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Athos M. Staub

A green stock market in an age of 'shareholder value'?

Which of you can imagine floating your own company on the stock market in the next five to ten years? Which of you already invests money in the stock market, or can imagine doing this in the near future?

How does the stock market function? My question is not about the technicalities, but about what 'good' and 'bad' value means. What does the often-used term 'shareholder value' mean, and where does the concept come from? Business people who want to act responsibly in relation to social and ecological issues are not respected by the stock market as we know it.

These reflections stem from my co-operation with Elmar Sing at the Alternative Bank Schweiz (ABS), which, like the Oekobank in Germany, has been wondering how to progress into the future. The ABS's objective is to become a bank that directs money to businesses which meet high ecological and social standards. In other words, money should be channelled into areas where good is being done. This objective gave rise to the idea of creating something like a green fund for the ABS's own customers. In the context of this discussion I jotted down some points. One of them was: if you want to be seriously green, you've got no chance. You'll end up putting money into places where it won't do any real good.
So what are the possibilities, then, if the stock market as we know it doesn't offer a solution? How can green businesses get hold of secured investment? Should green businesses avoid the stock market?

The concept of 'shareholder value'
'Shareholder value' is the concept by which the value of companies on the stock market is measured. The contemporary use of this tool in business economics has very negative consequences for the national economy. That's why any green business that considers flotation on the stock market faces a dilemma.

In the second half of the 'eighties an analysis looking back over an extended period concluded that there is a strong correlation between the flotation of a business on the stock market and the so called 'discounted cash flow' (DCF).

The DCF is the sum of a company's projected future cash-flow needs, which must be generated by current business activities, minus the company's taxes and minus any investments the company needs to make to remain competitive. Because this cash flow is a future projection, and will materialise at some future point which will vary from company to company, a method of comparing companies and their cash flows is needed. For this you need a discounting method; in other words, a rate, by which a business's projected future value can be used to determine what it is worth today. The current worth of a business is its so-called gross capital expenditure.

The gross capital expenditure consists of external capital expenditure (loans; investments in the business by financing companies) and 'own' capital expenditure (meaning, a company's own means, according to the figures in the annual balance). The calculation of 'own' capital expenditure is central to this method. At the beginning of the 'eighties, if you asked a Swiss board member of a company which is more expensive - loans or share capital, the answer would regularly be: loans, because the share holder only gets the dividends, which can be retained and reinvested. The concept of 'shareholder value' contradicts this. An investor in shares nowadays, comparing companies noted at the stock market, will not only rate them according to the dividends, but also try to estimate the companies' increase in value. In the latter respect, the estimated increase in a company's value must be at least as high as that of any competitors.
The higher the stock market index, the higher a company's 'own' capital expenditure. For example, Company X of a certain economic sector generates a cash flow of 1,000 German marks over ten years. Company X is financed through 70% external capital (paying an average of 6.5% interest on this), and 30% 'own' capital. It is hence possible to calculate this 'own' capital expenditure using the stock market index. What counts is how high the returns will be, meaning, what long-term average increase on the stock market can be expected. If the stock market increases by about 5% in the long-term, the 'own' capital expenditure will be different from if the stock market increases by, say, 20%. 'Own' capital expenditure can be calculated, using a formula, to be 5.6% in relation to a 5% increase on the stock market, and 24.4% in relation to a 20% increase. Then, the amount of external capital is added to this, and we end up with the gross capital expenditure. This demonstrates that, through the stock market's increasing returns (which is what we expect the stock market index to do in the long-term), capital expenditure increases too. And the higher the capital expenditure, the lower a company's value. Our example shows that, with an expected return of 5%, a share after ten years will be worth 7,138 German marks, while a stock market return of 20% would mean a value of 6,700 marks. This is related to discounting: the higher the interest, the less the money will be worth when taken out of the company in the future.

For an individual entrepreneur, this means that the higher the stock market index is, the more cash flow he/she needs to generate in order to maintain the value of his/her company in comparison with others. This 'spiralling' is a problem that has been introduced in recent years.

What can be done by a company to increase its own value?
This is the point where a consultant really starts working. It's at this point that the stock market value of the company has to be calculated. It may be that the stock market and the investors don't fully know a company's value or its strategy. Perhaps, in this case, relationships with shareholders and the care of investors need to be improved. The company's credibility needs to be worked on. Of course, it can be that this work makes the company sound as though it's worth more than it actually is.

One can start by improving efficiency, in other words by introducing strategic and operative improvements. Changes can be introduced at every level to increase efficiency. With such internal improvements, an increase in value can be achieved. In this context a lot of management tools have been developed; for example, board members of big companies can call up all important data on a monthly, or even weekly, basis, including cash flow statistics and the most recent value of the concern.

But we can go further. The portfolio of activities can be changed, getting rid of parts of the company that are more valuable to a competitor than they are for the company. Or conversely, other parts can be bought. By such external improvements, an increase in value can be obtained.

Another possibility is to change the structure of the financing, for example through replacing bank loans with shares, or selling company-owned installations which can then be re-leased. There's a whole spectrum of such 'financial engineering'. Such ongoing efforts to increase the value have the ultimate goal of maximising the value of the company.
Everyone working on value-increase today knows what such a range of measures can achieve. When all the steps taken have been properly applied, and have been recognised by the investors, then the value of a business will increase.

Excesses of 'shareholder values'
The real problems become apparent in the excesses of shareholder values. When the concept of 'share holder value' was introduced in 1992, people warned that such assessments of stock market growth would be too short-term. In order to estimate longer-term stock market development, it was suggested a comparison be made with stock market development between 1926 and 1992, i.e. to look at real long-term developments over seventy years. Unfortunately, people tend to blank out what they don't want to hear, and this suggestion hasn't been taken on board. Suggestions for short-term improvement are more easily accepted. Because of this short-term thinking, a spiral has been created which is economically very problematic. Say stock market values do increase: an investor who wants to optimise his/her portfolio will go to his/her bank's consultant, who will recommend taking on stock with an above-average increase in value, the so-called 'stars'. This means that a business showing a quick increase in value tends to become over-inflated, because everybody goes for that stock. Looking at the mergers of the last five years, we can see that companies haven't been bought with money but with shares. The more the stock market pushes share-prices up, the greater the opportunities are for companies whose shares don't rise to be taken over. Some internet companies which haven't made any profits whatsoever have a higher stock market capitalisation than General Motors.

The 'stars' have an inflated value; they are buying up other firms, and their managers are under constant pressure not to lose the company's 'star' status. Internal investments are made purely to increases the company's value in the eyes of the analysts. Where 5% used to be enough, today 25% has to be made in order to keep up with the increasing value of the market. The hurdles for business investment are getting higher. It is increasingly hard to find investments in areas such as employment-creation which fulfil such criteria. This is why businesses increasingly make finance-based investments; that is, buying shares in other companies. In this way, the cycle is closed and is being increasingly reinforced.

The value of the 'stars' is rising. They are seen as attractive investment opportunities. In Switzerland over the last ten years, many people have dissolved their savings accounts and bank obligations and changed over to the stock market. Today more than a quarter of the Swiss population are shareholders. At some point there was a change in attitude to pension schemes: instead of investing in schemes or else in real-estate, shares have been bought. A second spiral has been started, which is building up under its own impetus.

This increasing spiral has significant economic effects. The increase of the stock market index also puts management under pressure to increase their company's rendition. This then raises the hurdles for business projects even higher. Those parts of the business having returns of between 5-7% will be cut. There can be no investment in anything which won't cover, at the very least, the capital expenditure. We know, from business experience, that returns of 15-20% are very rare in the real economy, if they occur at all. But when one has to achieve an average of 15%, business risk is evaluated in a different way. Pressure is put on a business's expenditure: there will be cuts in employment, voluntary social contributions, etc. Further, 'flexibility' will be introduced into work expenses, with whole departments being dissolved and work being contracted out. At the same time, the state is beginning to be blackmailed. Alusuisse (a metalwork and energy-production company with one thousand employees) demanded that the local authorities in the canton of Wallis should cut its taxes, otherwise they would have to close down.

Another obvious consequence is the dearth of social and ecological investments, which is the main concern of green businesses. The pressure is on for prices to go on rising. There is pressure to create monopolies in commerce across the board. There is also pressure to side-step the law. That is how I choose to describe the secret arrangements made between pharmaceutical companies; it does not indicate evil or criminality on the part of management.

It is interesting that in 1998, the value - on paper - of American business on Wall Street rose by around 42%, while their stock market value rose by about 277%. No one can tell me that this was due to developments in technology. In 1991 in Switzerland, business generated 46 billion Swiss francs in available cash flow (profits or savings), and invested 49 billion Swiss francs. This means, businesses had 3 billion Swiss francs' worth of debts, or in other words 'advance investments'. By 1998 the situation was turned around: investment had fallen to 41 billion Swiss francs, although savings reached 56 billion SFr.

The dilemma for green business people
If you let the stock market value your business, you end up in its trap. As an example: a conventional business and a green business both generate 1,000 currency units per year of free cash flow. The green business prefers to invest 35% of this in social and ecological activities. This results in its stock market value being lower (at 4,640) than that of the conventional business, despite them having an identical value on paper and in terms of their investments in shares, etc, because 35% of the green business's profit is taken off. The stock market value of the conventional business stays at 7,138. The net value (DCF) of the green business's lost profit, therefore, is around 2,500 monetary units. This is a conscientious choice on the part of the green business. But then, when it comes to each firm having five hundred new shares to auction off, the conventional firm's shares will have an immediate value to an investor that is 35% higher than the immediate value of the green business's shares. In conclusion, we can see that the stock market doesn't make true comparisons of the actual share value of companies because it doesn't take account of direct investments. Investors in the stock market optimise their portfolios and compare businesses according to their stock market value; that is, they compare financial values. Other possible considerations, for example social and ecological investment, remain hidden. The consequence is that green businesses are systematically described as having a lower value than businesses that use every possible means to increase their cashflow. Green businesses don't have any choice. They either have to put up with their companies being badly valued on the stock market or they have to give up social and ecological investment.

There are exceptions: businesses which make 'greenness' a key to their success. However, to be 'green' as an imperative doesn't currently hold any merit. It will be interesting, especially in terms of the national economy, if business people do start taking up their social and ecological responsibilities and acting accordingly. But this 'acting accordingly' will not be honoured by the stock market.

A green stock market?
What can be done in this situation? How can green businesses be financed?

There are at least two ways. There are some current possibilities of exploring direct investment whereby investors themselves can see what they are doing in the biological and ecological spheres. Investors can take an interest in, and identify with, the aims of a business.

If such investment possibilities were exhausted (though we are very far from that), we would have to start thinking about a green stock market. There would need to be certain conditions. The conditions for stock market flotation would need to have minimum social and ecological standards. There would have to be a guarantee that all businesses noted on such a stock market were following a certain code. A 'green' stock market should measure, publish, control and value businesses, just as the conventional stock market does - but this process should include accounts of the use of profits for ecological and social activity. There would certainly have to be a formalising of concepts of ecological and social conditions. This would involve standards relating to accountancy, new rules for assessing concerns, and the development of appropriate evaluation methods. How may the worth of such additional investments, in the national economic context, be measured?

But even if all these criteria were guaranteed, they still wouldn't be enough to prevent the possibility of this potentially very attractive stock market from being taken over by investors who would reintroduce the valuation of green businesses in purely financial terms. We therefore need to see a kind of self-control among investors so that, in optimising their portfolios, they continue to take ecological and social criteria into account. Investors must commit themselves to giving a high value to ecological and social objectives.

Reprinted from: UnternehmensGruen (ed), Geld für den Umbau. Finanzierungskonzepte für zukunftsfähige Unternehmen (AG SPAK Bücher, Neu-Ulm; Ökom-Verlag Munich, 2001), ISBN 3-930830-23-X

Email: Athos M. Staub
Athos Staub is a business consultant.  Contact: Hardturmstraße 169, CH-8005 Zürich, Tel: 0041 1 2720009, Fax 0041 1 2720014