Business Management

The earnings per share and maximizing the value of a company

Maximizing the value of a company depends upon the level of earnings per share that is achieved. Companies achieve this by, for example:

a. Minimizing capital investment to reduce depreciation charges.
b. Increasing wages and salaries by less than the level of inflation and for example, sell the land that is currently used as a staff sports field.
c. Reducing overdraft charges by delaying payments to creditors.
d. Delaying expenditure on new equipment that will reduce pollution levels from the company’s factory.

What are the possible effects of these? Are they likely to result in an increased share price and value of a company?

It is normal for a company CEO to seek the maximization of the company’s share price and therefore its market capitalization. However, although a relationship does exist between reported profits, earnings per share and the share price, short-term profits are not in themselves the principal driver of the share price.

In reality, assuming a reasonably efficient market, the maximization of the share price will be brought about by the maximization of the present value of the future cash flows. The most effective way to increase the share price therefore is to concentrate on making investments that generate a positive net present value (NPV) when discounted at the cost of capital. Let’s look at the effects of each of the four strategies mentioned.

The first one is minimizing capital investment to reduce depreciation charges. As explained earlier, it is necessary to undertake investments that generate a positive NPV in order to maximize the share price. Minimizing capital expenditure in order to boost short-term profits could therefore mean that some important opportunities are missed. This in tum means that the value of the company will be lower than it could be, which will impact badly on the share price. It could also adversely affect the position of other stakeholders such as employees and suppliers.

Reducing real wages and employee benefits is likely to damage the morale of the employees, and could result in good employees being lost, while at the same time making it harder to recruit the right people. If morale is badly affected, this could also affect both quality and the efficiency of production. Abandonment of charity sponsorship is likely to meet with opposition, not only from employees involved in the events, but also from the wider community which has previously relied on the company’s support. This will in turn damage the standing of the firm in the local community.

Delaying payments to creditors beyond the terms allowed could have a number of damaging effects,
Valuable discounts may be lost and credit charges incurred. Tne credit rating of the company could be damaged making it difficult to obtain further credit from new suppliers in the future, or from other sources of finance. Also, supplies of material could be jeopardized if the company’s orders are moved down the priority list or even placed ‘on stop’.

Stringent controls on pollution exist, and the company must be certain that any delay in expenditure on measures to reduce pollution will not result in environmental standards such as discharge consents being breached. If this does happen, then the company will be liable for financial penalties, and again the standing in the local community will be damaged. If the problems are severe, then the company could come under pressure from environmental pressure groups which could result in more widespread damaging publicity.