In the post, I want to challenge an assertion made by the naked capitalism website on the topic of maximising shareholder value. There is an ostensible incompatibility at the micro level between maximising shareholder value and keeping everyone else happy, but only in the short term. At the aggregate level and over time this dissipates – competitive markets are at the core of capitalism and, despite its flaws, this is the system that works best at allocating resources and aligning with human interests.
The author correctly states that “[l]egally, shareholders’ equity is a residual claim, inferior to all other obligations. Boards and management are required to satisfy all of the company’s commitments, which include payments to vendors (including employees), satisfying product warranties, paying various creditors, paying taxes, and meeting various regulatory requirements (including workplace and product safety rules and environmental regulations).”
But the author uses that statement to back up the incorrect assertion that boards and management teams are not obligated to maximise shareholder value. I believe that this claim fails to appreciate the ownership and organisational structure of a firm.
The shareholders own the company. Because there are many shareholders with conflicting demands on their time, they elect a small group to represent their interests. This is what the board of directors does. Boards oversee the actions of management and delegate to them the power to make decisions about the running of the business. Shareholders can change the composition of the board and the board can change the composition of management. Ultimately, the responsibility of the nominated representatives is always to the owners.
Nevertheless, the owners of the business have responsibilities that range from paying creditors to abiding by regulations, and these have precedence over the claims of the shareholder over the revenue the business generates. But, these actions are perfectly compatible with the objective of maximising shareholder value for the following reasons:
- the value of the firm to shareholders is the sum of all future cash flows accruing to the owners, doing anything that reduces that stream of cash flows, such as not paying a supplier or failing to adhere to environmental regulations, reduces shareholder value
- it would be senseless to try maximise the value of the claim of any other stakeholder, companies that overpay their suppliers or undercharge their customers will go out of business – everyone involved, not just the shareholders, will lose out in that case.
We can debate whether any single decision is right or wrong in terms of achieving this objective (and this is what analysts and shareholders do on a regular basis), but ultimately the guiding principle of maximising shareholder value is what keep managements in check. This works. And will keep working as long as enough people don’t want to ditch capitalism and democracy and revert to some fiefdom approach that promises a subsistence-level standard of living.