Shareholder value

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Shareholder value is a business term, sometimes phrased as shareholder value maximization or as the shareholder value model, which implies that the ultimate measure of a company's success is the extent to which it enriches shareholders. It became prominent during the 1980s and 1990s along with the management principle value-based management or "managing for value".

Definition[edit]

The term "shareholder value" can be used to refer to:

  • The market capitalization of a company;
  • The concept that the primary goal for a company is to increase the wealth of its shareholders (owners) by paying dividends and/or causing the stock price to increase (i.e. the Friedman doctrine introduced in 1970);
  • The more specific concept that planned actions by management and the returns to shareholders should outperform certain bench-marks such as the cost of capital concept. In essence, the idea that shareholders' money should be used to earn a higher return than they could earn themselves by investing in other assets having the same amount of risk. The term in this sense was introduced by Alfred Rappaport in 1986.

For a publicly traded company, Shareholder Value (SV) is the part of its capitalization that is equity as opposed to long-term debt. In the case of only one type of stock, this would roughly be the number of outstanding shares times current shareprice. Things like dividends augment shareholder value while issuing of shares (stock options) lower it. This shareholder value added should be compared to average/required increase in value, making reference to the organizations cost of capital.

For a privately held company, the value of the firm after debt must be estimated using one of several valuation methods, such as discounted cash flow or others.

History[edit]

The first modern articulation that shareholder wealth creation is the paramount interest of the management of a company was published in Fortune magazine in 1962 in an article by the management of a US textile company, Indian Head Mills, in which they stated:[1]

The objective of our company is to increase the intrinsic value of our common stock. We are not in business to grow bigger for the sake of size, not to become more diversified, not to make the most or best of anything, not to provide jobs, have the most modern plants, the happiest customers, lead in new product development, or to achieve any other status which has no relation to the economic use of capital. Any or all of thee may be, from time to time, a means to our objective, but means and ends must never be confused. We are in business solely to improve the inherent value of the common stockholders' equity in the company.

Milton Friedman introduced the Friedman doctrine in a 1970 essay for The New York Times titled "A Friedman Doctrine: The Social Responsibility of Business is to Increase Its Profits".[2] In it, he argued that a company has no social responsibility to the public or society; its only responsibility is to its shareholders.[3] The Friedman doctrine was amplified after the publication of an influential 1976 business paper by finance professors William Meckling and Michael C. Jensen, "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure", which provided a quantitative economic rationale for maximizing shareholder value.[4]

On August 12, 1981, Jack Welch made a speech at The Pierre in New York City called ‘Growing fast in a slow-growth economy’.[5] This is often acknowledged as the "dawn" of the obsession with shareholder value.[citation needed] Welch's stated aim was to be the biggest or second biggest market player, and to return maximum value to stockholders.[citation needed] In 1983, Brian Pitman became CEO of Lloyds Bank and sought to clarify the governing objective for the company.[6] The following year, he set return on equity as the key measure of financial performance and set a target for every business within the bank to achieve a return that exceeded its cost of equity.[7]

The management consulting firms Stern Stewart, Marakon Associates and Alcar pioneered value-based management (VBM), or "managing for value", from the early to mid 1980s based on the academic work of Joel Stern, Dr. Bill Alberts and Professor Alfred Rappaport respectively.[8][9][10] Al Rappaport published "Creating shareholder value: The new standard for business performance" in 1986 which argued that "the ultimate test of corporate strategy, indeed the only reliable measure, is whether it creates economic value for shareholders".[11] Other consulting firms including McKinsey and BCG developed VBM approaches.[12] Value-based management became prominent during the late 1980s and 1990s.[13]

In March 2009, Welch criticized parts of the application of this concept, calling a focus on shareholder quarterly profit and share price gains "the dumbest idea in the world".[14] Welch then elaborated on this, claiming that the quotes were taken out of context.[15]

Interpretation[edit]

During the 1970s, there was an economic crisis caused by stagflation. The stock market had been flat for nearly 12 years and inflation levels had reached double-digits. The Japanese had taken the top spot as the dominant force in auto and high technology manufacturing, a title historically held by American companies.[16] This, coupled with the economic changes noted by Mizruchi and Kimeldorf, brought about the question as to how to fix the current model of management. Though there were contending solutions to resolve these problems (e.g.Theodore Levitt's focus on customer value creation and R. Edward Feeman's stakeholder management framework),[17] the winner was the Agency Theory developed by Meckling and Jensen.

Mark Mizruchi and Howard Kimeldorf offer an explanation of the rise in prominence of institutional investors and securities analysts as a function of the changing political economy throughout the late 20th century. The crux of their argument is based upon one main idea. The rise in prominence of institutional investors can be credited to three significant forces, namely organized labor, the state and the banks. The roles of these three forces shifted, or were abdicated, in an effort to keep corporate abuse in check. However, “without the internal discipline provided by the banks and external discipline provided by the state and labor, the corporate world has been left to the professionals who have the ability to manipulate the vital information about corporate performance on which investors depend”.[18] This allowed institutional investors and securities analysts from the outside to manipulate information for their own benefit rather than for that of the corporation as a whole.

Though Ashan and Kimeldorf (1990) admit that their analysis of what historically led to the shareholder value model is speculative, their work is well regarded and is built upon the works of some of the premier scholars in the field, namely Frank Dobbin and Dirk Zorn.

As a result of the political and economic changes of the late 20th century, the balance of power in the economy began to shift. Today, “…power depends on the capacity of one group of business experts to alter the incentives of another, and on the capacity of one group to define the interests of another.[19] As stated earlier, what made the shift to the shareholder value model unique was the ability of those outside the firm to influence the perceived interests of corporate managers and shareholders.

However, Dobbin and Zorn argue that those outside the firm were not operating with malicious intentions. “They conned themselves first and foremost. Takeover specialists convinced themselves that they were ousting inept CEOs. Institutional investors convinced themselves that CEOs should be paid for performance. Analysts convinced themselves that forecasts were a better metric for judging stock price than current profits”.[20] Overall, it was the political and economic landscape of the time that offered the perfect opportunity for professionals outside of firms to gain power and exert their influence in order to drastically change corporate strategy.

Agency theory and shareholder value[edit]

Agency theory is the study of problems characterized by disconnects between two cooperating parties: a principal and an agent.[21] Agency problems arise in situations where there is a division of labor, a physical or temporal disconnect separating the two parties, or when the principal hires an agent for specialized expertise.[22] In these circumstances, the principal takes on the agent to delegate responsibility to him.[23] Theorists have described the problem as one of “separation and control”:[24] agents cannot be monitored perfectly by the principal, so they may shirk their responsibilities or act out of sync with the principal's goals.[25] The information gap and the misalignment of goals between the two parties results in agency costs,[26] which are the sum of the costs to the principal of monitoring, the costs to the agent of bonding with the principal, and the residual loss due to the disconnect between the principal's interests and agent's decisions.[27]

Lastly, the shareholder value theory seeks to reform the governance of publicly owned firms in order to decrease the principal-agent information gap. The model calls for firms’ boards to be independent from their corporate executives, specifically, for the head of the board to be someone other than the CEO and for the board to be independently chosen.[28] An independent board can best objectively monitor CEO undertakings and risk.[29] Shareholder value also argues in favor of increased financial transparency. By making firms’ finances available to scrutiny, shareholders become more aware of the agent's behavior and can make informed choices about with whom to invest.[30]

Value-based management[edit]

As a management principle, value-based management (VBM), or managing for value (MFV), states that management should first and foremost consider the interests of shareholders when making management decisions.[12][31][32][33] Under this principle, senior executives should set performance targets in terms of delivering shareholder returns (stock price and dividends payments) and managing to achieve them.[34][35][36]

The concept of maximizing shareholder value is usually highlighted in opposition to alleged examples of CEO's and other management actions which enrich themselves at the expense of shareholders. Examples of this include acquisitions which are dilutive to shareholders, that is, they may cause the combined company to have twice the profits for example but these might have to be split amongst three times the shareholders. Although the legal premise of a publicly traded company is that the executives are obligated to maximize the company's profit,[37] this does not imply that executives are legally obligated to maximize shareholder value.

As shareholder value is difficult to influence directly by any manager, it is usually broken down in components, so called value drivers. A widely used model comprises 7 drivers of shareholder value,[38] giving some guidance to managers:

  • Revenue
  • Operating Margin
  • Cash Tax Rate
  • Incremental Capital Expenditure
  • Investment in Working Capital
  • Cost of Capital
  • Competitive Advantage Period

Looking at some of these elements also makes it clear that short term profit maximization does not necessarily increase shareholder value. Most notably, the competitive advantage period takes care of this: if a business sells sub-standard products to reduce cost and make a quick profit, it damages its reputation and therefore destroys competitive advantage in the future. The same holds true for businesses that neglect research or investment in motivated and well-trained employees. Shareholders, analysts and the media will usually find out about these issues and therefore reduce the price they are prepared to pay for shares of this business. This more detailed concept therefore gets rid of some of the issues (though not all of them) typically associated with criticism of the shareholder value model.

Based on these seven components, all functions of a business plan and show how they influence shareholder value. A prominent tool for any department or function to prove its value are so called shareholder value maps that link their activities to one or several of these seven components. So, one can find "HR shareholder value maps", "R&D shareholder value maps", and so on.

Disadvantages of the shareholder value model[edit]

Shareholder value may be detrimental to a company's worth. When all of a company's focus and strategy is concentrated on increasing share prices, the practice and ethics of the firm can become lost because of the following problems with the shareholder value model.[39][40]

Increased risk[edit]

In the shareholder value model, companies often take on much more risk than they otherwise would. The acquisition of debt makes the company unstable and at risk of bankruptcy. Plentiful debt is conducive to increasing share value because the company has greater potential to increase value when starting at a lower baseline. This however is a detrimental to the stability of the company.

Debt financing, or the purposeful acquisition of debt, causes the debt to equity ratio of the company to rise. Without shareholder value, this would normally be considered negative because it means that the company is not making money. In the shareholder value system, high debt to equity ratios are considered an indicator that the company has confidence to make money in the future.[41] Therefore, debt is not something to avoid but rather something to embrace and having debt will actually gain the company investors. Taking on large risk attracts investors and increases potential value gain, but puts the company in danger of bankruptcy and collapse.

Executive Compensation[edit]

In order to facilitate an incentive structure that supports shareholder value, the method of executive compensation has changed toward making a large portion of C-suite pay come from stock. The reasoning behind this decision was that it would bring the interests of CEOs in line with those of shareholders.[42] As a result of this decision, executive compensation has skyrocketed, quadrupling from the rate of compensation in the early 1970s.[43] This change has also shifted the motivations of C-suite managers in the direction of increasing share price over everything else, leaving other goals like long-term growth and stakeholders like employees and customers behind.[44]

Short term strategy[edit]

The short-term nature of shareholder value theory is one of the features focused on by critics. They argue that this fixation on the short term leads to neglect of more profitable long-term strategies.[45] In this way, shareholder value fails to attain the level of overall capital growth that might otherwise be expected. Given the emphasis on stock price inherent to shareholder value, incentives are created for corporations to inflate their stock price before its value becomes critical for assessment. One such incentive is that the compensation of executives and managers is increasingly tied to stock value through executive bonuses and stock options.[45] Corporations use several gimmicks to increase stock price, perhaps the most infamous being the mass layoffs of employees which creates the appealing image of increased efficiency and lower operating costs, in turn driving up stock price.[43] However, this and other such gimmicks have several negative consequences. Oftentimes, in the wake of mass layoffs, corporations have to refill some of the positions now vacant. This leads to a longer term inefficiency as new employees must be trained and the resources invested into the original employee (provided they were not rehired) are permanently lost.

A related criticism of shareholder value is the reliance on the process of assessing stock, which is itself vulnerable to manipulation and speculation.[45] Speculating on the firm's stock price is in the interest of managers that receive stock compensation and may therefore cause them to focus on speculating on the stock price rather than maximizing real production.[45]

Management experts also cite another criticism of shareholder value’s short term view, namely that it creates a corporate culture more concerned with maximizing revenue than with maintaining relationships with employees, customers, or their surrounding communities.[44]

Loss of Growth and Productivity[edit]

Business experts have criticized shareholder value for failing to materialize economic growth and increased productivity. Despite decades of research and dozens of studies, there is negligible strong evidence that shareholder value theory has produced better results for businesses (studies that did provide evidence of shareholder value being beneficial generally were not able to be replicated; Stout). Since the inception and widespread application of shareholder value theory, returns on invested capital have steadily decreased.[42] One explanation for this trend is reduced investment in innovation. Studies have shown that publicly traded companies (who have a share price) invest about half as much as privately held companies in the United States.[42] Even shareholders have had disappointing results with poor returns on investment and a reduction in the population of publicly traded companies by 40%.[46]

In addition to reduced growth, critics also point to reduced productivity. Shareholder value can have a negative effect on employee morale as the entire mission of the corporation becomes the generation of wealth for shareholders. Because of this reduction of motivation, corporations need to engage in more top-down and control-oriented management strategies, one such example being the massive rise in the use of non-compete agreements. Despite such efforts (or because of them), low employee morale has negative effects on business. Less motivated employees are less energetic and produce less and are less likely to innovate.[42]

A further inefficiency of shareholder value is the growth of financialization. The financial industry has ballooned in size following the use of shareholder value, largely due to the outsized importance placed upon shareholders by corporations.[47][42] The large financial sector is a drain on the entire United States economy, costing roughly 300 billion dollars per year.[42] This is because the financial sector does not engage in actual production.

Alternatives[edit]

While shareholder value is the most common framework for measuring a company's success and financial viability, a number of alternatives have been proposed. Indeed, maximizing shareholder value is not always the goal of successful companies.

Stakeholder value[edit]

The broad idea of "stakeholder value" is the most common basis of alternative frameworks. The intrinsic or extrinsic worth of a business measured by a combination of financial success, usefulness to society, and satisfaction of employees, the priorities determined by the makeup of the individuals and entities that together own the shares and direct the company. This is sometimes referred to as stakeholder value. Stakeholder value heavily relies on corporate social responsibility and long-term financial stability as a core business strategy.[48]

The stakeholder value model is prevalent in regions where limited liability laws are not strong. Some companies, choosing to prioritize social responsibility, elect to prioritize the social and financial welfare of employees and suppliers over shareholders; this, in turn, shields shareholders, the owners of the company, from liability when the law would not be lenient should the company engage in poor behavior.[48]

Despite its high potential social benefit, this concept is difficult to implement in practice because of the difficulty of determining equivalent measures for usefulness to society and satisfaction of employees. For instance, how much additional "usefulness to society" should shareholders expect if they were to give up $100 million in shareholder return? In response to this criticism, defenders of the stakeholder value concept argue that employee satisfaction and usefulness to society will ultimately translate into shareholder value.

Another related criticism is that it is difficult to determine how to equitably distribute value to stakeholders. The question of "who deserves what and how much" is a difficult one to answer.

Social enterprise[edit]

A company may choose to disregard shareholders completely. A social enterprise instead focuses its objectives on goals other than the profitability of its owners; indeed, the legal body of a social enterprise often precludes issuing dividends to shareholders. Social enterprises require significant investment in financial stability and long-term profitability, in the meantime taking very little risk.[48]

Social enterprises manifest themselves in the UK as community interest companies or limited by guarantee. In the United States, California allows companies to incorporate as flexible purpose corporations.[48]

See also[edit]

References[edit]

  1. ^ Kilroy, Denis; Schneider, Marvin (2017-08-21). Customer Value, Shareholder Wealth, Community Wellbeing: A Roadmap for Companies and Investors. Springer. ISBN 978-3-319-54774-9. This quotation was drawn from the Indian Head Mills company manual. It was used in an article entitled "The Chief shows them how at Indian Head" in the May 1962 edition of Fortune Magazine, (pp. 129-130), and was widely used in training material published by Marakon Associates in the 1980s and 1990s. It was reproduced in McTaggart, Kontes and Mankins, The Value Imperative, Free Press, 1994, p. 8.
  2. ^ Denning, Steve (27 April 2017). "The 'Pernicious Nonsense' Of Maximizing Shareholder Value". Forbes. Retrieved 12 July 2019.
  3. ^ Friedman, Milton (September 13, 1970). "A Friedman Doctrine: The Social Responsibility of Business is to Increase Its Profits". The New York Times Magazine.
  4. ^ Denning, Steve (17 July 2017). "Making Sense Of Shareholder Value: 'The World's Dumbest Idea'". Forbes. Retrieved 15 July 2019.
  5. ^ Betsy Morris, "Tearing up the Jack Welch playbook" (July 11, 2006) Fortune at CNNmoney.com
  6. ^ Kilroy, Denis; Schneider, Marvin (2017). Customer Value, Shareholder Wealth, Community Wellbeing: A Roadmap for Companies and Investors. Springer. p. 4. ISBN 9783319547749.
  7. ^ Pitman, Brian (2003-04-01). "Leading for Value". Harvard Business Review (April 2003). ISSN 0017-8012. Retrieved 2020-08-23.
  8. ^ "GSB | Chicago: The Distinguished Alumnus Awards: Joel Stern". web.archive.org. 2013-01-23. Retrieved 2021-02-25.
  9. ^ Chandra, Prasanna (2007). Financial Management. Tata McGraw-Hill Education. p. 817. ISBN 9780070656659. Marakon Associates, an international management consulting firm founded in 1978, has done pioneering work in the area of value based management.
  10. ^ Kilroy, Denis; Schneider, Marvin (2017). Customer Value, Shareholder Wealth, Community Wellbeing: A Roadmap for Companies and Investors. Springer. pp. 5, 12–16, 24–25. ISBN 9783319547749. The shift towards this approach gained momentum with the publication of The Value Imperative by McTaggart, Kontes and Mankins in 1994. ... Peter Kontes (a co-founder of Marakon Associates and one of the originators of MFV) pointed out … the central problem with EPS growth as standalone financial performance measure is that it can be purchased at any price. … the same telling point that Marakon partners first made with their clients in the mid-1980s. ... Marakon Associates, the firm that first developed the plan-based approach.
  11. ^ "Creating Shareholder Value: The New Standard for Business Performance - AbeBooks - Rappaport, Alfred". www.abebooks.co.uk. Retrieved 2021-02-09.
  12. ^ a b Chandra, Prasanna (2007). Financial Management. Tata McGraw-Hill Education. p. 817. ISBN 9780070656659.
  13. ^ Kilroy, Denis; Schneider, Marvin (2017). Customer Value, Shareholder Wealth, Community Wellbeing: A Roadmap for Companies and Investors. Springer. p. 5. ISBN 9783319547749.
  14. ^ Financial Times "Welch condemns share price focus" (March 13, 2009)
  15. ^ Business Week "Jack Welch Elaborates" (March 16, 2009)
  16. ^ Dobbin, Frank; Jiwook Jung. "The Misapplication of Mr. Michael Jensen: How Agency Theory Brought Down the Economy and Why it Might Again" (PDF). Sociology of Organizations. 30B.
  17. ^ Kilroy, Denis; Schneider, Marvin (2017-08-21). Customer Value, Shareholder Wealth, Community Wellbeing: A Roadmap for Companies and Investors. Springer. pp. 4–5. ISBN 978-3-319-54774-9.
  18. ^ Mizruchi, Mark; Howard Kimeldorf. "The Historical Context of Shareholder Value Capitalism" (PDF). Political Power and Social Theory. 17.
  19. ^ Dobbin, Frank; Dirk Zorn. "Corporate Malfeasance and the Myth of Shareholder Value" (PDF). Political Power and Social Theory. 17.
  20. ^ Dobbin, Frank; Dirk Zorn. "Corporate Malfeasance and the Myth of Shareholder Value" (PDF). Political Power and Social Theory. 17.
  21. ^ Kathleen M. Eisenhardt, "Agency Theory: An Assessment and Review," The Academy of Management Review 14(1989) 58.
  22. ^ Shapiro, Susan P. (2005). "Agency Theory". Annual Review of Sociology. 31: 275. doi:10.1146/annurev.soc.31.041304.122159.
  23. ^ Jensen, Michael C.; Meckling, William H. (1976). "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure". Journal of Financial Economics. 3 (4): 308. doi:10.1016/0304-405X(76)90026-X.
  24. ^ Jensen and Meckling, "Theory of the Firm," 310.
  25. ^ Eisenhardt, "Agency Theory," 61.
  26. ^ Shapiro, "Agency Theory," 265.
  27. ^ Jensen and Meckling, "Theory of the Firm," 308.
  28. ^ Shapiro, "Agency Theory," 269.
  29. ^ Dobbin and Jung, "The Misapplication of Mr. Michael Jensen," 31.
  30. ^ Dobbin, "The Rise of Shareholder Value," Sociology 25, Harvard University.
  31. ^ Kilroy, Denis; Schneider, Marvin (2017). Customer Value, Shareholder Wealth, Community Wellbeing: A Roadmap for Companies and Investors. Springer. pp. 12–16, 24–25. ISBN 9783319547749.
  32. ^ "What is value-based management?". McKinsey. Retrieved 2019-05-07.
  33. ^ McTaggert, James M.; Kontes, Peter W.; Mankins, Michael C (1994). Value Imperative: Managing for Superior Shareholder Returns. Free Press. ISBN 978-0029206706.
  34. ^ Fernandez, Pablo (2002). Valuation Methods and Shareholder Value Creation. Elsevier. p. 265. ISBN 9780080520377. parameters that have been proposed for measuring a firm’s “value creation” for its shareholders … are ... economic value added ... economic profit ... market value added ... cash value added
  35. ^ Gillis, Scott; McTaggart, James (1998). "Setting targets to maximize shareholders value". Strategy & Leadership. 26 (2): 18–21. doi:10.1108/eb054614. ISSN 1087-8572.
  36. ^ "Valuation: Measuring and Managing the Value of Companies, 6th Edition". mckinsey.com. Archived from the original on 2015-08-26. Retrieved 2015-08-05.
  37. ^ Maxwell S. Kennerly, Esq., "eBay v. Newmark: Al Franken Was Right, Corporations Are Legally Required To Maximize Profits" (September 13, 2010)
  38. ^ Corporate Financial Strategy, Ruth Bender, Keith Ward, 3rd edition, 2008, p. 17
  39. ^ Hillman, Amy J.; Keim, Gerald D. (2001-02-01). "Shareholder value, stakeholder management, and social issues: what's the bottom line?". Strategic Management Journal. 22 (2): 125–139. doi:10.1002/1097-0266(200101)22:2<125::aid-smj150>3.0.co;2-h. ISSN 1097-0266.
  40. ^ Srivastava, Rajendra K; Tasadduq A. Shervani; Liam Fahey (1998). "Market-Based Assets and Shareholder Value: A Framework for Analysis". Journal of Marketing. 62 (1): 2–18. doi:10.1177/002224299806200102. JSTOR 1251799. S2CID 51799845.
  41. ^ Lazonick, William; Mary O'Sullivan (2 December 2010). "Maximizing shareholder value: a new ideology for corporate governance". Economy and Society. 29 (1): 13–35. doi:10.1080/030851400360541. S2CID 218508129.
  42. ^ a b c d e f Denning, Steve. "Making Sense Of Shareholder Value: 'The World's Dumbest Idea'". Forbes. Retrieved 2020-12-18.
  43. ^ a b Yang, Jia (2014-12-31), "10. Maximizing Shareholder Value: The Goal that Changed Corporate America", The Best Business Writing 2014, Columbia University Press, pp. 160–170, ISBN 978-0-231-53917-3, retrieved 2020-12-18
  44. ^ a b Kennedy, Allan (2000). "The end of shareholder value". RSA Journal. 148: 50–53.
  45. ^ a b c d Koslowski, Peter (2000). "The Limits of Shareholder Value". Journal of Business Ethics. 27: 137–148 – via JSTOR.
  46. ^ Stout, Lynn A., "The Shareholder Value Myth" (2013). Cornell Law Faculty Publications. Paper 771.
  47. ^ Ho, Karen (October 12, 2020). "Why the Stock Market is Rising Amidst a Pandemic and Record, Racialized Inequality". American Ethnological Society.
  48. ^ a b c d "In Search of an alternative to Shareholder Value Maximization" Archived 2015-07-13 at the Wayback Machine

Further reading[edit]