Business leaders, the business press, and business schools have been touting the “truth” that good business is about maximizing shareholder value. A dean of an East Coast business school recently opened an executive MBA program with these words: “Make no mistake, managing shareholder value is your only objective. There are no others.” Don’t believe it. It is not true.
I believe the singular focus on shareholder value (the goal of accumulating wealth for investors in the business) has fundamentally failed as an objective for good business. I will develop why I believe this to be the case. But first, if shareholder value is not the right objective for good business, what is?
An Alternative to Shareholder Value
As an alternative, I suggest there are two legitimate purposes for good business:
- To create and distribute goods and services to meet the needs of people
- To provide employment that allows people to use their gifts and abilities creatively.
To achieve these goals, however, requires the management of numerous “constraints.” Among them are providing capital to carry out the business (hence providing a reasonable return to the shareholders over the long term), treating the communities in which the business is carried out in a responsible way (environmental stewardship, community support), treating suppliers and vendors well, acting within the law, etc. These and many other areas are critical and require the attention of any good business.
Before developing why shareholder value fails as an objective and the proposed approach is better, I need to make two side comments. One, the proposed objectives, though not the justification, are drawn from a four day workshop last summer involving several of the faculty in the School of Business and Economics at Seattle Pacific University. We were able to spend some focused time debating the real purpose of business and settled on the two objectives stated. Two, using the terms objectives and constraints borrows from the language of mathematical optimization, a significant branch of mathematics.
Learning from Mathematical Optimization
Optimization is the process of finding “best solutions” when the problem can be cast with an objective (or goal) and constraints that can be quantified. The aim of optimization is to maximize (or minimize) this objective subject to satisfying all of the constraints. An example of a mathematical optimization problem is to find the fastest way (minimize time) to complete delivery of a truckload of merchandise to multiple addresses while obeying the speed limits and avoiding certain parts of town at rush hour. Optimization algorithms allow you to at least approximate this fastest route.
Two other features of mathematical optimization problems will be important to us. One, the formulation of the problem (what is the objective, what are the constraints) makes a big difference in the outcome of the solution. I argue that changing the objective is more than semantics, and will make a real difference in the business results as it does in optimization. Two, often the calculated solution for real problems at first makes no sense at all. In this case, mathematical optimization plays a key role in showing that some constraints were missed, the objective was not well defined, etc.
Examples of Shareholder Value Failure
Returning to the problem of establishing legitimate goals for business, we can draw on this last observation about mathematical optimization. Dramatic and costly business failures over the past few years suggest that maximizing shareholder value has taken us to a place that makes no sense. One of the most dramatic examples of this is the case of Tyco International. Dennis Kozlowski, former Tyco Chairman and Chief Executive Officer, was selected by Business Week as one of twenty five managers of the year, in part because of demonstrating this commitment to shareholder value. Within weeks, he and his Chief Financial Officer Mark Swartz were charged with looting Tyco International of $600 million.
Or, consider the case of Al “Chainsaw” Dunlap, former CEO of Sunbeam and other companies. When he was riding high he said business should not be run for the stakeholders, such as employees or the communities in which they live, but for the shareholders—period. “Stakeholders are total rubbish,” according to Dunlap. “It’s the shareholders who own the company. Not enough American executives care about the shareholders.”
Sunbeam is now in bankruptcy, and Dunlap has agreed to a permanent ban by the SEC on his serving as an officer or director of a publicly traded company. His short-term, self-serving focus not only failed his company, it failed its shareholders as well.
Learning from These Failures
What caused these failures? Obviously a lack of personal integrity played a big part. The opportunity for greed and excess that the system offered allowed them to exploit this system for personal gain.
But let’s look closer at how a system would allow such individuals to rise to the top and why business journals would applaud them along the way. I believe the singular focus on shareholder value is the culprit, and here’s why. In two important areas (motivating employees and the “slip” to the short-term), shareholder value fails as an objective.
The Need for a Better Motivating Vision
The people doing the work need to be inspired by a great goal. Shareholder value as a goal offers no such motivation. With the shareholder value goal, employees in the organization see a few executives getting wealthy while they fear for their jobs. This is hardly the vision to inspire greatness! Even if everyone in the company has stock options, most of the people in the organization have a difficult time connecting their work with the stock price. The objective needs to be something more closely aligned with the work. That is what the proposed objectives accomplish.
Thinking personally, I will never forget the roll-out of the Boeing 777 airplane, and the sense of pride I had when I recognized the accomplishments my R&D staff (and of course many others) to that beautiful product. I also remember with pride when members of my staff were selected as Technical Fellows of The Boeing Company. The growth opportunity and recognition for them was a tremendous thrill.
The most difficult times of all were the layoffs. It was part of the job and sometimes had to be done, but even when I believed it was necessary to reduce costs through layoffs, many in the organization assumed this was being done for short-term gain leading to cynicism and terrible morale. Almost as difficult were the times when shareholder value became such a strong theme in our company that it seemed like some in leadership forgot to talk about our products.
Technology Encouraged Distortions
Stock price is a good measure of the value of a business in the long term. But even if we thought we could overcome the motivational shortcomings of the shareholder value model, it contains another flaw. This is the temptation to apply this measure in the short-term, and stock price is not a manageable measure of value in the short-term. Short-term variations in the stock price might measure speculation, general economic news, or other things but are a very poor measure of changing performance.
However, in our technological era there is a temptation to try to measure the value of the business too frequently. Stock price is available on an instantaneous basis with today’s communications capability. I know many executives who not only pick up the stock price of their company throughout the day on their computer, but have it sent to their pager or palm pilot when they are out of the office. This very short-term use of stock price as a measure distorts the truth in the same way a person on a diet would distort progress by weighing in every hour!
Interestingly, the proposed objectives are very difficult to measure accurately in the short-term, making them more difficult to distort.
Jim Sinegal, Costco CEO said it well in the March/April issue of Ethix, “The biggest thing that causes difficulty in the business world today is the short-term view. We become obsessed with it. But it forces bad decisions.”
Slowly, business seems to be awakening to the pitfalls of this singular, ever more short-term focus on shareholder value. In the Fall of 2002, Blake Nordstrom, CEO of Nordstrom’s, Inc., made the following statement. “In the 1990s, Nordstrom’s lost its way when it put its focus on shareholder value. Only when we got our focus back where it belongs, on our employees and our customers, have we begun to restore shareholder value.” I was in Finland recently talking with a group of Finnish business leaders. One said to me that he hoped it was true that American business is moving from the short-term focus on shareholder value. “In this era of globalization, we are stuck with whatever system is in vogue in America. This short-term focus is really hurting our business,” he said.
Replacing the singular focus on shareholder value, as measured by stock price, by the two objectives and multiple constraints may seem to add complication. Isn’t the proposed model too complicated? Isn’t it best to just focus on one thing? My response to this comes from my favorite words of Albert Einstein: “We should make things as simple as possible, but no simpler.” Managing a business is tough. Managing a good business is tougher. Don’t oversimplify it and distort the results.
Al Erisman is executive editor of Ethix, which he co-founded in 1998.
He spent 32 years at The Boeing Company, the last 11 as director of technology.
He was selected as a senior technical fellow of The Boeing Company in 1990,
and received his Ph.D. in applied mathematics from Iowa State University.