Goals of Financial Management

Valuation

Valuation, a goal of financial management, often relies on fundamental analysis of financial statements.

Learning Objectives

Describe the valuation process

Key Takeaways

Key Points

  • In finance, valuation is the process of estimating what something is worth. Valuation is used to for a variety of purposes: the purchase or sale of a business, appraisal to resolve disputes, managerial decisions of how to allocate business resources, and many other business and legal purposes.
  • Valuation often relies on fundamental financial statement analysis using tools such as discounted cash flow or net present value. As such, an accurate valuation, especially of privately owned companies, largely depends on the reliability of the firm’s historic financial information.
  • Not only do managers want to keep reliable financial statements so that they can know the value of their own businesses, but they also want to manage finances well to enhance the value of their businesses to potential buyers, creditors, or investors.

Key Terms

  • valuation: The process of estimating the market value of a financial asset or liability.
  • fundamental analysis: An analysis of a business with the goal of financial projections in terms of income statement, financial statements and health, management and competitive advantages, and competitors and markets.
  • financial statement: A formal record of all relevant financial information of a business, person, or other entity, presented in a structured and standardized manner to allow easy understanding.

Introduction

Financial management focuses on the practical significance of financial numbers. It asks: what do the figures mean? Sound financial management creates value and organizational agility through the allocation of scarce resources among competing business opportunities. It is an aid to the implementation and monitoring of business strategies and helps achieve business objectives. There are several goals of financial management, one of which is valuation.

image

Valuation: Valuation is, for some, one of the goals of financial management.

Valuation

In finance, valuation is the process of estimating what something is worth. Valuation often relies on fundamental analysis (of financial statements) of the project, business, or firm, using tools such as discounted cash flow or net present value. As such, an accurate valuation, especially of privately owned companies, largely depends on the reliability of the firm’s historic financial information. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company).

Valuation is used to determine the price financial market participants are willing to pay or receive to buy or sell a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establishing a formula for estimating the value of partners’ ownership interest for buy-sell agreements, and many other business and legal purposes. Therefore, not only do managers want to keep reliable financial statements so that they can know the value of their own businesses, but they also want to manage finances well to enhance the value of their businesses to potential buyers, creditors, or investors.

Maximizing Shareholder and Market Value

A goal of financial management can be to maximize shareholder wealth by paying dividends and/or causing the market value to increase.

Learning Objectives

Describe the relationship between shareholder value and market value

Key Takeaways

Key Points

  • One interpretation of proper financial management is that the agents are oriented toward the benefit of the principals, shareholders, and in increasing their wealth by paying dividends and/or causing the stock price or market value to increase.
  • The idea of maximizing market value is related to the idea of maximizing shareholder value, as market value is the price at which an asset would trade in a competitive auction setting; for example, returning value to the shareholders if they decide to sell shares or if the firm decides to sell.
  • There are many different models of corporate governance around the world. These differ according to the variety of capitalism in which they are embedded. The Anglo-American (US and UK) “model” tends to emphasize the interests of shareholders.
  • The sole concentration on shareholder value has been criticized, for concern that a management decision can maximize shareholder value while lowering the welfare of other stakeholders. Additionally, short-term focus on shareholder value can be detrimental to long-term shareholder value.

Key Terms

  • market value: The total value of the company as traded in the market. Calculated by multiplying the number of shares outstanding by the price per share.
  • principal: One who directs another (the agent) to act on one′s behalf.
  • shareholder: One who owns shares of stock.

Introduction

Financial management is concerned with financial matters for the practical significance of the numbers, asking: what do the figures mean? There are several goals of financial management, one of which is maximizing shareholder and market value.

image

Money to Shareholders: Maximizing shareholder and market value is, for some, one of the goals of financial management.

Maximizing Shareholder Value

The idea of maximizing shareholder value comes from interpretations of the role of corporate governance. Corporate governance involves regulatory and market mechanisms and the roles and relationships between a company’s management, its board, its shareholders, other stakeholders, and the goals by which the corporation is governed.

In large firms where there is a separation of ownership and management and no controlling shareholder, the principal–agent issue arises between upper-management (the “agent”) and shareholders (the “principals”). The danger arises that, rather than overseeing management on behalf of shareholders, the board of directors may become insulated from shareholders and beholden to management.

Thus, one interpretation of proper financial management is that the agents are oriented toward the benefit of the principals – shareholders – in increasing their wealth by paying dividends and/or causing the stock price or market value to increase.

Maximizing Market Value

The idea of maximizing market value is related to the idea of maximizing shareholder value, as market value is the price at which an asset would trade in a competitive auction setting; for example, returning value to the shareholders if they decide to sell shares or if the firm decides to sell.

There are many different models of corporate governance around the world. These differ according to the variety of capitalism in which they are embedded. The Anglo-American (US and UK) “model” tends to emphasize the interests of shareholders.

The sole concentration on shareholder value has been widely criticized, particularly after the late-2000s financial crisis, where attention has risen to the concern that a management decision can maximize shareholder value while lowering the welfare of other stakeholders. Additionally, short-term focus on shareholder value can be detrimental to long-term shareholder value.

Maximizing Value Without Harming Stakeholders

A goal of financial management can be to maximize value without harming stakeholders, the diverse set of parties affected by the business.

Learning Objectives

Explain how maximizing value for shareholders can harm the business’s other stakeholders

Key Takeaways

Key Points

  • Stakeholders are those who are affected by an organization’s activities. The stakeholders can be internal or external to the firm and some will be involved directly in economic transactions with the business, while others will not.
  • Owners, employees, customers, suppliers, trade unions, the government, local communities, and the environment can be considered stakeholders. Because of the potential breadth of the term, there are different views on whom to include in stakeholder considerations.
  • Debate is ongoing about whether firms should be managed for shareholder value maximization or also with stakeholders in mind. While the Anglo-American “model” tends to emphasize shareholders, some European countries formally recognize other stakeholders in corporate governance decisions.
  • Some proponents of stakeholder considerations argue that attention to other stakeholders is intimitely intertwined with market value and can enhance outcomes for all stakeholders. Others argue that value should be maximized without harming stakeholders.

Key Terms

  • stakeholder: A person or organisation with a legitimate interest in a given situation, action or enterprise.
  • market value: The total value of the company as traded in the market. Calculated by multiplying the number of shares outstanding by the price per share.

Introduction

Professionals in financial management are concerned with the practical significance of the numbers that appear in financial documents. Given a set of information about certain financial behavior, they ask, what do the figures mean? There are several goals of financial management, one of which is maximizing value without harming shareholders.

The Stakeholder Concept

The stakeholder concept is associated with the concept of corporate governance. Corporate governance involves regulatory and market mechanisms and the relationships that exist between a company’s management, its board, its shareholders, other stakeholders, and the goals for which the corporation is governed. Stakeholders are those who are affected by an organization’s activities. The stakeholders can be internal, like owners or employees. They can also be external, like customers, suppliers, the government, local communities, and the environment. Some stakeholders are involved directly in economic transactions with the business. Others are either affected by, or able to affect, an organization’s actions without directly engaging in an economic exchange with the business (for example, trade unions, communities, activist groups, etc). Because of the breadth of the term stakeholder, there are different views as to whom should be included in stakeholder considerations.

image

Environment as stakeholder: The environment can be seen as a stakeholder. Maximizing value without harming stakeholders is, for some, one of the goals of financial management.

Stakeholders vs. Shareholders

In the field of corporate governance and corporate responsibility, a major debate is currently occurring about whether a firm or company should make decisions chiefly to maximize value for shareholders, or if a company has obligations to other types of stakeholders. This increased after the financial crisis of the late 2000s, when concerns deepened about the potential of companies to lower the welfare of other stakeholders while maximizing their shareholder value. While the Anglo-American (US and UK) business “model” tends to emphasize the interests of shareholders over other implicated parties, some European countries formally recognize other stakeholders in corporate governance decisions.

Some people who argue that businesses should consider other stakeholders, like the government or the environment, argue that an attention to these types of stakeholders is intimately intwined with market value. They also argue that a holistic view can enhance general outcomes for all the stakeholders that are involved. Still others argue that stakeholders, even if they are not considered in business decisions, should at the very least not suffer harm, and that businesses should maximize value only if they can do so without generating harm.