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. The financial crisis of 2007–08 and the Great Recession that followed are only the most recent reminders that when managers, boards of directors, and investors forget this guiding principle, the consequences are disastrous—so much so, in fact, that some economists now call into question the very foundations of shareholder-oriented capitalism. Confidence in business has tumbled.1 1.An annual Gallup poll in the United States showed that the percent of respondents with little or no confidence in big business increased from 27 percent in the 1983–86 period to 38 percent in the 2011–14 period. For more, see “Confidence in institutions,” gallup.com. Politicians and commentators are pushing 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.
No question, the complexity of managing the 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—and companies that confuse the two often put both shareholder value and stakeholder interests at risk. Indeed, a system focused on creating shareholder value from business isn’t the problem; short-termism is. Great managers don’t skimp on safety, don’t make value-destroying investments just because their peers are doing it, and don’t use accounting or financial gimmicks to boost short-term profits, because ultimately such moves undermine intrinsic value.
What’s needed at this time of reflection on the virtues and vices of capitalism is a clearer definition of shareholder value creation that can guide managers and board directors, rather than blurring their focus with a vague stakeholder agenda. We do believe that companies are better able to deliver long-term value to shareholders when they consider stakeholder concerns; the key is for managers to examine those concerns systematically for opportunities to do both.
What does it mean to create shareholder value?
If investors knew as much about a company as its managers, maximizing its current share price might be equivalent to maximizing value over time. 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 the financial results are generated. Investors in most companies don’t know what’s really going on inside a company or what decisions managers are making. They can’t know, for example, whether the company is improving its margins by finding more efficient ways to work or by simply skimping on product development, maintenance, or marketing.
Since investors don’t have complete information, it’s not difficult for companies to pump up their share price in the short term. For example, from 1997 to 2003, a global consumer-products company consistently generated annual growth in earnings per share (EPS) between 11 and 16 percent. Managers attributed the company’s success to improved efficiency. Impressed, investors pushed the company’s share price above that of its peers—unaware that the company was shortchanging its investment in product development and brand building to inflate short-term profits, even as revenue growth declined. In 2003, managers were compelled to admit what they’d done. Not surprisingly, the company went through a painful period of rebuilding, and its stock price took years to recover.
In contrast, the evidence makes it clear that companies with a long strategic horizon create more value. The banks that had the insight and courage to forgo short-term profits during the real-estate bubble earned much better returns for shareholders over the longer term.2 2.Bin Jiang and Tim Koller, “How to choose between growth and ROIC,” McKinsey on Finance, September 2007. Oil and gas companies known for investing in safety outperform those that haven’t. We’ve found, empirically, that long-term revenue growth—particularly organic revenue growth—is the most important driver of shareholder returns for companies with high returns on capital (though not for companies with low returns on capital).3 3.Bin Jiang and Tim Koller, “How to choose between growth and ROIC,” McKinsey on Finance, September 2007. We’ve also found a strong positive correlation between long-term shareholder returns and investments in R&D—evidence of a commitment to creating value in the longer term.4 4.Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies, fifth edition, Hoboken, NJ: John Wiley & Sons, 2010.
The weight of such evidence and our experience supports a clear definition of what it means to create shareholder value, which is to create value for the collective of all shareholders, present and future. This means managers should not take actions to increase today’s share price if they will reduce it down the road. It’s the task of management and the board to have the courage to make long-term value-creating decisions despite the short-term consequences.
Can stakeholder interests be reconciled?
Much recent criticism of shareholder-oriented capitalism has called on companies to focus on a broader set of stakeholders, not just shareholders. It’s a view that has long been influential in continental Europe, where it is frequently embedded in the governance structures of the corporate form of organization. And we agree that for most companies anywhere in the world, pursuing the creation of long-term shareholder value requires satisfying other stakeholders as well.
Short-termism runs deep
What’s most relevant about Stout’s argument, and that of others, is its implicit criticism of short-termism—and that is a fair critique of today’s capitalism. Despite overwhelming evidence linking intrinsic investor preferences to long-term value creation,10 10.Robert N. Palter, Werner Rehm, and Jonathan Shih, “Communicating with the right investors,” McKinsey Quarterly, April 2008. too many managers continue to plan and execute strategy, and then report their performance against shorter-term measures, EPS in particular.
As a result of their focus on short-term EPS, major companies often pass up value-creating opportunities. In a survey of 400 CFOs, two Duke University professors found that fully 80 percent of the CFOs said they would reduce discretionary spending on potentially value-creating activities such as marketing and R&D in order to meet their short-term earnings targets.11 11.John R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “Value destruction and financial reporting decisions,” Financial Analysts Journal, 2006, Volume 62, Number 6, pp. 27–39. In addition, 39 percent said they would give discounts to customers to make purchases this quarter, rather than next, in order to hit quarterly EPS targets. Such biases shortchange all stakeholders.
Shareholder capitalism won’t solve all social issues
There are some trade-offs that company managers can’t make—and neither a shareholder nor a stakeholder approach to governance can help. This is especially true when it comes to issues that affect people who aren’t immediately involved with the company as investors, customers, or suppliers. These so-called externalities—parties affected by a company who did not choose to be so—are often beyond the ken of corporate decision making because there is no objective basis for making trade-offs among parties.
If, for example, climate change is one of the largest social issues facing the world, then one natural place to look for a solution is coal-fired power plants, among the largest man-made sources of carbon emissions. But how are the managers of a coal-mining company to make all the trade-offs needed to begin solving our environmental problems? If a long-term shareholder focus led them to anticipate potential regulatory changes, they should modify their investment strategies accordingly; they may not want to open new mines, for example. But if the company abruptly stopped operating existing ones, not only would its shareholders be wiped out but so would its bondholders (since bonds are often held by pension funds). All of its employees would be out of work, with magnifying effects on the entire local community. Second-order effects would be unpredictable. Without concerted action among all coal producers, another supplier could step up to meet demand. Even with concerted action, power plants might be unable to produce electricity, idling their workers and causing electricity shortages that undermine the economy. What objective criteria would any individual company use to weigh the economic and environmental trade-offs of such decisions—whether they’re privileging shareholders or stakeholders?
In some cases, individual companies won’t be able to satisfy all stakeholders. For any individual company, the complexity of addressing universal social issues such as climate change leaves us with an unresolved question: If not them, then who? Some might argue that it would be better for the government to develop incentives, regulations, and taxes, for example, to encourage a migration away from polluting sources of energy. Others may espouse a free-market approach, allowing creative destruction to replace aging technologies and systems with cleaner, more efficient sources of power.
Shareholder capitalism has taken its lumps in recent years, no question. And given the complexity of the issues, it’s unlikely that either the shareholder or stakeholder model of governance can be analytically proved superior. Yet we see in our work that the shareholder model, thoughtfully embraced as a collective approach to present and future value creation, is the best at bridging the broad and varied interests of shareholders and stakeholders alike.