Thursday, February 09, 2012

Shareholder Value Maximization Is Not Good for Society

Between 1960 and 1980, CEO compensation per dollar of net income earned for the 365 biggest publicly traded American companies fell by 33 percent. CEOs earned more for their shareholders for steadily less and less relative compensation. By contrast, in the decade from 1980 to 1990 , CEO compensation per dollar of net earnings produced doubled. From 1990 to 2000 it quadrupled. 
Meanwhile real performance was declining. From 1933 to 1976, real compound annual return on the S&P 500 was 7.5 percent. Since 1976, Martin writes, the total real return on the S&P 500 was 6.5 percent (compound annual).  The situation is even starker if we look at the rate of return on assets, or the rate of return on invested capital, which according to a comprehensive study by Deloitte’s Center For The Edge are today only one quarter of what they were in 1965.
Steve Denning
Denning in an article in Forbes magazine in 2011 argued that "shareholder value management" movement of the last quarter of the 20th century was very destructive. The movement was based on a theory that corporate managers should manage a firm to maximize the value of the shares of its shareholders. The theory went further to suggest that compensation of the top managers should be based on the increase in shareholder value.

There are some tricky details to work out in applying such a theory. Which stakeholder values are to be maximized? Do you maximize the value for the long term holder at the time she sells her stocks in the company, or do you maximize the value for the short term holder who plans to sell after the next annual report of the company is released? And what financial incentives to the managers will encourage the greatest increase in stockholder value?

I have argued in the past that the investors who hold stock in a company are not the only investors in the company. The employees have made investments in their own persons, and the human capital thus created is placed in the service of the company for which they work. There are investments in the markets, both input and output, on which a company depends. Government invests in public infrastructure on which the corporation also depends. As an example, consider a corporate management which channels all the growth of the firm into shareholder value, without channeling a fair amount into staff value. Will that firm not lose staff and find it difficult to recruit new staff members of comparable capabilities? Will that firm not thereby lose human capital?

We should also consider externalities. Somali pirates might be seen as prototypical maximizers of shareholder value, since the ransom that they obtain from hijacking a cargo boat is hugely more than the capitalization of their enterprise. Obviously, there is no value created by the pirate, only a cost to the global society. Consequently. societies seek to eliminate the pirates.

Many financial firms at the turn of the 21st century were taking large risks in order to maximize shareholder value (and to maximize managerial remuneration). The cumulative impact of all that risk taking was a financial crisis that resulted in high levels of unemployment, the Great Recession, and considerable pain to the public, not to mention the required bailout and stimulus packages from the government and loss of tax revenue to the government.

Certainly one of the roles of government policy is to find ways to internalize such externalities, or to regulate them away. One way to get management to consider the investments of the corporate workforce in determining its policies is to put worker representatives on corporate boards. So too, limiting the amount of risk that financial firms can take must be considered. At the very least, governments should prevent the Bernie Maddoffs of the world from emulating the Somali pirates.

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