What’s Wrong with Maximizing Shareholder Value?
It is time to take a hard look at the universally accepted principle that the goal of business is to maximize shareholder value.
Although the concept seems entrenched in business practice, it actually originated in a 1976 article by two business school professors at the University of Rochester who postulated that corporate executives act as agents on behalf of the shareholders, who are in turn the corporation’s principals.
This raised the specter of ‘agency costs’, which might be incurred if executives acted in their own interests rather than in the interests of their principals. The only safeguard against executives profiting at the expense of shareholders was to align both of their interests through a commitment to maximizing shareholder value, and best incentivized by stock options for senior executives.
This idea is so deeply ingrained that many people assume corporations are legally required to maximize shareholder value. But this erroneous assumption is thoroughly dispelled by Lynn Stout of Cornell Law School in a recent book, The Shareholder Value Myth and in a recent article in the Stanford Social Innovation Review by Antony Page and Robert Katz. These legal scholars persuasively debunk any such legal or fiduciary duty.
Another excellent book, Fixing the Game, by Roger Martin, dean of the Rotman School of Management at the University of Toronto, goes further by pointing out that maximizing shareholder value is actually a bad way to run a business.
Martin explains the danger of managers who aim to optimize the price of the stock rather than the performance of the company with an analogy of football players betting on their own games. If the players focus on winning the game, all of their incentives align with excellent performance. However, if they are rewarded based on the betting pool, they begin to worry about managing the odds.
Betting odds are like stocks
Betting odds, like stocks, are based on expectations of future performance. The better a team does, the higher expectations run. Players who want to make money by betting must manage the bookies’ expectations, either by strategically losing some games to lower expectations, or by taking greater and greater risks to achieve unprecedented levels of success. Either way, when players start playing to meet ‘expectations’ rather than to win the game itself, their team’s performance suffers.
The same insidious incentives arise when executives start managing to meet analysts’ expectations rather than managing the business itself.
Martin and Stout both compile evidence to suggest that the primacy of shareholder value has not actually benefitted shareholders but has instead turned into a bonanza for senior executives: in 1970, only 1% of a Fortune 500 chief executive’s compensation was in stock options and the average salary of was $700,000 (£438,000). Today stock and stock options account for 80% of the vastly inflated average compensation, which has increased more than 1,800% to $12.9m (£8m).
The ultimate irony
The ultimate irony may be that the allegiance to shareholder value has caused the very problem it was intended to cure: enriching senior executives at the shareholders’ expense.
Given long enough time on the horizon, the interests of the company, the investors, and the executives would ultimately align. But with an average chief executive tenure of four and a half years, and an average stock holding period of only four months, short-term pressures exacerbate the focus on manipulating the stock rather than building the business. The increase in high speed trading and the proliferation of hedge funds and private equity firms has further increased the short-term pressure for financial engineering rather than long-term value creation.
The biggest cost of all, however, is neither to the company nor its shareholders, but to our society and our planet. The ubiquitous mandate to maximize short-term shareholder value has driven a deep wedge between business and society. The long term success of any company depends on the health and wellbeing of its employees, customers, and the communities in which it operates.
Unfortunately, these factors do not affect the quarterly earnings that drive analysts’ expectations. CEOs who manage the stock, rather than the company, have little reason to think about the social and environmental consequences of their actions. And the result – whether in oil spills or credit derivatives – brings devastation far beyond the company’s own shareholders.
But a small, yet growing cadre of sophisticated business leaders are beginning to expand their focus beyond merely maximizing shareholder value to creating shared value. They are building strong companies and healthier societies at the same time; making money by reducing their environmental footprint, meeting the needs of low-income populations, and finding innovative, profitable solutions to social problems. One might expect that such an “altruistic” approach would diminish shareholder returns: instead, it keeps corporate leaders focused on the most powerful emerging trends and the long term fundamentals of their businesses.
As investors like Generation Investment Management are increasingly discovering, maximizing shared value is the best way to maximize shareholder value.
Article appearing courtesy 3BL Media.
photo: 401(K) 2012.
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