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The shareholder value concept and tourism

 

 

WHAT IS THE SHAREHOLDER VALUE CONCEPT ?

Every investor tries to make the best of his commitment. Shareholders want the best  possible return on their investments. Their value is expressed in the dividends paid out and in what is hoped will be a rise in the share price. These are the only earnings the investor can expect. In this sense, shareholder value is a rather simple concept, and there is  nothing new in it. 

The phrase "shareholder value" is often used to criticise a certain mentality, perceived as a sort of uncrupulous behaviour. Companies are thus divided into the "bad" ones that subscribe to the shareholder value concept, and the "good" companies that are said to be more concerned with the so-called "stakeholders".

The "good companies" are destined to disappear from the stock market sonner or later. The language of market forces is loud and clear. Capital seeks an acceptable level of security, together with appropriate remuneration. The capital markets are therefore considered efficient in scientific terms, since they place funds where they can be expected to obtain the highest returns.

No company in the world can afford to ignore the concept of shareholder value. The idea put forward for this debate, that an entrepreneur or a company's management are in a position to decide for or against shareholder value, is erroneous.

The judgement Churchill once expressed on the subject of democracy  that : "It is the worst possible system, except for all the others" applies equally to the concept of shareholder value.

 

DOES THE SHAREHOLDER VALUE CONCEPT APPLY EQUALLY TO THE SMEs OF TOURISM

Tourism is not really a sector that involves major corporations of the type listed on the stock exchange. It is the realm of the small-to-medium-sized enterprise. Is the shareholder value concept restricted to the big economic players, who are at home in the stock market? Can it not be applied equally to the SMEs of the tourism sector ? 

In the typical SME the investor is the entrepreneur himself, the company owner. The entrepreneur has the dual function of "shareholder" and manager. He too wants to make the best of his commitment. His concept of value is essentially identical to that of the shareholder. This value is made up of the annual payments he is entitled to receive from the company, in the form of the entrepreneur's remuneration for example, and of the growing value of the company. If the entrepreneur takes large sums out of the firm, its value sinks. If on the other hand he leaves the profits in the company, the latter's value will increase.

So as we can see the concept of shareholder value is equally valid for the SMEs of the tourism industry. Indeed in tourism as in the other fields, it is best for all the stakeholders when an entrepreneur does his best to make the company as good a success as possible.

 

THE CREDIT POLICY OF BANKS

Just as important as the owner's capital however is the funding that can be obtained from banks, for virtually tourism enterprises depend to a great extent on debt financing.

How do banks decide which firms to finance and which to leave alone ?

The credit worthiness of a company is determined in the same way all over the world (Graph 1). The costs incurred by the company subtracted from the revenues, but leaving the capital costs out of the equation. The positive balance that remains is the amount available for paying the capital. In other words this method enables the creditor to answer the question of how much spare cash the company will be able to generate so as to pay the interest plus depreciation on loans, and to remunerate the shareholder's equity, without going bankrupt. This surplus is also known as the free cash flow.

If one converts into capital the sum of discounted free cash flows, and divides this by the cost of the capital, one obtains the amount of capital that can be financed. This sum is also known as the enterprise value.

The enterprise value is thus the flow of future income that goes to the investor, not the value of the plant and installations. This is the economic value added that results from the company's activities. Shareholder value reflects also this economic value added, not profit or short run dividend policies.

The foregoing may be summed up as follows: The value of a firm equals it's economic value added which determines the shareholder value. Banks and private investors use this value as guideline for their investments.

 

MEASURES FOR INCREASING ENTREPRISE VALUE

There can be no doubting that applying the shareholder value concept creates real problems for companies operating in the tourism sector. And indeed various measures that could help to increase enterprise value have often been the subject of discussion. It may be worth mentioning the most important of these measures once again
(graph 2) :

Elimination of excess capacity, so as not to waste capital (the utilisation rate in the Swiss hotel trade is just 32 per cent !)

• Larger operating units, making use of economies of scale (80 per cent of all Swiss hotels have less than 50 beds/25 rooms !)
• External growth (co-operative ventures and strategic alliances)
• Qualified management so as to achieve a more competitive and market-oriented approach 
• Programmes for between seasons to even out the seasonal differences (many businesses must close for months at a time) 

A SHORTAGE OF SHALEHOLDER'S AQUITY IS THE MAIN PROBLEM

The most acute financing problem in tourism is the lack of shareholder's equity. In Switzerland the ratio of shareholder's equity in the hotel industry barely amounts to 10 per cent.

In tourism's small-to-medium-sized enterprises equity is provided above all by the owner and entrepreneur and his family. This is topped up by direct investments from third parties, who invest in tourism out of conviction. Today too much reliance is placed on this source of capital now that the banks have modified their lending policy. They are now willing to advance only between 50 and 60 per cent of the enterprise value in the form of bank credits, and they expect the owners to find the rest themselves. There is thus a shortfall or "gap" of about 30 per cent (graph 3).

Tourism SMEs have no access to the stock exchanges, to the markets for equity. This puts them at a real disadvantage, which has become even more noticeable of late. The boom in Europe's stock markets has increased the volume of equity and at the same time lowered the cost. This has mainly benefited the technology, media and telecommunications sectors. Tourism has been left out in the cold.

 

THE CAUSE : INSUFFICIENT RETURN ON EQUITY

The rules of the capital market require that the remuneration of shareholder's equity reflect the risks involved. When these increase, so must the return on equity. In the world of finance risk is measured by fluctuations in the size of earnings or profit. The statistical measure is known as the "standard deviation".

In tourism the fluctuations in earnings and profit tend to be high, due to such factors as the weather, exchange rates and the seasonal nature of demand. The risk in tourism is thus higher than in various other sectors (graph 4). This means that equity invested in this field should really include a sizeable additional risk premium. It would be clearly foolhardy to claim that this is the case in the SMEs of tourism. The return on equity in tourism is indeed small. And it is difficult for this very reason to find anyone willing to put up the necessary venture capital.

This brings me to the question set out in the programme for today's meeting, namely  "Is the volatility of an economy based on shareholder value compatible with the need for the sustainable development of tourism resorts?" With your permission I would like to rephrase the question another way: How can tourism reduce volatility in such a way as to satisfy the concept of shareholder value and the rules of the market? For clearly the markets are not going to adapt to the requirements of tourism.

 

PROFESSIONAL REPORTING

There are a number of ways in which the manager of a tourism operation can himself improve the framework conditions for financing.

Tourism often fails to attract capital because of the inadequacy of the information available. Banks require a modern approach to finance planning, complete with reporting and controlling. Otherwise we have what is known in the scientific jargon as "asymetric information". In the context of a credit worthiness check the bank finds itself at a disadvantage in relation to the debtor in the matter of information. The problem for banks is how to distinguish between good borrowers and bad ones. When a bank is unable to assess the risk factor due to the lack of appropriate data or of any basis for trust, the additional risk premium must inevitably be high. Poor quality information and a lack of transparency lead at best to higher credit costs. In a worst case scenario asymetric information means the company will obtain no financing at all.

In many cases tourism managers of SMEs are unable to raise the necessary financing regardless of the efforts they make. This means they are forced out of the market. Many governments however view tourism as a strategic sector and are therefore prepared to offer support. I shall briefly describe two such state support programmes.

 

GOVERNMENT PROGRAMMES FOR MEZZANINE CAPITAL

Within the framework of the European Recovery Programme, Germany set up a programme to help small-to-medium-sized enterprises with shareholder's capital. The objective of this programme is to increase the ratio of equity in such companies. The remedy offered takes the form of mezzanine financing. This is a form of financing that combines elements of self-financing with loan capital. 

This kind of programme would be helpful in the tourism sector, where many companies have a good earnings profile, but the wrong kind of financing (graph 5). Such companies have to finance as much as 90 per cent of the enterprise value through loans. Mezzanine financing from the state could help to restructure the financing of such companies in a sustainable way. This particular state promotional measure would have to be strictly linked to the enterprise value however, i.e. the enterprise's ability to bear all of its capital costs over the long term

Increasing the ratio of equity through such state support programmes has a positive effect on the rate of interest charged for loans. Banks indeed will be in a position to offer loans at lower rates, since the capital structure has improved.

 

SECURITISATION OF TOURISM ASSETS

The concept of asset securitisation has attracted considerable attention recently. This refers to the sale of a company's assets on the capital market, in the form of securities -- in other words "asset-backed" securities. In exchange the purchasers of these securities provide the company with capital. The advantage of this procedure is that it allows a company to trade its own assets on the market.

Such procedures mainly concern mortgages. The only condition is that these assets must regularly generate cash flow that can be used to service the interest and pay back the debt to the investor.

Securitisation is only possible when large volumes are involved. A fund must therefore be created that will make it possible to obtain the kind of volume required for the capital market. One example is a hotel fund (graph 6). The financing contract must be drawn up in such a way as to allow transfer of the property to the investors (a so-called "true sale"). Such a fund should include the widest possible range of enterprises so as to spread the risk. The spread of risk can be on the basis of hotel categories (stars), on the basis of location (city, mountain, lake or seaside hotels), or on the basis of different specialisations (e.g. congress hotels). The sector-related risk remains a characteristic of such a pool, which as well as the obvious drawbacks can also have advantages.

Asset-backed securities usually have a first-class rating. In many cases however this is not due to the particular credit  worthiness of the debtor (e.g. the hotels). It is possible to improve bad risks with the help of a variety of credit enhancements. 

The function of credit enhancement can be taken on by the state, to ensure the success of the issue. This kind of promotional state financing does not really amount to a distortion of competition. The government is securing a fund and not individual enterprises.

Since the level of risk in tourism is high, it is not sure that the toursm SMEs will be able to rescue themselves from the financial backwoods purely through self-help, which would require the resourcefulness of a Baron Münchhausen. Tourism will therefore require assistance from the outside.

 

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