Roger Martin is the dean of the Rotman School of Management at the University of Toronto and author of the new book Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn from the NFL. He was recently featured in an article for Forbes titled The Dumbest Idea in the World: Maximizing Shareholder Value in which he argues that “[o]ur theories of shareholder value maximization and stock-based compensation have the ability to destroy our economy and rot out the core of American capitalism.”
Martin begins by distinguishing between the real market and the expectations market:
The “real market,” Martin explains, is the world in which factories are built, products are designed and produced, real products and services are bought and sold, revenues are earned, expenses are paid, and real dollars of profit show up on the bottom line. That is the world that executives control—at least to some extent.
The expectations market is the world in which shares in companies are traded between investors—in other words, the stock market. In this market, investors assess the real market activities of a company today and, on the basis of that assessment, form expectations as to how the company is likely to perform in the future. The consensus view of all investors and potential investors as to expectations of future performance shapes the stock price of the company.
In 1976, academics Jensen and Meckling published a paper, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, which had the effect of shifting the focus of corporate managers from the business operations (the real market) to the share price (shareholder value, or the expectations market). This was nothing short of earth shattering in terms of altering management incentives:
“What would lead [a CEO],” asks Martin, “to do the hard, long-term work of substantially improving real-market performance when she can choose to work on simply raising expectations instead? Even if she has a performance bonus tied to real-market metrics, the size of that bonus now typically pales in comparison with the size of her stock-based incentives. Expectations are where the money is. And of course, improving real-market performance is the hardest and slowest way to increase expectations from the existing level.” …
Before 1976, professional managers were in charge of performance in the real market and were paid for performance in that real market. That is, they were in charge of earning real profits for their company and they were typically paid a base salary and bonus for meeting real market performance targets.
The consequences of this is that the corporate sector is led by a distracted management focusing on the wrong things, increased accounting scandals and ultimately a short-term focus at the cost of long-term stability:
‘What is the chance that could happen if earnings were not being “managed’?”’ Martin replies: infinitesimal.
In such a world, it is therefore hardly surprising, says Martin, that the corporate world is plagued by continuing scandals, such as the accounting scandals in 2001-2002 with Enron, WorldCom, Tyco International, Global Crossing, and Adelphia, the options backdating scandals of 2005-2006, and the subprime meltdown of 2007-2008. The recent demise of MF Global Holdings and the related ongoing criminal investigation are further reminders that we have not put these matters behind us.
What do you think? Is a shareholder value a distraction from the real market, or is Martin overstating the case? I’ll leave you with one more quote from Martin:
On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal. … Short-term profits should be allied with an increase in the long-term value of a company.
Read the whole article here.
Author Disclosure: None
Talk to Frank about this article
Related posts:
to follow a category