Shareholder value

Overview

Shareholder value is a business term, sometimes phrased as shareholder value maximization. The term expresses the idea that the primary goal for a business is to increase the wealth of its shareholders (owners) by paying dividends and/or causing the company's stock price to increase. It became a popular concept in business management during the 1990s and led to a management approach often called value-based management or managing for value.

Definition

The term shareholder value can be used to refer to:

The market capitalization of a company; The view 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 articulated in 1970); The more specific concept that planned actions by management and the returns to shareholders should outperform certain benchmarks 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 emphasized by Alfred Rappaport in 1986. For a publicly traded company, shareholder value is the part of its capitalization which 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.

History

The concept of measuring business performance as profit less an opportunity cost charge for the use of the funds employed in earning the profit dates back to Robert Hamilton who published An Introduction to Merchandize in 1777 in Edinburgh, Scotland. Hamilton's treatment may have its origins in Adam Smith's, The Wealth of Nations (first edition in 1776). The roots of shareholder value theory can thus be traced to the late 18th century when the capital investment required to finance new manufacturing businesses during the Industrial Revolution in the United Kingdom led to a change in the structure of businesses, from traditional small family-run businesses to large publicly-owned companies with dispersed shareholders and professional managers. This change in governance, called managerialism, led to new modes of coordinating enterprise, technology and planning.

In the United States, Alfred Marshall, in Principles of Economics, explained in 1890 that for firms to create wealth they must earn more than the cost of their debt and equity. General Motors applied the concept in the 1920s. It was called excess earnings by Canning (1929) and Preinreich (1938). In the 1950's General Electric labeled it residual income and applied it as a performance measure to their decentralized divisions. Fortune magazine published an article in 1962 by the management of a US textile company, Indian Head Mills, that articulated shareholder wealth creation as the paramount interest of the management of a company: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 these 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.In Divisional Performance: Measurement and Control (1965), David Solomons suggested that residual income be used as an internal performance measure and Robert Anthony (1973) suggested that it be an external performance measure. Economist Milton Friedman introduced the Friedman doctrine in a 1970 essay for The New York Times, entitled A Friedman Doctrine: The Social Responsibility of Business Is to Increase Its Profits. In it, he argued that a company has no social responsibility to the public or society; its only responsibility is to its shareholders. The Friedman doctrine was amplified after the publication of an influential 1976 business paper by finance professors Michael C. Jensen and William Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, which provided a quantitative economic rationale for maximizing shareholder value. Jack Welch, CEO of General Electric, made a speech in 1981 entitled Growing Fast in a Slow-Growth Economy, which is often acknowledged as the "dawn of the shareholder-value movement". Welch did not mention the term shareholder value, but outlined his beliefs in selling underperforming businesses and cutting costs to increase profits faster than global economic growth. In the United Kingdom in 1983, Brian Pitman became CEO of Lloyds Bank and sought to clarify the governing objective for the company. 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. In Creating Shareholder Value: The New Standard for Business Performance, published in 1986, Alfred Rappaport argued that "the ultimate test of corporate strategy, indeed the only reliable measure, is whether it creates economic value for shareholders". During the late 1980s, the management consulting firm Stern Stewart & Co revised the computation of residual income with a large number of accounting adjustments; the firm named this concept Economic Value Added (EVA) and trademarked it in 1989. The consulting firms Stern Stewart, Marakon Associates, and Alcar pioneered value-based management (VBM) based on the academic work of - respectively - Joel Stern, Bill Alberts, and Alfred Rappaport. Value-based management became prominent during the 1990s, and other management consulting firms including McKinsey and BCG developed VBM approaches. In 2009, Welch criticized parts of the application of this concept, saying he never meant to suggest boosting a company's share price should be the main goal of executives. He said managers and investors should not set share price increases as their overarching goal. He added that short-term profits should be allied with an increase in the long-term value of a company. "On the face of it, shareholder value is the dumbest idea in the world," he said. "Shareholder value is a result, not a strategy . . . Your main constituencies are your employees, your customers and your products." Welch later elaborated on this, clarifying that "my point is, increasing the value of your company in both the short and long term is an outcome of the implementation of successful strategies."

Interpretation

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. This, coupled with the economic changes noted by Mark Mizruchi and Howard 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), the winner was the Agency Theory developed by Jensen and Meckling. Mizruchi and 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". 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". 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". 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. The conflation of shareholder value maximization with profit maximization has been criticized by some economists and legal scholars. For example, Oliver Hart and Luigi Zingales argue that corporate directors have a duty to maximize the welfare of shareholders, broadly construed, not just their financial interests. Many shareholders are prosocial, and maximizing shareholder value may sometimes mean making business decisions that prioritize the social issues that investors care about, even at the expense of profits. Likewise, Lynn A. Stout writes that shareholder value is not a singular objective, because "different shareholders have different values. Some are long-term investors planning to hold stock for years or decades; others are short-term speculators."

Agency theory and shareholder value

Agency theory is the study of problems characterized by disconnects between two cooperating parties: a principal and an agent. 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. In these circumstances, the principal takes on the agent to delegate responsibility to him. Theorists have described the problem as one of "separation and control": agents cannot be monitored perfectly by the principal, so they may shirk their responsibilities or act out of sync with the principal's goals. The information gap and the misalignment of goals between the two parties results in agency costs, 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. 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. An independent board can best objectively monitor CEO undertakings and risk. 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.

Value-based management

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. 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. Studies have found that VBM relates to higher firm performance and better decision making. 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, 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, 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.

Criticism

The sole concentration on shareholder value has been widely criticized, particularly after the 2008 financial crisis. While a focus on shareholder value can benefit the owners of a corporation financially, it does not provide a clear measure of social issues like employment, environmental issues, or ethical business practices. A management decision can maximize shareholder value while lowering the welfare of third parties. Shareholder value coupled with short-termism has also been criticized as lowering the overall rate of economic growth due to reduced business capital accumulation. It can also disadvantage other stakeholders such as customers. For example, a company may, in the interests of enhancing shareholder value, cease to provide support for old, or even relatively new, products. Additionally, short term focus on shareholder value can be detrimental to long term shareholder value; the expense of gimmicks that briefly boost a stocks value can have negative impacts on its long term value. Marc Benioff, CEO of Salesforce, said that "[...] the obsession with maximizing profits for shareholders has brought us: terrible economic, racial and health inequalities; the catastrophe of climate change." According to critics, oversimplifying the corporation's role has neglected the imperfect world we live in.

Compensation packages

Within the 80's and 90's, numerous companies faced lawsuits from current and former employees alike for reducing or withholding workers from accessing benefits in the present or during retirement. The SV model has led to reduced pension support as a means of maximizing profits at the cost of the employees. Some companies have switched matching pension plans monthly to once a year. Critics remain alarmed at the nature of cutting out or underestimating the value of the labor a worker produces for maintaining or raising the value of stock. The reduced benefits are attributed to the trend of the corporate world's reduction in investing in non-shareholder constituents because it is not an immediate money producer—the main goal of SV theory.

Layoff practices

The aforementioned status of workers faces criticism when looking at how this "reduced pension matching" loophole becomes manipulated. If laid off before the pre-pension matching period is complete, there is no compensation. Furthermore, mass layoffs have affected companies in the home headquarters with many jobs either going overseas or being hired out to contractors from similar positions to those that were laid off for lower benefits and protections as critics and experts have noted. According to economic experts and critics alike, the downsize-and-distribute model invoked by SV theory extracts value and then further ingrains employee instability and greater income inequality.

End of corporate responsibility

In Milton Friedman's seminal piece advocating for shareholder value titled "The Social Responsibility of Business Is to Increase Its Profits", he makes the argument that the business of business is its business. Friedman's postulation suggests that if social responsibility and profit run counterintuitively, pick the latter. By prioritizing the accumulation of wealth by all means, it uncomplicates other responsibilities that may have a hindrance to achieving this goal. Some responsibilities include, but are not limited to: community development, employee investment, worker benefits, research and development, and more. These responsibilities are attributed to being long-term and do not immediately satisfy the short-term – and mainstream – interpretation of shareholder value.

Stock buyback

Stock buyback is criticized for its extractive nature which takes profit and uses it to make stocks look more profitable than they might be in the name of shareholder value. In 1982, the U.S. Securities and Exchange Commission (SEC) implemented Rule 10b-18 of the Securities Exchange Act, thus allowing for corporations to buy back stock under certain thresholds and circumstances. With low investigation and consequence rates for breaches, as well as loopholes, this opened up opportunity to legal stock price manipulation. With SV theory incentivizing the shareholder and tying executive pay, the stock price became intrinsically tied with success as critics note. One notable effect of this practice includes reduced investment. From 2003 to 2012, of the 449 firms in the S&P 500, 54% of earnings went to stock buyback and 37% to dividends. This leaves 9% of earnings to go elsewhere, a reduction from the previous rates of investment in past decades. Economists like Lenore Palladino point out the eventual consequence when this bubble will burst, the majority of Americans will face the consequence, not the ones leading the firms.

Under-emphasis of corporate entity

Peter Drucker, author of "The Concept of the Corporation", makes the argument that shareholder value in fact serves to underplay the important social role which corporations occupy in contemporary society. Drucker states "In the social reality of today, shareholders are but one of several groups of people who stand in a special relationship to the corporation. The corporation is permanent, the share-holder is transitory. It might even be said without much exaggeration that the corporation is really socially and politically a priori, whereas the share-holder's position is derivative and exists only in contemplation of law". Drucker's argument is expanded upon by anthropologist Karen Ho, who notes that in the immediate period following the second world war, the corporation existed primarily as a social institution which largely accepted its responsibilities to those involved in its operations outside of shareholders, concerning itself with the longevity and well-being of the corporation as an institution even if this meant undertaking actions that may run counter to the immediate concerns of the corporation's shareholders. This post-war outlook is contrasted by the attitude adopted by management of modern-day corporations, which according to former WebTV CEO Randy Komisar see themselves not as institutional stewards but rather as investors themselves. Critics such as Ho believe that the shift of management attitude towards treating corporations as investments has led to the decline of the corporation as a social entity, and allows corporate management to make decisions that may be against the interests of the corporation's social stakeholders or even longevity of the corporation itself.