A View From INSEAD

Maximising Shareholder Value

Theo Vermaelen

Theo Vermaelen
Programme Director of the Advanced International Corporate Finance programme

Maximising shareholder value is commonly held to be the raison d’être of all companies throughout the world. It is therefore at the heart of much research at INSEAD – one of the world’s leading international business schools – where many expert faculty approach it from many different perspectives.

However, the 2008 financial crisis shook many fundamental business beliefs to the core. Is it possible that the importance of maximising shareholder value has been overstated? Not according to INSEAD finance professor, Theo Vermaelen, who gives his views in the following interview…

Let’s go back to basics. What exactly does it mean to maximise shareholder value?

My basic message is that maximising shareholder value is not the same as maximising profits or the stock price! Shareholder value is defined as the present value of future expected cash flows, from now until infinity. These cash flows are discounted at a rate that reflects the risks to these cash flows. Managers should be taught to build a spreadsheet that incorporates the relevant cash flows and risks. Subsequently, they should try to execute the strategy implied by the spreadsheet. Clearly, this is not the same thing as maximising short-term objectives such as profits or earnings per share.

Can you give us a real-life example?

Sure, let’s take a private banker who sells a bad product to his clients. He may see bank profits rise as a result of the fees, but the value of his business will go down if, as a result of that sale, the client leaves the bank. In other words, the banker should consider the present value of all expected cash flows from his client.

Why do so many people assume that maximising shareholder value is the same as maximising stock prices?

In a truly efficient market, maximising the stock price would be the same as maximising shareholder value. In this case the stock price reflects the strategy reflected in the spreadsheet, and then there is no difference between long-term and short-term shareholder value. However, if the market is not efficient, stocks could be overvalued or undervalued relative to the predictions of the spreadsheet.

What are the implications for real-life managers?

What most managers will do, and should do, is to ignore these deviations and focus on implementing the strategy. Occasionally, they may want to buy back stock if the shares seem undervalued and to issue new shares when they seem overvalued. In that case, the objective is to maximise long-term shareholder value to the existing shareholders. Alternatively, the CEO may be encouraged to revise his forecasts as a result of “messages from the market.” For example, a sharp fall in the share price may make a CEO think about whether his strategic plans should be revised to reflect the new information revealed through stock price movements. In that case the stock price and shareholder value may converge again.

You make it sound so easy! Why do things go so horribly wrong?

The fact is that managers, like anyone else, maximise their own personal happiness subject to constraints. This problem can only be solved by appropriate corporate governance, that is, by providing the right carrots and sticks to ensure that the donkey walks! One thing we learned from the financial crisis is the importance of good governance and the alignment of incentive mechanisms with long-term shareholder value. Obviously, everyone likes to blame bankers’ bonuses tied to short-term profits, but the same problem lies behind the sovereign debt crisis – the lack of concern of managers (politicians) for shareholders (the taxpayers).

Can regulation solve the problem for banks and governments?

The problem with the banking sector is that regulators set the capital structure, in the same way that the government sets the speed limit. Like a car driver who drives as fast as is legally permitted, bankers try to reach the government-recommended leverage without asking whether this limit corresponds to shareholder-value maximisation.

In that case, what is the solution?

Although I cannot really argue that taking such a course will prevent the next crisis, it seems to me that having a bit more finance training for CEOs and company directors cannot hurt when the next crisis happens…

To maximise your own shareholder value, consider enrolling on an INSEAD Executive Education programme, such as Advanced International Corporate Finance, directed by Professor Vermaelen. To read the full article please click here.

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