Business Management

How a stock market-listed company maximizes shareholders’ wealth

There are large multinational companies listed on various stock markets in the world. These companies focus on maximizing shareholders’ wealth as the major goal. This single goal may not be appropriate or be subject to arguments if one considers the following, for example:

a. Cash flow generation
b. Profitability as measured by profits after tax and return on investment
c. Risk-adjusted returns to shareholders
d. Performance improvement in a number of areas such as concern for the environment, employees’ remuneration and quality of working conditions and customer satisfaction

Should maximizing shareholder wealth be the only goal? What are the advantages and disadvantages of of having alternative goals?

Maximizing shareholder wealth

The concept that the primary financial objective of the firm is to maximize the wealth of shareholders, by which is meant the net present value of estimated future cash flows, underpins much of modern financial theory.

While the relevance of the wealth maximization goal is under discussion, it might also be useful to consider the way in which this type of objective is defined, since this will impact upon both parallel and subsidiary objectives. A widely adopted approach is to seek to maximize the present value of the projected cash flows. In this way, the objective is both made measurable and can be translated into a yardstick for financial decision making. It cannot be defined as a single attainable target but rather as a criterion for the continuing allocation of the company’s resources.

There has been some recent debate as to whether wealth maximization should or can be the only true objective, particularly in the context of multinational companies. The stakeholder view of corporate objectives is that many groups of people have a stake in what the company does. Each of these groups, which include suppliers, workers, manager, customers and governments as well as shareholders, has its own objectives, and this means that a compromise is required. For example, in the case of the multinational firm with a facility in politically unstable third world economy, the directors may at times need to place the interests of local government and economy ahead of those of its shareholders, in part at least to ensure its own continued stability there.

Cash flow generation

The validity of cash flow generation as a major corporate objective depends on the timescale over which performance is measured. If the business maximizes the net present value of the cash flows generated in the medium to long term, then this objective is effectively the same as that discussed above. However, if the aim is to maximize all cash flows, then decisions are likely to be disproportionately focused on short-term performance, and this can work against the long-term health of the business. Defining objectives in terms of long-term cash flow generation makes the shareholder wealth maximization goal more clearly definable and measurable.

Profitability

Many companies use return on investment (ROI) targets to assess performance and control the business. This is useful for the comparison of widely differing divisions within a diverse multinational company, and can provide something approaching a ‘level playing field’ when setting targets for the different parts of the business. It is important that the measurement techniques to be used in respect of both profits and the asset base are very clearly defined, and that there is a clear and consistent approach to accounting for inflation. As with the cash flow generation targets discussed above, the selection of the time frame is also important in ensuring that the selected objectives do work for the long-term health of the business.

Risk adjusted returns

It is assumed that the use of risk-adjusted returns relates to the criteria used for investment appraisal, rather than to the performance of the group as a whole. As such, risk adjusted returns cannot be used in defining the top level major corporate goals; however, they can be one way in which corporate goals are made congruent with operating decisions.

At the same time, they do provide a useful input to the goal setting process in that they focus attention on the company’s policy with regard to making risky investments. Once the overall corporate approach to risk has been decided, this can be made effective in operating decisions, for example by specifying the amount by which the cost of capital is to be augmented to allow for risk in various types of investment decisions.

Performance improvement in non-financial areas

Recent work on corporate objectives suggests that firms should take specific account of those areas which impact only indirectly, if at all, on financial performance. The firm has responsibilities towards many groups in addition to the shareholders, including:

• Employees: to provide good working conditions and remuneration, the opportunity for personal development, outplacement help in the event of redundancy and so on
• Customers: to provide a product of good and consistent quality, good service and communication, and open and fair commercial practice.
• The public: to ensure responsible disposal of waste products.

There are many other interest groups that should also be included in the discussion process. Non-financial objectives may often work indirectly to the financial benefit of the firm in the long term, but in the short term they do often appeal to compromise the primary financial objectives.

Conclusions

It is very difficult to find a comprehensive and appropriate alternative primary financial objective to that of shareholder wealth maximization. However, achievement of this goal can be pursued, at least in part, through the setting of specific subsidiary targets in terms of items such as return on investment and risk adjusted returns. The definition of non-financial objectives should also be addressed in the context of the overall review of the corporate plan.