MAXMISING SHAREHOLDER VALUE: The By-product of Good Business Management and Not a Business Strategy.

On April 20th 2010 an oil well operated by British Petroleum in the Gulf of Mexico, deepwater horizon, exploded killing 11 men and injured 17 others. The oil well head was only capped 3 months later after it had released 4.9 million barrels of crude oil and caused extensive damage to marine and wildlife habitats, as well as the regions vibrant fishing and tourism industry. The disaster resulted in a 100 billion dollars loss in BP market capitalization and a 7.8 billion dollar settlement. 

The report published by the United States commission of enquiry into the disaster concluded that in an attempt to save $1 million a day, the company cut safety corners resulting in a defective cement job that ultimately caused the disaster. The example was highlighted by Professor Lynn Stout of the University of California, Los Angeles (UCLA) as a product of what she called “shareholder value thinking”, where executives aim to drive up the value of the share prices in the shortest time possible without considering the cost of their actions to society.

The concept of maximising shareholder wealth may have its roots in Adam Smith’s celebrated passage;

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner,but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”

The ideology was propagated in the 1970’s by Milton Freidman who argued that there is only one social responsibility of business, “to use its resources and engage in activities designed to increase its profit so long as it stays within the rules of the game”.

This ideology is based on the concept that businesses are entities and not individuals, whose sole purpose of existence is to make profits and maximize shareholder value over time. The proponents of this ideology argue that when corporations are run to maximise shareholder value the performance of the economy as a whole and not just the intent of the shareholder will be enhanced. This ideology was supported by the economic boom of the 1990’s and the success of Silicon Valley during the same period, gave powerful support to this concept, but the financial crisis of 2008 has made many economists to begin question the concept. Bob Berry on the other hand noted that the 2008 financial crisis was not a result of shareholder value maximisation but rather the companies (Banks) were being managed in the interest of the directors. Uwe Reinhardt in attempting to simplify how business should create wealth pointed out that for a corporation to contribute to national wealth it must go beyond increasing shareholder value and increase the “total gross value”. Only then will all the players (consumers, shareholders, employees and society) benefit from the added value.

Steve Denning writing in Forbes, noted that Jack Welch (CEO of General Electric from 1981-2001) said that the concept of maximizing shareholder value was not a smart idea rather “it turned out to be a disease it purported to cure”. 

He further noted that companies must shift focus back to the customers, away from shareholder value and rather focus on delighting their customers while earning acceptable returns for the shareholders. Michael Jensen argued that “we cannot maximise the long-term value of an organisation if we ignore or mistreat any important constituent” while Jack Welch argued in an interview with the Financial Times that shareholder value is a result NOT a strategy.

The main constituent of any business are its employees and customers. The point highlighted by Jack Welch is one which I believe. The concept of maximizing shareholder value, though noble in its intent to improve the company’s margins, becomes a misplaced intent when it becomes the sole purpose of the company. It takes life form of its own driving the executives to adopt a myopic shareholder centred view of management, neglecting the core of any business which is its customers and its ‘heart’ which is the employees. The argument here is that shareholder value should be the by-product of good business management and not the strategy. When adopted as a strategy, business executives may compromise standards as seen in the BP oil spill, adopt unsustainable environmental practises or be out rightly unscrupulous in their production methods. This argument does not suggest in any way that if shareholders obtain maximum returns from their investment, society must suffer. Rather it’s an argument on the merits of shared benefits by adopting a holistic approach to business management in contrast to the one-track shareholder centred management style.