Shareholder value is enshrined in our corporate system. Corporate officers are explicitly expected to take actions they believe maximize shareholder value, and boards of directors oversee the management with the same goal in mind.
By Lukasz Pomorski, Adjunct Professor and Brandmeyer Fellow for Impact and Sustainable Investing, Columbia University
Of course, no measure is perfect and one can identify situations in which maximizing shareholder value does not lead to best economic outcomes, especially when corporate decisions lead to externalities. Externalities are side consequences of economic decisions that affect other stakeholders and that typically are not captured by the prices of goods and services a company produces.
For an example of why maximizing shareholder value may not be ideal, consider a firm with a production process that generates toxic waste.[1] For the purposes of our example, let’s assume that the firm can either legally deposit the waste in a nearby lake, or build a costly treatment plant that would process the waste into harmless chemicals.
If the management of the firm wants to maximize shareholder value, they will prefer the former to the latter. The reason is simply costs: dumping waste into a lake is cheaper than investing in the treatment plant. With lower costs, the firm’s profits will be higher and hence the overall firm value will be higher as well (again, please note we are assuming the firm can legally dump the waste and that it won’t be exposed to potential fines, consumer boycott, etc.).
The standard argument, going back to the classic Milton Friedman’s article on the primacy of shareholder value,[2] is that this behavior is perfectly fine. The firm maximizes how much it is worth to investors. Investors are richer than they would have been otherwise, and if they want to invest part of their wealth in other objectives, that’s perfectly fine. In this example, shareholders who care about the environment might donate to an environmental charity to make up for their investment in the polluting firm.
This may seem a reasonable idea until we realize that the increase in corporate profits (i.e., the cost savings of not building the treatment plant) may be much smaller than the cost of cleaning up the lake after the waste is already deposited there. If the owners of the company care about a clean environment, then they may well be better off if the company invests in the costly treatment plant. Yes, the value of their investment would then be relatively lower, but they would not need to spend as much money on environmental clean up. The shareholder-value-maximizing alternative may well leave them poorer overall.
This is a powerful example. It illustrates that when there are externalities, then maximizing shareholder value could distort overall economic outcomes away from what asset owners would rationally prefer. Of course, there is nothing special about the environmental context into which we put our example. It is easy, perhaps depressingly so, to come up with similar examples for a variety of other issues.
Think about a social media company that maximizes user engagement and does not pay attention to the psychological damage it might cause some subset of its users. This course of action could be the best way to maximize shareholder value, but may clash with other shareholder needs.
Perhaps some shareholders decide to forbid their children from using the company’s product in its current form. They may have been happier overall with a lower shareholder value and with a product that generates less profit but serves their community better. As you may have noticed, this argument works even though we only considered the wellbeing and preferences of shareholders. You could extend this reasoning to also include other stakeholders, for example the firm’s employees, customers, etc.
Stakeholder capitalism
Given how pervasive such issues are, it’s not surprising that there is ongoing discussion about moving away from shareholder value and explicitly incorporating other stakeholders’ interests in corporations’ goals and objectives (hence, “stakeholder capitalism”).
Perhaps the most vivid example of this movement was the 2019 Business Roundtable Statement on the Purpose of a Corporation. The Statement was signed by 200 CEOs of the largest corporations in the United States, and the gist of the agreement was that firms should account not just for shareholders’ interests but also for those of customers, employees, suppliers, and the broader communities in which the firms operate.
While the statement reflected the prevailing sentiment at the time, it drew immediate criticism. Within a day, Pensions & Investments, a trade journal, published an editorial with a telling title “Well-intentioned, maybe, but wrong.” Indeed, some flaws in the statement are fairly apparent. For example, it is by no means clear how to measure the collective interest of all the various stakeholders that a company directly or indirectly interacts with.
Even if it is possible to come up with informative measures of how a firm influences its stakeholders, such measures are almost surely going to be subjective. Some well-meaning analysts or data providers may put more emphasis on employees, others on the environment, and so on.
As with ESG ratings, this is not necessarily a bad thing since different people may well care about different issues. However, the inevitable disagreement about the measures could lead to a diffusion of responsibility. It may be possible to defend just about any corporate decision by appealing to some such measure, or perhaps explicitly to some specific stakeholder interest, even if the decision harms other stakeholders—and shareholders in particular.
Moreover, while we are better at recognizing the weaknesses of shareholder value, it is not clear how stakeholder capitalism solves these issues. For example, think back to the firm that dumps toxic waste into a lake. Of course, we want to avoid such situations, but it may well be easier to do so by thoughtful regulation that directly addresses the externalities a firm creates, than by redefining the purpose of the corporation.
Overall, it is unlikely we will move away from shareholder value any time soon. At present at least, it is difficult to think of a realistic alternative that would be nearly as simple, timely, and—dare I say—objective. Moreover, there is also an even more powerful, if prosaic, reason for the dominance of shareholder value: its pivotal role in the current regulation. It is what guides the work of corporate officers and the boards that oversee them. As long as the current regulation binds these key actors to maximize shareholder value, they can hardly manage to other metrics.
Notes:
1. The example is adapted from Hart, O. and Zingales, L. (2017). Companies should maximize shareholder welfare not market value. Journal of Law, Finance, and Accounting, 2 (2): 247–274; https://scholar.harvard.edu/files/hart/files/108.00000022-hart-vol2no2-jlfa-0022_002.pdf. See this paper for a longer discussion about maximizing shareholder value and its alternatives.
2. Friedman, M. (1970). The social responsibility of business is to increase its profits. New York Times Magazine, 13 September: 32–33, 122–124.
This is an edited extract from The Puzzle of Sustainable Investment: What Smart Investors Should Know, by Lukasz Pomorski (published by Wiley, June 2024)
About the author:
Lukasz Pomorski is an author, professor, and investment professional. He teaches a Master-level ESG Investing class at Columbia University, where he is an Adjunct Professor and The Brandmeyer Fellow for Impact and Sustainable Investing. He is also a Senior Vice President at Acadian Asset Management and was previously a Managing Director and Head of ESG Research at AQR Capital Management. Lukasz has contributed to sustainable investment research through numerous publications, conference presentations, and his work on industry working groups and committees.
