The value of the piece of equipment that has been replaced, the value of that asset, a part of the total balance is not based on the PV-value. Total balance can be based on every valuation base but normally not PV-value. The PV-value in this whole story is not at stake at any time. Birds in the bush. Not in the hand yet. The principle of realisation, provided a correct interpretation, defines what profit is. Profit is like milk. There is milk after the milking; the milking-stool seems to have three legs: people, planet and profit. Before the milking there are expectations, promises, changing PV-values, whatever, but no milk. Profit is an ex post entity. Ex ante, profit projections and forecasts can be given. The measurement of profit however can only be done ex post. Ex post, looking in retrospect, of course one can calculate a difference of two shareholder values at start and end of a period under consideration. An increase is often better than a decrease. What is the meaning of the difference in a specific situation?
The company may become a minor one, still profitable. Shareholder value (economic value: what might happen, additional to the existing activities?) as well as total balance (embedded value: what is really present?) are snapshots i.e. parameters with a value at a point in time, while profit is a period parameter. Period profit and shareholder value are separate, but relate to each other. They inter-relate, strengthening or weakening and vice versa, but it is a loose relationship. One cannot take the place of another. It is possible by (extra) investing to maintain the same level or to level up PV-value (shareholder value), after which a (more) profitable corporation survives. PV-value is based on cash flows related to selling prices and these cash flows do not tell the whole story.
Between cash flow and profit there still is something and that something can be a lot. High(er) cash flows can go very well hand in hand with low(er) profits. Raising PV-value can be accomplished by better investing. Higher PV-values and higher profits usually go together. A rise in PV-value implies promises, expectations. To prove them, to fulfil them is another matter. Future profits will be the proof. The other way round, bad investments, lower PV-values, and the future will look bleak. By measuring subsequent period profits as accurately as possible after done investments, one can have the corporation at one’s finger tips. Triggering the whole operation. At the least little indicator one can give appropriate guidance on the necessary adjustment required. By not knowing the real period profit, one loses control.
For more than what is noted down in this article, re my freely downloadable ‘Period Profit, Shareholder Value, Share Capital, EVA®, CVA®, NVA and Cash Flow – Different Notions, Each Having Its Own Peculiarities’ http://ssrn.com/abstract=394140
Written by Jan Jacobs.
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