The idea of “maximizing shareholder value” (MSV) has been in the news a lot lately (see here and here). This is an idea generally associated with free market capitalism that states corporations should be run primarily for the purpose of maximizing the value they create for owners. This might not seem like a controversial idea, but many commentators argue that this mentality leads corporations to do bad things like overpaying executives, issuing options-based compensation, buying back shares, forgoing potential investment/innovation, paying workers too little, etc. All of this supposedly makes the economy worse off than it otherwise should be. Let’s look at this idea more closely and see how valid the criticism is.
What Does it Mean to Maximize Shareholder Value?
As Michael Mauboussin has explained, there is A LOT of confusion over this topic so let’s start from the beginning.¹ First, a basic definition:
Maximizing shareholder value is the idea that firms should operate in a manner in which shares will reflect higher expected future values.
Basically, businesses should be run to make their business as attractive as possible to current AND future potential shareholders. Importantly, share price and business operations are not the same thing. So businesses should be run to maximize the value of the firm and if the firm builds value then the share price should reflect this.
Companies do lots of things in the course of creating value, but at the end of the day a sustainable firm is in the business of generating a profit. So while there are many tangential things a corporation can do to create value the creation of profits and a sustainable underlying business is the essential component of creating shareholder value. And companies maximize profits by selling goods and services to customers. If you build a company that provides valuable goods and services then you will likely earn high profits and value for shareholders. So, we should be clear that “maximizing shareholder value” is primarily, in the long-term sense of business viability, logically equivalent to maximizing value to customers.
Of course, capitalism isn’t always an idealistic system. To screw up a Winston Churchill quote, it is the worst system aside from all the rest. Corporations sometimes do things that the rest of us might not like so much. They sell things that kill people (like guns, cigarettes and delicious cheeseburgers). They lobby government officials to make the rules better benefit themselves. They pay themselves huge gobs of money while sometimes making egregious mistakes. You get the point.
Capitalism is an imperfect system. But its inherent competitiveness weeds out those who cannot provide long-term value to shareholders. At the same time it also works to incentivize people to do things that others find valuable. Importantly, if there was no profit to be made then there would be no incentive to produce valuable goods and services. And since profit is the residual (goal) of adding value to customers’ lives then maximizing shareholder value is an aggregate good.
The key point here is, at its core it is illogical to argue that MSV is bad because this must mean that it is bad to provide value to customers. But this does not mean that all of the things corporations do in the process of maximizing shareholder value are good. But we should be clear – these are not critiques of the general theory of MSV – they are specific critiques, tangential to the core theory of MSV, about how to best run a business. Let’s explore some of those criticisms:
Criticism #1: MSV Causes Business Operating Short-Termism (not to be confused with asset allocation short-termism).
As we emphasized before, the core driver of value creation is profit creation. Since share value is the present value of future cash flows it is illogical to argue that MSV causes short-termism because the stock market is an inherently long-term instrument. In fact, a corporation is a perpetual instrument. It has no end date like a bond. As a result, a company that cannot create long-term sustainable value will cease to exist. This is a good thing as a firm that abuses its shareholders will die. If firms distributed all cash flow without investing a dime in ongoing operations they would cease to exist. So, if MSV creates short-termism then these firms are opening the door for other firms to become more competitive and capture value from them. If this is happening then we should applaud the slow death march of these firms.
But we should emphasize the temporal misconception at work here. Again, a firm is a perpetual entity. A firm that focuses on consistently beating short-term expectations must, by definition, be operating to meet long-term expectations as its long-term viability is a function of its short-term actions. Firms that engage in financial engineering and what is purportedly excessive short-termism will become less competitive and will cede market share to more innovative and productive firms. For more on this temporal inconsistency I highly recommend reading Cliff Asness on this subject.²
Most importantly, I would argue that the critics have this one backwards. The problem in today’s world is not that firms are being too short-term oriented. They are being too long-term oriented. That is, they are hoarding cash in record amounts waiting for a rainy day that never seems to be coming. Firms are being prudent and corporate balance sheets have never been healthier. As a result, they are investing too little and distributing too little to shareholders. The result is excess savings at the corporate level which is reducing aggregate demand and household savings.
Criticism #2: Buybacks and dividends Are Bad!
In a perfect world corporations would never feel the need to distribute cash to shareholders. They would all find optimal investments, shares would reflect the high rates of return on these investments and shareholders could distribute cash to themselves in the form of share sales. This, of course, is not the world we live in. Companies often find themselves with more cash than they know what to do with so they effectively say “here, you take this because you might have better ideas about what to do with it than we do”.
Companies return cash to shareholders in two primary ways: dividends and share repurchases. As Michael Mauboussin has reminded us, time and time again, buybacks and dividends are the same basic thing (all else equal) except that dividends incur a higher tax rate than share buybacks.³ There is widespread misconception that dividends are somehow better than buybacks when, in reality, they are very similar except that the dividend incurs a payment to Uncle Sam.
Importantly, cash distributions in the form of a dividend add to aggregate corporate profits (assuming households do not save more of this income) so while a cash distribution appears like giving away cash at the single entity level, it is a distribution to other corporations at the aggregate level.4 Therefore, it is a fallacy of composition to argue that cash distributions in the form of a dividend are bad as they are little more than corporations giving cash to shareholders to invest or consume on their own.
Buybacks are bit more murky. They have grown in popularity in recent decades because of the more favorable shareholder tax treatment than dividends, however, there are many (often false) assumptions that go into implementing buybacks. The primary assumption firms make is that their shares are inexpensive. If the expected return of a buyback is > cost of equity divided by the ratio of the stock price to intrinsic value then the buyback makes sense. On the other hand, buybacks implemented at high valuations can be bad for shareholders. Firms oftentimes overestimate the value of their shares resulting in widespread losses for shareholders. So the criticisms of buybacks hold more water than others, however, they too are generally overdone.
The bottom line is that distributions are the result of a lack of good investment options. If firms can’t find good investment options then returning capital (so shareholders can spend it and invest it) is a good thing! Whether this is done in the form of dividends or buybacks is an important entity level decision, but again, it is an entity level critique and not a MSV critique.
Criticism #3: Stock Based Compensation is Bad!
There is vast empirical evidence showing that stock based compensation improves corporate performance. It better aligns the interests of workers and owners by turning workers into owners. Strangely, some critics argue that this results in inequality when in fact the whole purpose is to turn the labor class into the capitalist class by paying them in the form of equity. This argument is also intertwined with the “short-termism” myth which we have already covered.
The fair criticism here is that stock based compensation, like buybacks, is a form of issuing potentially overvalued currency to workers. Stock based compensation can result in a tremendous amount of single entity risk in equity that is often illiquid. But without risk there is no reward (or something like that). On the whole, employees who choose to be paid in stock must properly assess the risks they are undertaking as ownership involves risks that are different from the security of a salary.
Criticism #4: MSV Increases Inequality.
We should be clear that capitalism is inherently unequal. Like a game of poker, capitalism does not distribute its chips equally to all of the players. There are winners and there are losers. At its core, capitalism has monopolistic tendencies as firms who are achieving their goal of maximizing profits will take more and more market share. At an extreme level the goal of a good capitalist is to own as much of the means of production as possible. Of course, we have rules that do not allow that because an economy cannot function well when one player holds all of the chips.
Capitalism and MSV create inequality. This is not controversial. But the success of capitalists is not the failure of capitalism. Extreme inequality that hurts the economy is the failure of government to properly maintain boundaries. As Milton Friedman once said:
“It is the responsibility of the rest of us to establish a framework of law such that an individual in pursuing his own interest is, to quote Adam Smith again, ‘led by an invisible hand to promote an end which was no part of his intention.’”5
I think there are fair criticisms here and I have voiced my opinion that, for instance, taxes on secondary market transactions do not deserve the favorable treatment they get, but this is not a criticism of MSV. It is a criticism of government. If we are to stop capitalists from monopolizing too much of the means of production then that is the responsibility of government and not the responsibility of corporate executives.
Criticism #5: The Stock market is a mechanism of extraction and not value creation.
Many people argue that the stock market has become a mechanism by which firms merely extract value. That is, it no longer serves as an investment funding market and instead serves as a way for owners and executives to ring the register. This is true to some degree, but the public markets provide tremendous good. To name a few things public markets achieve:
- While the public markets are increasingly used as an exit strategy for owners they are also an entrance strategy for households and other institutions. These markets provide high return savings vehicles to the general public that would not otherwise be available for households to own so easily. Said differently, the public market is a wealth inequality reducer.
- Public markets provide us with a transparent and publicly regulated market in which corporations are held accountable.
- The public markets are important signalling systems that help price financing needs, M&A, etc.
Becoming a public company is unbelievably difficult. By the time a company can be listed on a public exchange it has already provided an extraordinary amount of value to its customers. To argue that this wealth diversifying transparent market is somehow a bad thing is, frankly, silly.
At its core the concept of maximizing shareholder value is perfectly consistent with providing value to customers. And while this is a generally useful idea it does not mean that all facets of it are beneficial. Maximizing shareholder value is a highly useful but imperfect approach to managing a corporation. And while there are valid micro criticisms of how corporations should be run we should also be careful generalizing with these terms as they can result in misconceptions.
¹ – What Shareholder Value is Really About, M. Mauboussin
³ – Disbursing Cash to Shareholders, M. Mauboussin
All else equal is obviously a big caveat. As Mauboussin notes:
“More formally, buybacks and dividends are identical under certain assumptions, which include:
– No taxes or the timing and magnitude of taxation is identical;
– No or identical transaction costs;
– Shareholders reinvest proceeds at the same rate;
– Identical timing of the distributions;
– and the stock is at its fair price.”
Clearly, these are not all true, but for the purposes of general analysis it is a good starting point for identifying how best to distribute cash to shareholders.
4 – See, Dividends: The Secret Sauce in Corporate Profits, C. Roche
5 – See Capitalism and Freedom, University of Chicago Press, 2002, p 133.
NB – It’s interesting to note that most of these criticisms of MSV come from academics and other people who have never run a business. But the irony runs deeper than this. We know from the poor performance of active managers that outside asset allocators are bad at predicting what is good or bad for public companies. These active managers tend to be unusually involved in understanding these businesses and yet they still cannot make good predictions about what is good or bad for the companies. It begs the question – if an active manager is bad at predicting the performance of corporations then why in the world would anyone need to hear the opinion of academics, pundits and other outside investors who neither run companies nor study them professionally?