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Universita' Bocconi
01/04/2009

Rescuing Shareholder Value Maximization

The current financial meltdown has been accompanied by increasing criticism over the shareholder value maximization, a management model that has guided most companies during the past two decades

The current financial meltdown has been accompanied by increasing criticism over the basic model of management — that of shareholder value maximization — which has guided most companies during the past two decades. The shareholder value maximization model holds that the primary goal of the firm is to maximize its market value and implies that business decisions should seek to increase the net present value of the economic profits of the firm.

Putting aside philosophic and ethical objections to shareholder value maximization (e.g. undesirable pursuit of profit and wealth), I identify three undesirable consequences of shareholder value maximization:

  • To increase stock market value, firms have substituted (low cost) debt for (high cost) equity, failing to consider the risk implications—especially during economic downturns. For some banks, increased financial leverage had fatal consequences.
  • An emphasis on short term financial performance over the long-term development of the business.
  • It has provided a convenient cloak for self-enrichment by senior executives. To “align management incentives with shareholder interests,” CEOs have been awarded massive stock option and bonus packages while presiding over massive destruction of shareholder value.These problems are the result of the way in which shareholder value maximization has been interpreted and applied, not problems of the model itself.

There is no alternative objective function for the firm that offers a sound and consistent basis for decision making. The most favored alternative is the stakeholder model of the firm which views the firm as a coalition of stakeholders (owners, employees, suppliers, customers, etc.) where the firm attempts to reconcile these different interests. But unless the goals of these different groups and the trade-offs between them can be specified, the stakeholder model does not provide clear criteria for allocating resources, monitoring performance, or guiding other management decisions.Yet, if the shareholder value maximization model is to become a sound basis for strategy formulation and a reliable decision criterion for the firm, it needs to be applied more effectively than in the past. I offer three guidelines for applying shareholder value maximization to management:

  • Shareholder value creation should be the primary goal of the firm, the basic criterion for decisions, and means by which management keeps score of performance, but is not a substitute for business purpose. Evidence shows that the most successful long-term builders of shareholder value are companies with a clear sense of purpose. Shareholder value is inadequate as a purpose for the firm partly because it fails to inspire and partly because it fails to offer strategic direction. Indeed, shareholder value is created by the stock market not by management—the task of management is to generate the economic profits that will be capitalized into shareholder value through focusing the firm on exploiting the sources of these profit—whether this is “organizing the world’s information and making it universally accessible” (Google), “offering a wide range of well-designed, functional home furnishing products at affordable prices” (IKEA), or some other mission that guides the firm towards the establishing competitive advantage.
  • Focusing on the drivers of shareholder value also implies that firms should not ignore the interests of other stakeholders of the firm, or of society as a whole. Profitability over the long term requires satisfying customers, motivating employees, and building supplier relations. It also requires responding to the needs of society—otherwise a firm will not build the legitimacy that is critical to sustaining prosperity over the long term. The dire state of so many leading banks is not solely a result of balance sheet weaknesses—it also reflects the catastrophic loss of legitimacy that has made investors (including sovereign wealth funds) unwilling to provide additional equity.
  • We need to broaden our understanding of the sources of shareholder value to include not only the net present value of profits, but also option value. In turbulent times, the major source of shareholder value derives from the options a firm holds on future developments within its business environment. Failure to take account of option value will result in inadequate emphasis on building flexibility and investing in innovation. The pursuit of shareholder value through increasing debt-equity ratios is one example of this oversight: while substituting debt for equity increases post-tax profit, it reduces a firm’s options.

Navigating the recession requires clarity of direction, consistency of decisions, and meticulous attention to performance. Shareholder value maximization is the only objective that matches these requirements. The challenge is to deploy this approach in a way does not distort the attainment of value creation.

Robert Grant, Eni Professor of Strategic Management, UniversitÓ Bocconi
Translated by Alex Foti
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