Different Objectives: Profit Maximization, Shareholder Wealth

Maximization and Stakeholder Value Creation

The shareholder wealth maximization paradigm has its roots in the philosophy of utilitarianism,
the notion that the way to evaluate and select among alternatives is to choose the one that creates
the greatest amount of ‘utility’ or well-being. Prominent contributors to utilitarianism include
Francis Hutcheson, David Hume, Jeremy Bentham and John Stuart Mill. While these
philosophers and their successors disagreed as to what ought to be included within the definition
of well-being, Bentham focused on happiness, writing: ‘It is the greatest happiness of the greatest
number that is the measure of right and wrong’ (Bentham, 1776, Preface).
At the time Bentham wrote, and perhaps still, a major way people could increase their happiness
was through the acquisition of goods and services from businesses. So, within this philosophy,
the role of businesses was to provide the societies they served with maximum goods and services
at the lowest prices. But how to do this? It was Adam Smith, observing the emerging small
businesses of the Industrial Revolution, who concluded that this outcome was a natural result of
proprietors maximizing their own profits. As Smith wrote so memorably in The Wealth of
Nations:
“[H]e intends only his own gain, and he is in this, as in many other cases, led by an invisible
hand to promote an end which was no part of his intention. . . By pursuing his own interest he
frequently promotes that of society more effectually than when he really intends to promote it.”
(Smith, 1776, Book IV, Chapter 2)
These businesses were price takers. They produced simple, undifferentiated products such as the
straight pins that Smith wrote about. Marketing and branding as we understand them today were
unknown at the time, so businesses had no pricing power. In order to increase their profits they
had either to sell more of their product or service at the given market price or lower their costs.
The former meant they were delivering more of the goods and services demanded by customers;
the latter meant they were using resources more efficiently. And, by not excessively using
resources, more of those resources were available to other companies to produce still more goods
and services for society. Profits equaled cash flow; any proprietor who had more cash in the
evening than in the morning had made a profit for the day.
Although the phrase ‘profit maximization’ does not appear in the Wealth of Nations, later
economists applied it to Adam Smith’s famous conclusion and we still use that phrase today
when we speak colloquially about the financial goal of businesses. However, by the end of the
nineteenth century, businesses had evolved to the point where it was becoming increasingly
difficult to determine and calculate profits. Many businesses had grown beyond one product or
service. They were operating in multiple locations, often in multiple countries with multiple
currencies that changed in value relative to one another.
Purchases and sales on credit terms meant that cash flow often lagged the receipt of inputs and
the delivery of outputs. Large initial cash expenditures to acquire plant and equipment that
provided benefits over many years further separated cash flows and economic activity. In
addition, the largest companies were issuing common stock so that their ‘shareholder owners’
were no longer able to see, receive, or even understand the financial flows within the business.
The crash of the stock market in 1929 and the subsequent Great Depression led to the re-
evaluation of the data companies provided to their investors. In the United States, the securities
laws of 1933 and 1934 required publically held companies to issue annual audited financial
statements in a standardized format to facilitate interpretation and comparison and created the
Securities and Exchange Commission to oversee the rules and determine and penalize violations.
‘Profit’ now had a formal definition; it was now the result of the application of financial
accounting rules and was often quite different from cash flow.
Further concerns about the meaningfulness of profits arose as finance theory continued to
develop. The emergence of time value of money revealed the importance of when in time cash
flows take place, but the accounting system made (and still makes) no distinction among profits
regardless of when they occur. Neither do profits incorporate a measure of risk; one dollar of
profit from a risky venture is no different on the accounting books than a dollar guaranteed by a
safe sovereign nation. The result was a return to studying cash flows to evaluate a business, with
profits serving as important supplementary information.
With their new understanding that the value of a business depended on a combination of the
amount, timing and risk of cash flows, finance theorists and analysts sought a more inclusive
measure of a company’s value, and, for publically owned companies, they found it in the
company’s stock market price. Investors, as the holders of the company’s equity shares, were
seen as the ‘owners’ of the firm, the equivalent of the proprietors of Adam Smith’s era. Any
forecasts they might make or concerns they might have about the company’s future performance
would presumably be impounded into the stock price, so the maximum stock price would be
equivalent to maximum financial value.
The shareholder wealth maximization paradigm developed as an extension of its predecessor,
profit maximization, to modify the prior paradigm to respond to a world that had changed and
become financially more complex. Profit maximization failed to incorporate the distinction
between accounting profit and cash flow or the emerging understanding of time value of money
and risk. It had become unable to guide executives to make decisions in the best interests of
society and in the long-run interests of the company itself.
Three academic observations in the 1970s solidified the belief that the goal of a business should
be to maximize financial value, hence the wealth of the company’s shareholders, that is,
shareholder wealth maximization. In 1970 Eugene Fama published his review of capital market
efficiency and concluded that stock markets were weak-form and semistrong–form efficient so
that stock prices incorporated most or all that could be learned from studying past stock price
movements and publically available information (Fama, 1970). If capital markets were efficient,
stock prices reflected the value of the firm as well or better than any other metric. In 1970,
Milton Friedman argued that the pursuit of financial value was (still) the way businesses could
make the greatest contribution to society (Friedman, 1970). And, in 1976, Michael Jensen and
William Meckling used a framework derived from legal theory to help investors identify cases in
which business executives might not maximize their company’s share price and how that
‘agency problem’ might be remedied (Jensen and Meckling, 1976).
Assumptions underlying Shareholder wealth maximization
As is common in so much of economic theory and theorizing, the concept of SWM is grounded
in a series of assumptions, some explicit and some not so explicit. These include the following:
Shareholders are the ‘owners’ of the corporation. While there did exist some ‘joint stock
companies’ at the time of Adam Smith, most businesses were sole proprietorships in which the
proprietor was the founder of the business, its primary or sole investor and its chief executive. Of
these three roles – founder, investor, executive – SWM assumes that the investor role is the one
that identifies the company’s owner(s).
Capital is ‘the’ scarce resource. All other resources are either plentiful or easily substituted for.
This assumption was true for the small companies founded at the time of the Industrial
Revolution; the other inputs to production, land and labor, were plentiful relative to the needs of
the small companies of the time. To maximize production from the resources available,
companies had to compete for capital and use it wisely. And, if capital is the scarce resource,
then the providers of capital must be the most important contributors to the business.
The world is abundant in natural resources. Depletion of any single natural resource is unlikely
and inconsequential even if it occurs, because clever business leaders will find or create
alternative resources, often finding a better substitute, hence businesses need not pay any
attention to natural resources other than as they become inputs to the firm’s processes.
Capital markets are ‘efficient’. rapidly incorporating information about a company’s prospects to
match scarce capital smoothly, effectively and efficiently to where it is most needed (presumably
yielding the ‘best’ output of goods and services and providing just rewards to all resource
providers). Thus, maximum share price reflects investors’ belief that the company has achieved
the best combination of long-term cash flows and risk and provides effective feedback and
guidance to the company’s managers.
Human beings are entirely rational (‘Homo economicus,’ ‘rational economic man’). in making
economic decisions motivated only by maximizing the consumption of goods and services and
minimizing the effort required to gain those goods and services. Implicit in this assumption is
that all people have the same goals and values, none of which deviate from this definition of
rationality. Rational economic decision making by investors further supports the efficient capital
market assumption.
All voluntary economic transactions are positive for all parties concerned. Any transaction in
which someone is willing to pay a price for a good or service that provides a profit to the
supplier is by definition a win-win for company and customer. The ‘consumer is king’;
consumers are autonomous, independent decision makers who always choose wisely what is best
for themselves. Therefore, businesses should produce and deliver whatever people are willing to
pay for within the boundaries of the law.
Business organizations have limited if any impact on the physical environment, local cultures,
social justice and social relationships and do not have any reason to be greatly concerned about
such matters. The positive impact of businesses in the economic realm far outweighs any other
impact, hence these other matters should not enter business decision making.
Governments will always set fair and appropriate ground rules. It is the role of governments to
set the ground rules within which businesses operate. Governments, reflecting the will of the
people they serve, will protect the people because they can be relied upon to be balanced,
unbiased, wise and fair arbiters between interests of business and society. Laws and regulations
will always be fair and current, reflecting the latest in knowledge and the needs and desires of
society.
The financial success of business is equal to the success of society as a whole, hence anything
that increases business success must be good for society. One expression of this is the well-
known quotation often attributed to American President Calvin Coolidge: ‘The business of
America is business.’4 This assumption encourages governments to be particularly favorable to
business, as they attempt to balance the interests of business and society.
Seeking to maximize shareholder wealth leads to financial success, which in turn leads to
societal success. Hence, businesses should make the SWM goal their only goal. All other goals,
if there are any, should only be in the service of shareholder wealth maximization. Further, it is
possible to motivate business executives to achieve shareholder wealth maximization through
cleverly constructed compensation packages that align the executives’ motivations with
shareholder wealth maximization.
Corporations are legally required to pursue shareholder wealth maximization. Shareholders
have invested in the corporation for one reason only, to increase the financial value of their
investment. The corporation’s executives have been hired by the corporation’s shareholder
‘owners’ to act on their behalf and are agents with a fiduciary duty to act in the best interests of
the shareholders, hence to do everything in their power to achieve shareholder wealth
maximization.
 Stakeholder Value Creation

What is corporate sustainability?

Corporate sustainability can be viewed as a new and evolving corporate management paradigm.
The term ‘paradigm’ is used deliberately, in that corporate sustainability is an alternative to the
traditional growth and profit-maximization model. While corporate sustainability recognizes that
corporate growth and profitability are important, it also requires the corporation to pursue
societal goals, specifically those relating to sustainable development — environmental
protection, social justice and equity, and economic development.
There are four components of corporate sustainability view.
(1) Sustainable Development
Sustainable development is a broad, dialectical concept that balances the need for economic
growth with environmental protection and social equity. The term was first popularized in 1987,
in Our Common Future, a book published by the World Commission for Environment and
Development (WCED). The WCED described sustainable development as development that met
the needs of present generations without compromising the ability of future generations to meet
their needs. Or, as described in the book, it is “a process of change in which the exploitation of
resources, the direction of investments, the orientation of technological development, and
institutional change are all in harmony and enhance both current and future potential to meet
human needs and aspirations.” Sustainable development is a broad concept in that it combines
economics, social justice, environmental science and management, business management,
politics and law. It is a dialectical concept in that, like justice, democracy, fairness, and other
important societal concepts, it defies a concise analytical definition, although one can often point
to examples that illustrate its principles.
(2) Corporate social responsibility
Like sustainable development, corporate social responsibility (CSR) is also a broad, dialectical
concept. In the most general terms, CSR deals with the role of business in society. Its basic
premise is that corporate managers have an ethical obligation to consider and address the needs
of society, not just to act solely in the interests of the shareholders or their own self-interest. In
many ways CSR can be considered a debate, and what is usually in question is not whether
corporate managers have an obligation to consider the needs of society, but the extent to which
they should consider these needs.
Theoretical Foundations of Stakeholder Value Maximization:
The arguments in favour of corporate managers having an ethical responsibility to society draw
from four philosophical theories:
• Social contract theory. The central tenet of social contract theory is that society consists
of a series of explicit and implicit contracts between individuals, organizations, and institutions.
These contracts evolved so that exchanges could be made between parties in an environment of
trust and harmony. According to social contract theory, corporations, as organizations, enter into
these contracts with other members of society, and receive resources, goods, and societal
approval to operate in exchange for good behaviour.
• Social justice theory. Social justice theory, which is a variation (and sometimes a
contrasting view) of social contract theory, focuses on fairness and distributive justice— how,
and according to what principles, society’s goods (here meaning wealth, power, and other
intangibles) are distributed amongst the members of society. Proponents of social justice theory
argue that a fair society is one in which the needs of all members of society are considered, not
just those with power and wealth. As a result, corporate managers need to consider how these
goods can be most appropriately distributed in society.
• Rights theory. Rights theory, not surprisingly, is concerned with the meaning of rights,
including basic human rights and property rights. One argument in rights theory is that property
rights should not override human rights. From a CSR perspective, this would mean that while
shareholders of a corporation have certain property rights, this does not give them licence to
override the basic human rights of employees, local community members, and other
stakeholders.
• Deontological theory. Deontological theory deals with the belief that everyone, including
corporate managers, has a moral duty to treat everyone else with respect, including listening and
considering their needs. This is sometimes referred to as the “Golden Rule.”
(3) Stakeholder theory
Stakeholder theory, which is short for stakeholder theory of the firm, is a relatively modern
concept. It was first popularized by R. Edward Freeman in his 1984 book Strategic Management:
A Stakeholder Approach (Pitman Books, Boston, Mass, 1984). Freeman defined a stakeholder as
“any group or individual who can affect or is affected by the achievement of the organization’s
objectives.” The basic premise of stakeholder theory is that the stronger your relationships are
with other external parties, the easier it will be to meet your corporate business objectives; the
worse your relationships, the harder it will be. Strong relationships with stakeholders are those
based on trust, respect, and cooperation. Unlike CSR, which is largely a philosophical concept,
stakeholder theory was originally, and is still primarily, a strategic management concept. The
goal of stakeholder theory is to help corporations strengthen relationships with external groups in
order to develop a competitive advantage.
(4) Corporate Accountability
The fourth and final concept underlying corporate sustainability is corporate accountability.
Accountability is the legal or ethical responsibility to provide an account or reckoning of the
actions for which one is held responsible. Accountability differs from responsibility in that the
latter refers to one’s duty to act in a certain way, whereas accountability refers to one’s duty to
explain, justify, or report on his or her actions.