And no one could reasonably argue that an absence of long-term shareholders gives management the license to maximize short-term performance and risk endangering the company’s future. The competitive landscape, not the shareholder list, should shape business strategies.
But the real payoff comes in the difference that a true shareholder-value orientation makes to a company’s long-term growth strategy. For most organizations, value-creating growth is the strategic challenge, and to succeed, companies must be good at developing new, potentially disruptive businesses. Here’s why.
It’s become fashionable to blame the pursuit of shareholder value for the ills besetting corporate America: managers and investors obsessed with next quarter’s results, failure to invest in long-term growth, and even the accounting scandals that have grabbed headlines.
When executives destroy the value they are supposed to be creating, they almost always claim that stock market pressure made them do it. The reality is that the shareholder value principle has not failed management; rather, it is management that has betrayed the principle.
Under perfect competition, in the long run the cost of production will approach the lowest possible cost per unit, profits and losses will tend toward zero, and prices will fall to the point of generating maximum efficiency in the market.
Because there are no barriers to entry or exit from markets under perfect competition, firms tend to move to the markets in which they can maximize profit. The eventual effect of this freedom of movement is to move toward an equilibrium state where neither profit nor loss is earned by production and sales of goods or services.
The Diligent Institute and Stanford University's Rock Center for Corporate Governance collaborated in recent months to put this question (and others) to almost 200 directors of public and private corporations.
Diligent and the Rock Center for Corporate Governance also asked directors to consider which stakeholder groups play key roles in or are impacted by their companies' daily operations and long-term strategy. Almost nine of every 10 directors, 87%, identified employees as such.
No pressure, right? It depends on the company. Researchers asked directors how much pressure their respective companies receive from their largest institutional shareholders to meet the interests of stakeholders as their directors develop long-term strategies. Only 8% of directors reported that their companies experience high pressure.
Exercising options: Companies generally grant their employees stock options in place of cash or stock bonuses. The employees can exercise these contracts by converting options to shares and sell them in the market. It results in dilution of existing shares.
New acquisitions: In case a company is buying a new firm, it may offer the latter’s shareholders new shares in its company.
The issue of fresh shares may be an indication that the company has likely boosted its revenue.
Stock dilution is defined as a process by which a corporation issues fresh shares, increasing the number of outstanding shares, and brings down the ownership percentage of existing shareholders. Stock or share dilution can potentially reduce the value of shares held by the company’s pre-existing shareholders. Thus, stock dilution can generally have a negative impact on shareholders who hold ownership in the company.
Just because a company engages in share buybacks, however, doesn’t mean that it abides by this principle. Many companies buy back shares purely to boost EPS, and, just as in the case of mergers and acquisitions, EPS accretion or dilution has nothing to do with whether or not a buyback makes economic sense. When an immediate boost to EPS rather than value creation dictates share buyback decisions, the selling shareholders gain at the expense of the nontendering shareholders if overvalued shares are repurchased. Especially widespread are buyback programs that offset the EPS dilution from employee stock option programs. In those kinds of situations, employee option exercises, rather than valuation, determine the number of shares the company purchases and the prices it pays.
Value-conscious companies repurchase shares only when the company’s stock is trading below management’s best estimate of value and no better return is available from investing in the business. Companies that follow this guideline serve the interests of the nontendering shareholders, who, if management’s valuation assessment is correct, gain at the expense of the tendering shareholders.
What’s so bad about focusing on earnings? First, the accountant’s bottom line approximates neither a company’s value nor its change in value over the reporting period. Second, organizations compromise value when they invest at rates below the cost of capital (overinvestment) or forgo investment in value-creating opportunities (underinvestment) in an attempt to boost short-term earnings. Third, the practice of reporting rosy earnings via value-destroying operating decisions or by stretching permissible accounting to the limit eventually catches up with companies. Those that can no longer meet investor expectations end up destroying a substantial portion, if not all, of their market value. WorldCom, Enron, and Nortel Networks are notable examples.
Many firms sacrifice sustained growth for short-term financial gain. For example, a whopping 80% of executives would intentionally limit critical R&D spending just to meet quarterly earnings benchmarks. Result? They miss opportunities to create enduring value for their companies and their shareholders.
At the corporate level, executives must also address three questions: Do any of the operating units have sufficient value-creation potential to warrant additional capital? Which units have limited potential and therefore should be candidates for restructuring or divestiture? And what mix of investments in operating units is likely to produce the most overall value?
Second, companies can reduce the capital they employ and increase value in two ways: by focusing on high value-added activities (such as research, design, and marketing) where they enjoy a comparative advantage and by outsourcing low value-added activities (like manufacturing) when these activities can be reliably performed by others at lower cost. Examples that come to mind include Apple Computer, whose iPod is designed in Cupertino, California, and manufactured in Taiwan, and hotel companies such as Hilton Hospitality and Marriott International, which manage hotels without owning them. And then there’s Dell’s well-chronicled direct-to-customer, custom PC assembly business model, which minimizes the capital the company needs to invest in a sales force and distribution, as well as the need to carry inventories and invest in manufacturing facilities.
Make acquisitions that maximize expected value, even at the expense of lowering near-term earnings. Companies typically create most of their value through day-to-day operations, but a major acquisition can create or destroy value faster than any other corporate activity.