440 CHAPTER 12 Corporate Valuation, Value-Based Management, and Corporate Governance
management is making sure that managers focus on the goal of stockholder wealth
maximization.
The set of rules and procedures used to motivate managers falls under the gen-
eral heading ofcorporate governance.At the risk of oversimplification, it involves two
primary mechanisms: “sticks” and “carrots.” The sticks make it easier to replace a
poorly performing CEO. They include (1) provisions in the corporate charter that
affect the likelihood of a takeover and (2) the composition of the board of direc-
tors. The corporate charter may make it relatively easy for a takeover to occur, so
that a poorly performing CEO can be replaced; or the charter may make a takeover
more difficult, in which case poor managers can continue to perform poorly. The
board of directors can consist of strong outsiders, who will likely monitor the
CEO’s performance closely and replace him or her if things are not going well, or
of friends and colleagues of the CEO, who are willing to let things slide. The car-
rot involves the type of managerial compensation plan the company uses. If man-
agerial compensation is linked to the firm’s stock price, then managers are more
likely to focus on shareholder wealth maximization than if their compensation is just
a fixed salary.
This chapter discusses the corporate valuation model, value-based management,
and corporate governance, beginning with the corporate valuation model.Why is the corporate valuation model applicable in more circumstances than the
dividend growth model?
What is value-based management?
What is corporate governance?The Corporate Valuation Model
Corporate assets are of two types: operating and nonoperating. Operating assets, in
turn, take two forms: assets-in-place and growth options. Assets-in-place include
such tangible assets as land, buildings, machines, and inventory, plus intangible assets
such as patents, customer lists, reputation, and general know-how. Growth options are
opportunities to expand that arise from the firm’s current operating knowledge, expe-
rience, and other resources. The assets-in-place provide an expected stream of cash
flows, and so do the growth options. To illustrate, Wal-Mart owns stores, inventory,
and other tangible assets, it has a well-known name and reputation, and it has a lot of
business know-how. These assets produce current sales and cash flows, and they also
provide opportunities for new investments that will produce additional cash flows in
the future. Similarly, Merck owns manufacturing plants, patents, and other real assets,
and it has a knowledge base that facilitates the development of new drugs and thus
new cash flow streams.
Most companies also own some nonoperating assets, which come in two forms.
The first is a marketable securities portfolio over and above the cash needed to op-
erate the business. For example, Ford Motor Company’s automotive operation had
about $6.9 billion in marketable securities as of late 2001, and this was in addition
to $6.1 billion in cash. Second, Ford also had $2.7 billion of investments in other
businesses, which were reported on the asset side of the balance sheet as “Equity in
Net Assets of Affiliated Companies.” So, in total Ford had $6.9 $2.7 $9.6 bil-
lion of nonoperating assets, compared with its $87.6 billion of automotive assets, or
11 percent of the total. For most companies, the percentage is even lower. For ex-
ample, Wal-Mart’s percentage of nonoperating assets was only 1 percent, which is
more typical.