Beyond Shareholder vs. Stakeholder Value

In a recent article in the Economist (Analyse This), shareholder value is still seen as ‘the governing principle of firms’. Despite increasing calls to start running firms for the sake of stakeholders, the influential newspaper sticks to running the firm for shareholders and thus to an idea that was described by Milton Friedman in his seminal Capitalism and Freedom in 1962:

 There is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits so long as it … engages in open and free competition, without deception or fraud.

In contrast to Friedman’s (and The Economist’s) view, there’s an ever increasing movement that calls for running firms for the sake of its stakeholders (e.g. employees, local communities, public interest groups and financiers) instead of its shareholders. Frameworks are being developed that try to capture more than the financial value of a firm (e.g. the Integrated Reporting framework). Even arguably the most famous of the management scholars, Michael Porter, turns his back on shareholder value. In a 2011 Harvard Business Review article he argues:

A big part of the problem lies with companies themselves, which remain trapped in an outdated approach to value creation that has emerged over the past decades. They continue to view value creation narrowly, optimizing short-term financial performance in a bubble while missing the most important customer needs and ignoring the broader influences that determine their longer-term success. How else could companies overlook the well-being of their customers, the depletion of natural resources vital to their businesses, the viability of key suppliers, or the economic distress of the communities in which they produce and sell?

I propose to move away from the confusing discussion about shareholders and stakeholders for two reasons.

First, shareholder value never seems to be properly defined in the general debate. And certainly not when it’s in the hands of stakeholder-theory proponents. It often gets twisted into something that makes the business world look immoral: businesses will do just anything to make a profit at the expense of everything else. This is, however, not the shareholder theory Friedman had in mind. I included his quote at the start of this text to show that the shareholder view actually calls for ‘free competition, without deception or fraud’ (italics mine). The important phrase ‘without deception or fraud’ seems to be left out of the discussion by stakeholder-theory supporters all together. Furthermore, the attack on shareholder value usually includes the argument that shareholders aim for short-term profits. Business valuation theory, however, actually teaches us that the valuation of a firm is an outcome of its long-term operating income (or cash-flow) and not short-term profit (or short-term rise in stock prices). I do not think it is possible to change the general public’s feelings about the shareholder value concept. It has a tarnished reputation that cannot be mended.

Second, the concept of running a firm in the interest of all its stakeholders is flawed. Stakeholders often have conflicting interests. You cannot shut down environmentally damaging operations without cutting jobs (in the short-run at least). Cheap raw materials or supplied goods can keep prices for consumers down, but might fuel bad ethical practices by suppliers. A firm might be able to balance those interests but can never acquiesce to all without hurting the bottom-line.

Some concepts to change the debate

If a stand-off between a stakeholder and a shareholder view is not the answer, what is? First, try to think of businesses as entities that maximize value to the economic system, i.e. long-term positive cashflow that secures jobs and tax income. Second, acknowledge that firms cannot possibly adhere to all stakeholders’ demands instantaneous and simultaneous. That would certainly hurt the long-term positive cashflow, and thus jobs and tax income. Instead, allow firms to balance the interests of stakeholders and their own long-term positive cashflow goal. In fact, firms are increasingly adopting materiality analysis in which the social and environmental impacts are weighed against the impact on the firm’s profitability.

In combining these two aspects – a firm balances the interests of all stakeholders whilst safeguarding long-term positive cashflow – a model arises where a firm can perform its task of providing maximal value to the economic system by adjusting to changing stakeholder pressures. The task of stakeholders (maybe society in general is an even better concept) is to guide behavior of all entities in society to behavior it deems beneficial. Firms can choose to be front-runners by using Environmental, Social and Governance topics (ESG-topics) to craft strategies to gain competitive advantage (maybe even working together with certain groups of stakeholders). Or firms can take a more defensive stance and wait until regulators or market conditions push them to include ESG-topics into their business practices. For most firms, especially SMEs, the latter strategy may seem the only viable option considering available resources anyway.

In other words, if society wants to push sustainable strategies in companies it should not put pressure on companies alone. Society should put pressure on governments and regulators to adopt rules and regulations to develop the world it wants. A model would arise in which society as a whole moves the world in a direction it wants to go, a world that ought to be. (The ultimate guiding principles in this respect could be the 17 Sustainable Development Goals, which were put forward by the United Nations recently.) The world that ought to be should be translated in rules and regulations. For citizens. But also for companies.

There will, of course, always be companies that shape the world that ought to be in accordance with stakeholder views. But this is not the corporate world’s main task. A firm’s main task is to create maximum value to the economic system by supplying jobs and generating tax income. It should do so in a context where the rules are set by others.

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