Accounting Forum 31 (2007) 325–331

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Introduction

The pursuit of maximum shareholder value:Vampire or Viagra?

Keywords: Corporate governance; Economic value management; EVA; Finance shareholder value; Stock markets

Companies (and countries) which make maximization of shareholder value, that is shareholderwealth, the central aim of corporate governance perform better, it is claimed, than those whichadditionally acknowledge the rights of other interests—such as employees and the environment.The superior performance, it is said, not only increases shareholder wealth but also creates morecorporate growth, improved returns for employees, and welfare and economic benefits for societyat large. The ‘rising tide lifts all boats’. The pursuit of maximum shareholder wealth is, Bughin &Copeland (1997) state, “a virtuous cycle”. Maximizing shareholder wealth is therefore justifiednot only as consequence of ownership but on grounds of economic efficiency and wider socialgains. Not surprisingly these claims are contested.

How is the “virtuous cycle” supposed to be achieved? Usually it is said through three pro-cesses: efficient allocation of scarce economic resources; providing an effective mechanism formonitoring and rewarding top management; and internalizing maximum shareholder value as thebasis for decision-making within companies. Each of these claims is considered.

1. Allocation of scarce resources

At best, it is argued, that management has knowledge only of its own company and industry.At worst it pursues its own interests and awards itself excessive compensation or perks or misusesfree cash flow (Greenwood, 2007). Shareholder-value maximizing advocates however, regardthe ‘market’ as an epistemic device, a discovery procedure for processing, concentrating, andconcisely transmitting (via price signals) dispersed information. By punishing underperformingcompanies through refusing further investment and rewarding better performing companies byinvesting in them, better use of resources results.

But there are two crucial problems with the representation of the stock market as an efficientallocator of resources. Contrary to the widely held view, stock markets are almost insignificantas a source of investment funds. And stock market valuations of companies are often influencedby irrationalities and always by incomplete information.

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Stock markets are primarily mechanisms for the transfer of ownership of stocks/shares ratherthan to provide investment funds. Only when a share is issued for the first time does the amountpaid possibly (not always) become available for investment (or other uses) by the issuing company.Whenever shares are sold again the payment is to the owner of the shares not the company whichfirst issued them. The stock market is a second hand, third-hand, fourth-hand, . . ., nth market.Very rarely is it a first-hand market. In most countries the stock market is not, and never has beenan important source of investment funds for major corporations. Instead, as O’Sullivan points out,throughout the 20th century: corporate retentions (that is profits not distributed to shareholdersand capital allowances) and debt (borrowings) have been the main sources for business investment(2000: p. 78).

From the late 1920s (the period for which O’Sullivan’s data starts) corporate retentions overallin non-financial corporations in the US have never been less than 66% of all sources of fundingover any 5 or 6-year period. In contrast with that, shares have provided less than 18% of corporatefunding and only reached close to that level (17.8%) in 1927–1930 when companies sold largeamounts of shares to speculators. During the period 1982–1987 shares provided only 3.1% of netsources of funds for the 100 largest US manufacturing companies. But even the relatively smallfunding from new share issues overstates the amount of investment funds via the stock market asfunds from shares have “generally been used not to finance investment in new productive assets,but to transfer financial claims over existing assets” (quite often through an initial public offering(IPO) when the founders of a company sell their shares—they, not the company, get most or allof the money) or “to restructure balance sheets” (O’Sullivan, 2000: p. 79) (for instance, to payoff loans).

Eulogising the ‘efficient market hypothesis’, Michael Jenen states: “[There is] no other propo-sition in economics which has more solid empirical evidence supporting it” (1978). But doesthe evidence support this view? The Wall Street Journal describes it as “The most remarkableerror in the history of economic theory” (23 October, 1987) and Soros calls it “absurd” (2003:p. 3). There is an immense body of empirical studies demonstrating market irrationalities andimperfections. These include: dominance of short-term horizon; herd mentality; bubbles ‘irra-tional exuberance’; panics and over-reaction to prospects of losses; the Monday effect; the Fridayeffect, and so on (Montier, 2002; Shleifer, 2000). Cooper, Orlin, and Raghavendra (2001) foundin a study of the period June 1998 to July 1999 – a time of exuberance for shares in Internetcompanies – that the inclusion of a ‘.com’ suffix in a firm’s name resulted in a 53% increase inprice. Even firms with very little links to the Internet who added a ‘.com’ suffix got a 23% increasein price. As Lee states: “empirically we find that news about fundamentals explains only a fractionof volatility in returns. . . stock prices move for reasons that have little to do with fundamentals(2001).

2. Stock market-based incentive schemes

To ensure that top management, the ‘leaders’, of companies focus on maximizing shareholderwealth their incentive schemes should, it is argued be linked to the stock market performanceof the company’s shares. The remuneration of such managers, especially in Anglo-Americancountries has certainly increased dramatically since the rise of the ideology shareholder-valuemaximization. And the notion of disproportionality high pay for top managers has also beenadopted in the public sectors of some countries. ‘Leadership’, indeed ‘visionary leadership’ isrepresented as probably the most crucial element for success and those who fortunately possesthat quality (fortunate for us all) must be handsomely rewarded.

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Arguments for shareholder maximization incentive schemes have two key defects: acausal link between such schemes and shareholder value demonstrably does not exist andthe pursuit of maximum shareholder value is not the most effective way of achieving thataim.

The remuneration of top executives of major companies has increased enormously. The medianpay of a FTSE director is more than £1.5 million; that of a CEO almost £3 million. In 2006/2007alone the pay of full-time directors of the UK’s top companies soared by 37% following a riseof 28% in 2005/2006 (The Guardian, 2007). During 2006/2007 average earnings in the UK roseby 3.4% in the private sector and by 3.1% in the public sector (National Statistics, 2007). Similarrises in other Anglo-American countries such as Australia and New Zealand can also be observed.Somehow the ‘leaders’ of leading German, Korean, and Japanese companies have not requiredsuch hugely disproportional incomes.

But it seems that even these enormous levels and increases in pay are regarded as insuf-ficiently motivating and so the leaders must also be incentified by stock options and variousbonus schemes linked to share prices. And yet despite the shareholder-value bluster about incen-tives there is no identifiable link between such pay increases and corporate performance. AsDan Dalton et al.’s review of more than 220 studies showed share ownership and other shareprice-linked schemes have no consistent effect on corporate financial performance (Dalton,Daily, Certo, & Roengpitya, 2003). Based on a study of giant firms, Julie Froud et al. demon-strate that whilst these firms grew no faster than GDP the pay of the CEOs rose much faster.As Froud et al. point out “top managers. . .appear to be an averagely ineffectual officer classwho do, however, know how to look after themselves (Froud, Johal, Leaver, & Williams,2006: p. 7).

Should shareholder value be an aim or an outcome? The former is asserted by the shareholdervalue maximizing advocates. But, based on extensive empirical comparisons, Mary O’Sullivan,Richard Ellsworth, and others have shown that focusing on shareholder value – rather than onproduct or service quality – ironically results in lower shareholder value in the longer-term.Ellsworth found that “a corporate purpose focused on providing value to customers not only iscompetitively superior to a purpose of maximizing shareholder wealth, but also typically producesgreater long-term returns to shareholders” (2002: p. 27).

3. Internalising shareholder value

What beyond the desire to maximize shareholder value do its advocates offer as the routeto improving the management of companies? A range of certainty assuming calculative tech-niques, generically called ‘value-based management’ (VBM), often with proprietary names, suchas Economic Value Added (EVATM), Total Business Return, Cash Flow Return on Investment,Economic Value Management which purport to enable every major and minor decision in com-panies to enhance shareholder value are advanced by major management consultancy firms—andsome academics. EVA, said Fortune, is “the real key to creating wealth. . .it drives stock prices”.Besanger, Mottis, and Ponssard (2001: 45) claim that: “long-term observations do point to a strongcorrelation between adopting VBM-based incentives and long-term stock returns”.

The logic is that as it is supposed that a company’s current stock market value is the discountedvalue of all future cash flows which will accrue to the shareholders that the key to creatingmaximum shareholder value is to ensure that each decision within a company generates themaximum discounted cash flow. The aggregate of the micro-level decisions ensures maximumshareholder value.

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The assumption of perfect information and no uncertainty may be convenient for mathemizedscribblings on blackboards or in journal articles, or for those who want to pretend that they canprovide an answers ‘machine’, but the assumptions do not match the conditions of the real world.They are false theories but with very real consequences.

Organizations are conceived of as analogous to simple, static, and closed physical entities.There is no room for novelty, for surprises, for human reflexivity. The calculative shareholdervalue ‘enhancing’ techniques presume the availability of information which as King (1975) states:“only God could provide”. Forecasting is difficult if it really is about the future (McCloskey, 1991).Choices made in real time are never made with complete information. As Gigerenzer, Swijtink,Daston, Beatty, and Kruger (1989) observe “no amount of mathematical legerdemain can trans-form uncertainty into certainty” and as Jan Mouritsen states “EVA is a very sorry representation. . .

if it is possible to calculate the net present value [discounted cash-flow] of an organization overthe long run, then the world – for the organization – must be fantastically stable and the strategiesproposed must be very uninteresting” (1998: p. 480). Bessanger et al.’s (2001) eulogy (above)relied on data in Hogan and Lewis (2000) which covered a period of rising share prices sothat everything (including the number of days chips were provided in a company’s staff restau-rant) could be correlated with stock prices. And crucially they omitted to mention that Hoganand Lewis also found equal share price growth by non-adopters of value-based management.Superior performance by value-based management was thus not demonstrated. In fact just aboutevery study of the application of discounted cash flow techniques within organizations pointsto the absurdity of seeking to side-line complexity and uncertainty through the application of amere numerical technique. Independent studies of the degree of correlation of EVA (and othervariants) with the absolute level of changes in stock market valuations of companies find itis at best miniscule and often negative. For instance, a study of 582 US companies found acorrelation in only 18 companies. In 210 companies the correlation was negative (Fernadez,2003).

Overwhelmingly the evidence does not support the assertion from the advocates of maximizingshareholder value, that is shareholder wealth, that the pursuit of that aim is the best businessdevelopment policy and that everyone associated with a company which follows such a policybenefits (‘we all get a piece of the action’). But what of the wider claim that there are socialbenefits? These are said to result from greater economic growth (a view which as we have seenis not an evidence-based view) and through a variety of ‘trickle-down’ processes and indirectownership of shares through pension funds.

Take the US as an example where Drucker said there is “pension-fund socialism” (1976). In2001 the wealthiest 1% of Americans owned over one-third of total wealth and the next wealth-iest 9% owned another third. That is the wealthiest 10% owned two-thirds of total wealth. Theconcentration of wealth is even more extreme when residential wealth is excluded from thecalculations – as it is by most analysts as most people one cannot liquate their home (if theyown one) – otherwise they would have to live on the sidewalk. In 2001, the richest 10th ofthe US population owned over three-quarters of non-residential wealth. The richest 5% ownednearly two-thirds. By contrast the bottom 50% of the population owned less than 2%. In relationspecifically to shares, in 2001 the wealthiest 10% owned more than three-quarters of corporateshares. In contrast, the bottom half of the population owned only 1.4%. Poterba (2000) esti-mated that in 1998 even when indirect ownership through pensions is included the wealthiest10% owned over 86% of corporate share; the bottom 80%, that is overall 8 out of 10 peo-ple, owned a mere 4.1%. The boom in share prices has brought significant benefits only tothose at the very top of the wealth distribution” (Ireland, 2005: p. 72). In the US between

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1989 and 1998 the real value of tangible assets increased by only 14% and the real value offinancial assets, other than shares by 38%. On the other hand, the real value of shares roseby 262%.

The ideology of maximizing the shareholders’ wealth has captured many governments inAnglo-American countries and elsewhere. A consequence has been growing inequality. In theUK, for instance, inequality is back to the levels it was before the Second World War. By 1979,both income inequality and relative poverty were at or near their lowest levels. What followed wasthe most brutal reversal of all countries in the world with the exception of New Zealand (Hills,2005). The association between absolute levels of wealth/poverty and the quality of peoples’health is widely known. Absolute levels of poverty or wealth are respectively bad or good for aperson’s health. Individuals’ circumstances such as family assets and earnings are good predictorsof longevity—at what age one dies.

But there is far less awareness that wealth inequality per se is bad for national health, what-ever the absolute material standards of living are in a country (Smith, 1996). The rise even ofdiseases such as cardiovascular diseases and cancer (and its decline amongst the rich elite) isvery rapid in responses in rises in wealth inequality (Kaplan, Pamuk, Lynch, Cohen, & Balfour,1996). Multiple studies, across a wide range of countries, have related relative inequality to infantmortality, life expectancy, height, eyesight, mental breakdown tooth decay, and morbidity. Thericher live longer, the poorer die earlier, the richer have fewer ulcers, the poorer more, and soon. The lower down the social ladder one is the more detrimental the health effects. One diesearlier and whilst alive the quality of ones health is inferior not necessarily because one is poorbut because one is poorer. One does not just have fewer financial assets but fewer biologicalassets. Over the past 20 years the US has fallen from 11th in world ranking of life expectancyto 45th (Central Intelligence Agency, August 2007). But, of course, there is huge variation –life expectancy – and the quality of health whilst alive – depends upon which US an individuallives in.

The papers in this issue of Accounting Forum contribute to the debate about shareholder valuein a number of ways.

Jeffrey Unerman and Brendan O’Dwyer provide additional, and in an unusual way, supportfor the view that, aside from the valid rights of interests additional to those of shareholders,recognition of those rights may benefit shareholders. Inverting the shareholder value advocates’claim that the pursuit of maximum shareholder wealth benefits everyone—we all get a pieceof the action. Unerman and O’Dwyer, drawing from conceptual and empirical sources, arguethat increased regulation designed to protect the social and environmental interests of a rangeof stakeholders can also serve to enhance corporate economic performance and shareholdervalue.

Lee Moerman and Sandra van der Laan provide a valuable example of the application ofrhetorical criticism. A media release by a company announcing the establishment of a sep-arate entity to fund current and future asbestos litigation claims is unpacked and analysed.Accounting was implicated in the processes employed to persuade stakeholders of the finan-cial viability of the new entity. At the centre of the corporate reorganization which alienatedasbestos-related liabilities from the corporate group was the concept of shareholder value. Usingan organizational discourse analysis framework, the media release is ‘dismantled’ to exposethe rhetorical strategies used to create particular understandings and to privilege shareholdersonly.

Kenneth Kury points to key roles and consequences of institutional pressures ‘outside’ ofcompanies. Whatever or not companies are legally required to pursue maximum shareholder value

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– it varies even between US states – companies whose shares are traded on stock exchanges arepersistently pressurized to maximize shareholder value. The focus of analysis of recent accountingscandals has largely been on the role of management in financial statement manipulation. ButKury takes a different perspective in that he posits institutional pressures for legitimization asa root cause of accounting manipulations. Levels of institutional investors, competitor results,company performance, executive incentive-based pay, and non-executive directors, it is argued,contribute to an environment conducive to earnings management.

In the final paper, Bill Ryan’s field-work-based study considers how some aspects of theinstitutional environment described and analysed by Kury penetrated a specific company. Thefocus of his paper is on how the on-going pressure to increase, or avoid decline in, share-holder value in a particular company changed its budgetary control system and the manner of itsemployment.

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Brendan McSweeneyRoyal Holloway, University of London, United Kingdom

E-mail address: Brendan.mcsweeney@rhul.ac.uk