The Goals of Shareholder Wealth Maximization
What Every Business Should Know About Shareholder Wealth Maximization
Who owns a corporation? Shareholders do. These are the individuals, businesses, and institutions that have an ownership interest in a company after purchasing shares of that company's stock. Even if your business is a one-person shop, you are the shareholder based on your invested interest in your company. Because shareholders own the firm, they are entitled to the profits of the firm.
Shareholder wealth is the appropriate goal of a business firm in a capitalist society, whereby there is private ownership of goods and services by individuals. Those individuals own the means of production by the business to make money. The profits from the businesses in the economy accrue to the individuals.
Shareholder Wealth Maximization 101
When business managers try to maximize the wealth of their firm, they are actually trying to increase the company's stock price. As the stock price increases, the value of the firm increases, as well as the shareholders' wealth.
The Managers of the Firm
People often think that the managers of a firm are the owners. In the case of a small business or partnership, that might be true, such as sole proprietor owner who is also the manager. In a larger business, there may be many levels of management and staff, and they do not necessarily own the firm. Aside from their salaries and benefits, they only profit from the business if they own shares of stock in the company.
When employees are also shareholders, they tend to have a greater sense of responsibility to the firm. Consequently, many companies encourage employees to become shareholders. In fact, some businesses offer shares of stock to their employees at a discount through an Employee Stock Purchase Plan (ESPP).
Conflicts Between Owners and Managers
Because the managers of a firm are directed and guided by a Board of Directors, and because they do not profit directly from the firm's goal to maximize shareholder wealth, unless they are also shareholders, conflict can sometimes arise between stockholders and managers. This conflict is called the agency problem.
Managers serve as agents of the shareholders. If there is an agency problem, it is imperative to find a resolution as soon as possible to prevent problems within the business that can impede performance.
There is an idea that businesses focused on money are greedy and don't care about social issues or that socially responsible businesses can't increase stock values. The truth is that a company can be both profitable and socially responsible.
Consider the 2008 Great Recession and one of its main causes; the subprime mortgage crisis. Theses banks were more concerned about their investment portfolios instead of properly loaning money to customers, which is their charge. Those investment portfolios were filled with toxic assets, which eventually compromised the operations of many financial institutions and caused the failure of several big banks. As a result, their share prices fell right along with them. In this case, greed and a lack of social concern led to their downfall.
On the other hand, after almost failing during the Great Recession, GM turned itself around, repaid its debt, and developed "greener" vehicles. As a result, it realized an increase in its share price. GM took on the mantle of social responsibility rather than exploiting consumers for financial gain.
Business firms cannot exist and profit in the long run without being socially responsible.
Why are business firms not seeking profit rather than an increase in share price? One reason is that profit maximization does not take the concepts of risk and reward into account as shareholder maximization does. The goal of profit maximization is, at best, a short-term goal of financial management.