Shareholder value

The enduring power of the biggest idea in business

WHAT is the most influential contemporary book about the world economy? An obvious choice is “Capital in the Twenty-First Century”, a 696-page analysis of inequality by Thomas Piketty, a French economist. There is another candidate: “Valuation”, a 825-page manual on corporate finance and shareholder value. Some 700,000 copies of it encumber the bookshelves of MBA students, investors and chief executives around the globe.

Inequality and shareholder value are linked in the minds of many folk, who blame investors and managers for stagnant wages and financial crises. Ruthless corporations are a big theme in America’s election campaign. The near-collapse of Valeant, a drugs firm, seems to illustrate a toxic business culture. Its shares have fallen by 73% this year. It is restating its accounts and is in negotiations with its lenders and under investigation by regulators. Valeant describes itself as “bringing value to our shareholders”. While there is no indication of fraudulent or illegal practice, the company could end up joining a pantheon of corporate fiascos that includes Enron (which pledged to “create significant value for our shareholders”), Lehman Brothers, (“maximising shareholder value”) and MCI WorldCom (“a proven record of shareholder value creation”).

Yet the sixth edition of “Valuation”*, published last year, a quarter of a century after the first, is a reminder of why shareholder value is still the most powerful idea in business and why many criticisms thrown at it are unfair. The origins of the doctrine lie in the 1950s and 1960s, when Franco Modigliani and Merton Miller, two scholars, showed that a firm’s value is independent of its capital structure and dividend policy. That inspired a new framework for analysis, popularised in the 1980s by Joel Stern, a consultant, Alfred Rappaport, another scholar, and McKinsey & Co, a consultancy, among others.

Company analysis was antediluvian until then. Models were scribbled on paper covered in correction fluid. Profits were cheered, without much regard to the book-cooking done, risks taken and capital used to achieve them. The worth of a firm was estimated by placing its profits or book value on a multiple, whose value was best decided after a three-Martini lunch.

“Valuation” and a few books like it, offered new tools. Cashflow, not easy-to-manipulate accounting profit, mattered. An activity only made sense if capital employed by it made a decent return, judged by its cashflow relative to a hurdle rate (the risk-adjusted return its providers of capital expected). Two newish spreadsheet programs, Lotus 123 and Microsoft Excel, let analysts forecast firms’ long-term cashflows and gauge their present value today.

This breathed fresh life into an old idea—that shareholders had the whip hand. Technically, shareholders do not own a company: the firm is a legal person and a share represents a bundle of entitlements to dividends and voting powers. But a doctrine of “shareholder primacy” had been outlined in 1919, when a Michigan court observed that “a business corporation is organised and carried on primarily for the profit of stockholders”. The new science of corporate finance revolutionised the pursuit of that goal. Managers realised that by working out where firms employed capital and using it more efficiently they could increase their value. Outsiders had a methodology with which to second-guess incompetent managers.

These ideas lit up corporate America first. In the late 1980s and 1990s, profits relative to GDP were at historic lows and global competition intensified. Managers used the methodology of shareholder value to break up conglomerates and ditch weak business lines. The financial industry was deregulated, creating an army of number-crunchers to scrutinise firms.

By the turn of the century, big European firms were on board. Germany’s system of cross-shareholdings between financial and industrial firms was unwound: investors could buy the same exposure and did not need companies tying up capital. The jewels of French industry were privatised and their bosses obliged to think of profitability as well as impressing politicians.

Today shareholder value rules business. Abenomics, the plan to revive Japan’s economy, involves prodding firms to use capital better. Fosun, a private Chinese firm, devotes a page of its annual report to calculating the value it claims to have created. The only boardrooms that shareholder value has not reached are those of China’s state-run firms, whose party-appointed bosses look baffled if asked about return on capital and buzz for more tea.

Value cremation

Yet at this moment of ascendancy in the business world, shareholder value is under fierce attack beyond it, fuelled by a sense that Western economies are not delivering rising prosperity to most people. The criticism falls into two categories. The first is that shareholder value is a licence for bad conduct, including skimping on investment, exorbitant pay, high leverage, silly takeovers, accounting shenanigans and a craze for share buy-backs, which are running at $600 billion a year in America.

These things happen, but none has much to do with shareholder value. A premise of “Valuation” is that there is no free lunch. A firm’s worth is based on its long-term operating performance, not financial engineering. It cannot boost its value much by manipulating its capital structure. Optical changes to accounting profits don’t matter; cashflow does (a lesson WorldCom and Enron ignored). Leverage boosts headline rates of return but, reciprocally, raises risks (as Lehman found). Buy-backs do not create value, just transfer it between shareholders. Takeovers make sense only if the value of synergies exceeds the premium paid (as Valeant discovered). Pay packages that reward boosts to earnings-per-share and short-term share-price pops are silly.

Outbreaks of madness in markets tend to happen because people are breaking the rules of shareholder value, not enacting them. This is true of the internet bubble of 1999-2000, the leveraged buy-out boom of 2004-08 and the banking crash. That such fiascos occur is a failure of governance and human nature, not of an idea.

The second criticism is weightier: that firms should be run for all stakeholders, not just shareholders. In a trite sense the goals of equity-holders and others are aligned. A firm that sufficiently annoys customers, counterparties and staff cannot stay in business. Some bosses, such as Paul Polman of Unilever, and Joe Kaeser at Siemens, say that pursuing social and financial objectives is consistent. But it is disingenuous to pretend conflicts do not arise. A firm with a loss-making factory cannot shut it without destroying jobs.

The trouble is identifying a goal that could replace the pursuit of shareholder value. If firms had to promote employment they would be less productive and riskier borrowers, as China is discovering. The objective of maximising wealth is deeply embedded in the global savings system, with asset managers obliged to protect clients’ money. Asking firms to adopt objectives to solve inequality loads a giant problem on their shoulders.

For these reasons shareholder value—properly defined—will remain the governing principle of firms. It is still drawing recruits. In August Larry Page, the co-founder and boss of Alphabet (Google’s parent), reorganised the firm, partly to “rigorously handle capital allocation” and make a “return above the benchmark”. But shareholder value is not the governing principle of societies. Firms operate within rules set by others. Consequences of stagnation could include higher taxes, tougher antitrust policing, more regulation and more rules to protect jobs. How firms respond is an issue for the next bestseller to tackle.