The next component in our series on the three performances that drive a company’s investment performance is shareholder performance. Shareholder performance is driven almost entirely by the business performance of a company discussed in our last post. One of the better gauges of a top-performing company is how happy its shareholders are. Happy shareholders typically translate into sustainable business growth, which in turn translates into increased shareholder value and continued happiness.
Although shareholders don’t contribute directly to a company’s business performance, they can affect it through their voice and vote. The shareholders elect a company’s board of directors, who have the power to hire and fire management and make decisions about how capital is to be allocated. They expect management to look out for their interests by finding ways to increase shareholder value. And, if they’re not satisfied, they have the ear of the board of directors, who are seated at the behest of the shareholders.
Ways a Company Impacts Shareholder Performance
Shareholders are particularly interested in how the company manages its net income or return on equity. When the company generates profits, it’s up to the board of directors to decide how to utilize them. With a well-managed company that looks out for its shareholders, that decision is based in large part on how to best improve shareholder performance. While there are numerous ways a company can deploy its capital, three can directly impact shareholder performance.
- Share the profits in the form of a cash dividend
- Reinvest the earnings for business growth
- Use the capital to buy back shares
Each of these can contribute to shareholder performance but in different ways, and some companies will employ a combination of two or all three to increase shareholder value.
Share the Profits
The most direct way a business can affect shareholder performance is through a cash dividend. A cash dividend is simply a return of investment to the shareholders. Each year, or each quarter, the board of directors announces a dividend which is paid in cash—sometimes in stock—directly to shareholders. The better-performing companies will periodically increase their dividends. Some companies have been paying dividends for decades, so it becomes an expectation and a way for the company to attract new investors. Once a company starts paying a dividend, it will go through any length to continue to pay it because not to do so is an indication the company may be in trouble.
Reinvest for Business Growth
Most companies don’t pay a dividend, either because they don’t have predictable earnings or they are in a high growth phase. But the board of directors can still reward shareholders by retaining the company’s earnings and reinvesting them in the business to expand operations. That might mean investing in new plants or expanding locations to increase its capacity to generate more profits in the future. Done right, it should result in increasing the company’s value, which increases shareholder value.
Buy Back Shares
The quickest way for a company to impact shareholder performance is to buy back its shares. That has the effect of reducing the number of shares in the market. The board of directors may look at the company’s profits or cash on hand after a few good years and decide it would be in the shareholder’s interests to reduce the float and increase the value of the remaining shares. It’s one of Warren Buffett’s favorite ways for a company to improve shareholder value.
To understand the impact that could have on shareholder performance, imagine yourself as one of five partners in a business. At the end of the year, the business came through with big profits. One of the partners who had been thinking about leaving the business decides this is the right time. With the big profits on hand, the other partners agree to use them to buy out the departing partner. So, instead of sharing profits among five partners, each receiving a 20 percent share, they now share profits among four for a 25 percent share each. So, whether it’s a small business with five shareholders or a company with thousands, when the company buys back shares, it gives the remaining shareholders a larger interest.
Shareholder performance turns out to be an excellent barometer for gauging business performance. Generally, better-performing companies find ways to reward their shareholders through shared profits, reinvesting profits to increase the company’s value, or buying back shares. All you need do is examine what the company is doing with its net income and, if it’s being used in one of those three ways, you’ll find happy shareholders and an increasing return on equity.