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A big part of the problem lies with companies themselves, which remain trapped in an outdated approach to value creation that has emerged over the past decades.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.

The Business Case for Non-Financial Reporting

With an EU directive on non-financial disclosure now being translated into national legislature, social and environmental reporting seems to become a reality for an increasing number of organizations. Although it still isn’t mandatory for all companies to disclose non-financial information, the trend is clearly towards greater disclosure. In this month’s piece, I argue that your organization should start reporting on social and environmental topics even if regulators aren’t (yet) requiring this.

What’s the current status on non-financial reporting? The EU directive states that listed companies, banks and insurance firms will all have to disclose non-financial information on environmental and social topics. My guess is that it won’t stop there: the Netherlands is already opting to extend the scope to other public-interest entities such as pension funds, housing associations and utility firms.

Beyond the group of organizations already mentioned, other firms are also experiencing increasing pressure from stakeholders to disclose more information on their operations and supply chains. Whatever the reason (e.g. regulation, pressure from stakeholders, or maybe even new worldviews such as radical transparency or the purpose economy), companies are faced with mounting pressures to report beyond mere financial statements. We could see this as an increased attention to the distribution of “goods” and “bads” as Garrett Hardin already pointed out in his 1985 classic Filters Against Folly:

Every human activity produces both things that we want – “goods” – and things we don’t want – “bads”. How should society distribute these goods and bads?

Hardin goes on to argue that:

.. most people living today would say that even if it is historically true that the widespread externalizing of business costs was causatively responsible for the rise of modern civilization, we cannot, from here on out, tolerate the practice. Regardless of the past, future policy must insist on internalizing the cost of production.

It seems that with recently implemented policies like the EU directive on non-financial disclosure, the future that Harden writes about in 1985 is becoming a reality.

Two concepts that Hardin introduced in Filters Against Folly show that you can use non-financial reporting as an opportunity to boost the competitive advantage of your organization.

Non-financial reporting to update your business strategy

A useful mental model in analyzing the business world is what Hardin calls the “Double C–Double P Game”, which stands for commonize costs and privatize profits. (Commonizing here means the spreading of the cost of an activity over a population no matter who profits from the cost. Privatizing means the profit from activities accrues to the company, and the company alone.) This model seems to be under attack with the increased attention of stakeholders to disclose which costs are commonized (e.g. land and water use, CO2 emissions, etc.) and which profits are privatized (see the discussion on the relationship between tax evasion and corporate social responsibility in The Economist).

Although the increased scrutiny of stakeholders can seem troublesome to many an organization in terms of increased effort to dig up information from every nook and cranny of operations, I see opportunities to actually use it for a renewed look at the company’s strategy and perceived competitive advantage.

There are numerous frameworks available to help an organization structure its non-financial reporting, these include ISO 26000, the United Nations Global Compact and the Global Reporting Initiative. Rather than just use these as reporting guidelines, a company can actually use these frameworks to understand where it may be losing ground in the “Double C–Double P Game”. You may ask yourself which topics need more attention because costs are becoming increasingly internalized, or how you can continue privatizing the profits of the operations you undertake. Social and environmental analysis might prove indispensable in effectively adjusting your business strategy to accommodate  a new business environment where your current business’s specific and carefully crafted “Double C-Double P Game” is losing ground.

Non-financial reporting to build better stakeholder relations

In addition to the benefit of building a strategy matched to the new business environment, there is a second opportunity in reporting on non-financial performance. If done well, a company might actually improve the relationship with all stakeholders by melding together what Hardin calls numeracy, literacy and ecolacy filters. Companies might be under attack from differing interest groups that are biased toward using one filter only. Literacy, for example, can do much harm if it is not accompanied by numeracy to put statements into perspective. Hardin explains:

There is no royal road to rationality. Whatever means we are tempted to use, we must be wary of the poetic approach. Rhetoric (..) may give one a wonderful “oceanic feeling” (to use Freud’s term), but this feeling is more likely to prevent than to facilitate advances in understanding. It is when ecological rhetoric is most beautiful that we must be most on our guard.

And, again about abusing literacy:

.. the wish to escape debate disguises itself under a multitude of verbal forms: infinity, non-negotiable, never, forever, irresistible, immovable, indubitable, and the recent variant “not meaningfully finite.” All these words have the effect of moving discussion out of the numerate realm, where it belongs, and into a wasteland of pure literacy, where counting and measuring are repudiated.

Of course, the company itself should also avoid vague words and terminology. One of the techniques proposed by Hardin to make clear what is actually meant, is operationalism:

Faced with conflicting views, the critical analyst asks, “What operations are implied by these statements?” Once the operations are made clear, difficulties usually evaporate.

After answering the question ‘What do thew words actually mean’ (i.e. literacy), Hardin further proposes to go beyond mere numbers to numeracy:

In spite of its name, numeracy is concerned with more than numbers. The relative size of quantifiable factors is often more important than their exact measures. The importance of scale effects can be appreciated with little actual measurement.

He gives an example where the numerate filter is a useful addition to the literate filter:

Dichotomies are favored over quantities. It is so comforting to divide polluting substances sharply into the categories of “safe” and “unsafe”. (..) Nature is silent. Nature does not tell us when “safe” slips over into “unsafe”; men and women, reasoning together, must legally define “unsafe”. (..)“Safe” and “unsafe” are literate distinctions; nature is numerate. Everything is dangerous at some level. Even molecular oxygen, essential to human life, becomes lethal as the concentration approaches 100 percent.

Finally, Hardin proposes to combine literacy and numeracy with ecolacy ‘to ferret out at least the major interconnections’. With ecolacy we ask the basic question “And then what?” to sort out what the unwanted consequences are ‘to grant a modicum of justification for the position of society’s nay-sayers’:

Excessive ecolacy can lead to conservatism of the most stultifying sort. For prudence’s sake, ecolacy must be combined with numeracy. Any action that we take – and inaction is a form of action – leads to some unwanted consequences. Prudence dictates that we compare the advantages and disadvantages of all proposed courses of action, choosing the one that, on balance, is quantitatively best.

By using non-financial reporting not as ‘just another report’, but as an actual effort to communicate through multiple lenses (i.e. literate, numerate and ecolate), I see huge opportunities in creating a more effective strategy, and better stakeholder relationships with fewer controversies.

Successful Business and the Halo Effect

Being influenced in my thinking on business strategy and execution mostly by the work of Igor Ansoff (see Implanting Strategic Management), I have always wondered why business books like In Search of Excellence and Good to Great had such huge success. Ansoff stressed that business performance is highly dependent on the specific environment your business finds itself in at any given time. Consequently, he was very much against the notion of an ‘if you do this in any situation, it’ll always work’-approach as advocated by such business books.

So, following Ansoff, to me it seems that the prescriptive mantras for long-lasting high business performance are just not in sync with a situational or conditional approach (based on so-called turbulence levels of the business environment). Moreover, companies hailed as consistent high performers at one point in time, will sooner or later come crashing down. (As you may well ascertain when browsing through the companies listed as high performers in older business blockbusters.)

So, the question really is: what’s going on here? Are there really business laws (like laws in physics) that safeguard lasting high business performance? Or are these laws a mere fallacy?

It was only recently that I came across a fascinating theory called the The Halo Effect by Phil Rosenzweig (the book with the same name was first published in 2006 with an updated version published in 2014). It tries to shed some light on the apparent attractiveness of a recipe for long-lasting business success. Rosenzweig argues that our thinking about business performance is shaped by a number of delusions:

For all their claims of scientific rigor, for all their lengthy descriptions of apparently solid and careful research, they [i.e. science in business books] operate mainly at the level of storytelling. They offer tales of inspiration that we find comforting and satisfying, but they’re based on shaky thinking. They’re deluded.

He goes on naming a number of delusions in our thinking about business performance. The pre-eminent delusion Rosenzweig names the Halo Effect:

[The Halo Effect is the] tendency to look at a company’s overall performance and make attributions about its culture, leadership, values, and more. In fact, many things we commonly claim drive company performance are simply attributions based on prior performance.

It’s not so much the result of conscious distortion as it is a natural human tendency to make judgments about things that are abstract and ambiguous on the basis of other things that are salient and seemingly objective. The Halo Effect is just too strong, the desire to tell a coherent story too great, the tendency to jump on bandwagons too appealing.

It turns out that most business blockbusters that tell you precisely which companies to mimic for success, suffer from the Halo Effect. Consequently, the companies that are given as examples in most business books (e.g. Xerox in In Search of Excellence, Fannie Mae in Good to Great; also see this article in The Economist) are not consistent high performers after all:

Yet for all their promises of exhaustive research, Collins and Porras [in Built to Last: Successful Habits of Visionary Companies] didn’t address a basic problem: the Halo Effect. Much of the data they gathered came from the business press, from books, and from company documents, all sources that are likely to contain Halos.

You would have been better off investing randomly than putting your money on Collins and Porra’s Visionary companies.

But why the appeal then? Why are these prescriptive books such a huge success? Time after time? The answer, Rosenzweig argues, is that we like stories:

Managers don’t usually care to wade through discussions about data validity and methodology and statistical models and probabilities. We prefer explanations that are definitive and offer clear implications for action. We like stories.

Now, there’s nothing wrong with stories, provided we understand that’s what we have before us. More insidious, however, are stories that are dressed up to look like science. They’re better described as pseudo-science.


Readers, too, prefer clear stories. We don’t really want to hear about partial causation or incremental effects or threats to validity. And there’s a further problem compounding all of this. As Harvard psychologist Stephen Pinker observed, university departments don’t always represent meaningful divisions of knowledge. If you’re a professor of marketing, you care a lot about market orientation and customer focus, and there’s a natural tendency to want to demonstrate the importance of your specialty.

Does this mean that everything that is written about good business practices is just nonsense and everything might as well be left to chance? No:

Success is not random – but it is fleeting. Why? Because as described by the great Austrian economist Joseph Schumpeter, the basic force at work in capitalism is that of competition through innovation – whether of new products, or new services, or new ways of doing business. Where most economists of his day assumed that companies competed by offering lower process for similar goods and services, Schumpeter’s 1942 book, Capitalism, Socialism and Democracy, described the forces of competition in terms of innovation.

But the main point is that high performance is difficult to maintain, and the reason is simple: In a free market system, high profits tend to decline thanks to what one economist called “the erosive forces of imitation, competition, and expropriation.” Rivals copy the leader’s winning ways, new companies enter the market, consulting companies spread best practices, and employees move from company to company.

These findings show that performance is not random but persists over time, yet there is also a tendency to move toward the middle, a clear regression toward the mean. Competitive advantage is hard to sustain. Nothing recedes like success.

However, real science on business performance, as opposed to mere storytelling, is out there. But it might not make for such a good story:

Anita McGahan at Boston University and Michael Porter at Harvard Business School set out to determine how much of a business unit’s profits can be explained by the industry in which it competes, by the corporation it belongs to, and by the way it is managed. This last category, which they called “segment-specific effects,” covers just about everything we’ve talked about (…): a company’s customer orientation, its culture, its human resource systems, social responsibility, and so forth. Using data from thousands of U.S. companies from 1981 to 1994, McGahan and Porter found that “segment-specific effects” explained about 32 percent of a business unit’s performance. Just 32 percent. The rest was due to industry effects or corporate effects or was simply unexplained. So maybe all of the studies we’ve looked at make sense after all! It’s just that, as we suspected, their efforts overlap – they all explain the same 32 percent [italics mine]. Each study claims to have isolated an important driver of performance, but only because of the Delusion of Single Explanations.

Rosenzweig stays clear from coming up with his own take on a recipe for long-lasting business success. However, understanding that strategy always involves taking risks, that links between input and outcomes are sketchy at best and that flawless execution (once you have made up your mind about your strategic direction) is needed at all times, can veritably be read as a good starting point for discussing your company’s performance. It also means you do not have to resort to the latest and newest four, five, or eight-point list promising the holy grail of ever-lasting high business performance.

So, what’s the very mundane advice that Rosenzweig has to offer to managers?

When it comes to managing a company for high performance, a wise manager knows: (1) Any good strategy involves risk. (2) If you think your strategy is foolproof, the fool may well be you. (3) Execution, too, is uncertain – what works in one company with one workforce may have different results elsewhere. (4) Chance often plays a greater role than we think, or than successful managers usually like to admit. (5) The link between input and outputs is tenuous. But when the die is cast, the best managers act as if chance is irrelevant – persistence and tenacity are everything.

Will all of this guarantee success? Of course not. But I suspect it will improve your chances of success, which is a more sensible goal to pursue.

If you want to read your management books more critically, the lessons drawn by Rosenzweig in The Halo Effect  might just be invaluable.