Why Value Value?
The guiding principle of business value creation is a refreshingly simple construct: companies that grow and earn a return on capital that exceeds their cost of capital create value. Articulated as early as 1890 by Alfred Marshall, 1 the concept has stood the test of time. Indeed, when managers, boards of directors, and investors have forgotten it, the consequences have been disastrous. The financial crisis of 2007-2008 and the Great Recession that followed provide the most recent evidence of the point. But a host of other calamities, from the rise and fall of business conglomerates in the 1970s to the collapse of Japan's economy in the 1990s to the Internet bubble, can all to some extent be traced to a misunderstanding or misapplication of this guiding principle.
Today these accumulated crises have led many to call into question the foundations of shareholder-oriented capitalism. Confidence in business has tumbled. 2 Politicians and commentators push for more regulation and fundamental changes in corporate governance. Academics and even some business leaders have called for companies to change their focus from increasing shareholder value to a broader focus on all stakeholders, including customers, employees, suppliers, and local communities. At the extremes, some have gone so far as to argue that companies should bear the responsibility of promoting healthier eating and other social issues.
Many of these impulses are naive. There is no question that the complexity of managing the coalescing and colliding interests of myriad owners and stakeholders in a modern corporation demands that any reform discussion begin with a large dose of humility and tolerance for ambiguity in defining the purpose of business. But we believe the current debate has muddied a fundamental truth: creating shareholder value is not the same as maximizing short-term profits. Companies that confuse the two often put both shareholder value and stakeholder interests at risk. Indeed, a system focused on creating shareholder value isn't the problem; short-termism is. Banks that confused the two at the end of the last decade precipitated a financial crisis that ultimately destroyed billions of dollars of shareholder value, as did Enron and WorldCom at the turn of this century. Companies whose short-term focus leads to environmental disasters also destroy shareholder value, not just directly through cleanup costs and fines, but via lingering reputational damage. The best managers don't skimp on safety, don't make value-destroying decisions just because their peers are doing so, and don't use accounting or financial gimmicks to boost short-term profits, because ultimately such moves undermine intrinsic value that is important to shareholders and stakeholders alike.
What Does It Mean to Create Shareholder Value?
At this time of reflection on the virtues and vices of capitalism, we believe that it's critical that managers and boards of directors have a new, precise definition of shareholder value creation to guide them, rather than having their focus blurred by a vague stakeholder agenda. For today's value-minded executives, creating shareholder value cannot be limited to simply maximizing today's share price for today's shareholders. Rather, the evidence points to a better objective: maximizing a company's collective value to current and future shareholders, not just today's.
If investors knew as much about a company as its managers do, maximizing its current share price might be equivalent to maximizing value over time. But in the real world, investors have only a company's published financial results and their own assessment of the quality and integrity of its management team. For large companies, it's difficult even for insiders to know how financial results are generated. Investors in most companies don't know what's really going