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.
For a publicly traded company, shareholder value is the part of its capitalization which 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 organizations cost of capital.
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 concept of measuring business performance as profit less an opportunity cost charge for the use of the funds employed in earning the profit dates back to Robert Hamilton who published An Introduction to Merchandize in 1777 in Edinburgh, Scotland. Hamilton's treatment may have its origins in Adam Smith's, The Wealth of Nations (first edition in 1776). The roots of shareholder value theory can thus be traced to the late 18th century when the capital investment required to finance new manufacturing businesses during the Industrial Revolution in the United Kingdom led to a change in the structure of businesses, from traditional small family-run businesses to large publicly-owned companies with dispersed shareholders and professional managers. This change in governance, called managerialism, led to new modes of coordinating enterprise, technology and planning.
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. Fortune magazine published an article in 1962 by the management of a US textile company, Indian Head Mills, that articulated shareholder wealth creation as the paramount interest of the management of a company: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.In Divisional Performance: Measurement and Control (1965), David Solomons suggested that residual income be used as an internal performance measure and Robert Anthony (1973) suggested that it be an external performance measure. 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.
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 late 1980s,Building on the publication of Stern, J. (1985), Acquisition, Pricing, and Incentive Compensation, Corporate Accounting. 3(2): 26-31. 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 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."Business Week "Jack Welch Elaborates" (March 16, 2009)
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.
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 (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.
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