Wednesday, January 18, 2012

Maximizing shareholder value: the "dumbest idea in the world"

In his book "Fixing the Game," business school dean Roger Martin introduces the idea of an NFL coach who is paid not according to wins and losses, but instead according to whether his team covered the point spread. He pictures the coach holding a Wednesday press conference to convince analysts that the point spread should be moved up or down, or the team's quarterback apologizing for only winning by 3 points when the spread was 9 points in their favor.

In this Forbes article, Steve Denning argues that large businesses today are similar to that hypothetical NFL team, where CEO's and managers have much more incentive to focus on improving stock prices rather than improving their products and making real profits. He describes a shift that took place in the 1970's and 1980's  where companies began to prioritize shareholders over customers and employees. One thing that drives this is the fact that most CEO's are compensated largely in options or stock based incentives:
    "What would lead [a CEO] to do the hard, long-term work of substantially improving real-market performance when she can choose to work on simply raising expectations instead? Even if she has a performance bonus tied to real-market metrics, the size of that bonus now typically pales in comparison with the size of her stock-based incentives. Expectations are where the money is. And of course, improving real-market performance is the hardest and slowest way to increase expectations from the existing level." 
    Also, Denning points out an obscure accounting regulation which forces the write-down of a company's real assets if the share price falls significantly, thus mandating that CEO's give significant concern to managing expectations.

There are also the stories (which progressives love to tell) of profitable companies slashing benefits or outsourcing jobs simply to make more profit. While a movie villain might do this simply to pocket more money, in the real world it is quite valuable to have satisfied and motivated employees, so an employer who is already making money would need a very good reason to do this. One reason, though, could be concern over stock prices. If the company's managers felt like they needed to cut costs to meet quarterly numbers or raise short-term expectations, they might outsource jobs or cut benefits even when making a profit.

Ironically, the emphasis on maximizing shareholder value has coincided with a decline in corporate performance since 1976. The idea may very well have contributed to the rash of accounting scandals in the early 2000's. It also gives Wall Street an inordinate amount of power over the economy. Perhaps we should listen to Jack Welch, who called this emphasis on maximizing shareholder value "the dumbest idea in the world."

Denning recommends several actions that may convince employers to shift their attention back from the stock market to the real market: eliminating the regulation that forces the write-down of assets due to falling stock prices; forbidding executives from selling stock in their company until 5 years after leaving their posts (thus limiting the incentive of stock-based compensation); and putting more restrictions and regulations on hedge funds which benefit from market volatility. I don't know if any of these are the right solution. But I do think that this over-emphasis on the stock market is a threat to the capitalism that made America great.


  1. When the shareholder value concept first became popular it was not a bad idea. It was based on the observation, that, in most cases, stock price was the best single indicator and the summation of all the factors that go into success. A company with great products, R&D, low cost structure, etc would have the greatest success and this would show over time in the stock price. Shareholder value was a dependent variable and driven by these things. Then like many good ideas it got turned around and executives started trying to manage to a short term stock price goal. This often resulted in bad long term decisions. I saw this first hand at one major company and it contributed to the company being overtaken by competitors and eventually acquired.

  2. As dumb as $1000 fine for playing with a ball or Frisbee on the beach in S. CA?