From shareholder value to stakeholder value

The classical view of a firm’s objective holds that it is a profit maximizing organization operated by professional managers on behalf of the shareholders. All the activities of the professional managers on behalf of the firm are geared towards creating and maximizing the shareholder value. Shareholder value is considered as the most important measure of business performance and this performance metric is computed and analyzed at the end of each period. The figure arrived at indicates the financial value of the firm and represents the returns the firm should give its shareholders. 

Shareholder value may be measured using the traditional accounting methods (e.g., net profit before tax, net tangible asset, earnings per share and price/earnings ratio), generally accepted valuation approaches (income approach, market-based approach, and asset-based approach) or through market methods (share price returns, and economic profit or economic value added (EVA)). Of these methods, the use of EVA has emerged to be a favorite performance metric in recent years.

EVA is an estimate of true economic profit of a firm after making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital. Thus, it does away with the shortcomings of the traditional accounting measures. The basic computation of EVA is  net operating profit after tax (NOPAT) minus the invested capital multiplied by the cost of capital from the issuance of debt and equity, based on the company’s weighted average cost of capital (WACC).

NOPAT is a firm’s potential cash earnings if its capitalization were not leveraged, i.e., if it had no debt. On the other hand, cost of capital determines how the firm can raise money (which may be through a stock issue, borrowing or a combination of the two). This is the rate of return that a firm would receive if it invested in a different vehicle with a similar risk. It includes the cost of debt and the cost of equity. 

The underlying principle of shareholder value is that a firm adds value for its shareholders only when equity returns exceed equity costs. Once the amount of value has been calculated, targets for improvement can be set and shareholder value can be used as a measure for managing performance.

Since its introduction in the 1980s, the use of EVA and other shareholder value metrics has become a very popular tool for measuring business performance. Notwithstanding that calculation of these measures usually involves a number of adjustments to accounting data, they are based on fairly simple concepts. However, of late, the use of shareholder value metrics has been criticized for being narrowly focused on one particular group of stakeholders – the owners. The argument raised is that the firm has more constituents than shareholders alone. Employees, customers, suppliers, government and the community also make contributions and take risks in creating a successful firm. Another argument is that the use of shareholder value metric is a very “capitalist” approach to the measurement of performance. It is very focused on financial numbers particularly on the bottom line. It does not consider at all the intangible drivers of performance such as relationships, leadership, innovation, ethical behavior and knowledge.  

These arguments have given rise to the use of “stakeholder value approach,” a new management philosophy that regards maximization of the interests of the firm’s stakeholders as its highest objective. The objective of this approach is to maximize stakeholder value in three main areas:

Customer satisfaction. Customers can only be satisfied if they are happy with the firm’s products and services. Thus the firm must continuously develop and bring to market innovative, high quality products and services. Continuous product innovation is particularly relevant as it is linked to company performance and growth through improvements in efficiency, productivity, competitive positioning, market share, etc.

The firm must also adopt measures of customer satisfaction appropriate to the firm’s products and services, reflecting such data as customer satisfaction surveys, product returns, warranty claims, and product reviews by media and consumer organizations.

People development. Employees are an important stakeholder group in the firm, perhaps the most important stakeholder group being one of the ultimate drivers of value. After all, what is a firm if not a collection of people working toward common objectives? 

The firm must support a working environment characterized by high job satisfaction, opportunities for personal and professional development, and promotion of health and wellness in the workplace. All employees must be evaluated and rewarded based on a balanced dual focus on achieving financial targets and building the organization. They should be offered a total package that includes insurance, recreational activities and other benefits adapted to the local market and individual employees’ needs. 

Community development. Every firm interacts with its environment in its activity to provide goods and services that satisfy its customers. Ideally, something beneficial for society should also be created by that firm to justify its own existence. The firm should thus undertake activities and provide support designed to improve the social and economic circumstances of the communities in which it operates. Community development seeks to empower individuals and groups by providing skills to assist them in effecting sustainable positive change. This may be achieved through: building capacity within the community, access to basic health care and recreational facilities, provision of quality education, employment opportunities, sustainable access to food and clean water, provision of suitable housing, and support for indigenous peoples, women, children and minority groups.

Indeed, in the increasingly conscience-focused market of the 21st century, the classical view of the firm is giving way to the more balanced view that a firm is more than simply a financial vehicle and has more stakeholders than shareholders. Following this, traditional metrics like shareholder value are now also giving way to new performance metrics like the more encompassing stakeholder value.

Profits are and will remain to be important and so is providing a reasonable return to shareholders’ commensurate to their investment risk. That is what a business exists for and why investors put their money in a company. If the firm doesn’t make a profit it will cease to exist. That’s the bottom line, the most basic fundamental about business. However, shareholders are only one group and there are other stakeholders who make contributions and take risks in creating a successful firm. That being said, how the firm satisfies its other stakeholders can have a major effect on its profitability. Ignoring them altogether may negatively impact the bottom line, and could even force a firm to close.

(John S. Bala. is a Partner for Business and Financial Advisory Services of  Manabat Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. This article is for general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email [email protected] or [email protected]).