Shareholder value
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 by paying dividends and/or causing the company's stock price to increase. It became a prominent idea 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 of a company;
- The view that the primary goal for a company is to increase the wealth of its shareholders by paying dividends and/or causing the stock price to increase ;
- 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.
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 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, whose history can be traced back to the 1820s. The article stated that: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 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.
On August 12, 1981, Jack Welch made a speech at The Pierre Hotel in New York City called "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.
The management consulting firms Stern Stewart, Marakon Associates, and Alcar pioneered value-based management, also known as 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 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, 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, 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 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.