On Value

In the current business environment, “maximizing shareholder value” is often interpreted to mean focusing on the short term to meet Wall Street expectations rather than a long-term strategy for value creation. In fact, across most industries in the U.S. the bulk of corporate actions aimed at increasing shareholder value are closely tied to financial engineering efforts to enhance the company’s stock price.

The main claim from market participants and academic circles is that a company’s stock price reflects the investors’ consensus of the company’s future performance. However, when looked closely, it becomes evident that there is much more than the Efficient Market Hypothesis driving stock price behavior. Factors such as market momentum, supply and demand, algorithm-driven trading, and geopolitical events all influence stock price behavior in the short term.

Despite this fervent focus on stock price, the fundamental principles to increase shareholder wealth remain solidly grounded in pursuing strategies that lead to increasing a company’s cash flow. That entails coordinating corporate initiatives aimed at growing revenues, improving operating margins, optimizing capital efficiency and minimizing taxes.

Focusing on the maximization of a company’s free cash flow as a strategic objective often leads to better outcomes for all key stakeholders including employees, customers, suppliers and shareholders. When shareholder value is linked to stock price, including associated corporate incentives, the result often leads to value erosion rather than value creation.

The Rise of Institutional Investors – The explosion in M&A takeovers and buyouts during the 1980’s was one of the main catalysts for the change in corporate strategic focus from the long term to the near term. This was the period when junk bonds facilitated raising cash for hostile takeovers and lawyers such as Martin Lipton, Joe Flein and junk bond king Michael Milken became household names.

The deal mania of the 1980s and 1990s tilted the balance from individual investors owning the majority of the outstanding shares (80%+) in the 1960’s to institutional investors owning more than two-thirds of the outstanding shares in 2014.  It also refocused corporate governance away from running the company for the benefit of its stakeholders to an operating model governed by the behavior of the company’s stock price. To institutional investors, returns are what matters and the key metric is stock price.

Although takeover activity has slowed down considerably since the 1980s, it created a seemingly irreversible change in corporate focus and established the company’s institutional shareholders as the most important constituents. For them, the company’s stock price is how progress is evaluated.

The Lure of Executive Compensation – Having a company’s stock price as the key measure of shareholder value creates other unintended consequences. In the U.S., most of the CEOs’   incentive compensation is in the form of stock options (in 2016, stock awards comprised an average 47% of reported CEO compensation for the S&P 500) As a result, any action directed towards increasing stock price, not only makes institutional investors happy, but also makes corporate executives to focus on actions that create benefits in the short term at the cost of a company’s long-term improvements.

Back in the 1960’s and early 1970’s executive compensation was untethered from company performance. All that changed when intuitional shareholders outnumbered individual shareholders during the 1980’s and executives realized that linking their pay to the stock price, not only aligned their interests with the majority shareholders, but it could also make them very wealthy.

The Widespread Practice of Stock Buybacks – Another indicator of the focus by U.S. corporate executives on stock price behavior is the widespread practice of stock buybacks. In the second quarter of 2017, dividends and stock buybacks represented 91% of operating earnings for S&P 500 companies. The practice is not without merit, as stock buybacks increase the stock’s price by reducing the number of outstanding shares.

When paid from surplus funds, buybacks represent a sound tactic as they create flexibility over dividends and prevent mismanagement of surplus funds. However, the most prevalent practice is to curtail investments to hit earnings targets and satisfy Wall Street expectations. This, in turn, impairs the creation of value in the long term by restricting investments and cash flow growth.

In Short – The reliance on maximizing shareholder value as a measure of improving stakeholder wealth is not a false promise. In fact, when done right, it can lead to significant wealth creation and improved standards of living. It is when the strategy shifts from the long-term efforts of improving the company’s cash flow to the short-term tactics of enhancing its stock price that the wrong behaviors are incentivized, and corporate wealth is destroyed rather than enhanced.

About the Autor

Enrique C. Brito, MBA, CFA, CVA, CM&AA is a managing director of Kaizen Consulting Group, a strategy and M&A advisory firm headquartered in Richmond, VA providing merger and acquisition, capital formation and business strategy services. He has over 25 years of corporate finance and investment banking experience and lectures nationally on the subjects of M&A, business valuation and negotiation.