Corporate Governance and Shareholder Value Analysis

Rajeeva Sinha

In corporate governance today, there is a lot of emphasis on structural reform. Individual aspects of the
board have increasingly been the focus of policy reform and shareholder activism. Specific attributes of
board structure like the separation of the posts of chairperson and the CEO, percentage of outside directors
on the board, etc., have become important considerations in the quest for effective corporate governance. In
contrast, taking a process view of corporate governance, this article examines the utility of shareholder
value analysis for corporate governance. In value-based management, shareholder value maximization is
set as the objective of the firm. The adoption of this objective as the goal of the firm can promote effective corporate governance in three ways. First, it provides the necessary pre-commitment between shareholders
and managers regarding the goal of the firm. Second, it necessitates a greater flow of firm-specific information
and the disaggregation of financial information. In corporate governance a clear identification of the goal of
the firm and firm-specific information is important because of the incomplete contracts between shareholders
and managers. Substantive flows of firm-specific information are needed to bridge the gaps in the incomplete
contracts. Shareholder value management techniques, by providing this information in a non-agency context
can provide a valuable input towards effective corporate governance. Finally, the goal of shareholder wealth
maximization ensures a closer interdependence between strategy formation and the setting of operational
objectives for managerial decisions. We illustrate some of these points with examples from the LloydsTSB
experience of implementing shareholder value analysis and the findings of a study on investor communication.

Introduction
In the aftermath of a spate of corporate
governance failures in the US and elsewhere,

regulators around the world have undertaken a number of measures to restore confidence in corporate boards. The thrust of
these measures has been to introduce

Acknowledgement: We are grateful to Paul Stoneman, Peter Law of Warwick University, John Arnold Matt Davies
of Aston University, Professor David Norburn of the Imperial College, University of London and the participants
of the 2nd International Conference on Corporate Governance and Direction, Henley Management College, UK,
for their comments on earlier drafts of the paper.
Rajeeva Sinha is at the Odette School of Business, University of Windsor, Windsor, Ontario, Canada N9B 3P4.
E-mail: rsinha@uwindsor.ca
GLOBAL BUSINESS REVIEW, 7:1 (2006)
Sage Publications New Delhi/Thousand Oaks/London
DOI: 10.1177/097215090500700101
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2 l Rajeeva Sinha

requirements in the corporate governance

structure and disclosure that can be observed
by outsiders as indicators of good or bad corporate governance. The SarbanesOxley Act,
passed by the US Congress in 2002, incorporates several measures aimed at public accounting reform and investor protection. It
will serve as a checklist of all things that the
top management is expected to do as a signal
of good corporate governance practice.1
Apprehension has been expressed that the
SarbanesOxley Act and similar copycat
legislation in other countries will in effect
impose a set of legislated checklists for corporate governance. This has the danger of
creating a corporate governance ethos that
is not aspirational, so that there would be no
impetus to go beyond the minimum requirements of the rules. A lot of professional time
and acumen of lawyers, accountants and
advisers would be spent searching for loopholes. There is a real danger that this will
encourage a value system that if there is no
rule prohibiting an action then it is not illegal
and hence acceptable as corporate governance practice. Sonnenfield (2002) articulated
this view of corporate governance writing in
the Harvard Business Review:
We will be fighting the wrong wars if we
simply tighten the rules for the boards and
ignore their more pressing needto be
strong, high functioning work groups
whose members trust each other challenge
one another and engage directly with senior managers on critical issues facing corporations (Sonnenfield 2002: 106).
In some measure, the dangers of focusing
exclusively on board attributes as a signal of
corporate governance effectiveness has been

underscored by the controversial compensation package of the New York Stock exchange
(NYSE) chief Mr Richard Grasso, that ultimately led to his resignation. Post-Enron, the
NYSE has taken a very proactive approach
towards corporate governance by trying to
embed good corporate governance rules in
the listing requirements in the companies
listing requirements. Mr Grasso did not
break any rules when he awarded himself
a compensation package of 140 million
(reportedly greater than the net earnings
of the NYSE, a non-profit organization). It
was the manner in which the compensation
packages were being decided that upset the
investors.
We propose that shareholder value, or the
focus on the changes in the value of business
to shareholders that has emerged as the explicit focus of some corporations in the 1990s
(Black, Wright, Bachman and Davies 1998;
Kaplan and Atkinson 1998; Rappaport 1998),
can be a significant tool in the effective conduct of corporate governance. Corporate
governance is visualised as an institutional
arrangement that not only addresses the
agency problem between shareholders and
managers, but also provides the context for
the decisions taken by the top management
of the firm. Following Pound (1995), the corporate governance framework is defined as
an institutional device for not only correcting
the imbalance of power between shareholders
and managers due to the separation of
ownership from control, but also aiding the
decision making process of the firm. The objective of a corporate governance framework
is to identify a basis for strategic co-operation
between shareholders and managers such
that the agency problem is reduced and a
basis for decisions that promote the competitiveness of the firm is provided.

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Corporate Governance and Shareholder Value Analysis l 3

The potential of shareholder value analysis

for effective corporate governance can only
be appreciated if we move away from the
traditional conceptualization of corporate
governance in terms of principals and agents.
Even if we ignore, for the time being, the
other possible stakeholders of the firm and
limit ourselves to a property rights view with
only two stakeholdersshareholders and
managerscorporate governance has to be
perceived as a process. The conceptualization
of corporate governance in terms of principals and agents abbreviates this understanding and leads to a preoccupation with
structure and performance and ignores the
role of conduct. Shareholder value analysis
assumes significance in the conduct of corporate governance: It can be a valuable tool
for bridging the information asymmetry
between shareholders and managers and
thus contribute to the effective conduct of
corporate governance.
The article is organised as follows. Section
one discusses the concept of shareholder
value analysis in the context of value based
management. In section two, corporate governance is analyzed in terms of incomplete
contracts. The central argument of section
three is that the shareholder-management
relationship is based on a contract that has
to account for unforeseen contingencies. This
characteristic of the relationship implies that
firm-specific information will be critical for
sustaining the contracts. We examine the contribution that shareholder value analysis can
make in sustaining the strategic co-operation
between shareholders and managers. Shareholder value analysis can contribute towards
greater effectiveness in corporate governance in three areas. First, it can provide the
necessary pre-commitment between shareholders and managers regarding the goal of

the firm. Second, it encourages the flow of

firm-specific communication in the form of
non-financial information. Both these factors
will help to sustain the incomplete contracts
between shareholders and managers. Finally,
it provides an improved decision context as
it encourages a close interdependence between strategy formation and the setting of
operational targets. We draw upon the experience of LloydsTSB bank in the United
Kingdom and the findings of a study conducted in the United States on investor
communication (Healy & Palepu 1995), to
illustrate the potential of shareholder value
analysis for corporate governance.

Shareholder Value
With the growing globalization of business
and the financial markets, shareholder value
has become an increasingly important concern of firms. Market-based performance
indicators like shareholder value have
greater relevance than fundamentals based
on financial ratios like the profit margin or
sales growth. The greater liquidity of the
stock market and the globalization of business and investment opportunities have
meant that capital has greater mobility and
is more readily able to switch between investment opportunities. This, together with the
global context of business, has led many
firms to adopt value-based systems of management. Value based management seeks to
align a firms strategy, performance measurement and behaviour so that shareholder
value is maximized. A number of definitions
of shareholder value, such as economic value
added, cash flow returns on investment and
in the case of LloydsTSB, warranted equity

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4 l Rajeeva Sinha

value have been suggested (Black et al 1998;

Kaplan and Atkinson 1998). All the definitions have one basic concern, namely the
cash returns on investment. The measurement of shareholder value analysis is based
on the cash flow of the firm. Shareholder
value is determined by comparing the cash
flow return on capital with the cost of capital.
For example, economic value added is
defined as revenues less all costs associated
with producing the revenues, including the
cost of capital employed.
This is an aggregate view of shareholder
value. As a tool for decision-making, the concept of shareholder value will have to be
further disaggregated. Rappaport (1998)
identifies seven drivers for analysing the
shareholder value of a business: sales
growth, cash profit margin, cash tax rate,
working capital, capital expenditure, the
risk-adjusted inflation, weighted average
cost of capital and the time scale in which
competitive advantage period is assessed.
The disaggregation of shareholder value
analysis into these seven drivers provides
further insight into shareholder value. These
seven drivers by no means constitute an exhaustive list of factors affecting shareholder
value. The disaggregation of cash flow return
and the cost of capital will have to be based
on a number of subjective considerations
(Black et al. 1998). Thus in the LloydsTSB
case, the warranted equity value is defined
as the present value of future equity cash
flows that management expects a business
to generate given its market economics, competitive position and strategy over the short
terms and long term. Therefore, the maximization of shareholder value will require
firm-specific information. Shareholder value
drivers will have to be interpreted in the specific context of every firm taking into account

the complexities of the business environment

and the corporate culture of the firm.
In the next section, we examine the nature
of contracts in shareholder-management
relations. The incomplete contracts between
shareholders and managers require the use
of a learning mechanism for sustaining strategic co-operation between shareholders and
managers. The requirement of a learning
mechanism shows the significance of shareholder value analysis in the effective conduct
of corporate governance.

Incomplete Contracts and Corporate

Governance
Nature of Incomplete Contracts
The relationship between shareholders and
managers is one of strategic interdependence. The separation of ownership from
control and the firm-specific nature of managerial human capital implies that neither
shareholders nor managers can hope to pursue rational behaviour alone. Co-operation
between the two parties, characterised by the
pursuit of selfish interest, is the only way to
maximize the total surplus available for
distribution. Strategic co-operation between
shareholders and managers will require the
drawing of contracts between the two parties. These contracts could be either complete
or incomplete. Hart (1995) contends that
shareholder-management relations will have
to be based on incomplete contracts and lists
three reasons why this will be so:
a. cost of thinking and planning all the
different eventualities
b. cost of negotiation
c. cost of writing down the contract

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Corporate Governance and Shareholder Value Analysis l 5

The incomplete contracts between managers and shareholders require the use of corporate governance mechanisms to bridge the
gaps. The mechanisms comprising the corporate governance structure provide the
institutional basis for the interpretation of the
unspecified component of the contract. They
are channels for the communication of the
expectations and obligations of the shareholders and the managers on a continuing
basis. Wiggins (1990) in his evaluation of long
term contracts also concludes that firms will
use governance structures when they cannot
use (complete) contracts. While the rationale
by Hart (1995) for the use of corporate governance mechanisms in terms of incomplete
contracts is correct, there is little insight
provided into the design of the corporate
governance structure. The corporate governance structure is viewed as a collection of
mechanisms. The relative emphasis on different mechanisms is seen as the outcome of the
market forces (Hart 1995).
This analysis provides only a limited insight
into the design of the corporate governance
structure because the incomplete contracts
are under-identified. Schwartz (1992) further
analyses incomplete contracts and lists five
causes for contractual incompleteness:
a. vague wording of the contract
b. failure to contract an issue
c. prohibitive cost of writing a complete
contract
d. asymmetric information between the
contracting parties. The asymmetric
information can be observable and
verifiable ex-post. A contract will be
weakly non-contractible if the information can be observed but cannot be verified ex-post; strongly non-contractible

if the information can be neither observed nor verified ex-post

e. heterogeneity or variations in the
expectations on one side of the market
(that is on the side of shareholders) implies that a complete contract will only
be drawn when the uninformed type
can screen the informed type. Contracts
will be incomplete when screening
is not feasible or when the informed
party cannot disclose its type credibly
(Schwartz 1992).
A comparison of the factors leading to contractual incompleteness shows that Hart in
his specification does not account for strong
non-contractability and heterogeneity on one
side of the market. Deekel et al. (1998) make
similar observations in their assessment of
Harts incomplete contracts models: This approach assumes that some of the variables
which are relevant to the contracting parties
are observed by them but cannot be shown
in the court. They also make an important
distinction between unforeseen contingencies and standard uncertainty.
By the latter we mean those models, such
as nonadditive probability, which are
intended to represent an agent who knows
the state space but not the appropriate
probabilities and behaves conservatively
because of the lack of knowledge. Conceptually, at least there is a difference between
this and not knowing the state space
and behaving conservatively as a result
(ibid.).
Strong non-contractability and heterogeneity on one side of the market are important reasons for contractual incompleteness
in shareholder-management relationship.

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6 l Rajeeva Sinha

The shareholder-management contracts are

not discrete in time. It is not possible to specify a finite time span of the contract at the
time of its commencement. The length or the
period of the contract is a function of the expectations and obligations implied in the
contract. Termination of the contract is a
sanctionan indication that one of the parties has failed to fulfil its expectation or feels
that the other party has not fulfilled its obligations. Thus, the shareholder-management
contract is neither discrete nor repetitive but
an ongoing contract. Observability, let alone
verification, cannot be based on exogenous
objective criteria but will be a function of subjective interpretation of the interests of the
parties involved. It would be simplistic to
presume that these expectations and obligations are completely identified at the commencement of the contract and remain
unaltered during the contract. At any point
of time, the shareholder gets some information on the extent of fulfilment of the contract
and receives information that allows him or
her to form expectations regarding the possibilities of the remaining obligations being
fulfilled. Also, new expectations are being
added to the relationship. Thus, the degree
of observability and verifiability is endogenous to the incomplete contracts between
shareholders and managers.
The goal of shareholder wealth maximization is incompletely identified. The maxima
of shareholder wealth for different shareholders will depend on the rate of discount,
which in turn will depend on the different
time horizons and motivations behind the
investments. The rates of discount used for
different investments are implicit in the
transaction but unobservable for the top
management, the other party in the transaction. For example, Holland (1996) identifies

three types of investment policy employed

by financial institutions in the United Kingdom. These are relationships with large
stakes, long investment horizons and little
trading; stable holdings with some regular
trading around a stable target stake; and
short-term, transient, arms-length investing.
The financial institutions attach different
weights in the distribution of their holdings
in their investment policies. The weights
are frequently changed and for strategic
reasons not revealed. Similarly, in the United
States, amongst the three main groups of
investorscorporate retirement plans,
mutual funds and state and local retirement
plansthere is a difference in the time
horizon for investments. All three groups of
institutional investors may have an equal
interest in merger or takeover proposals.
However, only the state and local retirement
plans or the public funds have been interested in long-term investment horizons
while the mutual funds have been short-term
investors (Bogle 1998).
In addition to the factors identified by Hart
(1995), unforeseen contingencies (Dekel et al.
1998) or strong non-contractility (Schwartz
1992) are important reasons for contractual
incompleteness between shareholders and
managers. In such a contract environment,
learning becomes critical to the conduct of
their relationship. It becomes important to
understand how the two parties construct
their expectations and obligations in matters
relating to the contract. The existing literature on corporate governance lacks a theory
of learning. In fact, this gap is attributed to
the wider body of the literature on expectation formation in economics. (Dekel et al.
1998; Hodgson 1998; Salmon 1995; Shull et al.
1970). Hodgson defines learning as more
than the gathering of information. It is the

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Corporate Governance and Shareholder Value Analysis l 7

development of new means and modes of

cognition, calculation and assessment (1998).
It is about procedural rationality (Simon
1976). Thus, learning is about how information is accrued and how it is processed. The
environment and the agents approximation
of that environment play a critical role in both
aspects (Salmon 1995).
In the principals and agents framework of
corporate governance, there is no role for
learning in the interaction between shareholders and managers. The information
asymmetry is bridged by a system of incentives to align managerial motivations with
shareholder objectives. In his incomplete
contract justification, Hart (1995) does recognize the role of governance mechanisms
as channels of communication. Learning is,
however, limited to the gathering of information by the observable but not verifiable
component of the incomplete contracts. The
emphasis in the learning mechanism is left
to the market forces, or Friedmans natural
selection (Hart 1995). The scope for interdependence between the shareholders/managers and the environment, for the process
of learning itself, is not recognized. However,
as we have seen, shareholder-management
contracts are strongly non-contractible and
also display heterogeneity in the motivations
of the shareholders. Incomplete contracts
incorporating unforeseen contingencies and
strong non-contractibility will have to be
based on a learning process, which leads to
the construction of the state space. The state
space is the sum of expectations and obligations on matters relating to the contract. This
learning process will have to be based on a
cognisance of the symbiotic relationship
between the individual and the environment in the construction of the state space

(Hodgson 1998; Salmon 1995). The significance of this symbiotic relationship is clarified further by the distinction between
opportunism as an attitude and opportunism
as behaviour.

Opportunistic Attitude and Opportunistic

Behaviour
The role of opportunism is an important
consideration in the conduct of the strategic
co-operation between shareholders and
managers. Opportunism is distinct from selfinterest. The assumption of self-interest visualizes individual behaviour motivated by
own preferences. However, the individual
will candidly disclose all pertinent information on enquiry and meet all obligations
expected of him or her from the transaction.
Opportunism is pursuit of self-interest with
guile. The individual is not expected to
disclose all the truth and fulfil all obligations
under the contract (Williamson 1993). Individual behaviour can be based on influence
activities (Milgrom and Roberts 1988).
Dechow et al. (1995) provide evidence on the
manipulation of earnings information by
managers with the objective of inducing
shareholders to take decisions favourable to
the former. This is an example of managerial
influence activity. Studies also show managerial bias for investments, mergers and
acquisitions that enhance the significance of
the incumbent management team (Amihud
and Lev 1981; Shleifer and Vishny 1989;
Stiglitz and Edlin 1992).
In a property rights view of the firm, the
goal of the corporate governance structure
is to reduce the adverse effects on shareholders of opportunism in the shareholdermanagement relationship. Ghosal and
Moran (1996) draw a distinction between two

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8 l Rajeeva Sinha

types of opportunism, namely opportunism

as an attitude and opportunism as behaviour.
The former is a product of the human condition and the latter a product of institutions
and technology. Opportunism as an attitude
is the proclivity or inclination of the individual to act opportunistically-that is, to pursue
self-interest with guile. Opportunism as behaviour is positively related to the expected
benefits and is negatively related to
safeguards and controls. Thus, opportunism
as behaviour can be a variable of the institutional context.
Two factors will have an influence on
opportunism as behaviour. First, opportunism as behaviour will be a function of prior
conditioning. For example, the prior conditioning of the shareholder-management
relationship is a derivative of property rights.
The stakeholder view of the firm is an attempt to alter the prior conditioning of the
various constituents of the firm. Even within
the property rights view of the firm, the
prior conditioning will be a function of the
legal, social and cultural norms of each society. Secondly, opportunistic behaviour is a
function of the feeling for the entitythe
entity being the firm/organisation and its
various constituencies such as shareholders,
workers and customers. This perception emerges from the contracting parties assessment of each other. A positive perception will
reduce opportunism while a negative assessment will exacerbate opportunism. For example, hostile takeovers lead to large-scale
replacement of the top management (Franks
and Mayer 1996; Walsh 1988). A study of the
psychoanalytic response of managers shows
that hostile takeovers evoke images of unfairness, subjectivism and irrationality about the
event (Schneider and Dunbar 1992; Shleifer
and Summers 1989). As a consequence, when

faced with an active market for corporate

control, managers will have a significantly
reduced feeling for the entity.
The corporate governance literature fails
to make this distinction between opportunism as an attitude and opportunism as
behaviour. In effect, the implications of
opportunism as an attitude (the human
condition) have received the greatest attention. The primary focus of the various governance mechanisms has been to set up a
system of incentives and monitoring such
that the motivations of the managers and the
shareholders are closely aligned. The issue of
prior conditioning has received some attention at the margin and the appropriateness of the property rights view of the firm
has been called into question (Davis,
Schoorman and Donaldson 1997; Donaldson
and Preston 1995). However, there is little
cognition of the possible implications of
the corporate governance mechanism for the
feeling for the entity. Opportunistic behaviour, and consequently opportunism, can be
endogenous to the corporate governance
structure, if there is reduction in the feeling
for the entity because of the working of corporate governance mechanism.
In this section, the consequences of the
incomplete contracts between shareholders
and managers have been discussed. The
incomplete contracts require the incorporation of a learning mechanism in the institutional arrangement that governs the strategic
co-operation between shareholders and
managers. The distinction between opportunism as an attitude and opportunism as
behaviour shows that there is interdependence between the goal of strategic cooperation (reduction in opportunism), and
the process of the learning mechanism. In the

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Corporate Governance and Shareholder Value Analysis l 9

next section, the insights provided by the

analysis of shareholder value, the nature of
contracts between shareholders and managers and the distinction between opportunism as an attitude and opportunism as
behaviour are brought together to explain
how shareholder value analysis can contribute towards effective corporate governance.

Shareholder Value Analysis

and Corporate Governance
In this section, we show that shareholder
value analysis can contribute towards the
effective conduct of corporate governance in
three ways. First, it provides the necessary
pre-commitment towards the goal of the
firm. This simplifies the process of expectation formation in the interdependent
relationship between shareholders and
managers. Second, shareholder value analysis emphasises firm-specific information
flows and thus, provides the learning
mechanism for the sustaining of incomplete
contracts between shareholders and managers. Third, it increases the interdependence
between strategy formation and goal setting
within the organisation and thus, improves
the framework within which the top management decides.

Pre-commitment in Shareholder Value Analysis

The incomplete contracts between shareholders and managers make it difficult for
shareholders and managers to form expectations that are necessary for strategic cooperation between the two parties. As noted
earlier, Holland (1996) identifies a mix of motives that vary over time amongst institutional
shareholders regarding their shareholdings.

The problem of expectation formation can be

considerably minimized if at least one of the
parties makes an explicit and formal commitment towards the goal of the firms functioning. For example, LloydsTSB has been vocal
and explicit in its commitment to double the
share price every three years (LloydsTSB
1997). This facilitates co-operation between
two parties. In the strategically interdependent relationship between shareholders and
managers, shareholder value analysis by
identifying shareholder wealth maximisation
as the objective of the firm provides the basis
of such a formal commitment.

Firm-specific Communication in Shareholder

Value Analysis
In the section on shareholder value, the
importance of firm-specific information in
cash flow comparisons has been emphasized.
In the subsequent section on corporate governance, we have seen that firm-specific
information is important for sustaining the
strategic co-operation between shareholders
and managers because of the incomplete
contracts between the two. Thus, there is an
overlap in shareholder value analysis and
corporate governance in terms of their need
to be based on firm-specific information. In
this section, we show that shareholder value
analysis, with its inherent emphasis on firmspecific information, can provide the learning mechanism that not only meets the
information requirement of the incomplete
contracts, but also reduces the scope for
opportunism. The conception of shareholder
value as a learning mechanism in corporate
governance is explained in Figure 1.
The figure shows the significance of shareholder value analysis for corporate governance. The separation of ownership from

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10 l Rajeeva Sinha
Figure 1
Corporate Governance and Shareholder Value Analysis

control and the incomplete contracts between

shareholders and managers give rise to the
scope for opportunism in a shareholdermanagement relationship. The reduction of
opportunism is the goal of corporate governance. There is a distinction between opportunism as an attitude and opportunism as
behaviour. The principal and agents approach to corporate governance fails to make

this distinction. However, it seeks to make a

virtue of opportunism in general by incorporating incentive structures and monitoring
devices, like the structure of executive compensation, in the governance mechanisms. In
effect, these mechanisms are designed to
interact with opportunism as an attitude and
motivate managerial decisions towards the
goal of shareholder wealth maximization. In

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Corporate Governance and Shareholder Value Analysis l 11

the figure, the two drivers that determine the

level of opportunism as behaviour are identified. There is some recognition of one of the
driversprior conditioningin the form of
various theories of the firm that contest the
predominant property rights view of the
firm. It is the second driverthe feeling for
the entitywhich is largely ignored in corporate governance literature.
The row of three boxes in Figure 1 shows
how opportunism endemic to shareholdermanagement relations can be countered. The
first box (corporate governance mechanisms)
represents the various mechanisms such as
board composition, large shareholdings and
the market for corporate control. These different mechanisms provide the set of incentives and monitoring which interact with
opportunism as an attitude to promote
shareholder wealth maximization. The third
box represents the property rights view of
the firm. The property rights view represents the predominant view of the firm and
provides the prior conditioning for the formation of expectations in shareholdermanagement relations. There has been
discussion in the literature in recent years
about alternative views of the firm to replace
this system of prior conditioning.
Stakeholder and stewardship theories of
the firm have been proposed as alternatives
to the property rights view of the firm (Davis
et al. 1997; Donaldson and Preston 1995).
However, the stewardship theories and the
stakeholder theories may, at best, represent
desirable objectives and yet not represent
corporate practice.
The second box represents the shareholder value analysis. It shows the possible
effects shareholder value analysis can have
in countering opportunism in shareholdermanagement relationships. Shareholder

value analysis encourages a greater volume

of firm-specific communication. This contributes towards the effective conduct of corporate governance in two ways. First, it sustains the strategic co-operation between
shareholders and managers. The incomplete
contracts between shareholders and managers imply that the strategic co-operation
between the two parties can be maintained
and opportunism reduced only through a
continuous exchange of information on matters that affect the relationship. The second
favourable effect of the greater volume of
firm-specific communication is that it promotes the feeling for the entity. Several
studies have found a positive association
between communication behaviour and perceptions of fairness and justice (Greenberg
et al. 1994; Korsgaard et al. 1995; Miles and
King 1997; Sapienza and Korsgaard 1996).
In the analysis of relationships that cannot
be fully specified or controlled in advance
of their execution and where underlying
expectations can vacillate in unforeseeable
ways, the legal literature draws similar
conclusions. For the management of such
relationships, it is concluded that a communication infrastructure that does not simply
engage the parties to process information but
promotes sustained engagement is needed.
Such sustained engagement will depend on
relational assets like favourable prior belief,
trust and goodwill (Salbu 1995). Thus, information flows that are firm specific will
contribute towards the feeling for the entity
and contribute towards the reduction of
opportunistic behaviour in shareholdermanagement relations. There is a disclosure
agenda associated with shareholder value
analysis that has the potential of contributing
towards effective corporate governance. For
example, compared to the returns on capital

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12 l Rajeeva Sinha

employed as a measure of performance,

shareholder value analysis takes a more
pluralistic view of performance. Information
flows outside the boundaries of the firm will
have to go beyond financial accounts to categories like lines of business, investments
made, etc. Shareholder value analysis will
require that companies travel further down
the road suggested by Rappaports (1998)
seven drivers in the provision of information
beyond the boundaries of the firm.
Healy and Palepu (1995) provide an illustration of the disclosure agenda that is implicit
in market based evaluation of firm performance. CUC International is a United States
catalogue retail firm. The companys managers chose to report its marketing outlays
as assets. The managers believed that given
the line of their business, the marketing outlays for the acquisition on new members
were similar to investments on plants and
machinery in a conventional sense. The problem was that in the absence of widespread
availability of the firms market research
data, the investors were not willing to believe
the management. This led to persistent
misvaluation of the firms stocks. The study
found that accounting reports were not
always effective in investor communication.
Even financial signals in the form of leveraged recapitalization, early payment of debt
etc. had a delayed impact in correcting the
misvaluation. The authors of the study conclude that we need to understand investor
communication better to ensure such distortions in the market valuation of firms.
The emphasis on shareholder value in corporate performance appraisals is a positive
development for corporate governance. The
legacy of the conventional principal agents
framework is that corporate governance is
viewed as a confrontational process.

However, we have seen that there is a genuine need for firm-specific information in corporate governance because of the incomplete
contracts between shareholders and managers. If the effectiveness of the governance
mechanisms is to improve and the scope for
opportunistic behaviour is to be reduced,
there has to be a greater flow of firm-specific
information. However, in the current climate
there is little prior conditioning for a positive attitude towards a greater demand for
firm-specific information. For example, a
survey by the Financial Executives Research
Foundation in the United States found that
managers have a reserved attitude towards
the institutional investors and consider their
increased involvement as detrimental to the
companys interest. Shareholder value analysis, by making demands for more firm related communication, has the potential to
meet the requirements of corporate governance for such a communication in a nonconfrontational framework. There is a greater
acceptance (prior conditioning) of shareholder value as a legitimate concern in corporate circles than the demand for greater
information flows as emphasized by institutional shareholders activism.
There is little recognition of the potential
that shareholder value analysis has for the
conduct of corporate governance. In the
LloydsTSB case, shareholder value analysis
is used internally and there is little indication
that this firm-specific information is being
shared with outsiders. However, as illustrated by the CUC International case, there
will be increased pressure for greater information flows between shareholders and
managers with the adoption of market based
performance measures that is emphasized by
shareholder value analysis. If the use of
shareholder value analysis becomes more

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Corporate Governance and Shareholder Value Analysis l 13

widespread, it will no longer be enough to

make public commitments towards the creation of shareholder value. Firms will find it
increasingly necessary to provide greater
amounts of information on their strategy and
internal decisions. We illustrate this statement by examining the information required
for the calculation of warranted equity value
of LloydsTSB by Hoare Govett (1997). The
investment research identifies six drivers of
warranted equity value.
a.
b.
c.
d.
e.
f.

Economic profit
Return on equity
Equity invested
Trend profit growth
Return on new invested equity
Cost of equity

It is the last three drivers that Hoare Govett

have difficulty in quantifying. Thus, in the
case of the trend profit growth rate, the
assumption used is that it will stabilize at
some constant share of the GDP. The return
on investment is set at 15 per cent based on
anecdotal evidence on hurdle rates. This is
later cross checked by examining returns
available in the overall market. The cost of
equity, which is described as a nebulous concept, is taken as the near-term differential
between gilts and equities. The various subjective considerations lead to the calculation
of warranted equity values over a range of
discount rates. The calculated warranted
equity value is significantly dependent on
the return on new investment and the trend
growth rate.
These are problems not only for the external observer but also for the internal
decision-taker. It is one thing for a firm to
calculate its cost of capital historically, by

reference, for example, to its share price volatility as exhibited by its beta factor (and even
the choice of the beta factor involves an element of judgement). It is quite another thing
to determine an appropriate cost of capital
to apply to a future investment, the risk of
which may well vary from that observed historically for the business as a whole. Anecdotal evidence suggests that LloydsTSB is
itself aware of these problems and anxious
to overcome them.
Nevertheless, the public commitment
by a firm such as LloydsTSB to the pursuit
of a shareholder value goal can, up to a
point, be tested ex-post by the investment decision actually takenor considered but rejected. To the extent that the commitment is
judged credible and is reflected in such expost assessments, it will itself tend to reduce
the rate of discount applied by the market to
the firms future cash flows and thus, contribute directly to immediate shareholder value
creation.
Such a commitment lends itself naturally,
though not inevitably, to the provision of more
soft information on such matters as lines of
business emphasized and de-emphasized,
subsidiaries bought and sold, volumetric and
margin targets and so forth. It is likely that
firms adopting shareholder value maximization as their objective may be less forthcoming in conveying such information. However,
the logic of adopting shareholder value
analysis is that such information should be
passed to the market to the maximum extent
consistent with considerations of business
confidentiality. Healy and Palepu (1995) find
that when the CUC International could not
convince the investors, it decided not to
provide internal market research data that
justified its view of the value of marketing

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14 l Rajeeva Sinha

outlays with the disbursed outside shareholders. This would have undermined their
competitive position. Instead, it went in for
leveraged recapitalization. The private debtholder (GE Capital) was provided proprietary information about the firms marketing
strategies. This gave a credible signal about
the cash flow position of the firm to the market. Also, the private debt holder had a strong
incentive to monitor the management.

Decision Making and Shareholder Value Analysis

As defined in the first section of this article,
corporate governance is not only about
shareholder-management relations but also
about the framework it provides for top management decisions. Shareholder value analysis will have a number of implications for
the process of top management decisionmaking. The experience of LloydsTSB has
been that the use of shareholder value analysis has led to a decision-making framework
where targets do not determine the boundaries for strategy but the choice of strategy
and target setting is an iterative process.
Instead of business units trying to achieve
annual performance set by the group centre
and within the strategic boundaries set by
the group, under shareholder value analysis,
the emphasis is on the development of alternative strategies on a continuous basis to
maximize the contribution of individual
business units to the warranted equity value
of LloydsTSB. This involves an analysis of
market structures and the competitive position measured by its ability to earn abnormal
returns by each business unit.
The iterative process of strategy formulation is superior to the top-down approach,
as the challenge facing the modern corporation is entrepreneuralism and knowledge

management. Entrepreneuralism represents

the level of motivation amongst the top talent
within the organisation to seize opportunities. Knowledge management relates to the
ability to develop, apply and capture value
from new technologies and practices and to
create value-creating linkages between processes, business units and core functions
(Pitman 1998). The greater freedom enjoyed
by the business units in the shareholder value
framework as illustrated by the LloydsTSB
case should have favourable effects on
entrpreneuralism and knowledge management. However, internal disaggregation is,
by itself, not sufficient. The disaggregation
has to be supported by a clear identification
and commitment to a goal. Shareholder
value analysis meets both the requirements
of disaggregation and commitment expected
from an organisation geared to meet the challenges of entrepreneurlarism and knowledge
management.

Conclusion
The article has identified three possible
implications of shareholder value analysis
for corporate governance. First, shareholder
value analysis by providing the precommitment of managers with regards to the
objective of their decisions minimizes the
problem of expectation formation between
the strategically dependent shareholders and
managers. Second, shareholder value analysis also has the potential to support superior
managerial decisions. Effectiveness of corporate governance is increased because every
decision can be made within a framework
where its impact on shareholder value can
be measured and strategy formulation,

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Corporate Governance and Shareholder Value Analysis l 15

instead of being a top-down process, becomes an iterative process in which every

business unit enjoys considerable freedom.
Third, shareholder value analysis can also
serve as a useful tool in the conduct of corporate governance as it encourages firmspecific financial information flows. Another
advantage of shareholder value analysis is
that it encourages this greater exchange of
firm-specific information in a non-adversarial

framework. However, the value of shareholder value analysis as a source of firmspecific information only represents a
potential. There remains a distinct deficit in
the flow of soft financial information to
shareholders and business analysts outside
the boundaries of the firm. However, with
the wider adoption of shareholder value
as the goal of the firm the demand for such
information is likely to increase.

NOTE
Committee on corporate governance in the New
York Stock Exchange, visit http://www.nyse.com/
about/report.html.

1. For information on recent rules-based initiatives

in the US and in particular the report of the Corporate Accountability and Listing Standards

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