Does “shareholder value” make any sense?

By Felix Salmon
May 19, 2009

Justin Fox, in an excerpt from his new book, explains that “shareholder value” didn’t always mean “share price”:

The goal was to get corporate executives to pay less attention to accounting earnings and focus instead on economic earnings – which Alfred Rappaport, who taught at Northwestern University’s Kellogg School of Management, defined as anticipated cash flow discounted by the cost of capital. It was an argument for paying attention to what created value over time instead of stressing out about quarterly earnings. Which doesn’t sound dumb.

“I don’t know how many times I kept saying long term, long term, long term,” explains Rappaport, who is now 77 and living in semiretirement in Southern California, but still pens the occasional Harvard Business Review article and has a new book in the works. “To me, shareholder value was not about an immediate boost to stock price.”

This kinda assumes, however, that shareholders are in it for the long, long term too. If management’s incentives are aligned with the long-term interests of shareholders, and neither cares too much about short-term share-price fluctuations, that’s great.

But we live in a world where the overwhelming majority of stock-market investors mark their holdings to market daily, even if their time horizon is measured in years. In that world, shareholder value is the stock price, whether markets are efficient or not.

Justin says that the concept of shareholder value is not a dumb idea, as Jack Welch would have it. But in order to believe that shareholder value makes sense, you also have to believe that if you buy a stock at $100 and it drops to $50, then you haven’t lost any money so long as you haven’t actually sold the stock. And there aren’t many people who really believe that.

6 comments

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How long is long-term? Should companies strive to last forever, or have a good profitable run and call it a day?

Are shares just a convenience for rentiers?

It doesn’t require investors who are investing for the long haul to get prices reflecting long term value. You can get the same results with short term investors who plan to sell their investments to new investors with short time horizons. They in turn plan to sell to others and so on.

This can value a security at the same price as a single investor with a longer horizon.

interesting, but i think you’re confusing creating “shareholder value” as the goal of strategy with simple measures of economic value added. see comment 2 for an example of the logical flaw.

The fact is that the share price of companies that consistently make profits on their goods and services will go up. Those of us saving for retirement must take a long term view and accumulate those shares over our working life time. There’s really no other choice.

Posted by halkopous | Report as abusive

Felix,

Your assumption is that owners do not count.

Owners are the managers. If the crowd is demanding short term value, then the crowd will manage the company into products that have short term distribution networks, or exit the stock.

Didn’t Keynes make the same mistake? Didn’t he erroneously assume that voters do not manage government, that stockholders do not manage corporations; and didn’t that severe bias ruin his entire life’s work.

Posted by Mattyoung | Report as abusive

“But in order to believe that shareholder value makes sense, you also have to believe that if you buy a stock at $100 and it drops to $50, then you haven’t lost any money so long as you haven’t actually sold the stock. And there aren’t many people who really believe that.”

NO. I have to believe that the original Value Proposition is still intact (at which point I double- or treble-down, liquidity permitting.

Example 1: A judge declares a software company a monopoly and told to break up. I see this as a Value Proposition for the otherwise-bloated company. I buy the stock.

A year or so later, another, higher judge says, “eh, forget that. Keep making larger, more bloated, memory-hogging O/Ses as a long-term strategy.”

I sell the stock. (Whether I make or lose money is an accounting matter.)

Example 2: A small fast-food franchise specialising in rotisserie chicken and interesting side salads at a time when its main, Well-Established Competitor is fried-chicken-and-potato-product-specifi c gains some market share and launches an IPO.

The purpose of the IPO is to expand the franchise, placing it in direct competition with the Well-Established Competitor.

The WEC–knowing full well that a rotisserie chicken recipe is a non-rival good–expands its menu and adds a few sides. Whether it is as good may motivate some buyers, but most will stay with the Brand Name, and the small franchise with a relative monopoly is now competing with a Deep-Pocketed Near-Equivalent Rival, and taking on debt.

If you bought the IPO, you certainly sell it. In fact, if you’re looking for Value Proposition and reading the Prospectus, you probably don’t buy it in the first place–unless you’re buying to flip. And, again, profit or loss is an accounting consideration, not a Value Proposition.

Any similarity to real corporations above is entirely a matter for Google.