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The Governing Objective
We believe that all companies, especially publicly owned companies, should be managed to create as much wealth as possible. By this we mean that the company's resources should be managed to make them worth more than they would be if managed in any other way or by any other firm. This is an enormously demanding objective. To achieve it, management must focus on the continuous pursuit of opportunities to increase the value of the company's resources and establish maximizing wealth as not one of many equally important objectives, but as the preeminent or governing objective. Creating wealth is much more than a fiduciary responsibility, it is a hallmark of great management and great companies.
This book deals with the management of companies that are owned by private shareholders. For managers of shareholder-owned companies, maximizing wealth, or the worth of the company's human and financial resources, necessarily means the same thing as maximizing the value of the enterprise to its owners, or maximizing shareholder value. For the majority of companies with publicly traded shares, owners and managers have at their disposal a continuous objective appraisal of their success in wealth creation as reflected in the price of the companies' common stock. This assertion of the equivalence between the objectives of maximizing wealth and maximizing shareholder value is questioned by many managers who believe that investors typically undervalue, or fail to recognize, the wealth created by their companies. We will present considerable evidence to allay this concern, but for now, those with misgivings about the validity of capital market valuations might remember Winston Churchill's observation about democracy: "...it has been said that democracy is the worst system devised by the wit of man, except for the others."
Today virtually all chief executives and directors of publicly traded companies, especially in the United States, acknowledge that creating value for shareholders is an important corporate objective. But they face an awesome array of competing priorities, including other financial measures, such as earnings growth and return on investment; other strategic objectives, such as global cost competitiveness and market share leadership; and concerns for the welfare of their employees and the communities in which they operate. Thus, the major problem they face is not necessarily setting the objective itself but making it operational. One chief executive who obviously overcame this problem and expressed his conclusions as vividly as anyone ever has, put it this way:
The objective of our company is to increase the intrinsic value of our common stock. We are not in business to grow bigger for the sake of size, not to become more diversified, not to make the most or best of anything, nor to provide jobs, have the most modem plants, the happiest customers, lead in new product development, or to achieve any other status which has no relation to the economic use of capital. Any or all of these may be, from time to time, a means to our objective, but means and ends must never be confused. We are in business solely to improve the inherent value of the common stockholders' equity in the company.
We recognize, of course, that not everyone agrees that the governing objective of a company should be to maximize wealth or shareholder value. For example, here is one unequivocal opinion to the contrary:
Many managers in the United States still operate under the twin fictions that their most important stakeholders are shareholders, and that their primary purpose in management is to enhance shareholder value. Whether this is true from a legal perspective in the case of publicly traded firms is worthy of debate; but from a strategic and operational perspective, it is dead wrong for any firm publicly traded or privately held. A business does not exist for the benefit of investors, nor should it be run under that premise.
This and other challenges to managing for shareholder value are not uncommon, and we will respond to them later in this chapter. But first we need to clarify the governing objective and what it means for managers of public companies.
Elaborating the Governing Objective
The phrase "maximizing shareholder value" is often interpreted to mean something different from what we intend here, carrying at times even a negative connotation. By maximizing shareholder value, we do not mean that managers should make uneconomic decisions to try to hype a company' s stock price. The capital markets are much too astute to be fooled by any such maneuver, at least for long. Nor do we mean that managers should invest their time or energy in any sort of corporate image campaign designed to woo securities analysts to make "buy" recommendations or institutional investors to make "buy" decisions. The company's fundamental economic performance will speak for itself, and no amount of Madison Avenue spin control will have any but the most fleeting effect on a company's stock price. And finally, we do not mean to suggest in any way that corporations should become rapacious exploiters of their employees, customers, communities, or the environment.
In essence, the objective of "maximizing shareholder value" can only be achieved through a process of creating options and making choices. Every manager in every company is called upon to make thousands of decisions a year. All the most important decisions will involve making trade-offs, such as increasing R&D investments at the expense of current earnings, or increasing prices at the expense of volume growth, or investing to increase production efficiency at the expense of employment. On what basis are these decisions to be made, especially in huge decentralized organizations with operations spreading throughout the world?
Unlike very small companies, the modem corporation has no group of wise men and women at the top who can possibly oversee every decision and ensure that it complies with the company's objectives. Large, complex companies need a set of principles that are understood by all managers and can be used to inform their judgments about which decisions or choices to make. To be consistent and effective, these principles must be linked clearly to a single overriding decision criterion, or governing objective. We will argue that maximizing shareholder value is superior to any other governing objective a company might adopt because it will lead managers to make the decisions most likely to increase the company's competitive, organizational, and financial strength over time.
To make this point more concrete, it is useful to consider the following situation. The general manager of a highly profitable business unit within a large global company has identified three alternative strategies the business could pursue: the "Deluxe" strategy, which would focus on offering a highly differentiated product to select highend customers at a premium price; the "No Frills" strategy, which would focus on offering a good-quality but low-cost product at a low price to the mass market; and the "Everyman" strategy, which would serve all segments of the market by offering different features for the same basic product at attractive prices. Which strategy should the business pursue?
To answer this question, let us assume further that management has conducted a detailed analysis of each strategy, incorporating all the expected future benefits and costs to the business that would result from adopting any one of them. On the basis of this analysis, management has also estimated what the business would be worth if it were to implement any one of the alternatives successfully. The results of this analysis are shown in Exhibit 1.1.
With this information we can now rephrase the question to illustrate how the governing objective should be applied in this situation: Assuming that the business unit management team is capable of implementing each of these alternatives, are there any circumstances in which the general manager should choose either the Deluxe or the Everyman strategy?
We believe the answer is "No." The company's governing objective requires that choices of this type will be decided on the basis of maximizing value, which means in this case that management must choose to pursue the No Frills strategy. Note that this is true even when all three strategies in fact create value, because managing every business to create value is the minimum objective, not the governing objective, of a well-run company.
Experience tells us, however, that there are many instances where the No Frills strategy might not even have been identified, let alone selected, as the best strategy for this business. This is the central problem faced by all companies seeking to maximize wealth creation and, therefore, shareholder value: How can management ensure that each business in the portfolio will be able to identify, develop, and implement strategies to maximize the value of the resources with which it is entrusted?
We will deal with this question throughout the book. But we can begin to answer it by noting that managers must first overcome any hesitation they may feel about adopting wealth or value maximization as the governing objective of the company and every business, or business unit, within it. There are enormous internal and external pressures on management not to adopt such an objective, and many reasons are offered for not doing so. We address now the most commonly heard and accepted of these reasons and lay the groundwork for understanding why objectives other than wealth or value maximization will prove inferior in both the short run and the long run.
Addressing Challenges to the Governing Objective
The challenges to adopting value maximization as the company's governing objective generally fall into three camps. The first camp might be called the "capital market skeptics." This group, which includes many chief executives, generally accepts that increasing what they consider the intrinsic or warranted value of the company is an important objective. However, they argue, stock prices are such a poor measure of this warranted value that maximizing share price or shareholder value should not be the company's primary criterion for making important strategic and organizational decisions. The second camp takes the view that product market rather than capital market objectives should dominate decision making. This group of "strategic visionaries," which includes many academics as well as chief executives, argues that companies should focus on building market dominance or some specific competitive advantage in the product markets that will, by implication, also generate adequate financial performance. The third group argues that other stakeholders, such as employees and the community, have an equal or superior claim on the company's resources, and fairness mandates that management should make decisions to "balance" these competing interests. In this chapter we respond briefly to the challenge of the capital market skeptics and more fully to the strategic visionaries and those who argue for balancing stakeholder interests.
The Capital Market Skeptics
One of the most commonly heard objections to adopting maximization of shareholder value as the governing objective is that the prices set by investors in the stock market do not, on average, reflect what the company is really worth. Many believe that the stock market is guilty of "short-termism" or some other form of investor myopia that results in a persistent failure of stock prices to reflect the long-term value of the company. This argument was heard frequently in the 1980s as a management defense against hostile takeovers. For example, in 1986, when Champion International was rumored to be a takeover candidate, the company's CEO, Andrew Sigler, complained:
There is intense pressure [from investors] for current earnings, so the message is: Don't get caught with major [long-term] investments. And leverage the hell out of yourself. Do all the things we used to consider bad management.
The validity for capital market valuations is such an important subject that we will deal with it extensively, especially in Chapters Two, Four, and Five. We note here, however, that the claim that share price is not a good measure of value rests on the twin assumptions that (1) the capital markets systematically misprice (usually translated as underprice) the company's common stock, and (2) managers make strategic investment decisions using more robust, reliable measures of wealth creation than professional investors use. The evidence shows and our experience is, however, that both of these assumptions are wrong. We will demonstrate that in countries with reasonably weldeveloped capital markets, share prices provide the most accurate and least biased appraisal of a company's true value over time. Further, managers are generally not better than investors at estimating value, even though they typically have better information. In fact, it is only by understanding how investors determine values and set share prices that managers can begin to ensure that their strategic investment decisions will lead to consistent and significant wealth creation. We will return to this theme repeatedly throughout the book.
The Strategic Visionaries
Setting a strategic rather than a financial governing objective has considerable appeal for managers. Product market goals such as increasing or dominating market share (in a niche or on a global basis), maximizing customer satisfaction, or producing at the lowest cost all seem more immediate, easier to relate to, and easier to manage than maximizing shareholder value. In one important sense, we agree that good strategic management is essential to creating wealth. But the problem with product market objectives, as we see it, is that they do not have the relationship to good financial performance that their supporters seem to assume. In fact, depending on the particular circumstances of a business, investing to increase market share, to increase customer satisfaction, or to lower relative costs might well reduce shareholder value rather than increase it. Conversely, there are times when reducing market share, reducing customer satisfaction, or increasing relative costs will increase shareholder value. These conflicts, or tradeoffs, between product market and capital market goals are not rare. Indeed, they are the norm, and managers need to have a way of deciding what to do when these trade-offs, must be made.
To illustrate the problem in using a strategic or product market goal as a governing objective, it is helpful to look at maximization of customer satisfaction, which many managers and academics favor over maximization of shareholder value. One often-quoted viewpoint was expressed a number of years ago by Theodore Levitt of the Harvard Business School: "The purpose of a business is to create and keep customers." A very similar theme infuses the statements of many chief executives today, including this one from Paul Allaire, CEO of Xerox, who said: "I have to change the company substantially to be more market driven. If we do what's right for the customer, our market share and our return on assets will take care of themselves."
It goes without saying that no company can create wealth for its shareholders without having very satisfied and loyal customers. But this result is by no means achieved automatically. It is quite possible to achieve high levels of customer satisfaction and yet be unable to translate this seeming advantage into adequate returns for shareholders, let alone great wealth. A very good, if unfortunate, example of this situation can be found at American Airlines (AMR). American is generally recognized as the leader among major U.S. airlines in customer service, producing such innovations as the SABRE reservations system and the now-ubiquitous frequent-flyer programs. The company's management is clearly working hard to satisfy its customers and create good returns for shareholders. And yet, the economics of the industry have been and are currently so unfavorable that $100 invested in AMR shares in 1983 would have grown to only $325 by the end of 1992, far better than the performance of competitors whose shares grew to just $255 on average, but much worse than the $449 investors would have earned from the Standard & Poor's 500 Index.
We address here these specific questions: Under what circumstances does the objective of maximizing shareholder value conflict with the objective of maximizing customer satisfaction? And when a conflict arises, how should management resolve it?
We begin by noting that every product and service generates a value to the customer, as measured by its utility in relation to its price, and a value to the shareholders, as measured by the financial benefit in the form of dividends they will eventually receive from their investment in the customer offer. As we illustrate in Exhibit 1.2, there are strategies (characterized by arrows #1 and #4) that can cause both customer satisfaction and shareholder value to increase or decrease simultaneously. In these cases, clearly, there would be no conflict of interest between the two groups. However, there are also strategies (characterized by arrows #2 and #3) that would cause a direct conflict of interest. We will consider all these cases to propose how conflicts between customer and shareholder interests should be resolved.
When management pursues strategies that increase both customer satisfaction and shareholder value, as characterized by arrow #1, customer and shareholder interests are favorably aligned. This occurs when a strategy succeeds in enhancing customers' satisfaction to such an extent that the increase in price they are willing to pay more than offsets the increase in resources invested, producing both happier customers and an attractive return on the required investment, thereby creating value for the shareholders. A recent example of this win-win strategy was Microsoft's introduction of Windows, a new software product, which was designed to offer the same type of user-friendly features pioneered by Apple's Macintosh. Since its introduction in 1990, Windows has received rave reviews from customers, quickly grabbing 20 percent of the market. It has helped propel Microsoft's market capitalization up by more than $10 billion, more than doubling its value for shareholders.
Strategies characterized by arrow #2 present a conflict. Here, management's investment has produced increased customer satisfaction, but the economic cost has exceeded the returns on the investment, producing a negative impact on value for the shareholders. An example of this strategy is General Motors' introduction of the Saturn car, which has consistently ranked high in customer satisfaction surveys and been so popular that the company has been unable to keep up with demand. The shareholders, however, have not done so well. Through 1992 GM invested nearly $6 billion to develop and manufacture the Saturn, an amount so large that the company would have to operate existing facilities at full capacity forever and earn more than double standard profit margins, keeping 40 percent of the dealer's sticker price as net cash flow, simply to earn an adequate return for its shareholders.
Within large companies, we generally find that a significant percentage of the products and services has overshot the peak of the curve, providing far more than the customer is willing to pay for. Can these strategies be justified on grounds that any resulting increase in customer satisfaction will be worth it in the long run? Basically, the answer has to be "No." Whenever shareholders subsidize customers in a significant way, the financial health of the company is diminished, ultimately to the detriment of all stakeholders. Not only is the company's cash flow lower than it would be otherwise, but its long-term competitiveness is also eroded by the increase in its cost structure and investment base. Over time, any company that pursues this type of uneconomic investment will undoubtedly face competitors that position themselves closer to the peak in Exhibit 1.2, offering somewhat less customer satisfaction at a far lower cost. These competitors will then find themselves with a cost advantage that may well be exploited either by lowering prices in a bid for market share or by investing in a type of satisfaction that is appropriately valued by the customer.
We believe the best strategy for any business that has overshot the peak is one that moves the business back up the curve, as illustrated by arrow #3. In many cases, this can best be accomplished by identifying and reducing those costs that contribute little or nothing to customer satisfaction. This was the course chosen by Compaq Computer in late 1991, when the board forced out the founding chief executive and abandoned its "follow and upgrade IBM" strategy. Through a combination of reengineering and outsourcing, management cut costs by more than 30 percent and introduced more than 70 new models at far lower price points. This change in strategy enabled the company to recapture more than the share it had lost previously and produced a 140 percent return to shareholders during a period when the market return was 25 percent.
Once near the peak, it is always possible to move to the left, as depicted by arrow #4. In these cases, both customer satisfaction and shareholder value are declining, sending the strongest possible signal that the company's strategy needs a major overhaul. Perhaps the most celebrated example of this is the decision by the management of The Coca-Cola Company to introduce New Coke in 1985. Customers immediately let it be known that they much preferred the "old" Coke and stayed away from the new product in droves. However, having made the mistake, management reacted very swiftly. Without hesitation, the old product was reintroduced as Coca-Cola Classic, while New Coke, renamed Coke II in 1992, gradually faded to a niche brand, leaving both customers and shareholders much relieved.
To summarize, as long as management invests in higher levels of customer satisfaction that will enable shareholders to earn an adequate return on their investment, there is no conflict between maximizing shareholder value and maximizing customer satisfaction. If, however, there is insufficient financial benefit to shareholders from attempts to increase customer satisfaction, the conflict should be resolved for the benefit of shareholders to avoid diminishing both the financial health and long-term competitiveness of the business.
This proposition for resolving trade-offs between maximizing customer satisfaction and shareholder value is pertinent for other tradeoffs between product market, or strategic, objectives and value creation. When a strategy for increasing market share will increase shareholder value, it should be pursued, but if the opposite is the case and a strategy for reducing market share will create more value, this is the right decision for management to make. The same can be said of relative cost position or any other product market objective. Thus, these product market objectives should not be given the status of a company's governing objective, because to do so would as likely reduce shareholder value as increase it. Management cannot be indifferent to these outcomes.
The third common challenge to the objective of maximizing shareholder value is the claim that the interests of various stakeholders in the company somehow need to be "balanced." Until its acquisition by AT&T in 1991, NCR Corporation was one of the strongest advocates in this camp. In its last annual report, as an independent company, NCR described itself as follows:
NCR is a successful, growing company dedicated to achieving superior results by assuring that its actions are aligned with stakeholder expectations. Stakeholders are all constituencies with a stake in the fortunes of the company. NCR's primary mission is to create value for our stakeholders.
A recent survey of directors suggests that NCR was not alone in its views. The survey results led the authors to conclude that "boards of directors no longer believe that the shareholder is the only constituent to whom they are responsible." They state further that "this study reveals that these perceived stakeholders are, in the order of their importance, customers and government, stockholders, employees, and society."
Balancing the interests of stakeholders is not a capital market or a product market objective, it is a social or political objective based on the presumption that there are fundamental conflicts between the interests of shareholders and other stakeholders. When these conflicts arise, fairness demands that management arbitrate between presumed adversaries without showing undue favoritism to shareholders. We believe this line of reasoning suffers from two problems. First, we do not see the relationships between shareholders and other stakeholders as essentially adversarial. Wealth creation is not a zero-sum game where an increment to shareholder value must somehow diminish the welfare of other stakeholders. Indeed, the reverse is true increments to total welfare can come only from creating wealth. Second, balancing stakeholder interests is an impractical governing objective it leads the company nowhere. We look briefly at each of these balancing problems.
First, to the extent that customers are sometimes referred to as stakeholders in the company, we have already shown that customer and shareholder interests are not inherently conflicting, although (subject always to protecting customer safety) when conflicts arise, the company must find a way to compete without consuming shareholder value. What about conflicts between employees, suppliers, the community, and shareholders?
In general, employees and shareholders share many similar interests in having a vital, profitable, and growing enterprise. Further, creating value for shareholders demands enlightened human resource management, since the company's work force is a potential source of significant competitive advantage that can be translated directly into superior value creation. Companies that attempt to pay their employees below-market wages, or chum the work force, or treat their employees in a manner that does not fully utilize their skills and talents are unlikely to create the maximum possible value for shareholders. On the contrary, we find that those companies with the best track records of value creation are also among the very best at human resource management. Not only do they recognize the crucial role their work force plays in creating and sustaining competitive advantage, which translates into value creation, but they can more easily afford to invest in education and training and share some of the benefits of their success with their employees. Further, in the event of a recession or other temporary downturn in business activity, these companies are better able to avoid layoffs and more likely to continue investing in their employees as resources to be retained and developed.
When a downturn in business is not temporary but structural, however, all companies face a shareholder-employee conflict. From the shareholders' perspective, the highest-value strategy will involve a permanent reduction in work force, probably accompanied by shutdowns of various facilities. From the employees' perspective, those who are likely to be let go would very understandably prefer that their colleagues and the shareholders accept lower incomes to keep them on the job. Those unlikely to be let go would, of course, feel sympathy for their colleagues but would also want the company to downsize and return to financial health as soon as possible, since this would enhance their own job security. Should management rank the objectives of those employees likely to be let go above those of the remaining workers and the shareholders? Again, as in the case of unprofitable investment in customer satisfaction, the answer is "No." Over time, the company that continuously transfers shareholder value to its employees in order to avoid difficult restructuring decisions will become less and less competitive as its wage costs per unit produced climb above those of competing firms. Rivals with substantially lower wage costs will either lower prices or use their cost advantage to increase investment in customer satisfaction in a bid for market share. Inevitably, the highwage company will be forced to match the competition or face a steady decline in its fortunes. When this occurs, management usually faces a situation that forces it to restructure to survive, often involving a far greater reduction in work force than would have been required if top executives had acted sooner. In fact, those companies that manage for shareholder value tend to manage their employment levels so well that large-scale restructurings are very rare. Our conclusion: Pursuing the objective of maximizing value for shareholders also maximizes the economic interests of all employees over time, even when, regrettably, management is forced to downsize the company.
With respect to suppliers, we know of no one who seriously advocates that the governing objective of the corporation should be to maximize the economic interests of the company's vendors. Creating shareholder value requires treating suppliers fairly, meaning that as a customer, the business strives to pay "market" prices for its supplies, pay its bills on time, and generally treat its suppliers well. Switching suppliers frequently in an attempt to pay prices that are below market levels or delaying payment as much as possible will typically lead to supply disruptions or quality problems, which will damage the value of the business over time. Indeed, an important trend is for companies to view their suppliers as "business partners," working closely with them to improve quality and minimize cost. Such relationships are likely to help both the company and its suppliers create the maximum value for their shareholders.
As for reconciling the economic interests of the various communities in which it operates with those of shareholders, the objective of value creation does not preclude the company from making investments that enhance the environment for its employees and their communities. In fact, one could easily argue that these investments actually offer the prospect of creating value for shareholders since they reflect well on the company, enhance its image, improve the quality of life for employees, and make recruitment of talented people easier than it would be otherwise. Again, those companies that consistently create value for shareholders tend to be major contributors to improving the welfare of their local communities.
The second problem with the balancing argument is that it is an impractical governing objective. It offers decision makers no guidance to what the right "balance" is or how to achieve it. Faced with complex problems involving many trade-offs, managers can derive no guiding insight into how to resolve them. Thus every decision maker is left to rely entirely on his or her own personal instincts and judgment. In large organizations with thousands of decision makers, this would lead to complete chaos.
Maximizing shareholder value is not an abstract, shortsighted, impractical, or even, some might think, sinister objective. On the contrary, it is a concrete, future-oriented, pragmatic, and worthy objective, the pursuit of which motivates and enables managers to make substantially better strategic and organizational decisions than they would in pursuit of any other goal. And its accomplishment is essential to the welfare of all the company's stakeholders, for it is only when wealth is created that customers will continue to enjoy a flow of new, better, and cheaper products and the world's economies will see new jobs created and old ones improved.
Maximizing shareholder value is also the most demanding objective management can set for itself. It requires great imagination and skill, as well as focus and determination, to create substantial new wealth consistently and over long periods of time. This is why it is the single achievement that most clearly distinguishes the great companies from the formerly great and the mediocre ones. In Chapter Two we look at some of these great (and a few of the mediocre) companies and explore the potential for value creation as well as the path for achieving the governing objective.
Copyright © 1994 by The Free Press