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September 6, 2012


Changing the Rules – Shareholder Value Exposed

by Jeremy Arnone

Over the last three decades, the dominant mode of corporate economic thinking has been shareholder value.  A reaction to the corporate excesses and wastes of the 70’s and early ’80’s (see the gripping Barbarians at the Gate), this straightforward and seemingly commonsensical theory holds that the primary purpose of a corporation is to maximize the return received by its ‘owners’ – shareholders.

The general appeal of shareholder value is its simplicity:  Shareholder wealth is measured by a company’s stock price; through the collective wisdom of the market, the stock price captures a company’s short-term performance and long-term prospects; management is aligned with shareholders through the use of stock-based incentives; and the free market transforms corporate interest into society’s best interests.  On the surface, an entirely reasonable and logical approach, with the exception that every assumption is in fact false.

In Predictably Irrational, Duke professor Dan Ariely demonstrates that short-term thinking often dominates long-term thinking, even when the latter is more rationale and leaves us better off.  From eating a doughnut to buying an unaffordable car, the benefits of the short-term are clear, while the future costs – health issues, a deferred retirement – are ambiguous, hard to prove, and accumulate over time.  The conclusion is that humans are not the fully informed, highly rational beings assumed by market theory.  Confounded by contradictions, befuddled and bewildered, the only thing predictable about us is our irrationality.  To use Freud’s terminology, our id (the desire for immediate pleasure) dominates the superego (our conscience), despite our ego’s (rational self) best efforts.

We should be skeptical, therefore, of any economic plan that assumes individuals can properly balance the short and long term.  Indeed, the father of classical economics, Alfred Marshall, wrote in 1890 that individuals “act like children who pick the plums out of their pudding to eat them at once.”  Well-known economist, AC Pigou, opined in 1920 that, “Our telescopic faculty is defective.”  No matter how hard we squint, the future won’t come into focus.  And so we focus on what we can see, the short term.

By failing to incorporate these fundamental facts of human nature, shareholder value has led to a seemingly endless string of catastrophes.  From the frenzy of the housing bubble to the encouragement of highly dubious (and continuing) wagers in the financial industry, from extreme inequality of wealth, to BP’s Deepwater Horizon catastrophe, the singular focus on short-term shareholder value has had devastating consequences, not only for society but for shareholders themselves.  As Lynn Stout persuasively argues in The Myth of Shareholder Value:

In the quest to “unlock shareholder value,” management sell key assets, fire loyal employees, and cut back on customer support; drain cash reserves to pay large dividends and repurchase company shares, leveraging firms until they teeter on the brink of insolvency.

But if shareholder value is based on faulty assumptions (see here and here for powerful critiques and prescriptions), and has wrought such devastation, if even “neutron” Jack Welch now calls it “the dumbest idea in the world,” how has it lasted 30 years?  In Hans Christian Andersen’s The Emperor’s New Clothes, two charlatans create a suit of clothes so fine that they are invisible to anyone unworthy.  Though the emperor’s subjects think him mad, they all pretend to appreciate his new clothes; to claim otherwise would announce their unworthiness.  When charlatans set the rules, it’s easier to prolong a farce.

So if the despotic reign of shareholder value is ending, what will take its place?  Some argue that focusing on the customer is the place to start (see here, here, here).  Given what we know about individuals, can we expect them – in their roles as customers – to act in a collectively enlightened, long-term manner?  I have my doubts – for instance, a customer demand for the lowest prices has led in part to many objectionable practices by Wal-Mart, from outsourcing to bribery to below-subsistence wages.  And customers’ insatiable demand for fast, affordable, and tasty food has put a lot of dollars in McDonalds’ pockets while contributing to billions of dollars in medical expenses.

However, I think that individuals are the best focus when they are more fully informed and better organized.  What if we had an impartial scorecard to evaluate companies based on how they treat key constituencies – not just shareholders, but customers, employees, their communities, the environment?  And what if there was a way for us to organize ourselves, to express our satisfaction or dissatisfaction to companies in a way that mattered to them?  It’s unlikely that we as individuals can persuade companies to pursue non-profit motives.  However, it is in our power to control their profits, and hence, their behavior, by deciding whether to patronize them.  All we need is knowledge, a way to combine our influence, and the will to potentially sacrifice our short-term interest (convenience, price, etc.) for a better future for us and our children.  Groupon may fail, but it has unleashed a powerful idea, providing a blueprint for regaining our economic and social equilibrium.

17 Comments Post a comment
  1. Nancy Xu
    Sep 8 2012

    Didn’t realize how much SV has come under attack from reputable sources. About time, it’s been a disaster. Great links as well, thanks.

  2. Melissa Q
    Sep 8 2012

    Really like the idea at the end, using the groupon model as a starting point. Individuals have so little power compared to corporations, but only if we don’t organize.

    Understand your reservations on focusing on the customer but I think its the way to go personally.

    • Dec 28 2012

      The trouble with the Financial Services key word secrvies is they suck everything OUT of the economy they put nothing back in , like jobs or solid goods. not everybody can be a bond trader..they have unregulated for far to too long and i frankly am wanting punative damages filed against the scoundrels that suspenced laws , created new ones, to allow for breaking the common sense of the bedrock of any economy – being money good. balancing the books. Where exactly is this money gonna come from the ether. . The whole thing needs to melt down so it can be rebuilt thats how bad free reign Freidman Economics and the Shock Doctrine is but if we know we are being shocked We will NOT allow the draconian cutting of all social secrvies as is their plan to privatize everything.. disclaimer i am sorry for all the people who are hurting because of this but many of us were writing about this over a yr and half ago -my words for it are this what is HERE is NOW and is gonna continue , regardless of so called bail out is gonna make the GREAT depression LOOK LIKE A BAD MOOD. We must regulate speculators , get back to sound accounting and accountability and to think these NEO LIBS and CONs same beast would not cough up a few million to ensure children.. We need to clean house entirely in Washington.

  3. Sequel
    Sep 8 2012

    You’ve hit upon the forgotten secret of why the free market economy is a success. Because it is supposed to have a human component. Until around 1990, companies took pride in being good members of the community, or of making an excellent product that others envied, or of having built an amazing workforce … in addition to being profitable.

    With the fall of Communism, it seemed as if the free market became a soulless, money-obsessed culture in which the owners’ ability to manipulate the stock price had to be expanded at the expense of any other thing — most especially product quality. It is no accident that the Bain & Co ethic triumphed during this era, and corporations suddenly began to rival government by trumpetting the the need to dismantle government as a prerequisite to protecting individual freedom.

  4. KevDog
    Sep 8 2012

    I’ve always felt that the central problem with the focus on shareholder value is that it allows executives to morally distance themselves from the human costs of their decisions. Case in point: companies laying off workers while making huge profits because it will boost the share price. (Hello, Caterpillar).

  5. gm
    Sep 8 2012

    I doubt if the problem is in the share price maximand. There is a serious problem in corporate governance, and a serious lack of decency among senior execs. Directors do not control very well–they are very well compensated for supporting management. They are the ones who have authorized bonus/option programs that permit execs to enrich themselves by manipulating share price. Couple this with auditors more concerned about repeat engagements than truth, and CEOs who see nothing wrong in taking all they can get (200 x median employee pay, or more), and there is a situation that, unfortunately, is probably going to require more intense government regulation. One possible approach to remedy that would not intrude on the internal affairs of the company would be a sharply progressive income tax, that reduced the attractiveness of short-term gains.

  6. Sep 8 2012

    I think we give too little credit to consumers if we presume they will only act in their own best interest (e.g. lower prices). I have seen time and time again that many customers ask for improvements to products, more accountability from brands and an honest conversation about what’s on the roadmap. In grade school teachers often remind students that if a question pops into their head, it’s likely popped into the heads of several other students – so go ahead and ask. When a customer is engaged enough to ask for a product update or to flag a potential issue, you can rest assured that they are not alone in that request, they are just the only person to raise their hand (so to speak). With this in mind, the idea of an impartial scorecard is a much more accurate measure of a brand’s long term health because it takes into account something that shareholder value does not: loyalty. Brand loyalty is becoming increasingly important as consumers have upwards of 10 choices for everything from toothpaste to car repair and short-term, er, short-sighted decisions that have a positive effect and leave shareholders celebrating, may erode a brand’s long-term value. This is an opportunity for companies to train consumers to become more enlightened. By creating a feedback loop and actually applying customer insights, consumers will start to see that shouting for lower prices is less effective than telling a brand how to improve their offering. Most people will happily pay a reasonable price for a product or service they value and for a brand that they feel is aligned to their needs.

  7. Dec 22 2012

    Thanks for your personal marvelous posting! I actually enjoyed reading it, you could be a great author.I will ensure that I bookmark your blog and definitely will come back at some point. I want to encourage one to continue your great job, have a nice evening!

  8. Dec 25 2012

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  9. Feb 15 2013

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  10. Feb 15 2013

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  11. Feb 16 2013

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