What does it mean to create shareholder value?

If investors knew as much about a company as its managers, maximizing its current share price might be equivalent to maximizing value over time. In the real world, investors have only a company’s published financial results and their own assessment of the quality and integrity of its management team. For large companies, it’s difficult even for insiders to know how the financial results are generated. Investors in most companies don’t know what’s really going on inside a company or what decisions managers are making. They can’t know, for example, whether the company is improving its margins by finding more efficient ways to work or by simply skimping on product development, maintenance, or marketing.

Since investors don’t have complete information, it’s not difficult for companies to pump up their share price in the short term. For example, from 1997 to 2003, a global consumer-products company consistently generated annual growth in earnings per share (EPS) between 11 and 16 percent. Managers attributed the company’s success to improved efficiency. Impressed, investors pushed the company’s share price above that of its peers—unaware that the company was shortchanging its investment in product development and brand building to inflate short-term profits, even as revenue growth declined. In 2003, managers were compelled to admit what they’d done. Not surprisingly, the company went through a painful period of rebuilding, and its stock price took years to recover.

In contrast, the evidence makes it clear that companies with a long strategic horizon create more value. The banks that had the insight and courage to forgo short-term profits during the real-estate bubble earned much better returns for shareholders over the longer term. Oil and gas companies known for investing in safety outperform those that haven’t. We’ve found, empirically, that long-term revenue growth—particularly organic revenue growth—is the most important driver of shareholder returns for companies with high returns on capital (though not for companies with low returns on capital).  We’ve also found a strong positive correlation between long-term shareholder returns and investments in R&D—evidence of a commitment to creating value in the longer term.

The weight of such evidence and our experience supports a clear definition of what it means to create shareholder value, which is to create value for the collective of all shareholders, present and future. This means managers should not take actions to increase today’s share price if they will reduce it down the road. It’s the task of management and the board to have the courage to make long-term value-creating decisions despite the short-term consequences.

Can stakeholder interests be reconciled?

Much recent criticism of shareholder-oriented capitalism has called on companies to focus on a broader set of stakeholders, not just shareholders. It’s a view that has long been influential in continental Europe, where it is frequently embedded in the governance structures of the corporate form of organization. And we agree that for most companies anywhere in the world, pursuing the creation of long-term shareholder value requires satisfying other stakeholders as well.

We would go even further. We believe that companies dedicated to value creation are healthier and more robust—and that investing for sustainable growth also builds stronger economies, higher living standards, and more opportunities for individuals. Our research shows, for example, that many corporate-social-responsibility initiatives also create shareholder value, and managers should seek out such opportunities. For example, IBM’s free web-based resources on business management not only help to build small and midsize enterprises but also improve IBM’s reputation and relationships in new markets and develop relationships with potential customers. In another case, Novo Nordisk’s “Triple Bottom Line” philosophy of social responsibility, environmental soundness, and economic viability has led to programs to improve diabetes care in China. According to the company, its programs have burnished its brand, added to its market share, and increased sales—at the same time as improving physician education and patient outcomes. Similarly, Best Buy’s efforts to reduce attrition among women employees not only lowered turnover among women by more than 5 percent, it also helped them create their own support networks and build leadership skills.

But what should be done when the interests of stakeholders don’t naturally complement those of a company, for instance, when it comes to questions of employee compensation and benefits, supplier management, and local community relationships? Most advocates of managing for stakeholders appear to argue that companies can maximize value for all stakeholders and shareholders simultaneously—without making trade-offs among them. This includes, for example, Cornell Law School professor Lynn Stout’s book, The Shareholder Value Myth, in which Stout argues persuasively that nothing in US corporate law requires companies to focus on shareholder value creation. But her argument that putting shareholders first harms nearly everyone is really an argument against short-termism, not a prescription for how to make trade-offs. Similarly, R. Edward Freeman, a professor at the University of Virginia’s Darden School of Business, has written at length proposing a stakeholder value orientation. In his recent book, Managing for Stakeholders, he and his coauthors assert that “there is really no inherent conflict between the interests of financiers and other stakeholders.” John Mackey, founder and co-CEO of Whole Foods, recently wrote Conscious Capitalism, in which he, too, asserts that there are no trade-offs to be made.

Such criticism is naive. Strategic decisions often require myriad trade-offs among the interests of different groups that are often at odds with one another. And in the absence of other principled guidelines for such decisions, when there are trade-offs to be made, prioritizing long-term value creation is best for the allocation of resources and the health of the economy.

Consider employee stakeholders. A company that tries to boost profits by providing a shabby work environment relative to competitors, underpaying employees, or skimping on benefits will have trouble attracting and retaining high-quality employees. Lower-quality employees can mean lower-quality products, reducing demand and hurting reputation. More injury and illness can invite regulatory scrutiny and more union pressure. More turnover will inevitably increase training costs. With today’s more mobile and more educated workforce, such a company would struggle in the long term against competitors offering more attractive environments. If the company earns more than its cost of capital, it might afford to pay above-market wages and still prosper—and treating employees well can be good business. But how well is well enough? A stakeholder focus doesn’t provide an answer. A shareholder focus does. Pay wages that are just enough to attract quality employees and keep them happy and productive, pairing those with a range of nonmonetary benefits and rewards.

Or consider how high a price a company should charge for its products. A shareholder focus would weigh price, volume, and customer satisfaction to determine a price that creates the most shareholder value. However, that price would also have to entice consumers to buy the products—and not just once but multiple times, for different generations of products. A company might still thrive if it charged lower prices, but there’s no way to determine whether the value of a lower price is greater for consumers than the value of a higher price to its shareholders. Finally, consider whether companies in mature, competitive industries should keep open high-cost plants that lose money just to keep employees working and prevent suppliers from going bankrupt. To do so in a globalizing industry would distort the allocation of resources in the economy.

These can be agonizing decisions for managers and are difficult all around. But consumers benefit when goods are produced at the lowest possible cost, and the economy benefits when unproductive plants are closed and employees move to new jobs with more competitive companies. And while it’s true that employees often can’t just pick up and relocate, it’s also true that value-creating companies create more jobs. When examining employment, we found that the European and US companies that created the most shareholder value in the past 15 years have shown stronger employment growth.