Shareholder value

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”.[11] 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.[12] 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”.[13] 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.

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.[34] 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.

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 pay come from stock. The reasoning behind this decision was that it would bring the interests of CEOs in line with those of shareholders.[35] As a result of this decision, executive compensation has skyrocketed, quadrupling from the rate of compensation in the early 1970s.[36] 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.[37]

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.[38] 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.[38] 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.[36] 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.[38] 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.[38]

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.[37]

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.[35] One explanation for this trend is reduced investment in innovation. Studies have shown that publicly traded companies (who have a share price) invest about half as much as privately held companies in the United States.[35] Even shareholders have had disappointing results with poor returns on investment and a reduction in the population of publicly traded companies by 40%.[39]

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 agreements. 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.[35]

A further inefficiency of shareholder value is the growth of financialization. The financial industry has ballooned in size following the use of shareholder value, largely due to the outsized importance placed upon shareholders by corporations.[40][35] The large financial sector is a drain on the entire United States economy, costing roughly 300 billion dollars per year.[35] This is because the financial sector does not engage in actual production.

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 and long-term financial stability as a core business strategy.[41]

The stakeholder value model is prevalent in regions where limited liability 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.[41]

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.

A company may choose to disregard shareholders completely. A social enterprise 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.[41]

Social enterprises manifest themselves in the UK as community interest companies or limited by guarantee. In the United States, California allows companies to incorporate as flexible purpose corporations.[41]