Shareholder value is a business term, sometimes phrased as shareholder value maximization. It became prominent during the 1980s and 1990s along with the management principle value-based management or "managing for value".
Definition
The term "shareholder value", sometimes abbreviated to "SV", can be used to refer to:
*The
market capitalization
Market capitalization, sometimes referred to as market cap, is the total value of a publicly traded company's outstanding common shares owned by stockholders.
Market capitalization is equal to the market price per common share multiplied by t ...
of a company;
*The concept that the primary goal for a company is to increase the
wealth
Wealth is the abundance of Value (economics), valuable financial assets or property, physical possessions which can be converted into a form that can be used for financial transaction, transactions. This includes the core meaning as held in the ...
of its
shareholders
A shareholder (in the United States often referred to as stockholder) of a corporation is an individual or legal entity (such as another corporation, a body politic, a trust or partnership) that is registered by the corporation as the legal ow ...
(owners) by paying
dividends and/or causing the
stock price to increase (i.e. the
Friedman doctrine
The Friedman doctrine, also called shareholder theory is a normative theory of business ethics advanced by economist Milton Friedman which holds that the social responsibility of business is to increase its profits. This shareholder primacy appro ...
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
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new ...
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
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
. The term in this sense was introduced by
Alfred Rappaport in 1986.
For a publicly traded company, Shareholder Value is the part of its capitalization that is
equity
Equity may refer to:
Finance, accounting and ownership
* Equity (finance), ownership of assets that have liabilities attached to them
** Stock, equity based on original contributions of cash or other value to a business
** Home equity, the dif ...
as opposed to long-term
debt
Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...
. In the case of only one type of
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
, this would roughly be the number of outstanding shares times current shareprice. Things like
dividend
A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-in ...
s augment shareholder value while issuing of shares (
stock options
In finance, an option is a contract which conveys to its owner, the ''holder'', the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified da ...
) lower it. This shareholder value added should be compared to average/required increase in value, making reference to the organizations
cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new ...
.
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
The discounted cash flow (DCF) analysis is a method in finance of valuing a security, project, company, or asset using the concepts of the time value of money.
Discounted cash flow analysis is widely used in investment finance, real estate devel ...
.
History
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 its authors stated:
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.
Economist
Milton Friedman
Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
introduced the
Friedman doctrine
The Friedman doctrine, also called shareholder theory is a normative theory of business ethics advanced by economist Milton Friedman which holds that the social responsibility of business is to increase its profits. This shareholder primacy appro ...
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
Social responsibility is an ethical framework in which an individual is obligated to work and cooperate with other individuals and organizations for the benefit of the community that will inherit the world that individual leaves behind.
Social ...
to the public or society; its only responsibility is to its
shareholders
A shareholder (in the United States often referred to as stockholder) of a corporation is an individual or legal entity (such as another corporation, a body politic, a trust or partnership) that is registered by the corporation as the legal ow ...
.
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.
On August 12, 1981,
Jack Welch
John Francis Welch Jr. (November 19, 1935 – March 1, 2020) was an American business executive, chemical engineer, and writer. He was Chairman and CEO of General Electric (GE) between 1981 and 2001.
When Welch retired from GE, he receive ...
made a speech at
The Pierre
The Pierre is a luxury hotel located at 2 East 61st Street, at the intersection of that street with Fifth Avenue, in Manhattan, New York City, facing Central Park. Designed by Schultze & Weaver, the hotel opened in 1930 with 100+ employees, n ...
Hotel in New York City called "Growing Fast in a Slow-Growth Economy". 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 1983, Brian Pitman became CEO of
Lloyds Bank
Lloyds Bank plc is a British retail and commercial bank with branches across England and Wales. It has traditionally been considered one of the " Big Four" clearing banks. Lloyds Bank is the largest retail bank in Britain, and has an exte ...
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.
The
management consulting
Management consulting is the practice of providing consulting services to organizations to improve their performance or in any way to assist in achieving organizational objectives. Organizations may draw upon the services of management consultant ...
firms Stern Stewart,
Marakon Associates,
and
Alcar pioneered value-based management (VBM), or "managing for value", in the 1980s based on the academic work of
Joel Stern, Dr. Bill Alberts, and Professor
Alfred Rappaport. In "Creating Shareholder Value: The New Standard for Business Performance", published in 1986, Rappaport argued that "the ultimate test of corporate strategy, indeed the only reliable measure, is whether it creates economic value for shareholders".
Other consulting firms including
McKinsey
McKinsey & Company is a global management consulting firm founded in 1926 by University of Chicago professor James O. McKinsey, that offers professional services to corporations, governments, and other organizations. McKinsey is the oldest and ...
and
BCG developed VBM approaches.
Value-based management became prominent during the late 1980s and 1990s.
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". Welch then elaborated on this, claiming that the quotes were taken out of context.
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 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
Theodore Levitt (March 1, 1925 – June 28, 2006) was a German-born American economist and a professor at the Harvard Business School. He was editor of the ''Harvard Business Review'', noted for increasing the Review's circulation and popularizi ...
'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.
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”. 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.
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.
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
In economics, profit maximization is the short run or long run process by which a firm may determine the price, input and output levels that will lead to the highest possible total profit (or just profit in short). In neoclassical economics, w ...
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
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
Employment is a relationship between two parties regulating the provision of paid labour services. Usually based on a contract, one party, the employer, which might be a corporation, a not-for-profit organization, a co-operative, or any othe ...
,
environmental
A biophysical environment is a biotic and abiotic surrounding of an organism or population, and consequently includes the factors that have an influence in their survival, development, and evolution. A biophysical environment can vary in scale f ...
issues, or
ethical
Ethics or moral philosophy is a branch of philosophy that "involves systematizing, defending, and recommending concepts of right and wrong behavior".''Internet Encyclopedia of Philosophy'' The field of ethics, along with aesthetics, concerns ma ...
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
Marc Russell Benioff (born September 25, 1964) is an American internet entrepreneur and philanthropist. He is the co-founder, chairman and CEO of Salesforce, an enterprise cloud computing company. In September 2018, Benioff acquired ''Time (mag ...
, CEO of
Salesforce
Salesforce, Inc. is an American cloud-based software company headquartered in San Francisco, California. It provides customer relationship management (CRM) software and applications focused on sales, customer service, marketing automation, a ...
, 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.
Criticism for worker devaluation
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
A general contractor, main contractor or prime contractor is responsible for the day-to-day oversight of a construction site, management of vendors and trades, and the communication of information to all involved parties throughout the course of ...
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.
Company criticisms
End of corporate responsibility
In
Milton Friedman
Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
’s seminal piece advocating for shareholder value titled
The Social Responsibility of Business Is to Increase Its Profits makes the argument that the business of business is its business. Friedman’s postulation suggests that if social responsibility and profit run counterintuitive, pick the latter. By prioritizing the accumulation of wealth by all means, it uncomplicated 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
The Securities Exchange Act of 1934 (also called the Exchange Act, '34 Act, or 1934 Act) (, Codification (law), codified at et seq.) is a law governing the secondary market, secondary trading of securities (stocks, Bond (finance), bonds, and de ...
, 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
The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. As of D ...
, 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.
Anthropological criticisms
Under-emphasis of corporate entity
Peter Drucker
Peter Ferdinand Drucker (; ; November 19, 1909 – November 11, 2005) was an Austrian-American management consultant, educator, and author, whose writings contributed to the philosophical and practical foundations of the modern business co ...
, 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
Karen Ho is an American anthropologist. She contributed to anthropological research in Wall Street culture. , 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.
Economic criticisms
Failure of accurate modelling within neoclassical economics
The failure of the corporation to readily fit within the neo-classical economic model which dominates contemporary economics academia and policy is a frequently-targeted flaw by critics. Anthropologist
Karen Ho
Karen Ho is an American anthropologist. She contributed to anthropological research in Wall Street culture. argues that the concept of shareholders and subsequently shareholder value was developed primarily for the purpose of shoehorning the insertion of the corporation into the neoclassical economic model, and ignores that the neoclassical model, which was originally created in eighteenth and nineteenth century prior to the proliferation of corporate organization, was never designed to operate with number of inputs the modern corporation requires.
Ho claims that advocates of neoclassical proprietorship ran directly counter to the limited-input “owner and property” intentions of influential founding figures of neoclassical economics such as
Adam Smith
Adam Smith (baptized 1723 – 17 July 1790) was a Scottish economist and philosopher who was a pioneer in the thinking of political economy and key figure during the Scottish Enlightenment. Seen by some as "The Father of Economics"——— ...
, and that the neoclassical economic model hinges on the idea of the owner-entrepreneur being directly involved in the management and operation of their enterprise. As the modern shareholder typically has very limited or no connection to the regular operations of a corporation they have invested in, the shareholder does not fit within the owner-entrepreneur role required by the neoclassical economic model. Adam Smith himself noted his belief that managed corporations were not viable due to this issue, stating “The directors of
oint stockcompanies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own”.
Critics such as Ho and Smith believe that failure of the shareholder model to accurately represent the key neoclassical owner-entrepreneur concept is a foundational issue of the neoclassical economic model, leading to an inaccurate assumption that corporate interest remained identical to shareholder interest.
Legal criticisms
A common critique of shareholder value is the mystification surrounding its legal validity. It is often espoused that shareholders are the owners.
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.
Yet, none of these are rooted in any law because shareholder value is ultimately a management decision, not a legal requirement. Corporations are their own legal entity and shareholders simply hold shares, making them equal stakeholders to employees, suppliers, and more.
They only get guaranteed full access to residual funds in the case of liquidation. Otherwise, the firm has all control of how to do things as they please like investing into the company, raising salaries, etc.
And when it comes to the shareholder supremacy over structure, the ability is flimsy and hard to use. The few cases in which legal action can be taken is when a director is explicitly stealing.
In spite of the reality of shareholder obligation and abilities, corporate America has convinced itself, according to legal critiques, that there is a legal duty to their shareholders.
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.
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
Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor ...
. 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. 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
Corporate titles or business titles are given to corporate officers to show what duties and responsibilities they have in the organization. Such titles are used by publicly and privately held for-profit corporations, cooperatives, non-profit or ...
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.
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.
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.
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
In finance, speculation is the purchase of an asset (a commodity, good (economics), goods, or real estate) with the hope that it will become more valuable shortly. (It can also refer to short sales in which the speculator hopes for a decline i ...
.
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.
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.
Loss of growth and productivity
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.
One explanation for this trend is reduced investment in innovation. Studies have shown that
publicly traded
A public company is a company whose ownership is organized via shares of stock which are intended to be freely traded on a stock exchange or in over-the-counter markets. A public (publicly traded) company can be listed on a stock exchange (list ...
companies (who have a share price) invest about half as much as
privately held companies
A privately held company (or simply a private company) is a company whose shares and related rights or obligations are not offered for public subscription or publicly negotiated in the respective listed markets, but rather the company's stock is ...
in the United States.
Even shareholders have had disappointing results with poor returns on investment and a reduction in the population of publicly traded companies by 40%.
[Stout, Lynn A., "The Shareholder Value Myth" (2013). Cornell Law Faculty Publications. Paper 771.]
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 agreement
In contract law, a non-compete clause (often NCC), restrictive covenant, or covenant not to compete (CNC), is a clause under which one party (usually an employee) agrees not to enter into or start a similar profession or trade in competition again ...
s. 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.
A further inefficiency of shareholder value is the growth of
financialization
Financialization (or financialisation in British English) is a term sometimes used to describe the development of financial capitalism during the period from 1980 to present, in which debt-to-equity ratios increased and financial services acco ...
. The financial industry has ballooned in size following the use of shareholder value, largely due to the outsized importance placed upon shareholders by corporations.
The large financial sector is a drain on the entire United States economy, costing roughly 300 billion dollars per year.
This is because the financial sector does not engage in actual production.
Alternatives
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
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
Corporate social responsibility (CSR) is a form of international private business self-regulation which aims to contribute to societal goals of a philanthropic, activist, or charitable nature by engaging in or supporting volunteering or ethicall ...
and long-term financial stability as a core business strategy.
The stakeholder value model is prevalent in regions where
limited liability
Limited liability is a legal status in which a person's financial liability is limited to a fixed sum, most commonly the value of a person's investment in a corporation, company or partnership. If a company that provides limited liability to it ...
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.
["In Search of an alternative to Shareholder Value Maximization"](_blank)
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
A social enterprise is an organization that applies commercial strategies to maximize improvements in financial, social and environmental well-being. This may include maximizing social impact alongside profits for co-owners.
Social enterprises ca ...
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.
Social enterprises manifest themselves in the UK as
community interest companies
A community is a social unit (a group of living things) with commonality such as place, norms, religion, values, customs, or identity. Communities may share a sense of place situated in a given geographical area (e.g. a country, village, town ...
or
limited by guarantee
In British, Australian, Bermudian, Hong Kong and Irish company law (and previously New Zealand), a company limited by guarantee (CLG) is a type of corporation used primarily (but not exclusively) for non-profit organisations that require legal pe ...
. In the United States, California allows companies to incorporate as
flexible purpose corporations.
See also
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Adjusted present value
Adjusted present value (APV) is a valuation method introduced in 1974 by Stewart Myers. The idea is to value the project as if it were all equity financed ("unleveraged"), and to then add the present value of the tax shield of debt – and other ...
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Berle-Dodd debate The Berle-Dodd debate is the name for a series of exchanges over the purposes of the corporation between the New Deal architect, A. A. Berle, and Merrick Dodd, a law professor. In this debate, Berle argued that corporations should "serve... all soci ...
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Economic value added
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Enterprise value Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business (i.e. as distinct from market price). It is a sum of claims by all claimants: creditors (secured and unsecured) ...
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Financial modeling
Financial modeling is the task of building an abstract representation (a model) of a real world financial situation. This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or portfolio o ...
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Flows to equity
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Internal rate of return
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Market value added
Market value added (MVA) is the difference between the current market value of a firm and the capital contributed by investors. If MVA is positive, the firm has added value. If it is negative, the firm has destroyed value. The amount of value add ...
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Net present value
The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount ...
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Sustainability measurement
Sustainability measurement are tools and methods that attempt to measure the degree of sustainability of processes, products, services, businesses and so forth. Sustainability is difficult to quantify, perhaps even immeasurable. The metrics used to ...
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Time Value of Money
The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference.
The t ...
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Valuation using discounted cash flows
Valuation using discounted cash flows (DCF valuation) is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money.
The cash flows are made up of those within the “explicit ...
References
Further reading
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Corporate finance
Business terms
Value
Value or values may refer to:
Ethics and social
* Value (ethics) wherein said concept may be construed as treating actions themselves as abstract objects, associating value to them
** Values (Western philosophy) expands the notion of value beyo ...