Do the shareholders ask a lot of questions about your business? Do they constantly show interest in the success or challenges? While many firm leaders may perceive it as “constant interference”, it is essentially a good thing. And here’s why:
- You remain accountable to someone
- You are aware of your actions
- It helps you remain on track and seek guidance when you feel lost
And that is why, over the years, the SVA metric or Shareholder Value Added has become an important element in determining the success of businesses.
What is SVA?
Shareholder Value Added (SVA) is a metric for measuring financial performance to assess how effectively a company generates value for its shareholders. This is in terms of both the cost of capital and return and is unlike the traditional methods that focus only on profits and earnings. The question that this metric system answers “is the company creating value for shareholders?” The basic calculation is net operating profit after tax (NOPAT) minus the cost of capital, which is based on the company’s weighted average cost of capital.
What are the components of SVA?
- Operating Profit After Taxes (NOPAT): This is indicative of the company’s operating profit adjusted for taxes. It excludes non-operating income and expenses.
- Invested capital: It includes both equity (common and preferred stock, retained earnings) and debt (long-term and short-term debt, leases). The total capital employed by the company is also included here.
- Cost of capital: The cost of capital is the weighted average cost of debt and equity. This showcases the minimum return expected by investors for providing capital.
Why does SVA matter for businesses?
Times are changing and we live in a more aware world.
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Holistic Performance Measure
Traditional financial metrics no longer work. Even if they do, they do not reap the benefits they used to. Profitability can no longer be treated as the sole determining factor. SVA is gaining increasing acceptance as a financial metric because it provides a holistic measure of a company’s performance by factoring in the cost of both debt and equity. This makes it a more comprehensive indicator of value creation.
- Aligns Management with Shareholders
By focusing on the SVA metric, organizations can align their goals with shareholders’ interests and expectations. Since SVA directly measures the value created for shareholders, the management is incentivized to make decisions that enhance SVA, such as improving operational efficiency or optimizing capital structure.
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Better Capital Allocation Decisions
SVA helps in making better capital allocation decisions. In an organization, many factors need capital and attention. SVA helps give direction. By evaluating projects and investments based on their potential to generate positive SVA, companies can prioritize those that are most likely to create shareholder value, leading to more efficient use of capital.
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Long-Term Focus
SVA encourages a long-term focus by prioritizing sustainable value creation over short-term profit maximization. Companies that consistently generate positive SVA are more likely to achieve long-term success, as they are building a strong foundation for future growth.
How can firms achieve SVA?
Achieving positive SVA needs a strategic perspective. It helps manage a company’s operations, capital structure, and investment decisions. To ensure success, it is important to achieve the below parameters:
Helps in improving operational efficiency:
Operational efficiency helps drive NOPAT, the numerator in the SVA formula. By improving efficiency, companies can increase their NOPAT, leading to higher SVA. Here’s how:
- Cost Management: Firms need to focus on reducing operational costs without compromising quality. This can be achieved by optimizing processes, automating, and strategic sourcing.
- Revenue Growth: Firms should aim to Increase revenue through strategic initiatives such as expanding into new markets, launching new products and service lines, or improving customer retention.
- Lean Management: Adopting lean management principles helps eliminate waste and improve efficiency in operations. This can lead to higher margins and increased NOPAT.
Optimize Capital Structure
The capital structure in SVA is a mix of debt and equity. It plays a crucial role in determining WACC. An optimal capital structure minimizes WACC while increasing SVA. Here’s how to optimize capital structure:
- Debt vs. Equity: Firms need to find a balanced mix of debt and equity. While debt can be cheaper than equity due to tax benefits, too much debt increases financial risk. On the other hand, relying heavily on equity can dilute ownership and reduce returns for shareholders.
- Refinancing: Regularly reviewing and refinancing debt can be crucial in lowering interest rates. It reduces the cost of debt and WACC.
- Equity Management: Consider stock buybacks or issuing dividends to return excess capital to shareholders. This can help improve shareholder returns and optimize equity levels.
Strategic Investment Decisions
Firms should invest in projects that generate returns above the cost of capital. It is a key factor in achieving positive SVA. Here’s how to make strategic investment decisions:
- Rigorous Project Evaluation: Evaluate the potential of projects using metrics like NPV (Net Present Value) and IRR (Internal Rate of Return), along with SVA. It helps ensure they will generate positive returns above the cost of capital.
- Portfolio Management: Manage your investment portfolio by regularly reviewing and steering away from underperforming assets or businesses. Reallocate capital to higher-return opportunities that will enhance SVA.
- Innovation and R&D: Invest in innovation and research to develop new revenue streams. This will help maintain a competitive edge, which can lead to higher returns and increased SVA.
Focus on Value-Driven Management
The senior leadership team or the management plays a pivotal role in driving SVA. A value-driven management approach prioritizes decisions that will help improve shareholder value:
- Incentive Alignment: Aligning management incentives with SVA targets, and focusing on performance-based compensation tied to SVA metrics that can motivate the management to focus on long-term value creation.
- Transparency and Communication: Maintain transparent communication with shareholders regarding the company’s strategy, performance, and how the teams are working to enhance SVA. This builds trust and supports shareholder confidence.
- Corporate Governance: Strengthen corporate governance practices to ensure that management decisions are made in the best interests of shareholders, thereby supporting SVA growth.
Enhance Risk Management
Effective risk management is crucial for sustaining SVA. It helps mitigate potential losses that could reduce the shareholder value:
- Enterprise Risk Management (ERM): Implement a comprehensive ERM framework to identify, assess, and mitigate risks at all levels. This can help protect the company’s NOPAT and capital base.
- Financial Hedging: Use financial hedging strategies to protect against market risks such as interest rate fluctuations, currency exchange volatility, and commodity price changes.
- Scenario Planning: Engage in scenario planning and stress testing to prepare for various market conditions, ensuring the company can maintain positive SVA even during economic downturns.
Shareholder Value Added (SVA) is an important metric for evaluating a company’s ability to create value for its shareholders. Achieving positive SVA requires a strategic approach to improving operational efficiency, optimizing capital structure, making informed investment decisions, focusing on value-driven management, and enhancing risk management.
To know more about how SVA metrics can help your business, outsource with Finsmart Accounting to reap many benefits. Write to us at connect@finsmartaccounting.com to know all about our service offerings.
Maanoj is Co-founder & Director of Growth Strategy & Alliance at Finsmart Accounting. He is an Outsourcing Expert, a People Champion, and a Dynamic Leader with strong Business Strategy and Scaling-up experience. He has incubated businesses, sold & exited ventures; helped build strong enterprises in very diversified verticals like Fintech, HR & Consulting spaces in various CXO capacities over the last 20 years.
