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.

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.</blockquote>In Divisional Performance: Measurement and Control, D. Solomons (1965) suggested that residual income be used as an internal performance measure and Robert Anthony (1973) suggested that it be an external performance measure. In it, he argued that a company has no social responsibility to the public or society; its only responsibility is to its shareholders.

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 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 March 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.

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. 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". 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.

Company criticisms

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. 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 status as a shareholder comes with an assumed legal claim of all profits after contractual obligations have been fulfilled and that they have the ability to decide the structure of the corporation on the board level however they want.

Increased risk

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

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. 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

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. As a result of this decision, executive compensation has skyrocketed, quadrupling from the rate of compensation in the early 1970s. 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. Share repurchasing might cause misaligned incentives between market capitalization and executive compensation connected to share price due to the change in number of shares.

Short-term strategy

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. 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.

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. 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.

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.

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

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 constitution 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.