In their July 2016 Harvard Business Review article, “Reclaiming The Idea of Shareholder Value,” business school professors, Michael Mauboussin and Alfred Rappaport, attempt to rescue American business from its love affair with short-termism and maximizing shareholder value as reflected in the current stock price—an idea that even Jack Welch has called “the dumbest idea in the world.”
The need for a reclamation is certainly there: As the professors say, “Investors and others ask why companies binge on buybacks while skimping on value-creating investment opportunities… most public companies have extensive governance procedures but no governing objective.” And as The Economist recently declared, shareholder value is still “the biggest idea in business.”
But by limiting the possible options and misreading the evidence they cite, the distinguished professors from Columbia Business School and Northwestern University’s J.L. Kellogg Graduate School of Management fail to solve the problem. As Peter Drucker wrote, “there is only one valid purpose of a corporation to create a customer.”
Missing The Solution
The article begins by fatally limiting the possible choices into “two camps”:
The first believes the company’s goal is to maximize shareholder value. Countries that operate under common law, including the United States and the United Kingdom, lean in this direction.
The second advocates that the company balance the interests of all stakeholders. Countries that operate under civil law, including France, Germany and Japan, tend to be in this camp.
The professors miss the third option enunciated by Peter Drucker as long ago as 1954: that the purpose of a firm is to create a customer by continuously delivering value to customers, as shown by the experience of firms like Apple, Google and Amazon.
Reclaiming Shareholder Value?
The professors try to reclaim the idea of “maximizing shareholder value” as the goal of the firm by suggesting that it has been “hijacked by those who incorrectly believe that the goal is to maximize short-term earnings to boost today’s stock price. Properly understood, maximizing shareholder value means allocating resources so as to maximize long-term cash flow.”
The suggestion is thus that the true goal of the firm is to maximize the discounted value of long-term cash flow. The practical problem is that no firm can make day-to-day decisions based on the discounted value of the long-term cash flow implications of each individual decision.
Or as The Economist put it more precisely in its recent article: “the capital employed to make a decent return, judged by its cash-flow relative to a hurdle rate (the risk-adjusted return its providers of capital expected).”
Come again? If you didn’t immediately grasp that last paragraph, you are not alone. As the same article in The Economist makes clear, most CEOs don’t have the understanding or the financial smarts to master and implement that last paragraph either.
The reality is that although a measuring “the discounted value of long-term cash flow,” or “the capital employed to make a decent return, judged by its cash-flow relative to a hurdle rate” may be entertaining to test the mental dexterity of students in a business school setting, neither is a practical goal to adopt for day-to-day decision-making in a real business.
What happens in practice if a firm espouses such a goal, as a recent study by a Credit Suisse (“Capital Allocation—Updated”) makes clear, is that most key decisions are based on the reputation of the executive making the investment proposal and the CEO’s “gut feel.” Since the C-suite is hugely compensated for increases in the current stock price, guess what the “gut feel” tells the CEO? Decisions that boost the current stock price typically win the day. As the employees become aware that “long-term shareholder value” means the same thing as boosting the current stock price, the firm gets on the short-term shareholder value treadmill, rather than making new investments. When this happens on a large scale, the economy begins to suffer from “secular economic stagnation.”
Multiple Goals Don’t Work Either
The HBR article rightly points out that balancing multiple stakeholder interests is not a solution either: “it cannot serve as a company’s singular governing objective because it is impossible to simultaneously satisfy the interests of all stakeholders. In the absence of a singular governing objective, executives are free to decide as they see fit and to balance those interests however they think is right. And without knowing how managers decide, it is almost impossible to hold them accountable for what they decide.”
The attempt to satisfy multiple stakeholders was prevalent after the publication in 1932 of The Modern Corporation and Private Property Adolf Berle and Gardiner Means. The result was that many big firms had multiple goals and had become unfocused on performance. They began to resemble “garbage can organizations” that were confused and ineffective.
Thus in 1972, a trio of academics–Cohen, March and Olsen—explained that pursuing multiple goals caused organizations to operate on the basis of “a variety of inconsistent and ill-defined preferences.” As a result, the organization’s “own processes are not understood by its members; ... choices are made only when the shifting combinations of problems, solutions, and decision makers happen to make action possible… Poorly understood problems wander in and out of the system,” as “decision-makers have other things on their mind.”
Wrong Goal: Shareholder Value
Despite its flaws, shareholder value dealt with these problems in a fashion by creating a single unifying goal that could be understood throughout the whole organization and so overcome the "garbage can" syndrome.
The idea of having a single unifying focus therefore was good. Unfortunately, the goal chosen was bad.
In its sophisticated form of “long-term discounted cash flows,” it is unimplementable. And in its bastardized form as “the current stock price,” it leads to rampant short-termism, excessive share buybacks to the neglect of investment, skyrocketing C-suite compensation and misallocation of resources in the economy.
Misinterpreting Amazon
Curiously, the professors cite Amazon to support their case. “Take a look,” they say, “at the letter to shareholders that Jeff Bezos, founder and CEO of Amazon.com, wrote to shareholders in 1997. He states that the ‘fundamental measure of our success will be the shareholder value we create over the long term.’”
“Not only has Bezos been clear about the company’s objectives from the beginning, the company reprints the 1997 letter every year to reinforce the message. Bezos notes, ‘As far as investors go, our job is to be super-clear about our approach, and then investors get to self-select.’”
It’s true that Bezos has been super-clear about Amazon’s approach from the beginning, but only to those who actually read what he wrote.
What the professors miss is that Bezos is talking about the measure of Amazon’s success, not its goal. Long-term shareholder value, says Bezos, “will be a direct result of our ability to extend and solidify our current market leadership position. This value will be a direct result of our ability to extend and solidify our current market leadership position. The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.” (emphasis added)
Bezos could hardly be clearer. At Amazon, shareholder value is the result, not the operational goal. Amazon’s operational goal is market leadership.
“We first measure ourselves,” says Bezos, “in terms of the metrics most indicative of our market leadership: customer and revenue growth, the degree to which our customers continue to purchase from us on a repeat basis, and the strength of our brand. We have invested and will continue to invest aggressively to expand and leverage our customer base, brand, and infrastructure as we move to establish an enduring franchise.”
And also: “We will continue to focus relentlessly on our customers. We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.”
Moreover, Bezos goes on to explain how Amazon “obsesses over customers.”
“From the beginning, our focus has been on offering our customers compelling value... We maintained a dogged focus on improving the shopping experience. Repeat purchases and word of mouth have combined to make Amazon.com the market leader in online bookselling.”
Confusing Goals And Results
Confusing goals and measures is a harmful but common practice. The learned professors should perhaps pay more attention to Charles Goodhart's law: "When a measure becomes a target, it ceases to be a good measure.”
This is precisely what has happened with maximizing shareholder value. What was potentially useful as a measure—shareholder value—has become a goal. Once the measure becomes a goal, it ceases to be measure. Instead of reflecting a corporation’s true value, the stock price today has come to represent the outcome of large-scale financial engineering, with gargantuan stock buybacks and dividends artificially boosting the stock market.
A Retreat Into Academic Neutrality?
In the end, the professors retreat back into academic neutrality, “Our solution,” they say, “dwells not on which governing objective a company should select, but insists that the company be clear about what it is trying to do.” But talking as though it doesn’t matter which goal the company selects misses the point.
Maximizing shareholder value remains “the world’s dumbest idea.” Peter Drucker was right back in 1954: the only valid purpose of a firm is to create a customer. It's a pity that these insights have yet to reach our leading business schools.
And read also:
The Economist Defends The World’s Dumbest Idea
Salesforce Slams The World’s Dumbest Idea
How Corporate America Is Cannibalizing Itself
Big Firms Increasingly Resort to Corporate Cocaine
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