Thoughts on “Shareholder Value”…

A couple of weeks ago, after yet another corporate tax avoidance wheeze came to light, I was having a Twitter-based conversation with Steve and Gordon about “shareholder value” – specifically, whether the need to maximise shareholder value was dictated by company law. (The answer, by the way, is – predictably – “it depends”. More on that later!) It echoed something that economist Robert Shiller said when he spoke at he spoke at the RSA last May – he said something like the pursuit of shareholder value was so enshrined in (US common) law that social entrepreneurs needed new legal forms of organisation structures to do what they wanted to do – otherwise they could be sued for failing to maximise shareholder value. (I wasn’t convinced by Shiller’s argument that a new form of company was needed, at least within the UK.)

These exchanges made me question the concept of shareholder value: my background in finance meant that I took shareholder value for granted – a no-brainer: it was the orthodoxy when I was training, over twenty five years ago (that’s the late 1980s, in case you can’t do the maths!), and again, fifteen years later when I did my MBA. It struck me as being good to review my understanding of shareholder value.

“Shareholder value” – there are many definitions, but this one seems simplest:

the value that a shareholder is able to obtain from his/her investment in a company. This is made up of capital gains, dividend payments, proceeds from buyback programs and any other payouts that a firm might make to a shareholder

– is the be all and end all of management. It stems from the separation of ownership of an limited companies by shareholders from the management of those companies – the principal-agent problem. By focusing on shareholder value, managers should align their interest with shareholders.

I still think this is simply stating the bleedin’ obvious: managers of a firm should manage the firm in the interests of the owners (the shareholders). It is the same for all employees – if you behave in a way that is detrimental to the company whilst performing your duties, you are likely to be sanctioned.

In financial decision making, maximising shareholder value is often synonymous with maximising the net present value of future income streams – calculating the discounted cash flows of a company. That is essentially how the market prices of share are estimated (and they go up and down as the market reassesses those future values). Allegedly.

This gives a relatively simple way to estimate shareholder value, and companies regularly assess new projects to maximise shareholder value.

The duties of directors to act for the advantage of shareholders is set out in the UK Companies Act 2006 (and previous versions of it, too!). But CA 2006 goes beyond its predecessors by establishing “enlightened shareholder value”. Section 172 of the CA 2006 states

(1) A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to—
(a) the likely consequences of any decision in the long term,
(b) the interests of the company’s employees,
(c) the need to foster the company’s business relationships with suppliers, customers and others,
(d) the impact of the company’s operations on the community and the environment,
(e) the desirability of the company maintaining a reputation for high standards of business conduct, and
(f) the need to act fairly as between members of the company.
(2) Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, subsection (1) has effect as if the reference to promoting the success of the company for the benefit of its members were to achieving those purposes.

So whilst the company is to be run for the benefit of its members [shareholders] (s172.1), it requires a long term view (s172.1.a), consideration of employees (s172.1.b) and other stakeholders (s172.1.c and d), and maintaining a reputation for high standards (s172.1.e). Shareholders come first, but clearly CA 2006 reckons that the best way to maximise the benefit for shareholders is through its relationships with others. And, though I’m not a lawyer, I reckon that s172.2 means that the directors have discretion to do things other than in the immediate interest of shareholders for a longer term benefit. (Like making contributions to charity, perhaps?)

In the US, corporate law is set at a state level; for historic reasons, though, the small state of Delaware has over 50% of company registrations, and they are determined by Delaware General Corporation Law ((DGCL). This doesn’t set out directors’ duties, which are governed instead by common law.

The key ruling seems to be Dodge v Ford Motor Co (1919): Henry Ford wanted to expand production the company (of which he was the major shareholder) for the benefit of employees and customers – cutting prices in the process. (A strategy of going for growth and market share at the expense of profits.) The Dodge Brothers objected, and the court ruled in their favour:

A business corporation is organised and carried on primarily for the profit of shareholders. The powers of directors are to be employed for that end.

Shareholders have primacy.

This might seem unequivocal, but of course it isn’t. There is a huge amount of discretion for directors.

In public companies shareholders will have a huge range of objectives. Some may want a stream of dividends to supplement their income now; some might want future capital growth; some might simply want to have a say in what a company is doing (like protester at BP’s AGM). The CA 2006 covers this in s172.1.f – “the need to act fairly as between members of the company”.

But most shareholders are shareholders because they want some form of their wealth to increase through income or capital growth. The UK stockmarket was, in 2010, owned 11.5% by individuals, 41% by financial companies and institutions (pension funds, unit trusts, insurance companies and banks) and 41% by “rest of the world” (overseas financial companies and individuals). Anyone with a pension plan or investment has a direct or indirect investment in listed public companies.

Those financial institutions are increasingly measured by their relative, often short term performance: fund managers (the people managing the share portfolios of those unit trusts, pension funds and insurance companies) are measured on their quarterly performance, and so they assess the shares in those portfolios on quarterly performance as well. Focussing on “shareholder value” allows them to do this.

Additional focus on shareholder value has come from the rise of shareholder activism – particularly from hedge funds. Activist shareholders are nothing new – the Dodge brothers in Dodge v Ford were activist shareholders: they wanted to influence the company’s strategy in a particular direction.

There is no time-frame for shareholder value, which is what makes it rightly subjective: focus on the short term profit, like many hedge fund managers, and you’ll stuff future value. Focus on customers, employees, suppliers and (erm…) the broader community – focus on relationships, if you will – and your business will grow for the future but perhaps at the loss of those short term gains.

For instance, Starbucks may have maximised its current shareholder value by legally minimising its corporation tax liability, but at the expense of its reputation once the story broke and, if customers act on this knowledge and choose to buy someone else’s coffee, future profits.

I know which I prefer.

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