Shareholder value - a euphemism for lining the pockets of shareholders?

A committed capitalist - not a rich one though - I fail to see the silly arguments that I often read in the popular media occasionally about the interests of 'other stakeholders' (like employees) being sacrificed at the alter of shareholder value. A pointless debate to me - and here is why.
Shareholder value: The conflict with other stakeholders
By Mukul Pareek


Shareholder value is all about maximising the interests of the shareholders of a company. Of late, maximising shareholder value has emerged as the over arching goal for corporate management. A mild though interesting debate can also often be witnessed about the conflict of shareholder interests with those of other stakeholders. Interesting because there is no real conflict between maximising shareholder value and the benefit to the other stakeholders.

What is shareholder value?
Shareholder value is nothing but the total benefit to shareholders from investing in a company. This includes dividends, and perhaps more importantly, capital appreciation of the shareholders’ investments. Broadly, both are related to the capacity of the company to generate profits, and as a general rule higher profits, when measured in relation to invested capital, increase shareholder value.

Companies earn profits from their operations and from continued investment in profitable ventures. Shareholder value is created when the returns from investments exceed the company’s WACC (weighted average cost of capital), and conversely it is destroyed if the returns were to be lower than the WACC.

Most investors now look to capital appreciation as being the prime motivation for investing in a company. Capital appreciation happens when the share price of the company’s equity rises in the stockmarket. Share prices can rise due to a variety of factors, of which earnings is only one. In fact, the unsustainable dot.com valuations witnessed not too long ago clearly make the connection between earnings and shareholder value seem a bit suspect. However, the interrelationship between earnings and shareholder value remains strong, and what we are witnessing in the case of the dot.coms is a relationship between future anticipated profits and present share valuations. What is happening here is that earnings have expanded in meaning to include the perceived profits that will accrue in the future, and the linkage of shareholders value with earnings is actually even stronger.


Shareholder value is a long term concept
Shareholder value is not about the day to day gyrations of the stock markets. It is, by definition, a long term concept which takes into account the secular rises in share prices and returns to shareholders. It is driven by the strategic success of the company as also its operational performance. It is driven by the company’s competitive landscape, the fit of its products to what its customers require, and its positioning vis-à-vis new technology. In other words, it is the traditional drivers of value that drive shareholder value. Just making the right announcements and misleading the markets cannot drive real shareholder value though they can certainly cause short term ups and downs in the share price.

Shareholder value is all that matters
Shareholders exercise the ultimate control over their company. They are also the residual claimants to its assets – which means their claims come last after all other stakeholders have been paid off. Not only do they bear the risk in respect of their capital, they through their control of the management ultimately drive all strategic decisions. If shareholder value for a company operating in a free market economy is not maximised, shareholders will use this control to effect such changes in the management that the value to them is maximised. They are the only true stakeholders in a company, the rest are just commercial parties seeking to maximise the benefit from the current set of transactions that they undertake with the company. In an extreme situation where the management squanders its opportunities and does not maximise shareholders’ wealth, someone else who can do the job better will step in and offer to run the company for them – i.e. a takeover.

Empirical evidence suggests that such changes are neither frequent nor overnight and corporate management often does get more than a fair opportunity to ‘perform’. However, the same evidence also reveals that shareholders patience is not unlimited and if a given management is unable to deliver over a reasonable length of time, normally a change in management that will do so is inevitable.

Shareholders versus the other stakeholders
Companies are social beings, operating as part of the society with ethical and moral responsibilities to their employees, customers, suppliers, the government, and now increasingly to the environment. There are responsibilities that go with this social existence and it may seem that the discharge of these responsibilities may sometimes be wealth destroying for the shareholders. Thus the conflict of shareholders interest to that of other stakeholders. But is the conflict real? It may rightly be in the very short term, but over a reasonably long period of time there is no real contradiction between the interests of the shareholders and those of the other stakeholders. A company which is not profitable because it has been tending more to its employees or anyone other than its shareholders will destroy wealth by using useful economic resource less efficiently and reduce the investible surplus in the economy, a situation which is ultimately to the detriment of all stakeholders. At the end of the day, the only thing that really counts is shareholder value as the people that have borne the risk by investing in the business need to be rewarded. If they are not, the business will find it difficult to find others in the future who will, and existing investors will seek to get out in favour of better investments. Such a business is doomed to shrink and die. Clearly, such a situation is good for none of the stakeholders.


Let's not get all riled up about employees


It is easy to get emotional about employees' 'stake' in a company - after all, it is them who toil and make the company what it is with their sweat and blood. But is that so really? Employees, in a very detached sense, are no different from vendors of services to a company, and their own long term self-interest as a group is aligned with that of the shareholders. No one sheds a tear for steel makers when a car company, for example, substitutes steel for plastic in today's cars, or for oil companies, when more fuel efficient cars come out. As the economies in most of the world undergo structural change, the nature of employment, business, skills and locations will change too - and while there will be individual winners and losers, overall the society will be a net-net gainer only if shareholder value is pursued as a singular target. At the risk of going on like a broken record - if the shareholders are not taken care of, there will be no company in the end, and their will be no employees either.


In all relations with all employees, a company's management should constantly be making rational economic judgements. How much should we pay, in order to attract and keep motivated the quality of staff that we need, and how should we treat these people in other ways (location/quality of offices, fringe benefits etc etc) in order to maximise their economic output? Fortunately for the capitalist world, experience in developed economies teaches that these hard, cold judgements will usually result in working conditions and rewards that are at least tolerable and often very good. When these judgements are well made, they should result in respect for individuals, fair and reasonable treatment, drive for a happy working environment etc. A legal framework is necessary to enforce certain minimum standards, but beyond this point employees' quality of life at work can fairly reliably be left in the hands of the market - i.e. of shareholders' rational economic interests.



Does this justify sweatshops, or corporate thuggery?

But does it mean that it is justified to say, cheat on taxes, or create a sweatshop that maximises shareholder value? No not really – again because shareholder value is a long term concept – and such measures tend to be very short term-ish with significant long term disadvantages that lower shareholder value. Sports goods manufacturing companies have faced tremendous pressure from governments, customers and even faced litigation for sponsoring sweatshops in third world countries. This activism and litigation has a direct impact on their bottomlines – they become less preferred business partners for their suppliers and customers, and ultimate consumers may choose competitors’ products over theirs. Increased litigation costs may also mean lowering of profits – and all of this does not make for good shareholder value. Similar reasoning applies to environmental issues, bad publicity can have direct economic consequences in the medium term that forces good managers to review their decisions in the light of what can they afford better – the cost of keeping the environment clean, or the cost of bad publicity. In many situations, for example in emerging markets, customers may not yet be willing to pay a higher price for a ‘greener’ product, in which case environmental damage which would be unacceptable in the first world would be a wise economic choice.

Measuring corporate value is tough. Share prices are often taken as a proxy for shareholder value created, or destroyed, but the correlation between a company's real economic performance and its share price is at best a rather weak one. It is quite unfair to reward the managers of a business if they happen to be lucky bystanders witnessing a bull market - in fact that would be destructive to the concept of shareholder value, not to speak of the governance conflicts that creates. But unfortunately in the absence of anything better, share prices will probably continue to be used to measure corporate value added. And the reason for that is quite simple. Any half-clever person can probably come up with any number of metrics to measure the real economic performance of a company, but share prices are the only one that create cash in the pockets of shareholders.


Ultimately, the goal should always be to maximise shareholder value – though the means to do so would change with the situation. In the early days of the industrial revolution, the wealth that powered it was created on the backs of appalling work conditions for workers, not to speak of the criminal exploitation of colonies and slavery. Clearly even hinting at any such thing would be very bad for shareholder value for any business today. However, the same industrial revolution has today spawned the conditions for addressing these issues and generated the wealth needed to reduce human suffering. All that this means is that the shareholder is king and what is good for him is in the long term good for society as well.