Why Shareholder Value Management Still Matters

Is the world giving up on the idea of managing for shareholder value? Critics of the approach are certainly getting more vocal. Last March, former General Electric (GE) CEO Jack Welch told The Financial Times: "On the face of it, shareholder value is the dumbest idea in the world." In the Harvard Business Review, Roger Martin, dean of the Rotman School of Management at the University of Toronto, recently announced the end of the era of "shareholder value capitalism." Even the recent movie Avatar has joined the chorus, with a corporate bad guy using shareholders to justify the environmental destruction of the lush moon Pandora, saying: "if there's one thing shareholders hate more than bad publicity, it's a bad quarterly statement."

Such critics argue that managing for shareholder value contributed to the global economic crisis by encouraging executives to overemphasize the short-term, oversimplify their company's actual performance, and overpay for dangerous risk-taking by corporate management. What's more, considering that in late 2008 many investments declined in market value by half or more in the space of a few short weeks, why should we still trust shareholder value as a relevant measure of corporate performance?

To blame the concept of shareholder value management for such negative outcomes is to mistake remarkably poor—and in some cases, self-interested—corporate governance for defects of principle in the idea itself. There is nothing in the theory or practice of shareholder value management that forces companies to maximize short-term returns at the expense of long-term sustainability, or to reward owners at the expense of alienating customers, employees, or other stakeholders.

Understood correctly, the principles of managing for shareholder value are simple: First, ensure that a company delivers enduring economic returns above the cost of any new capital it employs; and second, increase the returns earned by its existing capital over time. There are three basic ways to achieve these goals: to grow healthy (that is, high-return) businesses; to fix or shrink unhealthy business whose returns are below the cost of capital; or to return cash to investors in the form of dividends or stock buybacks when a company has more cash on hand than opportunities for profitable growth.

cash-based metrics can focus managers

From this perspective, managing for shareholder value has nothing to do with "managing earnings" to fool investors into thinking that a company's fundamental performance is better than it actually is. It doesn't necessitate "borrowing from the future" to maximize today's returns or playing an "expectations game" with the goal of always beating quarterly estimates.

The tools of shareholder value enable managers to develop a granular view of where strategies, activities, and resources add value or subtract it. Cash-based metrics such as cash-flow return on investment, economic profit, and total shareholder return allow managers to compare performance across different businesses, identify and address wasteful or uncompetitive practices, quantify potential growth opportunities and tradeoffs, and measure performance outcomes against expectations and against peers. Such metrics also force companies to be disciplined about how they allocate capital and to evaluate potential investments carefully against the alternative of returning cash to investors.

Perhaps even more important, managing for long-term shareholder value gets management teams thinking of the company's owners as a resource to leverage rather than an audience to spin. Almost all companies have a core group of long-term owners who would like to see the business run in a way that drives competitive fundamental performance over a three-, five-, or even 10-year period. These owners are professional investors, managing your and my retirement savings, and they embody sophisticated views of the company, its businesses, and its changing competitive landscape. They represent a valuable feedback loop for senior management about the objective prospects of a company's strategies and priorities.

Six ways to assess value management

Finally, managing for shareholder value is one of the best ways for a public company to continue to serve other stakeholders, in addition to its investors. When a company delivers consistent and sustainable improvements in shareholder value, it lays the foundation not only for its own long-term survival, but also for long-term returns to all stakeholders—customers in the form of new innovations and ever greater customer value, employees in the form of rising wages and salaries, governments in the form of taxes, and communities in the form of stable jobs. Indeed, the more a company effectively monitors and adapts its strategy to deliver long-term shareholder value, the more likely it is to avoid crisis situations that require radical restructuring, massive employee layoffs, or government bailouts.

So how can a company make sure it is managing for shareholder value in the right ways? If you can answer the following six questions in the affirmative, you are on the right track:

Do you know where and how your businesses are creating value—by business unit, by product category, by customer segment?

Does your incentive compensation system require that senior executives have substantial "skin in the game" in the form of long-term direct equity exposure (not stock options)?

Are you measuring corporate shareholder value performance over longer time horizons (one, three, and five years), not on the daily stock price?

Are you assessing potential changes in your portfolio by the long-term value-creation potential of the reshaped business, not by whether the deals happen to accrete or dilute earnings per share in the short term?

Are your management processes—planning, budgeting, capital allocation, and the like—aligned with the goal of increasing shareholder value over the long term?

Are you engaged in an active dialogue with those investors who are long-term owners of your company in order to understand their objectives and priorities?

Despite recent reports, managing for shareholder value still matters—maybe now more than ever. At a time when there is a lot of uncertainty about the future, CEOs need to have a compelling plan for how they are going to create value in the business. Let's not confuse poor governance or bad execution with shortcomings in the principle itself. Managing for shareholder value isn't the problem—and doing it properly and thoughtfully is a big part of the solution.