Are mergers really worthwhile or just a case of extreme CEO greed?

Mergers and Acquisitions are an area of finance that attracts attention from not only finance specialists but also the general public. Announcements from high profile and well-known companies are reported in the press with much speculation often arising before official statements are even released. Reporters and analysts will follow the deal closely, offering their opinions on the proposed benefits and whether they believe the deal to be fair to each party involved. The recent announcement of the Heinz Kraft merger was no exception. This case will be the focus of my blog, with the motives behind the merger being discussed.

In late March, it was announced that the US food company Heinz was set to merge with Kraft Foods Group, to create the third largest food and beverage company in North America (BBC News, 2015). Heinz shareholders will own 51% of the combined company, whilst Kraft’s shareholders will hold a 49% stake (BBC News, 2015); therefore Heinz will hold the controlling interest. The deal has been engineered by Heinz’s wealthy owners, Brazilian private equity firm 3G and Warren Buffet’s Berkshire Hathaway (Armstrong & Roland, 2015). The cash and stock transaction will see Kraft’s shareholders receiving a special cash dividend of $16.50 per share, totalling $10bn which will be financed by Mr Buffet and 3G (BBC News, 2015). This agreed price represents a premium of 27% to Kraft’s closing share price on the day before the announcement (24^th March) which valued the business at $36bn (Armstrong & Roland, 2015), suggesting a good deal for Kraft’s shareholders.

The deal is considered the largest of the year so far and the biggest ever reported in the food industry (Armstrong & Roland, 2015). So apart from creating the 5^th largest food and beverage company in the world (Fontanella-Khan, Massoudi & Daneshkhu, 2015), what benefits will this merger bring? Watson and Head (2013) deem a merger only justifiable if the wealth of the shareholders of each company is increased. Warren Buffet stated “this is my kind of transaction, uniting two world-class organisations and delivering shareholder value” (Fontanella-Khan et al., 2015). However, will this be the case for the combined shareholders of the newly titled Kraft Heinz Company?

Firstly, the deal represents a horizontal merger as it will merge two companies in the same industry (Arnold, 2013) – the food sector. The normal rationales behind this type of merger include economies of scale and scope and the synergies that are created when operating as a combined entity (Watson & Head, 2013). Again, the Heinz-Kraft deal is no exception. The combined company expects to see annual cost savings of $1.5bn by the end of 2017 (BBC News, 2015) as they will benefit from economies of scale and operational synergies; however this will inevitably result in redundancies. This is typical of mergers and acquisitions as an obvious way of achieving scale economies is to streamline business operations by cutting the number of employees in duplicated functions (Watson & Head, 2013). Job losses in areas such as finance, marketing and IT have been speculated after the merger (BBC News, 2015).

Furthermore, as well as delivering synergies, Heinz’s international presence should help to expand Kraft’s portfolio of brands overseas allowing them to access new markets. This was one of the reasons why Kraft’s CEO John Cahill was open to the deal as Kraft are currently struggling due to slow growth in US markets (Armstrong & Roland, 2015). The deal is predicted to create a business with combined revenues of $29bn each year (Fontanella-Khan et al., 2015). Additionally, Kraft can use Heinz’s expertise to revitalise their outdated products. Kraft has failed to keep up to date with new consumer habits (BBC News, 2015). Overall, it appears that Kraft will benefit considerably from Heinz’s global presence and success in the food industry and enable them to better meet consumer demands.

However, it is wise to consider whether these proposed benefits will materialise. There has been much speculation as to whether mergers and acquisitions actually create value for those involved.  Studies suggest that there is no gain to shareholders or even the economy after a merger or acquisition has taken place. For example, Cowling, Stoneman, Cubbin, Cable, Hall & Dutton (1980) proposed that at best acquisitions have a neutral effect on the economy and there are no extreme efficiency benefits to be gained. Furthermore, they argue that most takeovers of a horizontal nature, as in the case of Heinz and Kraft, are neutralised by increased monopoly power (Cowling et al., 1980). The owners of Kraft Heinz Company will no doubt be pleased with this increase in market power; however consumers may suffer a decline in choice and also face increased prices. Watson and Head (2013) highlight that subsequent research has echoed the findings of Cowling et al (1980) and the effect of mergers and acquisitions on the economy is deemed mostly neutral.

In contrast, scope does still exist for particular parties to benefit at the expense of others. Singh (1971) suggests that acquisitions are unprofitable from the acquiring company’s view point. Jenson and Ruback’s (1983) study showed average abnormal returns to the acquiring company shareholders of 4% for successful bids, whereas shareholders of the target company on average experienced 30% for successful bids. This suggests that substantial benefits arise for the target company shareholders. This was demonstrated when the announcement of the Kraft Heinz merger was released (25^th March) as Kraft’s share price rose by 35% as shown on the graph I have constructed below.

 

(Share Price figures sourced from https://uk.finance.yahoo.com/q/hp?s=KRFT)

Although it could also be argued that wealth is not necessarily created but rather redistributed, i.e. transferring wealth from the acquiring company’s shareholders to the target company’s shareholders (Watson & Head, 2013), the benefits cannot really be quantified until after the merger has been approved and put into place. The deal between Heinz and Kraft has only been approved by the boards of each company; agreement is still waiting from regulators and also the shareholders of Kraft (BBC News, 2015). Only time will tell if Kraft’s shareholders considerably benefit from the merger.

However, if there is not much to gain in practice, why have 3G and Warren Buffet masterminded this merge between Heinz and Kraft? Is this more a case of managerial greed? Arnold (2013) suggests that managerial motives behind mergers and acquisitions are not always concerned with maximising shareholder wealth.  Instead it is proposed that some managers simply enjoy creating an empire as it gives them a sense of achievement and purpose. Both 3G and Warren Buffet are no strangers to mergers and acquisitions. During the past seven years 3G have acquired Heinz, Burger King and the brewer Anheuser-Busch, with Warren Buffet teaming up with them on their last three food deals (Fontanella-Khan et al., 2015). Have they become transfixed with pulling off these high profile mergers?

Furthermore, the deal has been structured to keep Berkshire Hathaway and 3G in control of the new company. The special dividend of $16.50 a share allows them to keep their combined ownership at 51% (Solomon, 2015). This again highlights Lemann and Buffet’s desire for power.  Reports have suggested that both Buffet and 3G will appoint three directors each with five other directors being appointed by Kraft (Solomon, 2015). This means 3G and Buffet will remain in control as they can simply act together and replace Kraft directors if they wish. Therefore, Solomon (2015) proposes that the company will be predominantly run by 3G and Berkshire Hathaway, with very little input from Kraft’s shareholders.

Moreover, when considering what Lemann and Buffet may plan to do with the merged Heinz Kraft Company, it must be highlighted that 3G is a Brazilian private equity firm. Private equity investors have recently become dominant players in the merger and acquisition market (Watson & Head, 2013). Many private equity firms have made headlines as high profile listed companies have been purchased and taken private with the aim of re-floating the company at a later date (Watson & Head, 2013). In 2013, 3G and Buffet bought and privatised Heinz (BBC News, 2015). Therefore, it is natural to question whether this is the intended path for their latest merger. Buffet assured investors that “3G is unlike other private equity firms, they don’t just buy to sell, they buy to keep” (Armstrong & Roland, 2015). However, only time will tell what 3G and Warren Buffet really have planned for Kraft.  

To conclude, I believe the motives behind this merger may be more to do with establishing power and status within the food industry rather than creating wealth for shareholders. Although it must be noted that Kraft should gain considerably from Heinz’s global presence, what is certain is that Warren Buffet and Jorge Lemann won’t be sparing a thought for those who will be rendered jobless because of the merger. I believe it won’t be long before they will be planning their next purchase to satisfy their “insatiable appetite for acquisitions” (Armstrong & Roland, 2015).

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

Armstrong, A. & Roland, D. (2015, March 25). Heinz to merge with Kraft to create US food  giant. The Telegraph. Retrieved from http://www.telegraph.co.uk

BBC News. (2015, March 25). Kraft shares soar in Heinz merger. BBC News. Retrieved from http://www.bbc.co.uk/news/

Cowling, K., Stoneman, P., Cubbin, J., Cable, J., Hall, G. & Dutton, P. (1980). Mergers and Economic Performance. Cambridge University Press .

Fontanella-khan, J., Massoudi, Arash. & Daneshkhu, S. (2015, March 25). Heinz swallows Kraft in deal engineered by Warren Buffet and 3G. Financial Times. Retrieved from http://www.ft.com

Jensen, M. & Ruback, R. (1983). The market for corporate control: the scientific evidence. Journal of Financial Economics, 11 (1), 5-50. Doi: 10.1016/0304-405X(83)90004-1

Singh, A. (1971). Takeovers: Their Relevance to the Stock Market and the Theory of the Firm. Cambridge University Press.

Solomon, S.D. (2015, March 26). Reading the fine print in the Heinz-Kraft deal. The New York Times. Retrieved from http://www.nytimes.com

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.

Dividends: Relevant or not?

Dividend Policy is the determination of the distribution of profits generated by the company to its shareholders (Arnold, 2013). This is usually done in the form of dividends and is often paid out twice a year, one after the publication of interim results and the other after the year end.  However, companies are under no obligation to do so.

Dividend Policy has sparked much debate with some authors arguing dividends are essential in maintaining company value and others deeming them irrelevant to the firm’s value and consequently shareholder wealth. The Norwegian oil and gas producer, Statoil, recently announced that it would be continuing its dividend policy despite a drop in operating income (Bloomberg, 2015), caused by falling oil and gas prices. Therefore, I will be considering whether it is really necessary for Statoil to maintain its dividend policy during these tough business conditions. 

The two opposing arguments of dividend policy are briefly presented below:

·         Miller and Modigliani (1961) proposed that in a perfect world (and in turn making many assumptions) dividend policy is irrelevant to shareholder wealth. They argued that a company’s investment policy determines the valuation of a company, as investment decisions are responsible for the company’s future profitability.

·         Whereas, Gordon (1959) contended this by presenting the ‘bird in the hand’ theory – that investors prefer to receive a dividend payment now as future capital gains are uncertain. Therefore, if dividends are the preferred choice for shareholders, dividend policy has a role in determining the value of a company.

Last month, Statoil announced that its 4^th quarter net operating income was NK 9bn, significantly lower than its forecasted income of NK 26.3bn (Bloomberg, 2015). The newly appointed CEO, Eldar Saetre attributed this to the recent drop in oil and gas prices, which he believes to have fallen by approximately 10%. Eldar says Statoil are taking steps to combat this problem and improve their position by cutting capital expenditure by $2bn (Bloomberg, 2015). However, he confirmed that Statoil will not cut their dividend and are ‘highly committed’ to their policy. The dividend will remain at a flat rate for the next 3 years which he thinks reflects the current market environment but continues to offer a competitive rate (Bloomberg, 2015).

It could be argued that Statoil are maintaining their dividend policy despite these tough business conditions as they believe the value of their company could otherwise be negatively impacted. As mentioned before, the ‘bird in the hand’ theory presented by Gordon (1959) suggests that dividends are preferable to capital gains because of their unpredictable nature. Investors favour dividends as it means they receive cash now rather than leaving their money tied up in uncertain investments. Therefore, the dividend policy of a company will influence its market value (Gordon, 1959). For example, if Statoil decided to reduce its dividend payment, investors may decide to sell their shares and buy stocks in another company paying a higher dividend which would cause Statoil’s share price to deteriorate.

This relates to the informational content of dividends. As investors don’t have access to internal information an asymmetry of information exists (Arnold, 2013). Shareholders see dividends as providing them with information regarding a company’s performance and future prospects. A high dividend will signal good news to the investor, whereas a declining dividend can indicate that directors have a pessimistic view of the company’s future (Arnold, 2013). Also, Baker, Powell and Veit (2002) suggest that firms that decrease cash dividends should experience negative price reactions. Therefore, Statoil obviously do not want investors to lose confidence in the future of their shares, therefore have decided to maintain their dividend despite the drop in income.

Conversely, a criticism of this thought is that high dividends could indicate a lack of positive NPV investment projects and therefore lower future returns for shareholders (Watson & Head, 2013). However, Statoil insist they are continuing to invest in a high quality portfolio and have approved many projects in recent years and still have upcoming projects planned (Bloomberg, 2015) which suggests that the high dividend payment is not covering up for a lack of future investment projects – good news for investors!

As shown in the table below, Statoil have maintained their cash dividend at NK 1.80 per share since quarter 1 of 2014.

Quarter	Cash dividend (NOK)	Announcement date	Payment date
1Q 2014	1.8	29.04.2014	05.09.2014
2Q 2014	1.8	25.07.2014	05.12.2014
3Q 2014	1.8	29.10.2014	05.03.2015
4Q 2014	1.8	06.02.2015	04.06.2015

(Dividend figures sourced from - http://www.statoil.com/en/InvestorCentre/Share/DividendPolicy/Pages/DividendAmounts.aspx)

This appears to be the right approach for Statoil as the graph constructed below shows that their share price has remained reasonably steady over the past six months, indicating that shareholders on the whole are happy with the decision and have not chosen to invest elsewhere.

 

(Share price figures sourced from - http://www.statoil.com/en/investorcentre/share/pages/historicshareprices.aspx)

However, Reuters (2015) reported that analysts have suggested that Statoil should reduce or even suspend their quarterly dividend, warning that the low oil prices are draining its cash. Statoil have already had to sell some of their assets to cover their spending.

When following the argument of Miller and Modigliani it could be claimed that Statoil’s share price would not have been affected if they had chosen to reduce or even suspend their dividend as dividend policy has no beneficial impact on shareholder wealth (Baker et al., 2002). The timing of dividend payments is irrelevant and investing in projects with positive NPVs is of greater concern in securing future success. Miller and Modigliani (1961) conclude that share valuation is independent of the level of dividend paid by the company.

Miller and Modigliani suggested that investors who are rational, are indifferent to whether they receive capital gains or dividends on their shares. What is most important is that the company maximises its value by adopting an optimal investment policy – investing in all projects with a positive NPV (Watson & Head, 2013). Saetre, the CEO, emphasised that project quality must remain high (Reuters, 2015), indicating that Statoil are adopting a good investment policy. Therefore, it could be concluded that it is not necessary that Statoil continue to maintain their divided policy and should instead focus on investments to secure future value for the company.

However, it must be noted that the theory is based on many assumptions; Miller and Modigliani frame their paper on a perfect capital market with rational investors (Baker et al, 2002). And also assume no transaction costs or taxes – in reality we live in a very different world!

To conclude, I agree with the idea proposed by Miller and Modigliani that investment decisions are key to a company’s profitability and these will be essential to Statoil in improving their future income. However, as Baker et al (2002) argue, market imperfections such as information asymmetries, agency problems and transactions costs to name but a few, may make the dividend decision relevant. Therefore, I can most identify with the ideas of Gordon (1959) in the case of Statoil, as failing to pay a dividend may result in investors losing confidence in the business and exiting, which would ultimately leave Statoil in a worse position.

I believe companies should aim to provide a stable dividend with stable growth as this is most likely to be sustainable in the future. This conservative approach allows managers to set dividends at a low enough level to ensure they can maintain future pay-outs but should also provide shareholder satisfaction so they don’t look elsewhere for higher returns – the perfect balance!

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

Baker, H.K., Powell, G.E. & Veit, E.T. (2002). Revisiting the dividend puzzle – Do all the pieces now fit?, Review of Financial Economics, 11(4), 241-261. Doi: 10.1016/S1058-3300(02)00044-7

Bloomberg. (2015, February 6). Statoil CEO Says `Highly Committed' to Dividend Policy. Bloomberg. Retrieved from http://www.bloomberg.com

Gordon, M.J. (1959). Dividends, earnings and stock prices. Review of Economics and Statistics, 41(2), 99-105. Retrieved from JSTOR http://www.jstor.org

Miller, M.H. & Modigliani, F. (1961). Dividend Policy, Growth and the Valuation of Shares. Journal of Business, 34 (4), 411-433. Retrieved from JSTOR http://www.jstor.org

Reuters. (2015, January 8). UPDATE 1-Statoil CEO sticks to dividend policy despite low oil prices. Reuters. Retrieved from http://uk.reuters.com

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.

 

Capital Structure – Is it possible to create the optimal capital structure?

As discussed previously, the main aim of a company is to maximise shareholder wealth. With this in mind, is it possible to achieve increased wealth for shareholders by changing the company’s capital structure? In simple terms, a firm can choose to finance their business through a mixture of debt and equity, but to what ratio? This is an issue I will explore, using current examples to highlight the different choices and preferences of certain businesses.

The optimal capital structure debate centres on the question of whether a company can minimise its cost of capital by adopting a particular combination of debt and equity finance. Companies seek a lower WACC as this is a fundamental determinant of market value; cost of capital is used as the discount rate in investment appraisal decisions (Watson & Head, 2013). Therefore, it is an important figure as it can determine a company’s strategic option set, in effect influencing future cash flows of the firm.

Norwegian oil producer, Det Norske Oljeselskap ASA, is currently trying to create an optimal capital structure (Holter, 2015) in order to restore wealth to shareholders. This is because share price has deteriorated over the past year as shown in the graph i have constructed below. A net loss of $287m was reported in the fourth quarter due to the significant drop in oil prices recently (Holter, 2015), causing the company to consider both sources of financing. CEO Karl Johnny Hesvik said the company would be able to raise more debt and may also issue new shares (Holter, 2015).

(Share price figures sourced from https://uk.finance.yahoo.com/q/hp?s=DETNOR.OL&b=9&a=03&c=2014&e=10&d=03&f=2015&g=w)

However, equity and debt both have their benefits and drawbacks. Firstly, issuing shares on the stock exchange can result in relatively hefty transactions costs. Equity finance is also considered highly risky; investors have no guarantee of either dividend payments or capital gains. They are also ranked lowest on the creditor hierarchy should the company go into liquidation (Watson & Head, 2013). Due to these uncertainties faced by the investor, a higher return is demanded to compensate for the risk taken, increasing the cost of equity capital.

Contrastingly, lenders require a lower rate of return than ordinary shareholders, due to finance providers having secure claims on income (interest payments) and in liquidation (Arnold, 2013). Moreover, further benefits include the tax advantage and much lower transaction costs than issuing shares (Arnold, 2013). Therefore, debt is a much cheaper source of finance than equity.

Taking these factors into consideration, you would assume maximising shareholder wealth through capital structure is simple – just load up on debt as it has a lower cost than equity. Job done!!

But why then do companies continue to finance through issuing shares? For example, last week the UK furniture chain DFS returned to the stock market after privatisation in 2004 (BBC News, 2015). DFS are seeking to expand internationally and view floating on the stock exchange as a valuable way of securing finance, expecting to raise £105m by floating 25% of the private equity-owned company (Monaghan, 2015). They plan to use the capital raised to reduce their current debt and provide access to a lower cost of financing (Chapman, 2015). This highlights the issue of acceptable levels of gearing, which companies must take into account when considering their capital structure.

Increasing levels of debt can increase risks. Although debt decreases WACC as it’s a cheaper source of finance, the cost of equity actually increases as shareholders will demand higher returns for the risks they are taking (Arnold, 2013). Investors view increased gearing as risky as the financial risks a business takes are amplified and the risk of financial distress and ultimately liquidation increase. Therefore WACC will increase, reducing the value of the company and shareholder wealth (Arnold, 2013).

I believe DFS may have wanted to reduce their levels of risk and financial distress by issuing shares on the stock exchange- a period of expansion could mean uncertain times ahead for the company. So a reduction in debt and therefore interest payments will be beneficial and DFS will also be under no obligation to pay shareholders dividends. However, DFS have been cautious and set their share price at the lower end of the market range, this reduces the value of the company to £543.2m, despite initially valuing the company at £585m (Chapman, 2015). This could reflect the fact that there is still debt in the balance sheet and investors may be weary of this.

Nevertheless, Nobel Prize winners Miller and Modigliani (1958) suggested that a company’s capital structure has no impact on the WACC and value of a firm. Thus, advising that no optimal structure exists. Miller and Modigliani (1958) argued that as the cost of equity rises with the level of gearing, the increase is exactly offset by the cost of debt being lower, constant and a larger proportion of the capital structure. This implies that both Det Norske and DFS could choose to load up on debt and their WACC would remain the same, despite investor’s worries of financial distress.

But their theory was widely criticised for being based on many assumptions such as perfect efficient markets existing, no tax and also no costs of financial distress (Miller & Modigliani, 1958). They later published updated versions that took into account the effect of tax (1963) and financial distress (1971) and their theory dramatically changed, suggesting an optimal structure was possible.

To conclude, I believe that an optimal capital structure does exist. However, there is not one set combination, I think it will vary from company to company depending on investors and managerial preferences. The current economic climate and situation of the business will also influence this structure. For example, since the financial crisis many managers have become more cautious of the level of borrowing their firm undertakes (Arnold, 2013) and I believe this is the case with DFS, choosing to source finance through equity rather than debt. As the dramatic drop in oil prices and industry conditions will influence Det Norske’s choice of future capital structuring.

Furthermore, companies are beginning to consider alternative methods of finance that managers perceive to involve less risk. BBC News reported that many Northern Irish start-up firms were choosing to by- pass the banks to finance start-ups and expansions and instead favour methods such as Crowdfunding, with 4% of the UK's small business funding coming from this source last year (BBC News, 2015). These new emerging methods may be preferred by investors as they see crowdfunding as lower risk than lending from the bank.

 

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

BBC News. (2015, March 6). Furniture chain DFS returns to stock market. BBC News. Retrieved from http://www.bbc.co.uk/news/business

BBC News. (2015, March 8). Alan Watts: NI start-up firms 'bypassing banks' says leading entrepreneur. BBC News. Retrieved from http://www.bbc.co.uk/news/business

Chapman, M. (2015, March 6). DFS valuation drops £40m as it sets share price at lower end of range. Retail Week. Retrieved from http://www.retail-week.com

Holter, M. (2015, February 25). Billionaire Roekke’s Det Norske Reviews Funding as Oil Drops. Bloomberg. Retrieved from http://www.bloomberg.com

Miller, M.H. & Modigliani, F. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48(3), 261-297. Retrieved from JSTOR http://www.jstor.org 

Monaghan, A. (2015, February 6). DFS Furniture to float on stock market. The Guardian. Retrieved from http://www.theguardian.com
Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.

Stock Market Efficiency – Can the market be predicted?

In my previous blog, I briefly discussed the concept of stock market efficiency; this topic will be my next focus, considering the somewhat controversial subject in more depth by comparing the effects of a recent profit announcement from Centrica to an older example from Royal Dutch Shell. Stock market efficiency divides people in opinion, with some believing that share price movements are completely random and others of the view that share price increases and decreases can be predicted.

Both academics and investors have questioned pricing efficiency – the concept that prices of securities fully and fairly reflect  all information regarding both past events and future events the market expects to occur and therefore that the prices  of securities are priced fairly (Watson & Head, 2013). The testing of markets for efficiency led to the recognition of three different forms of market efficiency. Fama (1970) identified these as follows:

·         Weak-form efficiency

·         Semi-strong form efficiency

·         Strong-form efficiency

The concept of market efficiency will be discussed through the examples mentioned above.

In February, Centrica (the owner of British Gas) hit the news regarding their reported drop in profits. Their full year operating profits fell by 35% with profits at British Gas falling by 23% (BBC News, 2015). Centrica also announced that they had taken the decision to cut dividend payments to shareholders by 30% (Ficenec, 2015). Shares in Centrica ended on the day of the announcement (19^th February) 8.5% lower than the previous day (BBC News, 2015) as shown in the share price graph constructed below. I believe this demonstrates a semi-strong form efficient market because the share price reflects all relevant publicly available information, not just past price movements (Fama, 1970). It is no surprise that investors would sell their shares upon news of a significant dividend cut.

(Share Price figures sourced from http://www.centrica.com/index.asp?pageid=28&type=chart_)

Fama (1970) also suggests that you cannot beat the market by analysing publicly available information after it has been released as the market has already absorbed it into the price. The graph shows that the share price dropped considerably on the day of the announcement and therefore investors would have nothing to gain by acting on the news in the following days.

Centrica are suffering because of the drop in oil prices and the warmer weather in the UK this winter. Global oil prices have halved as supplies increased but demand slumped (BBC News, 2015). The Telegraph’s Questor column which publishes share and stock market tips strongly advised investors to avoid investing in Centrica after the announcement, due to the impact of these factors on Centrica’s profits (Ficenec, 2015). This will have further encouraged investors to sell their shares and contributed to the reduction in share price as this information was readily available to the market.

In contrast, I believe a lack of efficiency was demonstrated in 2012 when Royal Dutch Shell announced a 54% rise in full year profits (Macalister, 2012). Shell were benefiting from higher oil prices even though production had fallen, which also contributed to an increase in net income from $5.7bn to $6.5bn (BBC News, 2012). In an efficient market you would expect the market to react positively to this news as it suggests improved performance. Therefore you would assume the share price would increase. However, this news was met with a reduction in share price as shown in the graph I have constructed below. The significant rise in both profit and income was reported on 2nd February but as you can see the share prices dropped considerably on this day.

(Share Price figures sourced from http://www.shell.com/global/aboutshell/investor/share-price-information/historical-share-prices/london-rdsb.html_)

This could suggest that markets are completely random as you would expect security prices to increase after positive news announcements. This supports Kendall’s (1953) theory of Random Walks - the idea that share prices change in a random fashion, indicating there is no systematic link between one price movement and subsequent ones.

However, Kendall (1953) also suggested that prices were random because they reflect all known information and changes only occur when new information enters the market. The case of Royal Dutch Shell does not seem to support this. Does this then display a lack of efficiency from the market as they are not acting rationally to known information? Or alternatively, do investors simply not value this information regarding profit and income rises? I suppose an investor is most concerned with what return they can expect from a company and therefore value dividend announcements more highly as demonstrated in the recent example of Centrica.

Nevertheless, I believe one critique of Kendall’s theory would be the existence of chartists and investment analysts. I believe this should be considered when thinking about my original question. If analysts are continuing to make considerable returns in their line of work, how can share price movement be totally random? 

To conclude, I believe you cannot predict the stock market and share price movements are completely random because you do not know what will happen day to day and therefore what news will come to light. Analysts can make educated guesses and predictions; however you will never truly know how the market will react for definite. Additionally, the release of news has varying levels of effect on the share price depending on how the market values this information. Investors must value the news as significantly important to act upon the announcement.

Furthermore, to create value for shareholders, I believe it is essential that stock markets are efficient. An efficient market will correctly price shares therefore providing managers with the necessary signals to make good financial decisions (Arnold, 2013). If the market gets the price wrong, managers will find it hard to know what they have to do to increase shareholder wealth, as demonstrated by the example of Royal Dutch Shell. Shell’s managers would have predicted that a rise in profits would result in positive gains in relation to the share price. Therefore, they may have been left confused as to what strategy to implement in order to please their shareholders.

On the other hand, managers also have a responsibility to disclose information. Shares will only be priced efficiently if all relevant information has been released to the market (Arnold, 2013). However, managers may consider holding back information they believe could result in a negative effect. This could also lead to managers manipulating information to produce more favourable news as we saw in the case of Tesco that I discussed in my previous blog post. These actions could also have a detrimental effect on stock market efficiency as a whole.

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

BBC News. (2012, February 2). Shell plans production expansion as profits rise. BBC News. Retrieved from http://www.bbc.co.uk/news/business

BBC News. (2015, February 19). British Gas owner Centrica sees profits fall steeply. BBC News. Retrieved from http://www.bbc.co.uk/news/business

Fama, E. (1970). Efficient capital markets: a review of theory and empirical work. Journal of Finance, 25(2), 383-417. Doi: 10.1111/j.1540-6261.1970.tb00518.x 

Ficenec, J. (2015, February 19). Questor says Avoid. The Telegraph. Retrieved from http://www.telegraph.co.uk

Kendall, M. (1953). The analysis of economic time series, part 1: prices. Journal of the Royal Statistical Society, 96, 11-25. Doi: 10.2307/2980947

Macalister, T. (2012, February 2). Shell profits up 54% to £2m an hour. The Guardian. Retrieved from http://www.theguardian.com

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.

Should Shareholder Wealth Maximisation be the objective of companies?

It has been widely argued that the ultimate objective of any company should be to maximise shareholder wealth which involves the long term increase of share price and dividend stream. However, alternative objectives often arise that take a more stakeholder considered approach. Should companies only strive for shareholder wealth or should corporations consider the views of their wider stakeholders?  The corporate objectives of companies will be discussed through the case of Tesco following the revelations regarding their overstated profit figures in 2014 and their subsequent actions at the beginning of 2015.

In September, Tesco announced that they had overstated their half-year profit guidance by over £250m (BBC News, 2014). This was due to accounting errors that arose from the way they were recognising income from suppliers. Essentially, accounting for revenue too early and delaying the recording of costs until a later date. It became apparent to Tesco’s shareholders that Tesco’s managers had been focusing on maximising profits in the short term and employing accounting techniques that effectively manipulated figures to do so. Shareholders showed their feelings with their feet as the share price dropped considerably after this announcement (BBC News, 2014), as shown on the Share Price Graph that I have constructed below.

Graph 1 – Tesco’s Six Month Share Price

(Share Price Figures sourced from http://www.tescoplc.com/index.asp?pageid=36#tabnav)

The drop in share price also demonstrates stock market efficiency, the theory that the price of securities fully and fairly reflects all relevant available information (Watson & Head, 2013). When news of the overstatement of profit figures broke in the media, shareholders quickly voiced their views with a sudden decrease in the share price as shown above.

It could be argued that Tesco’s managers’ decision to use these accounting techniques to manipulate profit figures was not consistent with the objective to maximise shareholder wealth. This demonstrates the Agency problem (Watson & Head, 2013) as the goals of the managers (agents) clearly differed from those of the shareholders (principals) as they were seeking to maximise their own wealth rather than create value for shareholders. I believe Tesco’s managers were trying to reach their profit targets in order to secure rewards and bonuses for themselves instead of maximising shareholder wealth. 

Tesco have been heavily criticised for these actions in the media, but were they the only ones to blame? Jenson’s (2010) “enlightened” value maximisation theory suggests that the problem lies with government in not setting rules and regulating companies effectively. Tesco confirmed that there was no chief financial officer (CFO) in place after Alan Stewart resigned and his replacement was not due to start until December (BBC News, 2014). This could lead to people questioning how the company is run, questioning the board of directors and the company’s auditors. However, as Jenson suggests maybe we should be blaming the government for not enforcing harsher and stricter laws and boundaries regarding these matters.

More recently, Dave Lewis the newly appointed CEO and the man deemed with the responsibility to bring Tesco out of the dark and rebuild its market reputation announced plans to close 43 unprofitable stores in order to reduce overheads by 30% (Felsted & Oakley, 2015). This could be viewed as an attempt to create value for their suffering shareholders whilst demonstrating one of the 5 actions that managers take as part of the value action pentagon. Lewis has chosen to divest assets from negative spread units to release capital for more productive use (Arnold, 2013). This will release resources from unprofitable units which can them be employed more productively elsewhere, leading to significant cost reductions, an urgently needed action for Tesco. The news was welcomed by investors as demonstrated by a 15% increase in share price (as shown in the share price graph); with shareholders saying the decision will allow Tesco to regain some competitiveness (Felsted & Oakley, 2015). Again, also demonstrating stock market efficiency. 

However, Tesco’s recent actions have this time been criticised by their wider stakeholders, saying these actions will affect communities and diminish their relationships further (Felsted & Oakley, 2015).  Freeman (1984) presents the idea of Stakeholder theory which argues that managers must take into account the interests of any group or individual who can effect or be affected by the actions of the company. Should Tesco be concerned by their other stakeholders when they are finally managing to satisfy shareholders and create value for them?

It would appear that they should. Tesco is currently locked in a vicious price war with competitors as they battle the rise and increasing success of discount retailers such as Aldi and Lidl (Felsted & Oakley, 2015). Can Tesco really afford to disappoint and aggravate local communities, their potential customers? Dave Lewis must consider this when deciding his strategy to cut costs as falling sales have been a prevalent problem for Tesco, suffering further drops over the Christmas trading period (Felsted & Oakley, 2015). This is clearly the time that Tesco needs every little bit of help they can get.

I believe it is imperative that Tesco seek to satisfy shareholders as they are currently in a poor state and struggling to compete within the market. Contractual theory (Arnold, 2013) supports this as shareholders invest money into the business at high risk; there is no guarantee that they will receive a return like other stakeholders. Due to this unfair balance of risk, it is deemed reasonable that these investors should be entitled to any surplus returns from the business. Furthermore, as we operate in a free market system (Arnold, 2013); if a company chooses to reduce returns to shareholders, shareholders have the right to sell their shares and walk away from the business. Watson & Head (2013) suggest that financial managers should focus on making ‘good’ financial decisions that in turn increase shareholder wealth as the market will interpret these actions and the share price will adjust appropriately. Another considerable drop in share price could be very damaging for Tesco therefore I believe it is essential to satisfy their shareholders.

Additionally, Adam Smith expressed the argument, over 200 hundred years ago, that benefits are created for society when the business focuses on returns to the owner (Arnold, 2013). Therefore, in creating value for their shareholders, Tesco will in turn produce benefits for their wider stakeholder. 

To conclude, I believe that a company’s main objective should be to maximise shareholder’s wealth. However, I recognise that achieving this goal is where the problem lies. Aligning manager's and shareholders’ interests is key to success but this is clearly a difficult task as the case of Tesco has highlighted. Furthermore, will a company ever be able to really win and keep everyone happy? Tesco’s latest step has clearly satisfied shareholders as demonstrated by the rise in share price, however has led to wider stakeholders questioning if Tesco can really be trusted (Felsted & Oakley, 2015).

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

BBC News. (2014, September 22). Tesco suspends execs as inquiry launched into profit overstatement. BBC News, Business. Retrieved from http://www.bbc.co.uk/news/business 

Felsted, A. & Oakley, D. (2015 January 8). Tesco soars 15% on news of biggest overhaul in retailer’s 96-year history. Financial Times. Retrieved from http://www.ft.com 

Freeman, R.E. (1984). Strategic Management: A Stakeholder Approach. Boston: Pitman

Jenson, M.C. (2010). Value Maximisation, stakeholder theory, and the corporate objective function. Journal of Applied Corporate Finance, 22(1), 32-42. Doi: 10.1111/j.1745-6622.2010.00259.x

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.