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Shareholder Value and Corporate Governance

by AppliedCG
Has Alfred Rappaport been unfairly judged?

A recent article by Professor Alfred Rappaport in the Financial Times defended his very influential and widely followed philosophy of the primary importance of the pursuit of shareholder value. This has come under increasing criticism in recent years, as the concept of a more balanced stakeholder approach has gained wider acceptance, and particularly as capitalism itself has come under fire since the 2008 financial collapse. So we thought it would be interesting to go back to the source of the controversy and review Prof. Rappaport’s defining book, Creating Shareholder Value, thirty years after its publication, in the light of current views about corporate governance, and see whether we agreed with Prof. Rappaport’s self-justification. 

Summary of what Prof. Rappaport says in his book

Achieving maximum financial return for shareholders is the fundamental objective of any business”

The overall theme of the book is perhaps summarised from our point of view in the first chapter when he acknowledges that management is generally looked on as balancing the interests of the various stakeholder groups, but emphasises the critical importance of the financial dimension. But he then goes on to say that he is addressing the implementation of product/market strategies rather than just financial return. Nonetheless, he makes it clear that in his view, achieving maximum financial return for shareholders is the fundamental objective of any business.

The thread running through the rest of the book relates to what that financial return actually is, and how it can be achieved. In his view, the financial return to shareholders consists of dividends distributed and increases in share price, and he goes on to criticise the use of pure accrual accounting methods to measure those returns. For him, total return is what matters, and creating that total return is how you create real value for shareholders.

He criticises existing methods of judging likely success in strategic planning processes for not giving due account to risk and for ignoring subsequent dividend policies when predicting the impact on shareholders’ future worth. Similarly he criticises accounting based methods of measuring success, like earnings per share, used in assessing how well management has served the interests of shareholders, for not calculating properly the actual value of the businesses concerned, and hence the net improvement (or otherwise) in shareholder value.

Similarly, he criticises dividend policies which cause short term increases in share price but which may adversely affect the long term value of the company if the funds would have been better spent on improving customer service.

He then goes on to challenge measures such as Return on Investment (ROI) and Return on Equity (ROE) as giving a misleading indication of the business performance compared with cashflow based methods of arriving at the value of the business to shareholders. He strongly favours the economic return method of valuation and points out that there is no reliable relationship between the two.

From here on the orientation of the approach becomes clearly stock market related and he develops the theme that the value of a business and the methods used to assess corporate and business strategies ought to be directed at the impact on the subsequent market valuation. Hence in calculating capital, for rate of return purposes, the value taken for capital should be the market value of the business rather than the book value of the assets in that business. Similarly, the cost of capital as an input to discounted cash flow projections should be derived from the expected market rate of return and market risk premium, plus the return based on the company’s beta rating derived from its expected price volatility. In other words, the market’s view of the company should drive strategic decisions.

He then picks up Michael Porter’s approach to Competitive Strategy and devotes a chapter to a methodology to incorporate shareholder value principles into assessing the corporate and business unit strategies addressed by Prof Porter and helping to select the best strategy for shareholders. In this section, two quotes are, perhaps, revealing:

In assessing which strategies will create value for shareholders:

“I proceed with two basic beliefs: first that business can create shareholder value by superior planning; second that managers are particularly motivated in the current climate of corporate takeovers by the knowledge that “capitalism offers no refuge for companies that don’t maximise their value””

An example of restructuring to create shareholder value is quoted approvingly:

“Esmark in 1979 had 48K shareholders, 44K employees, revenues of $6.8bn and was worth $550m with share price worth $39.88 book value. After restructuring in 1980 it had 31K employees, revenues of c$3.5bn and 33.9K shareholders and was worth $500m with shares worth $57.06 at book value.”

There is an interesting chapter comparing “sustainable growth” strategy as defined by the Boston Consulting Group approach, being the maximum growth rate a company can sustain without issuing new equity, and his preferred “sustainable value creation” which in his examples avoids the limitations and misleading results of the earlier method and which is designed to sustain competitive advantage. He leads on to describe an “affordable sales growth rate” which measures the fundability of a strategy without issuing new equity.

The next chapter looks at the stock market assessment of a company’s strategy and the impact on share prices, and there is an interesting table comparing the perspectives of shareholders and the company regarding investment return. He considers whether the market price would reflect an optimistic, realistic or pessimistic view of the likely outcome of the strategy, and this would appear to have serious implications for management decision-making in terms of the different impact a given corporate strategy could then have on shareholder returns.

He expresses a strongly held view that the stock market is actually very long term in how it values companies, and companies are led by the wrongly held opposite view into short term strategies. However, he then goes on to criticise portfolio managers for going into and out of shares far too frequently, to try to beat each other in their performance, causing short term price fluctuations which managements believe have nothing to do with their underlying business performance. But his conclusions lead him to say that corporate required rates of return almost certainly have to be higher than shareholder rates of return to achieve shareholders’ required objectives.

Then he has a chapter lamenting the shortcomings of executive compensation schemes in delivering their targeted value for shareholders and suggesting ways of improving these by incorporating his shareholder value approach based on cash flow rather than accrual accounting measures. He quotes, approvingly, Peter Drucker’s suggestion that top executives limit their pay to a given multiple of that of the average worker, but quotes three “road blocks” to better schemes:

  • increased pay for increased size
  • relatively heavy weighting to short term performance
  • reliance on accounting measures such as earnings per share and return on investment rather than economic performance measures

He suggests that part of the problem comes from the separation of ownership and control and that when a company is taken private key changes will include a tighter control of expense, a different attitude to risk and longer time horizons.

Finally there is a section on Mergers and Acquisitions in which he is generally very critical of mergers in the quality of analysis by the buyer. Usually they deliver any value to the seller, he says, not the buyer. And he describes using the shareholder value approach to acquisitions.

Recent criticisms of the SV approach

A few quotes probably sum up the current views of the critics of shareholder value.

In the Huffington Post blog of February 2015, Mark Benioff, chairman and CEO of SalesForce, declared:

“The renowned economist Milton Friedman preached that the business of business is to engage in activities designed to increase profits. He was wrong. The business of business isn’t just about creating profits for shareholders — it’s also about improving the state of the world and driving stakeholder value

“That was the vision of Professor Klaus Schwab when he founded the World Economic Forum in 1971, and it remains the core principle underlying the annual Davos gathering. He believes that we have an imperative to shift from creating shareholder value to stakeholder value. His “stakeholder theory” asserts that corporate management isn’t just accountable to shareholders, and that businesses must focus on serving the interests all stakeholders — customers, employees, partners, suppliers, citizens, governments, the environment and any other entity impacted by its operations.”

In an article in Forbes, in July 2014, Steve Denning quotes Roger Martin, Academic Director of the Martin Prosperity Institute, in an interview at the Aspen Institute, as saying that short-termism is not the real problem.

“[You can best serve your shareholders] by not pursuing shareholder value at all. The best way to serve shareholders is to have a great company. Who determines shareholder value? You don’t determine shareholder value. Shareholder value is a completely ethereal thing. The market capital of a company at any given point in time is the collective belief of market participants in the likely future events concerning that company. It is no more concrete than that. That’s why it can change incredibly rapidly. It’s not like your return on equity, or your return on assets, which you have control over. It’s an ethereal thing that changes quickly. So the notion that the job of a CEO is to always make sure that the collective view of the market of the future prospects of this company go up, good luck!”

In an earlier Forbes contribution by Steve Denning, reviewing Roger Martin’s book Fixing the Game, he quotes Martin as arguing that the focus on markets has created a situation where managers are guessing the market’s assessment of what they should be delivering, then focusing on delivering that, rather than running the business.

He points out that although Jack Welch was seen during his time as CEO of GE as a prime success story in delivering shareholder value, achieving his targets with great precision year after year, after he retired he seems to have changed his perception. In 2009, in an interview with the Financial Times, he is quoted as saying that

“On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal. … Short-term profits should be allied with an increase in the long-term value of a company.”

What does Professor Rappaport say?

In his recent Financial Times article, he robustly defended shareholder value, instead saying that

“The culprit [for short-term behaviour] is not shareholder value but rather corporate executives, investment managers and the business press who incorrectly believe that the governing objective of shareholder value is to boost a company’s near term stock price by meeting the market’s quarterly earnings expectations.”

He mentions the importance of cash flow management and risk considerations in capital allocation and their influence on long term thinking. He also refutes the criticism that shareholder value encourages exploitation of other stakeholders, saying that long term success depends on a solid relationship with each of the stakeholders, particularly mentioning customers and employees. Indeed, he says

“Companies risk their viability if any one stakeholder gets too much or two little for an extended period.”

In response to the challenge that shareholder value ignores social issues, he simply says that if companies prioritise the interests of stakeholders other than their shareholders they have a fiduciary duty to their investors to “disclose the circumstances in which they would invest in social initiatives that are expected to yield returns below the minimum return required to create value”.

In conclusion, he says, effectively, that executives who say they have no choice but to focus on short term objectives because of portfolio managers’ short term holdings are simply wrong. They should concentrate on the horizons of the investors in those portfolios, which are usually much longer. In other words “Shareholder value has not failed management. Management has failed the true principles of shareholder value.”

ACG assessment of the effect of shareholder value on corporate governanceGolden Rules

As regular readers will know, our definition of good corporate governance is holistic, and comprises five elements:

  • an ethical approach which is in tune with the societies and cultures in which a company operates
  • balanced objectives which fulfil the goals of all the key stakeholders
  • strategic management rather than opportunism or clientilism driving the policy and decision-making process approach
  • an organisation structured and resourced to deliver the strategic plan
  • a culture of accountability and transparency to all stakeholders.

As we have spelled out before many times, the interests of different stakeholders carry different weight, though all stakeholders should be treated with respect. Let’s look at the likely interests of the main stakeholder groups and then assess how the shareholder value approach affects them:

  • owners: 
    • long-term investors, some of whom may be looking for a steady income with maybe the need to finance dividends out of borrowing, others at long-term capital growth and minimal distributions
    • short term shareholders who are most likely to be looking at rapid capital gains, but who may also include short-sellers
  • customers: who will be looking at the company’s ability to survive and grow and to supply consistent quality without making excessive profits at their expense; possibly with the more demanding requirement for regular innovation in the products and services they supply and hence investment
  • employees: who will expect security of employment, which in turn requires financial soundness, but not at the expense of restricting levels of remuneration
  • suppliers: who will look to financial soundness and the ability to pay their bills on time
  • bankers: who will be expecting financial soundness and security against loans, coupled with an adequate level of cover on interest payments
  • general public: whose interest is likely to be in maintaining existing levels of employment in local communities or even in expanding them, which may conflict with the company’s need to restructure to preserve its future
  • government and regulatory authorities: who will be relying on compliance with rules and the payment of as much tax as possible.

Firstly, let’s consider if Prof. Rappaport’s defence of his shareholder value approach is consistent with the principles outlined in his book, or whether he has modified his ideas. Then let’s see how the principles marry with our holistic approach to corporate governance.

The short answer to the first question is that he does indeed seem to be consistent, though a five hundred word article can’t really be compared with a two hundred and fifty page book. This is important, since valid criticism of the approach as spelled out thirty years ago would appear to be just as valid now.

The short answer to the second question would appear to be that shareholder value was not, and is not, anything like our holistic approach to corporate governance. The key points of difference are:

  • fundamentally, despite Prof Rappaport’s acceptance of the need to take account of the different stakeholder groups, the whole orientation is towards delivering value to shareholders. hence there is no attempt to measure directly the company’s performance in its obligations towards the other stakeholder groups
  • the focus on what the stock markets think, or might be expected to think, would indeed lead one to say, along with Roger Martin, that managers are being encouraged to guess the market’s assessment of what they should be delivering, then focusing on delivering that, rather than running the business
  • regarding our five elements of good corporate governance, shareholder value:
    • doesn’t touch on ethics, despite the fundamental importance of this in corporate culture and consequent behaviour
    • ignores a balance of the goals of stakeholders, despite Prof Rappaport’s stress on the importance of the customers and employees, and ignores all but shareholders in terms of specific performance measures
    • does address strategic management in depth in its linkage to Michael Porter’s approach
    • addresses organisation and staffing resource only through a financial lens
    • mentions accountability only in relation to shareholders.

So, overall, we would say that, within the limited context of assessing the impact of a strategy in creating value for the stakeholder group called investors, it has a sensible cash-based approach and a valuable methodical approach which is more comprehensive and potentially less misleading than earlier capital allocation models.

However, from a holistic corporate governance viewpoint, to apply shareholder value as the overarching model in planning and managing complex corporations is to bias decisions away from the paramount customer focus and the need to build a skilled and well-motivated workforce.

And even on its own terms, with the best of intentions towards the individual investor, it’s not working. By Prof Rappaport’s own admission, investment managers are not taking a long view as a result of its implementation by executives, and those executives themselves are interpreting it in a short term way. So even if it should work in principle, it would appear not to be delivering in practice.

So we would conclude that the major impact that shareholder value has had on the world of big corporations and major investment groups has been detrimental to good corporate governance and continues to be so.


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