Shareholder value added is a measure of the incremental value of a business to those who have invested in it. In essence, the calculation is designed to show the amount of additional earnings that a company is generating for its investors that is in excess of its cost of funds. It provides more relevant information than the net profit figure normally reported by a business, since net profit alone does not take into account the cost of funds. The calculation is:
Net operating profit after tax - Cost of capital = Shareholder value added
Several points regarding the calculation are:
- Only operating profits are included in the calculation, thereby excluding the extraneous effects of any income or expense related to financing issues or extraordinary items.
- The cost of capital is comprised of the company's weighted average cost of debt and equity, which includes preferred stock.
When using this measurement, be aware of the following issues:
- The company's performance and the cost of its debt are linked. That is, lenders will increase the cost of funds if the company's results decline, which in turn increases the cost of capital and therefore reduces the shareholder value added result. Thus, poor company performance tends to trigger an accelerated decline in this measurement. The reverse is also true when performance improves.
- The measurement should be based on the last 12 months of performance on a rolling basis, to give the most current results. Longer-term measurements based on old historical results may have little relevance, especially if there has been a substantial recent change in company performance.
- The cost of capital may be difficult to ascertain if a company is privately held, so restricting the use of this measurement to publicly-held companies is advised.