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Edition/Copyright: REV 98
SHAREHOLDER VALUE AND CORPORATE PURPOSE
The idea that management's primary responsibility is to increase value has gained widespread acceptance in the United States since the publication of Creating Shareholder Value in 1986. With the globalization of competition and capital markets and a tidal wave of privatizations, shareholder value rapidly is capturing the attention of executives in the United Kingdom, continental Europe, Australia, and even Japan. Over the next ten years shareholder value will more than likely become the global standard for measuring business performance.
In the early 1980s there were very few companies with an unambiguous commitment to shareholder value. While many companies used piecemeal applications of the shareholder value approach, such as discounted cash-flow analysis for capital budgeting decisions and for merger-and-acquisition pricing, management thinking largely was governed by a short-term earnings orientation. The takeover movement of the latter half of the 1980s provided a powerful incentive for managers to focus on creating value. Many companies, particularly those in mature industries such as oil, allocated their very substantial excess cash flow toward uneconomic reinvestment or ill-advised diversification. Other companies failed to seek the highest valued use for their assets. For example, retailing establishments, particularly large department stores sitting on valuable downtown real estate, missed the opportunity to sell the real estate and redeploy the cash to value-creating growth or, in the absence of profitable investment opportunities, distribute the cash to shareholders. In each of these cases the stock market predictably penalized the companies' shares. This led to the infamous ''value gap,'' i.e., the difference between the value of the company if it were operated to maximize shareholder value and its current market value. A positive ''value gap'' was an invitation to well-financed corporate raiders to bid for the company and replace incumbent management. The only compelling takeover defense is to close the ''value gap'' by delivering superior shareholder value. Whatever one thinks of raiders and their tactics, the threats of takeovers did prompt CEOs to give long-overdue focus to delivering value for shareholders.
The excesses of the late-1980s takeover movement -- payments of unwarranted acquisition premiums financed by high leverage -- led to the demise of ''financial'' acquisitions. Entering the 1990s CEOs of many public companies were relieved to see Wall Street raiders move backstage. But there was to be no return to business as usual. Over the past few years institutional investors have substantially increased their efforts to gain better returns for the beneficiaries of the funds they manage. Their primary approach has been to shine the spotlight on underperforming companies and promote changes in either corporate strategy or in management itself. For example, the California Public Employees' Retirement System (CalPERS) screens annually for the ten most seriously underperforming stocks in its portfolio. The Council of Institutional Investors, a trade organization for public pension funds, publishes a ''bottom 20'' list comprised of companies in the Standard & Poor's 500 who most underperformed their industry in total shareholder returns, i.e., dividends plus stock price change. In 1992 Robert Monks and Nell Minow founded LENS, a fund exclusively devoted to investing in ''companies with strong underlying values, but whose performance lags due to lack of focus by the management or the board.'' After four years of constructive involvement with its portfolio companies, $1 invested in 1992 compounded to $2.28 versus $1.69 for the S&P 500. Active institutional investors have helped displace CEOs at such major companies as American Express, Eastman Kodak, General Motors, IBM, K-Mart, Sears, and Westinghouse.
Maximizing shareholder value is now embraced as the ''politically correct'' stance by corporate board members and top management in the United States. As is the case with other good ideas, shareholder value has moved from being ignored to being rejected to becoming self-evident. It is invariably invoked in annual reports, press releases, meetings with financial analysts, and management speeches. However, the critical role of the shareholder value approach in allocating resources in a market-based economy is far from universally accepted. Years of restructuring and employee layoffs frequently attributed to shareholder value considerations coupled with politicians who charge top management with self-interest and a shortsighted focus on the current stock price have promoted frustration and uncertainty. In other parts of the world, such as the European continent, there is increasing political tension between the shareholder value business practices required in a competitive global market and the long-standing tradition of social welfare. In light of these developments, a reassessment of the fundamental rationale for the shareholder value approach is warranted.
MANAGEMENT VERSUS SHAREHOLDER OBJECTIVES
It is important to recognize that the objectives of management may in some situations differ from those of the company's shareholders. Managers, like other people, act in their self-interest. The theory of a market economy is, after all, based on individuals promoting their self-interests via market transactions to bring about an efficient allocation of resources. In a world in which principals (e.g., stockholders) have imperfect control over their agents (e.g., managers), these agents may not always engage in transactions solely in the best interests of the principals. Agents have their own objectives and it may sometimes pay them to sacrifice the principals' interests. There are, however, a number of factors that induce management to act in the best interests of shareholders. These factors derive from the fundamental premise that the greater the expected unfavorable consequences to the manager who decreases the wealth of shareholders, the less likely it is that the manager will, in fact, act against the interests of shareholders.
Consistent with the above premise, at least four major factors will induce management to adopt a shareholder orientation: (1) a relatively large ownership position, (2) compensation tied to shareholder return performance, (3) threat of takeover by another organization, and (4) competitive labor markets for corporate executives.
Economic rationality dictates that stock ownership by management motivates executives to identify more closely with the shareholders' economic interests. Indeed, we would expect that the greater the proportion of personal wealth invested in company stock or tied to stock options, the greater would be management's shareholder orientation. While the top executives in many companies often have relatively large percentages of their wealth invested in company stock, this is much less often the case for divisional and business unit managers. And it is at the divisional and business unit levels that most resource allocation decisions are made in decentralized organizations.
Even when corporate executives own shares in their company, their viewpoint on the acceptance of risk may differ from that of shareholders. It is reasonable to expect that many corporate executives have a lower tolerance for risk. If the company invests in a risky project, stockholders can always balance this risk against other risks in their presumably diversified portfolios. The manager, however, can balance a project failure only against the other activities of the division or the company. Thus, managers are hurt by the failure more than shareholders.
The second factor likely to influence management to adopt a shareholder orientation is compensation tied to shareholder return performance. The most direct means of linking top management's interests with those of shareholders is to base compensation, and particularly the incentive portion, on market returns realized by shareholders. Exclusive reliance on shareholder returns, however, has its own limitations. First, movements in a company's stock price may well be greatly influenced by factors beyond management control such as the overall state of the economy and stock market. Second, shareholder returns may be materially influenced by what management believes to be unduly optimistic or pessimistic market expectations at the beginning or end of the performance measurement period. And third, divisional and business unit performance cannot be directly linked to stock price.
The third factor affecting management behavior is the threat of takeover by another company. Tender offers have become a commonly employed means of transferring corporate control. Moreover the size of the targets continues to become larger. The threat of takeover is an essential means of constraining corporate managers who might choose to pursue personal goals at the expense of shareholders. Any significant exploitation of shareholders should be reflected in a lower stock price. This lower price, relative to what it might be with more efficient management, offers an attractive takeover opportunity for another company, which in many cases will replace incumbent management. An active market for corporate control places limits on the divergence of interests between management and shareholders.
The fourth and final factor influencing management's shareholder orientation is the labor market for corporate executives. Managerial labor markets are an essential mechanism for motivating management to function in the best interests of shareholders. Managers compete for positions both within and outside of the firm. The increasing number of executive recruiting firms and the length of the ''Who's News'' column in the Wall Street Journal are evidence that the managerial labor market is very active. What is less obvious is how managers are evaluated in this market. Within the firm, performance evaluation and incentive schemes are the basic mechanisms for monitoring managerial performance. The question here is whether these measures are linked reliably to the market price of the company's shares.
How managers communicate their value to the labor market outside of their individual firms is less apparent. While the performance of top-level corporate officers can be gleaned from annual reports and other publicly available corporate communications, this is not generally the case for divisional managers. For corporate level executives, the question is whether performance for shareholders is the dominant criterion in assessing their value in the executive labor market. The question in the case of division managers is, first, how does the labor market monitor and gain insights about their performance and second, what is the basis for valuing their services.
SHAREHOLDERS AND STAKEHOLDERS
Environmentalists, social activists, and consumer advocates such as Ralph Nader have argued since the 1960s that corporations should be ''socially responsible'' and serve the broader public interest as well as shareholder interests. In the 1990s corporate governance discussions are replete with references to ''balancing the interests of all stakeholders.'' While corporate social responsibility and stakeholder advocates sometimes embrace different issues, each calls for the corporation to have a purpose beyond maximizing returns to shareholders.
In a market-based economy that recognizes the rights of private property, the only social responsibility of business is to create shareholder value and to do so legally and with integrity. Critical social issues in education, health care, drug abuse, and the environment pose enormous social challenges. Corporate management, however, has neither the political legitimacy nor the expertise to decide what is in the social interest. Our form of government calls for elected legislators and the judicial system to be the mechanisms for collective choice. Ironically, costs that social responsibility advocates would impose on corporations often are costs that voters through the political process would be unwilling to bear. Such imposed costs invariably will be passed on to consumers by way of higher prices, to employees as lower wages, or to shareholders as lower returns. There still is no free lunch.
Fortunately, there are powerful market incentives that lead value-maximizing managements to make decisions with socially desirable outcomes. Workplace safety serves as an excellent example. The passage in 1970 of the Occupational Health and Safety Act apparently did little to reduce job-related accidental deaths, since they declined at about the same rate before and after its passage. The steady improvement in workplace safety over the years is more reasonably explained by the employer's strong economic incentives to avoid accidents. First, there is a significant wage and benefits premium that employees demand for the higher risk associated with a dangerous workplace. When an accident occurs there are additional losses due to lost worker time and increased turnover arising from safety fears of coworkers. Second, there are workers' compensation insurance premiums paid by the employer, which are affected by accident rates. There are significant savings to be realized for relatively small reductions in accident rates. Managements governed by shareholder interests would invest in technology, training, or reengineered workplaces that reduce safety costs.
Because of its ambiguity and lack of enforceability, the corporate social responsibility model gets little support from policymakers and corporate governance activists today. Primarily as a response to significant employee layoffs, ''balancing the interests of stakeholders'' has commanded increasing attention in the 1990s. This is not a new idea. Chief executives of some of our largest companies have contended that shareholder interests should not be their primary obligation. Hicks B. Waldron, the former chairman of Avon Products, for example, states: ''We have 40,000 employees and 1.3 million representatives around the world. We have a number of suppliers, institutions, customers, and communities. None of them have the democratic freedom as shareholders do to buy or sell their shares. They have much deeper and much more important stakes in our company than our shareholders.'' Critics charge that balancing stakeholder interests is simply rhetoric by entrenched managers who wish to deflect attention away from their poor performance for shareholders.
It is precisely this casualness toward shareholder interests that precipitated the 1980s takeovers with all their unpleasant and largely avoidable consequences to many employees and communities. The takeover movement demonstrated little tolerance for managements not attentive to shareholder value. Takeovers as well as restructurings, which were management's response to the threat of takeover, unlocked billions of dollars of value for shareholders. It would, however, be a profound error to view increases in a company's value as a concern just for shareholders. Most executives and public policymakers recognize that increases in stock price reflects improvements in productivity and competitiveness, which benefit everyone with a stake in the company and the overall economy. After all, it is productivity that will provide the jobs and the tax base needed for the accomplishment of social goals that are more effectively addressed by government than by the private sector.
The stakeholder model that attempts to balance the interests of everyone with a stake in the company makes it easier for corporate managers to justify uneconomic diversification or overinvestment in a declining core business, since these moves are likely to be endorsed by constituencies other than shareholders. For employees it means more jobs -- in the short run. Suppliers enjoy the prospect of additional business, and the local community gets a larger tax base resulting from the increased size of the company. Also, business decisions based on social criteria often bring personal praise for the chief executive officer. But it is these decisions that subordinate shareholder interests that trigger the much maligned corrective mechanisms of takeovers and restructuring.
Fortunately there is an alternative approach to stakeholders that is consistent with shareholder interests, competitiveness, and, in the final analysis, socially responsible business behavior. This view recognizes that to continue to serve all stakeholders, companies must be competitive if they are to survive. This view further recognizes that a company's long-term destiny depends on a financial relationship with each stakeholder that has an interest in the company. Employees seek competitive wages and benefits. Customers demand high-quality products and services at competitive prices. Suppliers and bondholders seek payment when their financial claims fall due. To satisfy these claims management must generate cash by operating its businesses efficiently. This emphasis on long-term cash flow is the essence of the shareholder value approach.
In brief, a value-creating company benefits not only its shareholders but the value of all other stakeholder claims, while all stakeholders are vulnerable when management fails to create shareholder value. Enlightened self-interest dictates that shareholders and other stakeholders actively engage in a partnership of value creation.
Customers and Employees
Two stakeholders, customers and employees, merit further examination. First consider the case of customers. Even the most persistent advocate of shareholder value understands that without customer value there can be no shareholder value. The source of a company's long-term cash flow is its satisfied customers. On the other hand, providing customer satisfaction does not automatically translate into shareholder value. Providing a comparable product at a lower cost than competitors, or providing superior value to the customer through higher quality, special features, or postsale services, are not genuine advantages if the total long-term cost, including the cost of capital, is greater than the cash generated by the sale. A business that provides more value than customers are willing to pay for is hardly competitive -- and may not even be viable. The euphoria associated with investments in total-quality programs sometimes exempts such major investments from careful shareholder-value scrutiny. Consider, for example, the Wallace Company, a Houston, Texas-based pipe and valve distributor that won the prestigious Malcolm Baldrige National Quality Award in 1990. Wallace's quality program significantly increased on-time deliveries as well as its market share. Customers, however, were unwilling to accept the price increases initiated to offset the costs of the quality program. As a result, the company began to lose money, lay off employees, and, finally, it declared bankruptcy. While shareholders subsidized customers for a time, all stakeholders -- including shareholders -- became the ultimate losers. The lesson is clear: When confronted with a conflict between customer value and shareholder value, management should resolve it in favor of shareholders and the long-term viability of the business.
While conflicts between customer value and shareholder interests can be quantified and appropriately resolved by sound shareholder value analysis, conflicts between employee and shareholder interests pose a substantially more difficult challenge. A curious coalition of liberal and conservative commentators has laid the blame of employee insecurity on CEOs who downsize their companies to increase stock price. The same commentators that just a few years ago were lambasting CEOs for underperforming against foreign competitors are now criticizing CEOs for downsizing to improve competitiveness. In most cases CEOs are responding to advances brought about by stunning new technology, pressure from more efficient domestic or foreign competitors, opportunities to produce better or less costly products by outsourcing, deregulation, or simply too much capacity chasing too little demand. It is important to distinguish between the causes of layoffs and the CEOs who as agents of change respond to ensure the competitiveness and survival of their companies. Spare the messenger.
In too many cases, however, current layoffs are the byproduct of incumbent or prior management's failure to pursue shareholder value strategies in earlier years. If shareholder value management had been implemented earlier, the level of downsizing in the 1990s would have been considerably less. After all, work force reductions have been largely triggered by structural changes in the economy rather than by transitory business cycles. If management defers a 10 percent reduction in staff that is needed to make the company cost competitive, how long will it take before its industry rivals aggressively lower prices or invest in improved customer satisfaction, thereby threatening the very survival of the company? The tradeoff is a 10 percent reduction now or a possible loss of jobs for many more if not all employees in the near future. Setting aside for the moment shareholder interests, do the 10 percent of employees facing layoffs merit a higher priority than the remaining employees? Layoffs are a very painful short-term price that must be paid for remaining competitive. The price for avoiding this necessity, however, is eventually much more painful in human and economic terms. Experience teaches the bitter lesson that this type of kindness often turns into unintended cruelty. While the corporate downsizing that began in the 1980s continues, there is also an impressive number of jobs being created in the overall economy. Some of these jobs are in fact materializing in the very same companies that had eliminated other jobs during an earlier restructuring.
Government regulation that presumably ''helps'' companies to act in the social interest invariably leads to even greater employee insecurity. Many European governments and unions try to protect jobs by making it very costly to lay off employees. This interference with market forces has led to less competitive, high-cost companies and unemployment rates more than twice those experienced in this country. In contrast to the significant restructuring undertaken in the United States, overstaffed companies in Japan and Germany are just beginning to acknowledge that global competition will compel them to do the same. Even at extraordinarily low interest rates in Japan, there is virtually no net increase in corporate borrowing because there are so few profitable investment opportunities. To regain its momentum, Japan will have to reestablish itself as an attractive place to invest in by lowering its costs through a combination of corporate restructuring and government deregulation. In the meantime, implementation of shareholder value has helped transform American industry into the most competitive in the world, after a period when all the talk focused on its dismal performance. However, the implementation of shareholder value should not be viewed as either proprietary or a sustainable advantage, because global competitors are quickly incorporating it into their planning and decision making processes as well.
There is unfortunately another side to restructuring and employee layoffs. Not all downsizing is based on long-term shareholder value considerations. Some downsizing decisions are predicated on reporting better short-term earnings rather than focusing on the longer term position of the business. For example, layoffs in companies that depend heavily on personal relationships with customers can adversely affect longer term profitability. Moreover, such downsizing may also adversely affect the morale and productivity of the remaining work force. The source of the problem here is not the use of the shareholder value approach. The problem instead is its misuse or nonuse, which has led to value-destroying downsizings for companies and their shareholders and uncalled-for dislocations and pain for employees.
Innovation and customized products and services developed by highly skilled employees are increasingly a critical source of value creation. In many cases these employees have developed highly specialized, firm-specific skills that have substantial value to their employers but less value to other organizations. These employees are unlikely to find jobs elsewhere that pay as much as their current employment. Some economists argue that employees with firm-specific skills bear the residual risk of the company along with its shareholders and therefore should have rights on par with shareholders. This is not the place to examine the legitimacy of this argument or its implications for corporate governance. It is, however, important to examine briefly the most frequent suggestion on how to align the interests of employees with those of shareholders.
How can employee interests be aligned with shareholder interests in the face of restructuring and layoff announcements that so often trigger increases in the share price? The most frequent suggestion is that employees be granted meaningful stakes in the company's stock. The argument is that because employees are now also shareholders who will benefit from efficiency-enhancing plant closings and layoffs, they would support these value-creating actions. But such support will come only from those whose stock appreciation exceeds their loss from being laid off. The proportion of stock required in compensation packages to align employee interests with those of shareholders is in most instances simply not feasible. Even if it were, employees concentrating their human and financial capital in one company ignores the wisdom of diversification. I believe that the better solution lies in offering employees meaningful incentives for creating value. Recommended measures and their linkage to incentives are detailed in Chapter 7.
The mutual interdependence among shareholders and other stakeholders makes it imperative that they engage in a partnership for value creation. But stakeholders must perceive the value-sharing process to be fair before they can be expected to maximize their commitment to a company. Simply said, I will help grow the pie if you give me my fair share. While most discussions of corporate purpose address the concerns of various stakeholders, comparatively little attention is devoted to who the shareholders of corporate America are today. When we realize that shareholders are not ''them'' but are ''us,'' the case for shareholder value becomes even more compelling.
SHAREHOLDERS ARE ''US''
About 40 percent of U.S. households own individual stocks or mutual funds. Millions of employees have an indirect stake in stock performance by their participation in defined-benefit pension plans sponsored by their employers. Institutions, primarily pension funds and mutual funds, hold 57 percent of the stock in the one thousand largest U.S. corporations and 47.5 percent of the total U.S. equity market. By some estimates, personal stock holdings and retirement plans account for over 75 percent of Fortune 500 company shares. With the phenomenal growth in defined-contribution plans, particularly 401(k) plans, investment decisions along with the associated risk now belong to employees. A substantial majority of retirees and active employees depend on dividends and stock price appreciation for their retirement security. Shareholders are not the frequently demonized wealthy, self-serving Wall Street caricatures, but instead are largely individuals who invest human capital in their place of employment and financial capital across a broad cross section of the economy. Indeed, Main Street is fast replacing Wall Street. Losses, whether taken in the name of social responsibility or due to poor decision making, come out of the pockets of retirees, workers, and other individuals who depend on management to maximize shareholder value. The broader participation of so-called ''middle America'' also means that security market prices are likely to affect the real economy more than in the past. This is the case because the larger the investment in securities the greater the propensity of market movements to affect consumer spending decisions. Some economists fear that a significant correction in the stock market could induce a ''loss-of-wealth effect,'' reduce consumer spending, and trigger a recession.
What's on the horizon? Perhaps no prospect looms larger than the potential privatization of Social Security. Those favoring privatization argue that allowing people to invest at least a part of their retirement money in an account similar to a 401(k) or an Individual Retirement Account would ensure the long-term viability of the Social Security system without major cuts in benefits or increases in taxes. Privatization advocates argue that forecasted Social Security shortfalls can be offset by the higher returns earned from a diversified portfolio of stocks and bonds versus the returns from Treasury notes, which by law Social Security must now invest in. Privatization of Social Security is a complex and politically sensitive issue that will take some time to resolve. However, if privatization does materialize, the transition from ''them'' to ''us'' will be complete. In such a world, fund managers will be monitored as never before and they, in turn, can be expected to push the companies in their portfolios for performance as never before. Funds with large stock holdings have difficulty selling the shares of underperforming companies. Because of limited market liquidity, shares would have to be sold at a discount to their most recent price. In contrast, investors dissatisfied with their fund's performance are free to move their money to another fund for a relatively small fee or in some cases no fee. Fund managers competing for investors' money will be more motivated than ever before to ride herd on underperforming CEOs with disappointing track records.
Copyright © 1986, 1998 by Alfred Rappaport
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