Changing the Rules – Shareholder Value Exposed
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.