Shareholder Theory/Shareholder Value
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Technological University Dublin ARROW@TU Dublin Articles School of Accounting and Finance 2020-3 Shareholder Theory/Shareholder Value Maeve O'Connell maeve.oconnell@tudblin.ie, maeve.oconnell@tudublin.ie Anne Marie Ward University of Ulster, Emaiam.ward@ulster.ac.uk Follow this and additional works at: https://arrow.tudublin.ie/buschacart Part of the Business Commons Recommended Citation O’Connell M., Ward A.M. (2020) Shareholder Theory/Shareholder Value. In: Idowu S., Schmidpeter R., Capaldi N., Zu L., Del Baldo M., Abreu R. (eds) Encyclopedia of Sustainable Management. Springer, Cham. Online ISBN:978-3-030-02006-4 doi:10.1007/978-3-030-02006-4 This Book Chapter is brought to you for free and open access by the School of Accounting and Finance at ARROW@TU Dublin. It has been accepted for inclusion in Articles by an authorized administrator of ARROW@TU Dublin. For more information, please contact arrow.admin@tudublin.ie, aisling.coyne@tudublin.ie. This work is licensed under a Creative Commons Attribution-Noncommercial-Share Alike 4.0 License S Shareholder Theory/ maximize the combined value of dividends and Shareholder Value share price increases. However, shareholder the- ory fails to consider that shareholders and corpo- Maeve O’Connell1 and Anne Marie Ward2 rates may have other objectives that are not based 1Technological University Dublin, Dublin, on financial performance. For example, as early as Ireland 1932, Berle and Means argued that corporations 2Ulster Business School, Ulster University, have a variety of purposes and interests including Newtownabbey, Northern Ireland encouraging entrepreneurship, innovation, and building communities. This wider view is gaining more traction in recent decades as evidenced by an Synonyms increased interest in ethical investment funds. This suggests that shareholders and potential Shareholder primacy theory; Shareholder value shareholders are not only interested in financial creation; Shareholder value maximization; Share- gains but are also interested in corporates being holder wealth maximization; Shareholder-centric socially responsible (Kyriakou 2018). Therefore approach shareholder value creation is important; however, it needs to be balanced with other stakeholders’ interests. This is referred to as an enlightened Definition/Description approach to shareholder value maximization. This entry outlines the origins of shareholder Shareholder theory states that the primary objec- value theory, provides a rationale for prioritizing tive of management is to maximize shareholder shareholder value theory, documents arguments value. This objective ranks in front of the interests for taking a wider view beyond shareholder of other corporate stakeholders, such as value, and explains enlightened shareholder employees, suppliers, customers, and society. value. Shareholder theory argues that shareholders are the ultimate owners of a corporate’s assets, and thus, the priority for managers and boards is to The Origins of Shareholder Value Theory protect and grow these assets for the benefitof shareholders. Shareholder theory assumes that The origin of shareholder value maximization as shareholders value corporate assets with two mea- the primary objective of corporates was surable metrics, dividends and share price. There- influenced by changes in the structure of busi- fore, management should make decisions that nesses, the economic environment, and © Springer Nature Switzerland AG 2020 S. O. Idowu et al. (eds.), Encyclopedia of Sustainable Management, https://doi.org/10.1007/978-3-030-02006-4_49-1 2 Shareholder Theory/Shareholder Value financialization of the markets. These are now motivated management to focus on shareholder outlined in brief. wealth maximization. However, it is also argued Business structure and the economic environ- to have fueled a focus on short-term gains that ment: The roots of shareholder value theory can be benefit transient investors and directors, to the traced to the late eighteenth century when the detriment of long-term shareholders and other capital investment required to finance innovative stakeholders that are interested in the sustainabil- manufacturing businesses during the industrial ity of the corporate (Clarke and Friedman 2016; revolution led to a change in the structure of Englander and Kaufman 2004). businesses, from traditional small family-run cor- Financialization: During the 1980s financial porates to large publicly owned corporates with institutions became substantial investors in corpo- dispersed shareholders and professional man- rate shares. Financial institutions pursue wealth agers. This change in governance, called maximization as their primary investment objec- managerialism, led to new modes of coordinating tive. This increased attention from well-informed enterprise, technology, and planning. From the investors and led to pressure on directors to 1970s, the focus on managerialism gave way to deliver high returns on their tangible assets. If a growing focus on shareholder value maximiza- high returns are not reported, then corporates tion. The economic environment is considered to faced the risk of being taken over and broken up. have contributed to this change in focus. The This shifted the priorities of corporates to cost- 1970s was a challenging time for US corporates cutting, divesture, outsourcing, and offshoring as as they experienced a decline in competitiveness managers did whatever was necessary to meet the due to the rise of foreign corporates. The result earnings expectations of the market (Dallas 2017). was decreases in their share prices. Questions Improvements in information technology in the were being asked about the performance of man- 1980s and 1990s also resulted in easier access to agement in this era. The widespread reduction in information on corporates, increased interest from the value of corporate stocks led to a focus by a wider range of investors and hence greater business leaders, policy makers, regulators, and liquidity in the stock market. In particular, it politicians throughout the 1980s and 1990s on the enabled more trading by transient shareholders role of the board and their duty and relationship to whose main focus is liquidating short-term abnor- shareholders. In particular, agency theory, an eco- mal gains. The shift in focus to reporting short- nomic theory that argues that humans are inher- term gains is argued to conflict with the long-term ently self-serving, was deemed to provide an sustainability of corporates. appropriate explanation for the poor performance The arguments for and against the pursuit of of corporates. The view being that boards were shareholder wealth maximization are now taking decisions that benefited directors, not outlined in brief. shareholders. This resulted in the widespread pro- motion of shareholder wealth maximization as the primary goal of corporates. Directors were not The Rationale for Prioritizing opposed to this approach as they believed that Shareholder Value by focusing on wealth maximization, they could avoid their corporate being the target of a takeover Four main arguments in support of the primacy of bid. This reason was particularly pertinent in the shareholders over other stakeholders are 1980s as a wave of merger activity was sweeping forwarded in the literature; the agency perspec- through major stock markets. In addition to being tive, the control perspective, the residual claims a defense against takeover, a focus on wealth perspective, and congruence with social wealth. maximization also led to calls for the alignment The agency perspective: The first view, the of director and shareholder incentives. The result agency perspective, is that directors have a con- was a higher executive director pay that was typ- tractual obligation to prioritize shareholder value ically linked to share price increases. This further maximization over other stakeholder claims. Shareholder Theory/Shareholder Value 3 Under agency theory the corporate is seen as a Residual claims: Shareholders provide funds “nexus of contracts” (Alchian and Demsetz 1973). to the corporate for investment. The corporate Shareholders are the owners. They are external to invests these funds in assets. Therefore, any assets the corporate and hence cannot manage the cor- purchased with shareholders’ funds are the prop- porate. Therefore, shareholders hire agents (man- erty of the shareholders. However, under law, the aging boards) to protect their interests and to run contractual rights of other claimants, such as the corporate on their behalf (Jensen and employees and suppliers, rank in front of share- Meckling 1976). To fulfill their contractual obli- holders’ contractual claims. This means that gation, boards should take decisions that promote shareholders are only entitled to the residual the long-term sustainability of the corporate. The value when the corporate is wound up after all traditional view is that long-term sustainability is other contractual claimants have been satisfied. synonymous with financial prowess. Therefore, Consequentially, shareholders bear more risk and the focus should be on financial decision-making hence have a greater interest in the corporate’s that maximizes shareholder value in terms of div- long-term sustainability relative to other stake- idend returns and increases in share price. This holders. Each decision made by the board has a traditional view is captured by Friedman when he direct impact on shareholder wealth, whereas all stated: “Few trends could so thoroughly