The idea that directors should seek to maximise shareholder value has come in for a lot of flak in recent years. James Montier of GMO even wrote a piece on it called “The World’s Dumbest Idea” (PDF).

One of the most prominent criticisms of maximising shareholder value is that it causes directors to focus too much on their company’s share price, which leads them to underinvest in its long-term future in order to boost short-term profits (and therefore, the share price).

This is not so much a failing of the concept of shareholder value maximisation as it is a failure to understand what shareholder value is and what directors can do in their attempts to maximise it.

True shareholder value is a measure of long-term value

The value of a company is essentially the value of all the cash it will return to shareholders over its remaining lifetime.

Let’s assume that Sainsbury will survive another 100 years before closing its doors for the last time.

In that case the value of the company today is the value of all dividends paid out over the next 100 years plus any cash returned to shareholders when the company is would up (which we can ignore because it is usually zero).

A dividend today is preferable to a dividend in 50 years’ time, so future dividends are usually “discounted” by an annual discount rate. If you want a 10% annual return on your Sainsbury investment then you would discount the value of future dividends by 10% each year, in which case a 100p dividend 10 years from now would have a “present value” of about 42p.

Add up those discounted future dividends and hey presto, you have the present “shareholder value” of Sainsbury, at least according to an investor who wants a 10% rate of return. A different discount rate would provide a different shareholder value.

Because the company’s shareholder value is the discounted sum of 100 years of dividends, only a fraction of Sainsbury’s value today comes from dividends paid in the next 10 years. Most of its shareholder value comes from dividends that are expected to be paid more than 10 years in the future, as is the case for most mature companies.

This is the true meaning of shareholder value; a multi-decade stream of dividends which directors should be attempting to maximise, without taking unnecessary risk.

True shareholder value maximisation should be much more about working to…

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