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Small Business Digest


Does ‘Maximize Shareholder Value’ Really Make Sense?

Maximize shareholder value.

If people have heard it once, they’ve heard it a thousand times. It’s the pledge of allegiance recited in boardrooms around the world, the North Star to guide the decisions of the business masses.

But Dan Adams wants people to consider a provocative notion: What if that pledge is just a collection of meaningless words? And what if that faithfully followed star is actually a mirage? What if people get to where they think they’re going only to find…nothing?

Don’t get him wrong. Adams believes maximizing shareholder value is a lovely result – but he also believes it’s a lousy goal.

“Think about it this way,” says Adams, president of Advanced Industrial Marketing and author of New Product Blueprinting: The Handbook for B2B Organic Growth (AIM Press, 2008). “What happens when you give your employees a rousing speech about maximizing shareholder value? Once they wake up from their boredom-induced nap, they’ll go back to doing exactly what they had been doing before. After all, what can they do that will raise earnings per share? It’s like you’re asking them to count all the stars in the sky.”

In other words, maximizing shareholder value – a mantra made popular in 1976 by the most-cited academic business article of all time, Jensen and Meckling’s “Theory of the Firm” – is just too vague and uninspiring to move employees to action, Adams says. He notes that this viewpoint was also expressed by Peter Drucker, who insisted that the primary purpose of a business is to acquire and keep customers.

“People need something tangible and actionable to focus on – something that will result in maximizing shareholder value,” says Adams. “Tell an employee to increase shareholder value, and he’ll struggle. Tell him to increase customer value, and he can think of a dozen things to do, many of them actionable, measurable and beneficial to your bottom line.”

The uninspiring nature of the “shareholder value” mantra is only one reason Adams suggests people consider embracing a new one. He says the whole notion of shareholder value is built on a foundation of failed logic.

Here are five reasons why he believes it’s time to focus instead on understanding and meeting the needs of customers:

Shareholders care more about how healthy the company looks than how healthy it is. According to the authors of the 2008 Harvard Business Review article “Innovation Killers,” “Over 90% of the shares of publicly traded companies in the United States are held in the portfolios of mutual funds, pension funds and hedge funds. The average holding period for stocks in these portfolios is less than 10 months.”
In other words, that hedge-fund manager the company was trying so hard to please last year has already dumped the stock. Shareholders have very little interest in the long-term health of the company, only in the appearance of long-term health. It might be more accurate to refer to today's shareholders as “sharehandlers.” It’s time to stop thinking of the typical shareholder as a grandma in Peoria holding shares of stock for 20 years, Adams says.

Asking an executive to maximize shareholder value can be a very bad idea. If a stock’s P/E ratio is 20-to-1, then only 5% of a firm's value is driven by this year's earnings. To put it another way, 95% of shareholder value is driven by shareholders’ expectations of the future…which can be manipulated. Most of those shareholders are not actually going to be around to see whether the company meets its long-term earnings goals. So the executive with stock options has great incentive to manage investor expectations.

“And when managing the expectations of Wall Street analysts conflicts with the actual job of building the firm's long-term competitive strength, guess which wins?” Adams asks.

“Every quarter becomes ‘the most important quarter in the company's history.’ Employees will become numb to this familiar refrain because they hear it all the time. Expectations might stay the same or increase or decrease, but not as a result of the proactive effort of the company to create long-term strength. If the executive team is driving with its parking lights on instead of its high beams, won’t the board of directors at least be concerned about investors’ long-term financial gains? Unfortunately, that’s a pleasant but outdated notion.”

Maximizing shareholder value doesn't work anyway. Adams says people should not be shocked to find this failed logic has led to failed results. Roger Martin (“The Age of Customer Capitalism,” Harvard Business Review, January 2010) researched and compared the pre-maximize era (pre-1976) with the post-maximize era (post-1976). Here’s what he found: The compound annual real shareholder return actually dropped from 7.6 % to 5.9%. The new goal of maximizing shareholder value did nothing to…maximize shareholder value.

“Companies that were successful often found they had created more illusion than reality,” Adams says. “Jack Welch, the ‘poster child’ for maximizing shareholder value, was highly successful over his tenure. But GE shareholder value plummeted after his retirement, most likely because investors were trading on the appearance of health – not the actual long-term health – of GE. And that appearance changed dramatically with Mr. Welch’s retirement. It’s been 10 years since he retired, and GE’s market capitalization is still only one-third of what it was when he left. It may be a long time before his successor(s) can ‘manage expectations’ to the peak he reached.

“Failed logic and failed results do not mean we should ignore shareholder value. We simply must understand shareholder value for what it is and what it is not. Let’s look more closely.”

Only tangible goals, pursued day after day, ultimately get results. Finishing a marathon is a noble goal. But it’s important to note that the personal satisfaction people feel afterwards is the result of achieving their goal…is not the actual goal. If they planned to run a marathon and made personal satisfaction their goal, they would fail to focus their training on the more tangible task of running more than 26 miles. During the marathon, they would be tired, sore, and frustrated…and fall well short of personal satisfaction. By confusing the result with the goal, they’d miss out on both….

“The more happy customers you have, the happier your shareholders will be. The more miles you run leading up to the marathon, the more likely you'll put in a satisfying performance on the day of the race. I truly believe that the organization behaving as though its goal is to understand and meet the needs of its customers will outperform competitors fixated on shareholder value.”

Employees need a higher calling to be inspired. Napoleon said, “Small plans do not inflame the hearts of men.” If the CEO thinks his or her employees are passionate about this quarter’s earnings per share, the CEO is out of touch, Adams says. The CEO might be excited about it because he or she has large stock options, but that’s not the kind of passion that’s going to rub off on employees, Adams says. In fact, many employees will question the CEO’s motivation to reach the goal when they know he or she will benefit disproportionately – sometimes wildly disproportionately – from the achievement of that goal, Adams says.

These same employees, however, can become very motivated when given the opportunity to deliver real and measurable value,” Adams says. “As Steve Jobs asked when recruiting John Sculley from Pepsi, ‘Do you want to sell sugar water for the rest of your life, or do you want to come with me and change the world?’ Employees will quickly forget last quarter’s earnings, but years from now they’ll be telling their grandkids how they were on a new-product team that turned their industry upside down.”

Meeting customer needs requires understanding them – and from that understanding can flow a river of profits. Adams challenges companies to make a worthy new goal: “Understand and meet the needs of my customers.” Two points of clarification: First, “customers” includes both existing and new customers (sometimes in new markets). Second, “meeting needs” must include both value creation and value capture. Value creation is a new offering that provides value beyond the customer’s next-best alternative. Value capture is returning some of this customer value to the supplier through appropriate pricing. Done correctly, meeting customer needs will not reduce profits; it will increase them, Adams says.

-But why should the goal be to understand and meet – not just meet – customers’ needs? Nearly four decades of research says the new product battle is usually won or lost in the “understanding” phase…often referred to as the “front end of innovation.” Companies that directly engage their customers to understand their needs have operating income growth rates three times higher than those that do not, Adams says (The Global Innovation 1000, Booz Allen Hamilton, 2007).

“When you see a gulf that large between good and poor practitioners, it should scream ‘opportunity!’ ”  Adams says. “I’m not sure what your corporate goal would be if you were engaged in a wordsmithing exercise…but if you want to change behavior to drive profitable growth, I think ‘understand and meet the needs of customers’ will do nicely.”

The executive’s dilemma, of course, is to find a way to survive the short term while building the long term. After all, those short-term “sharehandlers” will continue to form expectations, and the board of directors will continue to watch these expectations impact stock price, Adams says.

The only solution, he says, is to take a two-pronged approach of finding new ways to influence investors while rapidly seeking to understand the customer needs that have, so far, gone unmet.

Prong 1: Help investors look forward, not just backward. A consistent stream of quarterly “good news” is one way of influencing investors’ expectations…but not the only way. For example, the stock price of a pharmaceutical company can be driven by its pipeline of new products…something that is “knowable” because of the public reporting of clinical trials.

Consider ways to supplement the “backward-looking” metric of consistent earnings with appropriate “forward-looking” insight. One may not be able to ignore quarterly earnings reports, but take a cue from Steve Jobs or Jeff Bezos (who ran Amazon at quarterly losses for seven years) and look for other ways to inspire investors, Adams says.

Prong 2: Work to rapidly understand customer needs. Regardless of one’s message to investors, one probably needs to show tangible financial results sooner than one would like. Most suppliers are squandering over half of their R&D resources on new products that will fail…usually because customer needs were not understood. The shortest line between this state and blockbuster new products is to close the gap in understanding customer needs, Adams says.

Summing Up

“Will this require a lot of energy and focus? Absolutely,” Adams says. “And that’s why it’s such a great idea. Not everyone is willing to expend the blood, sweat and tears it takes to create a new reality inside their company and make a mark in the marketplace. Just imagine what will happen if you’re able to make this shift before your competitor

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