The idea that directors should seek to maximise shareholder value has come in for a lot of flak in recent years. James Montier of GMO even wrote a piece on it called “The World’s Dumbest Idea” (PDF).
One of the most prominent criticisms of maximising shareholder value is that it causes directors to focus too much on their company’s share price, which leads them to underinvest in its long-term future in order to boost short-term profits (and therefore, the share price).
This is not so much a failing of the concept of shareholder value maximisation as it is a failure to understand what shareholder value is and what directors can do in their attempts to maximise it.
True shareholder value is a measure of long-term value
The value of a company is essentially the value of all the cash it will return to shareholders over its remaining lifetime.
Let’s assume that Sainsbury will survive another 100 years before closing its doors for the last time.
In that case the value of the company today is the value of all dividends paid out over the next 100 years plus any cash returned to shareholders when the company is would up (which we can ignore because it is usually zero).
A dividend today is preferable to a dividend in 50 years’ time, so future dividends are usually “discounted” by an annual discount rate. If you want a 10% annual return on your Sainsbury investment then you would discount the value of future dividends by 10% each year, in which case a 100p dividend 10 years from now would have a “present value” of about 42p.
Add up those discounted future dividends and hey presto, you have the present “shareholder value” of Sainsbury, at least according to an investor who wants a 10% rate of return. A different discount rate would provide a different shareholder value.
Because the company’s shareholder value is the discounted sum of 100 years of dividends, only a fraction of Sainsbury’s value today comes from dividends paid in the next 10 years. Most of its shareholder value comes from dividends that are expected to be paid more than 10 years in the future, as is the case for most mature companies.
This is the true meaning of shareholder value; a multi-decade stream of dividends which directors should be attempting to maximise, without taking unnecessary risk.
True shareholder value maximisation should be much more about working to improve and expand the business for the next 10 years and the 10 years after that, rather than hitting short-term profit expectations.
Share prices have almost nothing to do with shareholder value
Those who believe in the wisdom of crowds might say that yes, the true shareholder value of a company is indeed the discounted value of its future cash returns to shareholders, but we can never know those cash flows and therefore can never calculate an accurate figure for shareholder value.
They might go on to say that our best estimate of shareholder value is the market value or share price of a company, and so it is entirely sensible for directors to pay attention to share price and to be paid according to its performance.
Utter drivel, is what I would say to that.
The share price or market value of a company is, at most, a combined “best guess” by investors as to what a company’s shareholder value really is.
However, calling it a “best guess” is wildly optimistic as a large portion of equity trades are carried out by traders who don’t even know the names of the companies whose shares they are buying and selling (especially the computer-driven High Frequency Traders who own shares for thousandths of a second).
Even if all market participants were long-term dividend-focused investors they still wouldn’t have the faintest idea what dividend Sainsbury will be paying 10, 20 or 30 years from now, and therefore no idea what its shareholder value is (and the same would be true for pretty much all companies).
Rather than an estimate of shareholder value, share prices are more closely connected to factors like current dividends, current earnings and any and all combinations of news, noise, expectations and emotions; none of which have anything to do with true shareholder value.
So the idea that maximising shareholder value means maximising the share price is a joke, which means that compensating executives with one way bets on the share price (otherwise known as stock options) is equally daft.
If executive directors are to be compensated by share price movements at all, it should be by insisting that they invest a significant amount of their own money into the company and to keep it invested for as long as they are on the board.
In addition they should be encouraged to focus on maximising true shareholder value rather than the company’s market value. As Lawrence Cunningham describes in the introduction to his book, The Essays of Warren Buffett:
“The CEO’s at Berkshire’s various operating companies enjoy a unique position in corporate America. They are given a simple set of commands: to run their businesses as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for a hundred years. This enables Berkshire CEOs to manage with a long-term horizon ahead of them, something alien to the CEOs of public companies”.