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Leadership & Organisations

Debate: Should Business Schools Teach Students to Maximise Shareholder Value?

Chris Howells, Editor, INSEAD Knowledge |

Since the financial crisis, the merits of shareholder value maximisation have been called into question. Is it the most effective path for sustainable business growth or should we consider alternatives?

The idea that the objective of the firm is to maximise shareholder value has become the centre of fierce debate. It has been blamed for creating short-term incentives that force companies to take unneccesary risks and for contributing to a widening wealth gap.

Even Jack Welch, the former CEO of General Electric and widely regarded as the personification of the idea that the firm's purpose is to maximise shareholder returns has called it the "dumbest idea in the world".

Proponents, however, point to the risk that shareholders take when investing their money in firms. They maintain that companies must be attractive to raise capital and must remain nimble in an increasingly competitive landscape. Prompting the question, should shareholder value maximisation be the aim or the byproduct of a competitive pursuit of economic gains for firms?

In the following in-depth articles, our experts debate whether students should only be taught shareholder value maximisation as the purpose of the firm or whether it is time to consider alternative models that could be more effective at achieving sustainable business.

"We should teach our students that there are alternatives to the view that the purpose of business is shareholder value maximisation" 

David Rönnegard, INSEAD Visiting Scholar & N. Craig Smith, the INSEAD Chaired Professor of Ethics and Social Responsibility 

Educational and professional institutions have significant influence in setting norms for legitimate organisational practices. In this sense, business schools play an important normative role when they convey the paradigms through which managers should analyse the corporate environment. If business school students only get taught that shareholder value maximisation (SVM) is the purpose of the firm, then this is the most likely lens through which they will see their future professional roles.

What is often left out from such a lesson is that profit is not the same as shareholder value and furthermore directors are unlikely to face a legal requirement to maximise shareholder value. Intellectual honesty demands that this be taught. CONTINUE READING 

 

"Maximising value for shareholders is the best way for firms to stay competititve and sustainable"

Theo Vermaelen, INSEAD Professor of Finance

In a recently published paper Craig Smith and David Rönnegard argue that business schools should teach stakeholder value maximisation, on equal footing with the current practice which focuses on shareholder value maximisation. Their argument is basically a legal one, arguing that recent changes in legislation no longer specify that board members have a fiduciary responsibility to maximise shareholder value. They also point out the existence of so-called B-corporations (Benefit corporations) in the U.S. who make the explicit promise to make a positive impact on society at large. 

However, in our finance courses we don’t teach shareholder value maximisation because it is a legal obligation. We teach it because other objective functions are not sustainable in a world with a competitive labour market for CEOs and a competitive market for goods and services.  CONTINUE READING

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Comments
Steven,

Rönnegard and Smith make the point that the definition of shareholder value should be enlarged to encompass a wider set of metrics, so that can be created for a wider set of stakeholders than merely the shareholders.

Theo Vermaelen argues that they are wrong: a) their argument is fundamentally out of step with the realities of business, and b) maximising shareholder value per definition requires taking a long-term view.

However, in that senses, Vermaelen commits the same sin that he accuses Rönnegard and Smith of: The free market immune system is as likely to destroy firms that attempt to maximise shareholder value in the long term by eschewing short-term returns as it is to destroy firms that pursue an enlarged definition of what that value ought to be.

Essentially, these two concepts represent different problems of optimisation.

The problem with trying to optimise a basket of stakeholder values is that it does not work. You can only optimise for one metric at a time; all others measures must necessarily be subordinate to it. Essentially then, you optimise nothing, which prompts the market to chew you up. And if you do not stay in business, you are creating no value at all.

The alternative is to optimise one thing, and you might as well choose a metric that is ostensibly most likely to assure the long-term survival of the firm: shareholder value. The problem with this approach becomes evident when corporations start trading long-term value (the global optimum) for short-term value (the local optimum). It is a problem of temporal occlusion – we cannot see far enough into the future to make globally optimal choices. And even if we could, we would probably not be able to convince the market that we are right.

Neither concept is completely right. Both are just fragments of a more fundamental solution. Yet given the terrible predicament that our planet is in, from rotten economies to global warming, it is unambiguously clear that such solution must be found at all cost.

The answer lies deeper than we want to admit. It cannot be solved by simplistic admonitions of shareholder or stakeholder value. It requires us to change the very fabric of the system in which our corporations operate. We must change the way that the system rewards companies for doing good and not just doing well, by providing incentives that deliver real, short-term, bottom-line results.
This still does not give us a crystal ball, but it does provide a way for companies to optimise shareholder value in a way that also creates stakeholder value.

Mirjam Staub-Bisang,

As a board member of INSEAD I feel very strongly about this issue.

If business schools teach students to optimise long-term shareholder value they teach them to optimise stakeholder value too. Long-term stakeholder value optimises long-term shareholder value. There are enough academic studies, which confirm that and many examples in the corporate world. And here I am not speaking of lovey-dovey, touchy-feely corporate social responsibility actions but rather the successful integration of sustainability considerations into corporate strategy and processes which increase shareholder value through better risk management and taking advantage of business opportunities presented by sustainability challenges. Shareholders are a stakeholder like employees or the local community or the environment.

Should we teach B-school students the concept and the benefits of stakeholder value optimisation over shareholder optimisation? Yes, of course we should, as it is the responsibility and the business case of B-schools today to educate the leaders of tomorrow and to prepare them for a successful corporate career or entrepreneurs. As the corporate world is moving into the direction of stakeholder value optimisation as we see it with large corporates, such as Unilever, who embrace the concept of stakeholder value, it is important to prepare B-students for that new corporate reality. These corporates will hire many B-school graduates.

Moreover, more and more of the world’s largest institutional investors (pension funds, sovereign wealth funds) are embracing the concept of responsible/sustainable investing and consider sustainability criteria in their investment process. As they are long-term investors they will identify and invest in companies who are managed for long-term stakeholder and thus long-term shareholder value and not only for short term shareholder value at the cost of stakeholder value. Some companies even incentivise their long-term investors with financial benefits, such as loyalty shares which are issued by a number of leading French companies such as L'Oréal, Air Liquide or Michelin.

If B-school graduates want to play a role in the game they need to know the rules of the game. And the game is different from the eighties and the nineties, when the guru of shareholder value, the Harvard professor, Michael Porter, was teaching shareholder value only. He has moved on since then. I still remember the defining moment at the WEF 2010 when Porter was presenting his concept of shareholder value to the business community and received a standing ovation. If leading academic thinkers and business leaders change their mind, I believe there is some value to it and I hope other academic in business schools will realise that and teach their students accordingly.


And should we teach b-school students the concept and the benefits of stakeholder value optimisation over shareholder optimisation? Yes we should. It is the responsibility of b-schools today, as they educated the leaders of tomorrow. As the corporate world is moving into the direction of Stakeholder value optimisation as we see it with large corporates, such as Unilever, who embrace the concept of stakeholder value, it is important to prepare b-students for that new corporate reality. These corporates will hire many b-school graduates.

Theo,

Dear Myriam

Good to hear from you!

First, there is no such thing as short-term shareholder value. Per definition shareholder value has an infinite horizon. I understand that many people are confused about this as they confuse shareholder value with the stock price or profits. For example, I contacted the IR manager at Unilever and asked him whether I should avoid the stock considering the anti-shareholder value statements made by the CEO. He kind or argued that the CEO was talking about short term profits, not shareholder value.

Second, in a DCF spreadsheet we incorporate expected cash flows and risk. Your argument seems to be that we should incorporate risks related to sustainability to make sure we properly measure shareholder value. Of course when you put the discussion in this framework there is no inconsistency between stakeholder value and shareholder value maximization. However, reasonable people can have different opinions on how to assess risk. You may argue that investment in fossil fuels is more risky than investing in green energy because expected costs of regulation to fight global warming. However, I could also argue the opposite : the alternative energy survives thanks to subsidies and regulation that blocks the development of shale gas in Europe. These subsidies lead to higher energy costs and taxes, reduce European competitiveness and employment. Now, people are willing to bear this cost because they believe they are saving the planet for future generations. But there is also a risk that people start doubting the validity of climate science. There has been no statistically significant global warming for 18 years, a fact known by climate scientists ( and referred to as "the pause" ) but largely hidden from the public, at least in Europe. Insurance companies have made record profits in recent years (just ask Warren Buffett) because the number of disasters have fallen signficantly, in contrast to the predictions of climate change models. So there is a risk that people stop believing that they are responsible for climate change, which means the end of the green energy subsidy stream. That is also a risk that should be incorporated in the spreadsheet, I think.

Third, my critique is on those who want to lower shareholder value to benefit other stakeholders, i.e. the balancing act. The problem I have with this is that don't know how to do this balancing. Investing in green energy may be less profitable than alternative energy but it benefits future generations. But current generations pay higher taxes and energy prices. So how am I to choose between these different people ?

Finally I doubt that shareholder value maximisation is a concept that is going out of fashion.Just today the FT announced that Vanguard who manages $ 3 trillion "seeks board-rooms shake-up". They complain that "board members are not engaged enough with shareholders as they should be". So I think board members who want to keep their jobs should learn how to make shareholders happy, which is what we try to teach,

Connor Barry,

Dear Theo,

I've already recently publically pointed out your error in making completely unfounded claims of fact that "there has been no warming in 18 years", which you based on propaganda from Climatedepot, a US fossil fuel sponsored political blog, and data cherry picked from REMSS.com, a science research institute, rather than the broad physical empirical evidence. To repeat from our previous discussion, please read what the Chief Scientist of REMSS, your reference says on your interpretation of their data:
http://www.remss.com/blog/recent-slowing-rise-global-temperatures

"Does this slow-down in the warming mean that the idea of anthropogenic global warming is no longer valid? The short answer is ‘no’. The denialists like to assume that the cause for the model/observation discrepancy is some kind of problem with the fundamental model physics, and they pooh-pooh any other sort of explanation." "The denialists really like to fit trends starting in 1997, so that the huge 1997-98 ENSO event is at the start of their time series, resulting in a linear fit with the smallest possible slope."

There has never been a single published peer reviewed paper making the finding you claim for the good reason that it is a fiction. In contrast, there is a large body of published research on the increase in ocean temperatures, reduction in glacial volumes, time lags in suface air warming, decrease in Arctic polar ice caps, decrease in Antarctic land ice, increase in Antarctic sea ice, increase in drought, change in biodiversity, change in bio-migration patterns - all as or above predictions by the last 6 decades of climate science.

It may be harsh but I find it deeply inappropriate for someone of your standing to propogate as "facts" statements which have no basis in the empirical evidence, particularly when presented so recently with what the empirical evidence is.

A lack of foundation in fact also serves to weaken the overall thrust of your argument, and undeservedly so.

Connor

Connor Barry,

Dear Theo

I agree with you - there should be no such thing as short term shareholder value. However, from my experience working in Finance for large companies (Google and Cisco) and smaller 20-50 employee companies, where I worked directly for the shareholders, I would have the following observations:

1. The voice of the Shareholder (the Board and market analysts, or even shareholders themselves) apply a DF which is significantly higher than the WACC of the company - that is to say they demand, appreciate and reward returns in the 1-4 Q term much higher than they do 2-3 year term, with rewards > 3 years almost completely discounted, and treated as an incidental nice to have. The result is a focus on ST profitability. Larger companies such as Google or Cisco may have side LT projects when budget provides, but these are seen by employees and managers as incidental to the core business activity of ensuring an uptick in the ST business run rate. Even the strategy function is largely focussed on the ST GTM strategy rather than LT return maximisation and risk mitigation. It is a brave manager/CEO who defies that voice to say they know better than the market/board on how to maximise shareholder value - they normally have more information than the shareholder, so are potentially better placed to make that call - but ceding all decision making on "what is true shareholder value" leaves you wide open to agency cost. So it's not that simple.

2. "Reasonable" individual shareholders may not be rational in pricing risk. Typically they inflate the value of return and discount the downside of risk in the messaging provided to managers and in the information sought from management. The need to produce return for shareholders is embedded in the messaging and reward structures for all staff across the organisation, and virtually all KPIs across the organisation, whereas risk management and the documentation thereof is a small subset of the finance or strategy functions.

A large % of smaller companies, which make up >90% of companies in absolute termsm are invariably run by entrepreneurs whose DNA is to be blind to risk. Even as majority shareholders, they inflate their perception of their own abilities, and discount the risks.

Finally, an irrational shareholder or manager, who for example, based on ideology rather than a basis in empirical evidence, exaggerates the risk of error in the scientific consensus will destroy shareholder value by leading the corporation down a path with higher existential risk for the company. We are seeing this currently in the reports of Exxon Mobil and others who underestimate the risk of stranded assets on their balance sheets. Indeed, I understand the Bank of England is currently undertaking an equiry into this matter: http://www.parliament.uk/documents/commons-committees/environmental-audit/Letter-from-Mark-Carney-on-Stranded-Assets.pdf

Again, as a manager working for such a shareholder, it can be very difficult to push against the shareholder in the shareholder's best interests.

3. I think there is definite merit in your balancing act argument - it is very difficult when faced with decision making between two conflicting aims. However, again from experience, I would observe that the lifeblood of managers is an ability to make decisions between multiple competing courses of action, all of which have opportunity costs. As it is, I need to make a decision between the perceptions of what is "shareholder value" from my homelife, my peers, my boss, the CEO, my Board, my Analysts, and above all the voice of what my head says is the best thing to create shareholder value, all of whom may reward me in different ways, based on each of those party's different versions of what constitutes shareholder value. Simply by telling MBA students that their job is to maximise shareholder value is pointless because
- most of the time it's not clear exactly what that is
- even if that's exactly what the employee isn't doing, because of all the conflicting voices, that can't be proven until significantly after the fact, at which stage it's too late to correct the error.

On the basis of portfolio theory, and the fact that the corporation exists within a market, within a society, with an environment, rather than the other way round, imparting a broader awareness of all stakeholders who interact with the corporation would seem more prudent than a singular arguably unattainable focus on the mythical rational investor?

Connor

Theo,

Dear Connor

The "global warming hiatus" is now so well established that it has its own Wikepedia website. From this website I quote Bill Collins of Lawrence Berkeley National Laboratory lead author of the modelling Chapter 9 of the fifth IPCC report :

"Now, I am hedging a bet because, TO BE HONEST WITH YOU, if the hiatus is still going on as of the sixth IPCC report, that report is going to have a large burden on its shoulders walking in the door because recent literature has shown that the chances of having a hiatus of 20 years are vanishingly small "

So honest scientists admit there is problem with their models, which implies in my DCF world a high risk of betting on green energy subsidies in the long run.

Now your comment on shareholder value argues that people don't incorporate the long run in their forecasts. That may well be but fiinance profs can't help it if MBAs don't take our advise. Although if people dont care about the long run, why is Tesla's market cap $ 28 billion ? Why did internet stocks trade at huge multiples of short term performance measures in 2000 ?

DCF proviides a tool to make decisions. Garbage in, garbage out. My argument is about the tool, not the quality of the inputs.

Theo

Abel,

Maybe we should distinguish between publicly owned firms and privately owned firms.

Publicly owned firms mostly have non-controlling shareholders who are not involved in the business. Running the business is left too management. This is where all the agency problems result from. As an example, the short-termism of public co shareholders and the incentive structures of the management agents is such that we see a lot of share buy-backs, returning cash to shareholders and more worryingly, this is increasingly financed by debt. This makes the business more risky by stealth. This is short-term SVM and the resulting lack of investment puts the sustainability of the firm at risk. A stakeholder model governance structure could be appropriate for publicly listed companies to compensate for the drawbacks of short-termism and the agency problem.

Private companies on the other hand, often have controlling shareholders that hold other values than SVM, because these shareholders are known, and apart from being shareholders also have a stake in the community and/or have a reputation to be concerned about; they inherently apply stakeholder philosophy in the way they run the business. Often less agency problems as there is less division between shareholders and management. No need to teach these fish how to swim.

SVM can work well for privately owned firms as

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