Shareholder value

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 popular during the 1980s, and is particularly associated with former CEO of General Electric, Jack Welch.

The term used in several ways:

To refer to the market capitalization of a company (rarely used)
To refer to 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
To refer to 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.

Definition

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 cost of capital.

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

History

On August 12, 1981, Jack Welch made a speech at The Pierre in New York City called ‘Growing fast in a slow-growth economy’.^[1] This is often acknowledged as the "dawn" of the obsession with shareholder value. Welch's stated aim was to be the biggest or second biggest market player, and to return maximum value to stockholders.

In March 2009, Ashan 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".^[2] Welch then elaborated on this, claiming that the quotes were taken out of context.^[3]

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”.^[4] 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.

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. Also, the Japanese had recently taken the spot as the dominant force in auto and high technology manufacturing, a title historically held by American companies.^[5] 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, the winner was the Agency Theory developed by Jensen and Meckling, which will be discussed in greater detail later in this entry. 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.^[6] 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”.^[7] 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

Agency theory is the study of problems characterized by disconnects between two cooperating parties: a principal and an agent.^[8] 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.^[9] In these circumstances, the principal takes on the agent to delegate responsibility to him.^[10] Theorists have described the problem as one of “separation and control”:^[11] agents cannot be monitored perfectly by the principal, so they may shirk their responsibilities or act out of sync with the principal’s goals.^[12] The information gap and the misalignment of goals between the two parties results in agency costs,^[13] 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.^[14]

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.^[15] An independent board can best objectively monitor CEO undertakings and risk.^[16] 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.^[17]

Maximizing shareholder value

This management principle, also known under value based management, states that management should first and foremost consider the interests of shareholders in its business actions. (Although the legal premise of a publicly traded company is that the executives are obligated to maximize the company's profit,^[18] this does not imply that executives are legally obligated to maximize shareholder value.)

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.

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,^[19] 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,^[20] particularly after the late-2000s 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.^[21]

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.

Disadvantages of the shareholder value model

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.

Lack of transparency

The value of the company’s share depends on how much profit they have made in a given time. In the shareholder value system, the firm’s main concern is getting the share value to be as high as possible. To do this, companies found ways to make it seem like they were making far more profit than they actually were. These strategies to make the company seem profitable were often fraudulent. When the companies’ reports of their own finances are untrue, there becomes a lack of transparency: investors and employees alike do not know what profit was actually made and what profit was born from fraudulent schemes.

An example of how a company can appear profitable to investors without actually being profitable is the use of subsidiary companies. The firm has one parent company for which they are concerned about the shareholder value, and the firm also has one or more smaller subsidiary companies that has no substance and is only used as facade. The smaller companies are made to lose money so that the parent company may gain money. Debt and profits can be transferred between companies in such a way that financial reports claim the parent company is making a profit when it’s actually nothing more than a scheme.^[22]

This is a disadvantage to companies and the market at large because it allows profit to be made without any successful business practice being conducted. The ethics of firms are compromised in the interest of increasing share value.^[23]

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, 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.^[24] 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.

Short term strategy

When companies use the shareholder value model, firm behavior is focused on increasing the shareholder value rather than the long-term success of the company. Because employees are given stock options instead of salaries, it is in their interest for the share value to go up. In order for it to go up repeatedly, a strategy would be to allow the share price to alternate rising and falling. After the value has fallen, the amount of increase can be maximized. This type of oscillation is not beneficial to the long-term success of the company. Repeatedly decreasing share value so that it can be again increased generates profit for shareholders, but does not generate profit for the company; instead the company could become stagnant and fragile. Short-term strategies to increase share value are beneficial to investors and employees with stock options but are a disadvantage to sustained success of the company.^[25]

Alternative: stakeholder value

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.

However, 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.

Notes

↑ Betsy Morris, "Tearing up the Jack Welch playbook" (July 11, 2006) Fortune at CNNmoney.com
↑ Financial Times "Welch condemns share price focus" (March 13, 2009)
↑ Business Week "Jack Welch Elaborates" (March 16, 2009)
↑ Mizruchi, Mark; Howard Kimeldorf. "The Historical Context of Shareholder Value Capitalism". Political Power and Social Theory 17.
↑ Dobbin, Frank; Jiwook Jung. "The Misapplication of Mr. Michael Jensen: How Agency Theory Brought Down the Economy and Why it Might Again". Sociology of Organizations 30B.
↑ Dobbin, Frank; Dirk Zorn. "Corporate Malfeasance and the Myth of Shareholder Value". Political Power and Social Theory 17.
↑ Dobbin, Frank; Dirk Zorn. "Corporate Malfeasance and the Myth of Shareholder Value". Political Power and Social Theory 17.
↑ Kathleen M. Eisenhardt, "Agency Theory: An Assessment and Review," The Academy of Management Review 14(1989) 58.
↑ Susan P. Shapiro, "Agency Theory," Annual Review of Sociology 31(2005) 275.
↑ Michael C. Jensen and William H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure," Journal of Financial Economics 3(1976) 308.
↑ Jensen and Meckling, "Theory of the Firm," 310.
↑ Eisenhardt, "Agency Theory," 61.
↑ Shapiro, "Agency Theory," 265.
↑ Jensen and Meckling, "Theory of the Firm," 308.
↑ Shapiro, "Agency Theory," 269.
↑ Dobbin and Jung, "The Misapplication of Mr. Michael Jensen," 31.
↑ Dobbin, "The Rise of Shareholder Value," Sociology 25, Harvard University.
↑ Maxwell S. Kennerly, Esq., "eBay v. Newmark: Al Franken Was Right, Corporations Are Legally Required To Maximize Profits" (September 13, 2010)
↑ Corporate Financial Strategy, Ruth Bender, Keith Ward, 3rd edition, 2008, p. 17
↑ Tirole 2001; Aglietta and Reberioux, 2005
↑ Masouros, Pavlos E., "Corporate Law and Economic Stagnation: How Shareholder Value and Short-termism Contribute to the Decline of the Western Economies" Eleven International Publishing. pp. 6-9
↑ Srivastava, Rajendra K; Tasadduq A. Shervani and Liam Fahey (1998). "Market-Based Assets and Shareholder Value: A Framework for Analysis". Journal of Marketing 62 (1): 2–18. JSTOR 1251799.
↑ Hillman, Amy J; Gerald D Keim (February 2001). "Stakeholder Management and Social Issues: What's the Bottom Line?". Wiley-Blackwell 2 (22): 125–139.
↑ 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.
↑ Rappaport, Alfred (1998). Creating Shareholder Value: A guide for managers and investors. New York: The Free Press. pp. 13–29.

References

Rappaport, Alfred (1986). Creating shareholder value: The new standard for business performance. New York: Free Press. ISBN 0-02-925720-4.
Prahalad, C. K. (1994). "Corporate Governance or Corporate Value Added?: Rethinking the Primacy of Shareholder Value". Journal of Applied Corporate Finance 6 (4): 40. doi:10.1111/j.1745-6622.1994.tb00247.x.
Lazonick, William; O'Sullivan, Mary (2000). "Maximizing shareholder value: a new ideology for corporate governance". Journal Economy and Society 29 (1): 13–35. doi:10.1080/030851400360541.