© 2000 John Petroff
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© 2000 John Petroff |
G- Minority and majority shareholders
As opposed to outside investors described in the previous section,
investment strategy and analytical approach become deeply involved
in corporate affairs when a shareholder acquires a controlling
interest in a corporation. A controlling interest gives the shareholder
the power to influence corporate decisions by, for instance, being
represented on the board of directors. Formally, one can distinguish
three levels of ownership:
- small shareholder with less than
5% of shares outstanding that has no power to influence corporate
strategy, which are those studied in the previous section,
- minority shareholder with more than
5% but less than 50% of shares outstanding has some influence
on corporate decision, except if another shareholder owns even
more shares,
- majority shareholder with more than
50% of shares outstanding that has complete control over the corporate
strategy.
The 5%, 25% and 50% barriers are merely
arbitrary indicative averages of different shareholder control
levels. For very large corporations with millions of shareholders,
even 5% ownership represents considerable power because the majority
of shareholders do not participate in votes and just sign their
proxy statements for the existing board. Moreover, small shareholders
may form a group that supports some given point of view of a given
small shareholder, and that group may be so vocal that other shareholders
do not dare stand up against it. On the other hand, in some closely
held corporations, even 25% of the stock ownership may give no
effective say in running of business.
See review questions Q-4G.1 through Q-4G.5.
The small shareholder looks at the corporation strictly as a portfolio investment. Only dividends paid currently and price appreciation are the basis of stock valuation as described in the previous section. But, as noted, potential for sales growth, revenue instability, competitive threats, resource bottlenecks and price volatility, each raise or lower perceived return and risk, and consequently value of a share.
2)- minority shareholder:
The minority shareholder is in an intermediate position. The value is essentially that stemming from dividends and price appreciation as for the small shareholder. But because if a minority shareholder were to put a large portion of his/her holding up for sale, the market share price would be significantly affected, minority shareholders are important to the corporation and have the potential to influence its strategies. Consequently, an approach to valuation of this holding has to go beyond dividends, and give consideration to reinvested earnings, capital budgeting, debt structure, cost efficiency and sale strategy that can prompt the minority shareholder to sell his/her holding or put pressure on the board of directors.
The minority shareholder can view the stock either as part of a portfolio holding, or as a fractional owner with some degree of influence. In the second alternative, the valuation is that used by the majority owner (discussed in next subsection), and the value of the holding is a proportion of the overall corporate valuation corresponding to the fractional ownership. Then such value is marked down for lack of effective control over the business.
[It may be noted that GAAP accounting, recognizes the peculiar valuation situation of the minority shareholder. Whereas the accounting treatment of a small shareholder, called the cost method when the holding less than 20%, consists in showing the shares at cost with adjustment of value only if the market price drops and the decrease is other than temporary, the accounting treatment of minority shareholder, known as the equity method, consists in incrementing the value of the investment recorded initially at the purchase price by the proportion of earnings less any dividends received. There is also a GAAP recommendation that if the shareholder owns less than 50% but has effective control, then the parent company should include the corporation in which the investment is made, in its consolidated statements. Consolidation naturally becomes an accounting requirement in the case of ownership of more than 50% of the shares, and it is the case which is discussed next.]
See review questions Q-4G1.1 through Q-4G2.3.
3)- majority shareholders:
A majority shareholder is the parent company of an affiliate. As such, it controls affiliate's assets and strategies, but does not actually carry out those strategies. The approach to financial analysis reflects this situation where responsibility is delegated, but a minority owner may have significant influence over affiliates operations. The financial analysis differs considerably depending on the degree of delegation of responsibilities. If the affiliate has significant autonomy and must only answer for its results of operations, its valuation is essentially the same as that of an entire company, described in next two sections, but the fraction of the minority interest is deducted from the overall affiliate valuation.
When there is less autonomy, and
management of the company has to report to an owner which delegates
only a portion of the responsibilities, then the processes of
decision making and analysis occur in two different locations.
The head office, which can be a holding company, a diversified
conglomerate or a government ministry, makes some of the decisions
and allocates the means of production to its affiliates. The affiliate
or branch is then responsible to carry out the plans and to achieve
the targets. The difference between this situation and the previous
one, is that the affiliate does not control its destiny but must
abide by decisions taken at headquarters. The head office can
either
- decide on product line, sales region, sales volume target and
price, (such as in the case of government utilities, for instance)
- allocate physical and financial resources, (such as in theaters
or museums),
- or, most commonly, both.
In this case, a financial analysis
consists in an evaluation of the efficiency with which the affiliate
generates the required output or uses the allocated resources.
Generally speaking, an affiliate cannot be evaluated on the basis
of its sales because these may be assigned to it, nor on the basis
of procurement of resources because the affiliate may not have
a choice but to use the suppliers or subcontractors which it has
been assigned to use.
The extreme case is where the affiliate is wholly owned by the parent, and practically no responsibility is delegated. Then, the affiliate can only be judged on the basis of efficiency of achieving targets. One approach to assess efficiency, but not a complete affiliate valuation, was developed by the chemical conglomerate Du Pont is to evaluate the performance of its large number of subsidiaries (which count exceeds one hundred) with what is called the Du Pont break-out or break down. The name comes from the way the rate of return is broken down into its analytical components:
Return on Equity = PAT/equity
= PAT/assets * assets/equity
= ROA * leverage
and ROA = PAT/assets
= PAT/sales * sales/assets
= net profitability * turnover of assets
This method (which is further noted in evaluation of profitability in Chapter 13 Section B-3) separates areas of responsibility: the net profitability is the responsibility of the sales and marketing department in pricing the products and finding customers, whereas the turnover of assets is the responsibility of the production department in using the equipment to its full potential. [In Russia, the Du Pont break out approach is commonly used in financial analysis, as one would expect for government owned productive units, and is known as the pyramid of coefficients.]
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See review questions Q-4G3.1 through Q-4G3.4.
The evaluation of a joint venture can fall in either the approach of a minority or that of a majority shareholder depending on which side has the real control of the undertaking. If both sides have exactly the same amount of control, then each side should treat the undertaking as if each had a majority ownership in it.
See review question Q-4G4.1.
See research assignment R-4.23.
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