SHAREHOLDERS WANT MANAGERS TO MAXIMIZE MARKET VALUE
For small firms, shareholders and management may be one and the same. But for large companies, separation of ownership and management is a practical necessity. For example, AT&T has over 2 million shareholders. There is no way that these shareholders can be actively involved in management; it would be like trying to run New York City by town meetings. Authority has to be delegated.
How can shareholders decide how to delegate decision making when they all have different tastes, wealth, time horizons, and personal opportunities? Delegation can work only if the shareholders have a common objective. Fortunately there is a natural financial objective on which almost all shareholders can agree. This is to maximize the current value of their investment.
A smart and effective financial manager makes decisions which increase the current value of the company’s shares and the wealth of its stockholders. That increased wealth can then be put to whatever purposes the shareholders want. They can give their money to charity or spend it in glitzy night clubs; they can save it or spend it now. Whatever their personal tastes or objectives, they can all do more when their shares are worth more.
Sometimes you hear managers speak as if the corporation has other goals. For example, they may say that their job is to “maximize profits.” That sounds reasonable.
After all, don’t shareholders want their company to be profitable? But taken literally, profit maximization is not a well-defined corporate objective. Here are three reasons:
1. “Maximizing profits” leaves open the question of “which year’s profits?” The company may be able to increase current profits by cutting back on maintenance or staff training, but shareholders may not welcome this if profits are damaged in future years.
2. A company may be able to increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. That is not in the shareholders’ best interest if the company earns only a very low rate of return on the extra investment.
3. Different accountants may calculate profits in different ways. So you may find that a decision that improves profits using one set of accounting rules may reduce them using another.
In a free economy a firm is unlikely to survive if it pursues goals that reduce the
firm’s value. Suppose, for example, that a firm’s only goal is to increase its market share. It aggressively reduces prices to capture new customers, even when the price discounts cause continuing losses. What would happen to such a firm? As losses mount, it will find it more and more difficult to borrow money, and it may not even have sufficient profits to repay existing debts. Sooner or later, however, outside investors would see an opportunity for easy money. They could offer to buy the firm from its current shareholders and, once they have tossed out existing management, could increase the firm’s value by changing its policies. They would profit by the difference between the price paid for the firm and the higher value it would have under new management. Managers who pursue goals that destroy value often land in early retirement.
We conclude that managers as a general rule will act to maximize the value of
the firm to its stockholders. Management teams that deviate too far from this
rule are likely to be replaced.
ETHICS AND MANAGEMENT OBJECTIVES
We have suggested that managers should try to maximize market value. But some idealists say that managers should not be obliged to act in the selfish interests of their stockholders. Some realists argue that, regardless of what managers ought to do, they in fact look after themselves rather than their shareholders.
Let us respond to the idealists first. Does a focus on value mean that managers must act as greedy mercenaries riding roughshod over the weak and helpless? Most of this book is devoted to financial policies that increase firm value. None of these policies require gallops over the weak and helpless. In most instances there is little conflict between doing well (maximizing value) and doing good.
The first step in doing well is doing good by your customers. Here is how Adam
Smith put the case in 1776:
It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
By striving to enrich themselves and their shareholders, businesspeople have to provide their customers with the products and services they truly desire.
Of course ethical issues do arise in business as in other walks of life. So when we say that the objective of the firm is to maximize shareholder wealth, we do not mean that anything goes.
In part, the law deters managers from blatantly illegal action. But when the stakes are high, competition is intense, and a deadline is looming, it’s easy to blunder, and not to inquire as deeply as they should about the legality or morality of their actions.
Written rules and laws can help only so much. In business, as in other day-to-day affairs, there are also unwritten rules of behavior. These work because everyone knows that such rules are in the general interest. But they are reinforced because good managers know that their firm’s reputation is one of its most important assets and therefore playing fair and keeping one’s word are simply good business practices. Thus huge financial deals are regularly completed on a handshake and each side knows that the other will not renege later if things turn sour.
Reputation is particularly important in financial management. If you buy a well-
known brand in a store, you can be fairly sure what you are getting. But in financial transactions the other party often has more information than you and it is less easy to be sure of the quality of what you are buying. This opens up plenty of opportunities for sharp practice and outright fraud, and, because the activities of rogues are more entertaining than those of honest people, bookshelves are packed with accounts of financial fraudsters.
The reaction of honest financial firms is to build long-term relationships with their customers and establish a name for fair dealing and financial integrity. Major banks and securities firms know that their most valuable asset is their reputation and they emphasize their long history and their responsible behavior when seeking new customers.
When something happens to undermine that reputation the costs can be enormous.
Consider the case of the Salomon Brothers bidding scandal in 1991. A Salomon trader tried to evade rules limiting its participation in auctions of U.S. Treasury bonds by submitting bids in the names of the company’s customers without the customers’ knowledge. When this was discovered, Salomon settled the case by paying almost $200 million in fines and establishing a $100 million fund for payments of claims from civil lawsuits. Yet the value of Salomon Brothers stock fell by far more than $300 million. In fact, the price dropped by about a third, representing a $1.5 billion decline in market value.
Why did the value of the firm drop so dramatically? Largely because investors were worried that Salomon would lose business from customers that now distrusted the company. The damage to Salomon’s reputation was far greater than the explicit costs of the scandal, and hundreds or thousands of times as costly as the potential gains it could have reaped from the illegal trades.
It is not always easy to know what is ethical behavior and there can be many gray areas. For example, should the firm be prepared to do business with a corrupt or repressive government? Should it employ child labor in countries where that is the norm?
The nearby box presents several simple situations that call for an ethically based decision, along with survey responses to the proper course of action in each circumstance.
Compare your decisions with those of the general public.
DO MANAGERS REALLY MAXIMIZE FIRM VALUE?
Owner-managers have no conflicts of interest in their management of the business.
They work for themselves, reaping the rewards of good work and suffering the penalties of bad work. Their personal well-being is tied to the value of the firm.
In most large companies the managers are not the owners and they might be tempted to act in ways that are not in the best interests of the owners. For example, they might buy luxurious corporate jets for their travel, or overindulge in expense-account dinners.
They might shy away from attractive but risky projects because they are worried more about the safety of their jobs than the potential for superior profits. They might engage in empire building, adding unnecessary capacity or employees. Such problems can arise because the managers of the firm, who are hired as agents of the owners, may have their own axes to grind. Therefore they are called agency problems.
Think of the company’s net revenue as a pie that is divided among a number of
claimants. These include the management and the work force as well as the lenders and shareholders who put up the money to establish and maintain the business. The government is a claimant, too, since it gets to tax the profits of the enterprise. It is common to hear these claimants called stakeholders in the firm. Each has a stake in the firm and their interests may not coincide.
All these stakeholders are bound together in a complex web of contracts and understandings. For example, when banks lend money to the firm, they insist on a formal contract stating the rate of interest and repayment dates, perhaps placing restrictions on dividends or additional borrowing. Similarly, large companies have carefully worked out personnel policies that establish employees’ rights and responsibilities. But you can’t devise written rules to cover every possible future event. So the written contracts are supplemented by understandings. For example, managers understand that in return for a fat salary they are expected to work hard and not spend the firm’s money on un-
warranted personal luxuries.
What enforces these understandings? Is it realistic to expect managers always to act on behalf of the shareholders? The shareholders can’t spend their lives watching through binoculars to check that managers are not shirking or dissipating company funds on the latest executive jet.
A closer look reveals several arrangements that help to ensure that the shareholders and managers are working toward common goals.
Compensation Plans. Managers are spurred on by incentive schemes that provide big returns if shareholders gain but are valueless if they do not. For example, when Michael Eisner was hired as chief executive officer (CEO) by the Walt Disney Company, his compensation package had three main components: a base annual salary of $750,000; an annual bonus of 2 percent of Disney’s net income above a threshold of “normal” profitability; and a 10-year option that allowed him to purchase 2 million shares of stock for $14 per share, which was about the price of Disney stock at the time.
Those options would be worthless if Disney’s shares were selling for below $14 but highly valuable if the shares were worth more. This gave Eisner a huge personal stake in the success of the firm.
As it turned out, by the end of Eisner’s 6-year contract the value of Disney shares had increased by $12 billion, more than sixfold. Eisner’s compensation over the period was $190 million. Was he overpaid? We don’t know (and we suspect nobody else knows) how much Disney’s success was due to Michael Eisner or how hard Eisner would have worked with a different compensation scheme. Our point is that managers often have a strong financial interest in increasing firm value. Table 1.4 lists the top-earning CEOs in 1998. Notice the importance of stock options in the total compensation package.
The Board of Directors. Boards of directors are sometimes portrayed as passive supporters of top management. But when company performance starts to slide, and managers don’t offer a credible recovery plan, boards do act. In recent years, the chief executives of IBM, Eastman Kodak, General Motors, and Apple Computer all were forced out. The nearby box points out that boards recently have become more aggressive in their willingness to replace underperforming managers.
If shareholders believe that the corporation is underperforming and that the board of directors is not sufficiently aggressive in holding the managers to task, they can try to replace the board in the next election. The dissident shareholders will attempt to convince other shareholders to vote for their slate of candidates to the board. If they succeed, a new board will be elected and it can replace the current management team.
TABLE 1.4
Highest earning CEOs in 1998
Takeovers. Poorly performing companies are also more likely to be taken over by another firm. After the takeover, the old management team may find itself out on the street.
Specialist Monitoring. Finally, managers are subject to the scrutiny of specialists. Their actions are monitored by the security analysts who advise investors to buy, hold, or sell the company’s shares. They are also reviewed by banks, which keep an eagle eye on the progress of firms receiving their loans.
We do not want to leave the impression that corporate life is a series of squabbles and endless micromanagement. It isn’t, because practical corporate finance has evolved to reconcile personal and corporate interests—to keep everyone working together to increase the value of the whole pie, not merely the size of each person’s slice.
The agency problem is mitigated in practice through several devices:
compensation plans that tie the fortune of the manager to the fortunes of the
firm; monitoring by lenders, stock market analysts, and investors; and
ultimately the threat that poor performance will result in the removal of the
manager.
For small firms, shareholders and management may be one and the same. But for large companies, separation of ownership and management is a practical necessity. For example, AT&T has over 2 million shareholders. There is no way that these shareholders can be actively involved in management; it would be like trying to run New York City by town meetings. Authority has to be delegated.
How can shareholders decide how to delegate decision making when they all have different tastes, wealth, time horizons, and personal opportunities? Delegation can work only if the shareholders have a common objective. Fortunately there is a natural financial objective on which almost all shareholders can agree. This is to maximize the current value of their investment.
A smart and effective financial manager makes decisions which increase the current value of the company’s shares and the wealth of its stockholders. That increased wealth can then be put to whatever purposes the shareholders want. They can give their money to charity or spend it in glitzy night clubs; they can save it or spend it now. Whatever their personal tastes or objectives, they can all do more when their shares are worth more.
Sometimes you hear managers speak as if the corporation has other goals. For example, they may say that their job is to “maximize profits.” That sounds reasonable.
After all, don’t shareholders want their company to be profitable? But taken literally, profit maximization is not a well-defined corporate objective. Here are three reasons:
1. “Maximizing profits” leaves open the question of “which year’s profits?” The company may be able to increase current profits by cutting back on maintenance or staff training, but shareholders may not welcome this if profits are damaged in future years.
2. A company may be able to increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. That is not in the shareholders’ best interest if the company earns only a very low rate of return on the extra investment.
3. Different accountants may calculate profits in different ways. So you may find that a decision that improves profits using one set of accounting rules may reduce them using another.
In a free economy a firm is unlikely to survive if it pursues goals that reduce the
firm’s value. Suppose, for example, that a firm’s only goal is to increase its market share. It aggressively reduces prices to capture new customers, even when the price discounts cause continuing losses. What would happen to such a firm? As losses mount, it will find it more and more difficult to borrow money, and it may not even have sufficient profits to repay existing debts. Sooner or later, however, outside investors would see an opportunity for easy money. They could offer to buy the firm from its current shareholders and, once they have tossed out existing management, could increase the firm’s value by changing its policies. They would profit by the difference between the price paid for the firm and the higher value it would have under new management. Managers who pursue goals that destroy value often land in early retirement.
We conclude that managers as a general rule will act to maximize the value of
the firm to its stockholders. Management teams that deviate too far from this
rule are likely to be replaced.
ETHICS AND MANAGEMENT OBJECTIVES
We have suggested that managers should try to maximize market value. But some idealists say that managers should not be obliged to act in the selfish interests of their stockholders. Some realists argue that, regardless of what managers ought to do, they in fact look after themselves rather than their shareholders.
Let us respond to the idealists first. Does a focus on value mean that managers must act as greedy mercenaries riding roughshod over the weak and helpless? Most of this book is devoted to financial policies that increase firm value. None of these policies require gallops over the weak and helpless. In most instances there is little conflict between doing well (maximizing value) and doing good.
The first step in doing well is doing good by your customers. Here is how Adam
Smith put the case in 1776:
It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
By striving to enrich themselves and their shareholders, businesspeople have to provide their customers with the products and services they truly desire.
Of course ethical issues do arise in business as in other walks of life. So when we say that the objective of the firm is to maximize shareholder wealth, we do not mean that anything goes.
In part, the law deters managers from blatantly illegal action. But when the stakes are high, competition is intense, and a deadline is looming, it’s easy to blunder, and not to inquire as deeply as they should about the legality or morality of their actions.
Written rules and laws can help only so much. In business, as in other day-to-day affairs, there are also unwritten rules of behavior. These work because everyone knows that such rules are in the general interest. But they are reinforced because good managers know that their firm’s reputation is one of its most important assets and therefore playing fair and keeping one’s word are simply good business practices. Thus huge financial deals are regularly completed on a handshake and each side knows that the other will not renege later if things turn sour.
Reputation is particularly important in financial management. If you buy a well-
known brand in a store, you can be fairly sure what you are getting. But in financial transactions the other party often has more information than you and it is less easy to be sure of the quality of what you are buying. This opens up plenty of opportunities for sharp practice and outright fraud, and, because the activities of rogues are more entertaining than those of honest people, bookshelves are packed with accounts of financial fraudsters.
The reaction of honest financial firms is to build long-term relationships with their customers and establish a name for fair dealing and financial integrity. Major banks and securities firms know that their most valuable asset is their reputation and they emphasize their long history and their responsible behavior when seeking new customers.
When something happens to undermine that reputation the costs can be enormous.
Consider the case of the Salomon Brothers bidding scandal in 1991. A Salomon trader tried to evade rules limiting its participation in auctions of U.S. Treasury bonds by submitting bids in the names of the company’s customers without the customers’ knowledge. When this was discovered, Salomon settled the case by paying almost $200 million in fines and establishing a $100 million fund for payments of claims from civil lawsuits. Yet the value of Salomon Brothers stock fell by far more than $300 million. In fact, the price dropped by about a third, representing a $1.5 billion decline in market value.
Why did the value of the firm drop so dramatically? Largely because investors were worried that Salomon would lose business from customers that now distrusted the company. The damage to Salomon’s reputation was far greater than the explicit costs of the scandal, and hundreds or thousands of times as costly as the potential gains it could have reaped from the illegal trades.
It is not always easy to know what is ethical behavior and there can be many gray areas. For example, should the firm be prepared to do business with a corrupt or repressive government? Should it employ child labor in countries where that is the norm?
The nearby box presents several simple situations that call for an ethically based decision, along with survey responses to the proper course of action in each circumstance.
Compare your decisions with those of the general public.
DO MANAGERS REALLY MAXIMIZE FIRM VALUE?
Owner-managers have no conflicts of interest in their management of the business.
They work for themselves, reaping the rewards of good work and suffering the penalties of bad work. Their personal well-being is tied to the value of the firm.
In most large companies the managers are not the owners and they might be tempted to act in ways that are not in the best interests of the owners. For example, they might buy luxurious corporate jets for their travel, or overindulge in expense-account dinners.
They might shy away from attractive but risky projects because they are worried more about the safety of their jobs than the potential for superior profits. They might engage in empire building, adding unnecessary capacity or employees. Such problems can arise because the managers of the firm, who are hired as agents of the owners, may have their own axes to grind. Therefore they are called agency problems.
Think of the company’s net revenue as a pie that is divided among a number of
claimants. These include the management and the work force as well as the lenders and shareholders who put up the money to establish and maintain the business. The government is a claimant, too, since it gets to tax the profits of the enterprise. It is common to hear these claimants called stakeholders in the firm. Each has a stake in the firm and their interests may not coincide.
All these stakeholders are bound together in a complex web of contracts and understandings. For example, when banks lend money to the firm, they insist on a formal contract stating the rate of interest and repayment dates, perhaps placing restrictions on dividends or additional borrowing. Similarly, large companies have carefully worked out personnel policies that establish employees’ rights and responsibilities. But you can’t devise written rules to cover every possible future event. So the written contracts are supplemented by understandings. For example, managers understand that in return for a fat salary they are expected to work hard and not spend the firm’s money on un-
warranted personal luxuries.
What enforces these understandings? Is it realistic to expect managers always to act on behalf of the shareholders? The shareholders can’t spend their lives watching through binoculars to check that managers are not shirking or dissipating company funds on the latest executive jet.
A closer look reveals several arrangements that help to ensure that the shareholders and managers are working toward common goals.
Compensation Plans. Managers are spurred on by incentive schemes that provide big returns if shareholders gain but are valueless if they do not. For example, when Michael Eisner was hired as chief executive officer (CEO) by the Walt Disney Company, his compensation package had three main components: a base annual salary of $750,000; an annual bonus of 2 percent of Disney’s net income above a threshold of “normal” profitability; and a 10-year option that allowed him to purchase 2 million shares of stock for $14 per share, which was about the price of Disney stock at the time.
Those options would be worthless if Disney’s shares were selling for below $14 but highly valuable if the shares were worth more. This gave Eisner a huge personal stake in the success of the firm.
As it turned out, by the end of Eisner’s 6-year contract the value of Disney shares had increased by $12 billion, more than sixfold. Eisner’s compensation over the period was $190 million. Was he overpaid? We don’t know (and we suspect nobody else knows) how much Disney’s success was due to Michael Eisner or how hard Eisner would have worked with a different compensation scheme. Our point is that managers often have a strong financial interest in increasing firm value. Table 1.4 lists the top-earning CEOs in 1998. Notice the importance of stock options in the total compensation package.
The Board of Directors. Boards of directors are sometimes portrayed as passive supporters of top management. But when company performance starts to slide, and managers don’t offer a credible recovery plan, boards do act. In recent years, the chief executives of IBM, Eastman Kodak, General Motors, and Apple Computer all were forced out. The nearby box points out that boards recently have become more aggressive in their willingness to replace underperforming managers.
If shareholders believe that the corporation is underperforming and that the board of directors is not sufficiently aggressive in holding the managers to task, they can try to replace the board in the next election. The dissident shareholders will attempt to convince other shareholders to vote for their slate of candidates to the board. If they succeed, a new board will be elected and it can replace the current management team.
TABLE 1.4
Highest earning CEOs in 1998
Takeovers. Poorly performing companies are also more likely to be taken over by another firm. After the takeover, the old management team may find itself out on the street.
Specialist Monitoring. Finally, managers are subject to the scrutiny of specialists. Their actions are monitored by the security analysts who advise investors to buy, hold, or sell the company’s shares. They are also reviewed by banks, which keep an eagle eye on the progress of firms receiving their loans.
We do not want to leave the impression that corporate life is a series of squabbles and endless micromanagement. It isn’t, because practical corporate finance has evolved to reconcile personal and corporate interests—to keep everyone working together to increase the value of the whole pie, not merely the size of each person’s slice.
The agency problem is mitigated in practice through several devices:
compensation plans that tie the fortune of the manager to the fortunes of the
firm; monitoring by lenders, stock market analysts, and investors; and
ultimately the threat that poor performance will result in the removal of the
manager.
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