On the maximisation of shareholder value
This isn’t a post specifically about banking and finance, for once. A few days ago, this Economist’s Schumpeter column reminded me how misunderstood the ‘maximisation of shareholder value’ concept was. Milton Friedman’s famous principle that corporations’ only social responsibility was to maximise shareholder value (see his original article here) has been taken out of context and crucified as an inhuman example of corporate raider short-termism. I still remember my university corporate governance classes, showing us a chart depicting a corporate governance spectrum with ‘financial markets’ (aka Friedman) on one side and CSR on the other.
In a world of rule of law and property rights, there is no question that Friedman was right. Shareholders own the firm and put managers in charge of a strict and defined mission. This is a contractual agreement. When managers decide to deviate from their mission for broader ‘social’ purposes, they violate property rights and the terms of their contract.
But this is not where the misunderstanding lies. The misunderstanding is about short-termism. Maximising shareholder value does not imply maximising profits in the short-term. In reality, it is pretty much the opposite. People who believe that it is sufficient to target short-term results in order to boost the value of a firm are making a grave economic and financial error.
What maximises current shareholder value is the expectation that the firm is going to perform (increasingly) well in the future. Here, ‘future’ is not defined as the next quarterly, or even yearly, results. ‘Future’, here, in the absence of market-wide distortions, is long-term.
Let me explain. Investors, like everyone, are subject to time preference. As the future is uncertain, they value more highly present goods over future goods. As such, they discount future purchasing power according to their own time preference. This implies that the present value of a company’s share price is determined by the discounted expected future free cash flows generated by this company. And most of those cash flows (like 70 or 80%) reside in what we call the ‘terminal value’. This value is the aggregate of ‘all’ cash flows expected beyond a 5 or 10-year horizon.
Now let’s imagine that management has the opportunity to report great quarterly results at the expense of longer-term performance. Does beating market expectations necessarily mean that the share price will jump? No. If investors believe that management‘s actions have jeopardised longer-term performance, the share price will eventually decline*. Think about it: the coming period cash flow will be maximised, but the cash flows of the following periods, including those of the terminal value, will suffer. This evidently cannot qualify as ‘maximising shareholder value’.
Therefore, accusing the ‘maximisation of shareholder value’ concept of short-termism negates both finance theory and the power of expectations. When investors are confident in a company’s ability to generate long-term growth, they have no issue whatsoever in accepting lower short-term cash returns (i.e. dividend/share buybacks…), which usually translates into higher short-term (unrealised) capital gains. As The Economist points out:
far from being slaves to the share price, as progressives imagine, most companies are engaged in a constant process of negotiation between managers and investors over their strategy and time horizons. Mature companies such as Shell, Intel and Nestlé often invest for the long term without a squeak from fund managers. New-economy companies such as Google, Facebook and, particularly, Amazon have had no difficulty in persuading investors to sacrifice short-term returns (and indeed any control whatsoever) in return for long-term rewards.
Indeed, I have already pointed out that fears that activist hedge funds could dismantle healthy companies, or make ‘a quick buck at the expense of long-term performance’ was largely unfounded, and unlikely to happen in the vast majority of cases: “You can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time”.
Now, some would argue that management could maximise shareholder value by engaging in ‘anti-social’ behaviour (from fraud to pollution…), which could positively affect performance/free cash flows in the long-term. In a market free of political or regulatory interference, this line of reasoning can only be valid in the short-term, as long as managers succeed in hiding their activities. However, when the news come out, investors are extremely likely to downgrade their expectations of future cash flows as they factor in reputational damage (i.e. loss of customers and/or suppliers) as well as litigation risks. By engaging in anti-stakeholders, fraudulent or ‘anti-social’ activities, managers have not been maximising shareholder value.
Unlike what The Economist says (“several companies that proudly practised shareholder-value maximisation went up in flames: Enron, Arthur Andersen and WorldCom, among others”), Enron did obviously not maximise shareholder value as it fell to… zero. It managed to get away with the illusion of performance as long as its fraud remained hidden. Once again, this is not what maximising shareholder value means.
*Perhaps not on announcement day, but as soon as a deeper analysis of the managers’ decision has been made.