The Find: Many blame an excessive focus on maximizing shareholder value for the implosion on Wall Street, but one INSEAD professor argues that the real problem is the failure to fully understand exactly what shareholder value maximization means in the first place.- The Source: Comments by Theo Vermaelen, professor of finance at INSEAD, on INSEAD Knowledge.
The Takeaway: There’s no shortage of discussion on whether an excessive focus on short-term results contributed to the fall of some of the biggest names on Wall Street. Shouldn’t businesses concern themselves with more than just creating value for shareholders? Not if you have a correct understanding of what shareholder value maximization actually means, says INSEAD’s Vermaelen.
Though maximizing shareholder value seems straightforward enough to the layperson - get the most money for those who own a piece of the company ASAP - Vermaelen reminds us that it is actually a more nuanced concept:
Shareholder value is defined as the present value of free cash flows from now until infinity, discounted at a rate that reflects the risks of these cash flows. So, maximizing shareholder value is not the same thing as maximizing short-term profits, earnings per share or manipulating stock prices through accounting fraud.
It’s a point well taken, but the problem, which the current crisis has made clear, is that it is often possible to sweep risks under the carpet. How do we fix this? Vermaelen advocates reminding businesspeople of their ethical responsibilities and the true, longer-term meaning of shareholder value:
It is difficult, if not impossible to solve the problem [with compensation schemes that align the interest of stockholders and managers], as the current credit crisis indicates. Bonuses based on short-term profits led bankers to take risks that produced short-term profits and short-term stock price increases without creating long-term shareholder value…. there is a need to promote the ethical view that the right thing to do is to maximize shareholder value.
The Question: How exactly should businesses “promote” an ethical, longer-term view of shareholder value?
(Image of telescope for taking the long view by quinn.anya, CC 2.0)
