Introduction
How should we conceptualize a contemporary business organization? Should we conceptualize it as an entity that exists solely to benefit and increase the wealth of the shareholders, or should we view it as an entity that seeks to benefit the various stakeholders, including the shareholders? Analysts in this field have made several arguments in support of either of the positions above. Many have come up with explanations of the contemporary business firm.
Some explain the role of the organization in society from an organic perspective. These are, for example, those scholars who are of the view that an organization should exist to benefit other organs of society.
This is, for example, the community within which the firm is operating, the employees of the firm, the customers, and the investors among others. Scholars, such as Beurden & Gossling (2008), are of the view that the operations of the contemporary business organization impact the society within which those operations are carried out. For example, the corporation may improve the quality of life for individuals in such a society by providing employment. This being the case, the management should take into consideration the welfare of the members of the society in making decisions touching on the operations of the firm.
In an article published in 1970 by the New York Times Magazine, Milton Friedman provided what appeared to be a contradiction of the ‘organist’ view of the corporation (Bejou 2011). Friedman is one of the most popular economic theorists whose works continue to draw criticism and praise in equal measure. However, this article which was aptly titled “The Social Responsibility of Business is to Increase Profits” (Cosans 2009: p. 391) seems to attract more attention than any other work by this scholar (Smith 2003). In this article, Friedman asserts that “……the sole purpose of business (organization) is to maximize profits” (Bejou 2011: p. 4).
The scholar (Friedman) purports that such an act will not only be beneficial to the shareholders but to the society at large. This is given the fact that a firm that is making profits is likely to expand its operations, and in the process, provide more employment opportunities and such other benefits to members of the society.
Since Friedman’s provocative article, many studies have been conducted (and various arguments fronted), explaining the degree to which contemporary organizations should be socially responsible. The question many analysts in this field have tried to address is: should the primary objective of management be to increase the wealth of shareholders and owners or not?
This essay seeks to address this question. This author believes that the maximization of shareholders’ wealth is an important aspect of the contemporary business organization. The author further believes that those individuals criticizing Friedman’s observations and arguments fail to fully understand what the scholar is talking about. It is true that Friedman advocates for the maximization of the shareholders’ wealth by the management. However, he does not advocate for the negligence of the welfare of the community or other stakeholders in the business as many detractors seem to contend.
In this essay, the author will first provide an overview of the shareholders’ wealth maximization concept for the contemporary business organization. The aim is to provide the reader with an idea of what this concept is all about. The author will then provide arguments in support of this concept. Opposing views will also be provided, with the author highlighting their weaknesses and limitations.
Shareholders’ Wealth Maximisation Objective for the Contemporary Business Organisation: An Overview
Definition
The term ‘shareholder value’ has been in existence for several decades now. Stout (2002) is of the view that the term was popularised in the early 1980s by corporate magnates such as Jack Welch. The latter was the chief executive of General Electric, one of the most prominent corporations at that time. The concept is also referred to as ‘shareholder value maximization’ (Moyer, McGuigan & Kretlow 2008: p. 5) or ‘shareholder value model’ (Lupa 2011).
The concept implies that the success of a contemporary business organization is gauged by the extent to which it increases the wealth of the shareholders (Wilcke 2004). This means that a firm that lowers the value of the shares held by the investors is failing in its mandate. The management in such a firm should be replaced with one that is dedicated to the creation of value for the shareholders’ investment.
Contemporary firms are operating within a capitalist society. As such, the operations of such entities have to “…….adhere to the dictates of capitalist principles” (Moyer et al. 2008: p. 8). Maximization of shareholders’ wealth is an obvious objective for an organization operating within a capitalist society. This is especially so given the fact that one of the most important tenets of capitalism is private ownership of property. As such, it is the shareholder who owns the means of production (read the capital used to support the operations of the entity).
Managers and other parties tasked with the responsibility of running the organization are alive to the fact that one of their major objectives is to increase (or maximize [Shaw 2009]) the wealth (or worth) of the business entity. At the end of the day, the manager increases the price of the company’s stock. This is especially so for those firms which are publicly traded in securities’ markets, such as the New York Stocks Exchange (herein referred to as NYSE).
When this happens, the wealth (or net worth) of those individuals who hold stock (or own shares) in the company increases (Shaw 2009). The wealth of the shareholder (or the owner of the business) is influenced by the price of the stock in the market. What this means is that, as the price of the shares rises, the wealth of the shareholder goes up.
The concept of shareholders’ wealth maximization can be illustrated using the example of Krispy Kreme Corporation’s shares in the early 2000s. When this company issued the Initial Public Offer (herein referred to as IPO) to the investors, one share was trading at 21 dollars. This was in April 2000.
One year down the line, the price of the share more than quadrupled, going for more than 100 dollars per share (Moyer et al. 2008). What this means is that the wealth of the shareholders increased from 21 units to more than 100 units in 365 days. About this, it can be argued that the management at Krispy Kreme performed extremely well as far as maximization of the shareholders’ wealth is concerned.
However, it is important to note that by early 2007, the value of the company’s shares had decreased by more than 50 percent. The share was now trading for less than 40 dollars (Moyer et al. 2008). This means that between 2001 and early 2007, the management in this company failed to maximize the wealth of the shareholders.
The Purpose of the Contemporary Firm is to Increase the Wealth of the Shareholder: The Shareholder Theory
Pfarrer (2010) is of the view that two opposing theories try to explain the purpose of a contemporary business organization. One of them is the stakeholders’ theory. The theory purports that the organization should exist to satisfy the needs of all stakeholders. These include the customers, the community members, the suppliers, and such others. This theory underpins the corporate social responsibility perspective proposed by scholars, such as Bejou (2011), Beurden & Gossling (2008), Shaw (2009), and Wilcke (2004) among others. According to Beurden & Gossling (2008), “……..(corporate social responsibility) touches upon issues (that are) relevant to the phenomena of the modern economy and their consequences for individuals, societies, and organizations” (p. 407).
What the scholars are trying to say is that the operations of the contemporary business organization have various effects on the society, including on the individuals in such a society. As such, the management and the business entity at large should make efforts to address the expectations of the larger society.
On their part, Moyer et al. (2008) provide that majority of contemporary organizations now acknowledge the “…..importance of the interests of all their constituent groups, or stakeholders- customers, employees, suppliers, and the communities in which they operate- and not just the interests of the stockholders” (p. 6). This means that the organization affects not only the shareholders but also the society as a whole. For example, if such an organization goes down, many people in society will lose their source of livelihood.
To underscore the significance of corporate social responsibility, Moyer et al. (2008) provide the example of Tucson Electric Power Company. This company supplies electricity to the Tucson area in Arizona. Moyer et al. (2008) argue that this company recognizes its responsibilities to its different constituencies. One of the missions of this company is to maximize the return on investment for shareholders.
The company also aspires to provide quality services to the clients, in addition to the provision of corporate leadership to the Tucson community (Moyer et al. 2008). An analysis of the 5 objectives of the company will reveal that it takes into consideration the interests of the employees, the shareholders, the customers, and the larger community within which it is operating. This is the basic argument of the stakeholder’s theory of contemporary business organizations.
However, the arguments made by those scholars supporting the stakeholders’ perspective of contemporary organizations are opposed by those made by the scholars who subscribe to the shareholders’ perspective. According to Pfarrer (2010), this theory argues that the contemporary business organization exists to create wealth for the owners (shareholders). In addition to this, this school of thought minimizes the significance of the entity’s interaction with the other constituencies (such as suppliers, employees, and society). This means that the theory is not blind to the interests of the other ‘stakeholders’.
However, the significance of the interests of the other stakeholders pales in comparison to that of the shareholders. The interests of the shareholders are effectively placed on a pedestal, looking down upon those of the suppliers, the employees, and the community at large.
While scholars, such as Ahlstrom (2010) and Cosans (2009), trace the shareholders’ profit maximization concept back to the 1980s- from the controversial writings of Friedman- others, such as Pfarrer (2010) go back more than 200 years ago. According to Pfarrer (2010), the tenets of this theory can be traced back to Adam Smith’s book The Wealth of Nations. This book was published in 1776.
In line with Adam’s arguments, the theory recognizes the significance of the free market to the contemporary business organization operating in a capitalist society. The free markets are ‘self-regulatory’, meaning that the government and such other agencies exercise little or no control over such markets (Pfarrer 2010). The theory also recognizes the important role played by ‘enlightened self-interest’ (Pfarrer 2010: p. 86). What this means is that the shareholders invest in a given business entity out of self-interest. Their main objective is to maximize their investment. If they feel that a firm is not increasing their wealth, they have the freedom to withdraw from such a firm (by selling their shares) and invest in an alternative firm that they believe will maximize their wealth.
Pfarrer (2010) links this theory to what he refers to as “……..(the) Chicago School of Economics” (p. 87). This school of thought is associated with scholars, such as Milton Friedman and others. This indicates the convergence of Pfarrer’s ideas with those of other scholars, such as Cosans (2009), who trace back the shareholders’ wealth maximization objective to the writings of Friedman. This, however, does not mean that Pfarrer (2010) acknowledges Friedman as the original proponent of this theory. On the contrary, Pfarrer (2010) argues that Friedman’s arguments were anchored on Adam’s writings.
The author has already looked at the theory underpinning the maximization of shareholders’ wealth as the major objective for a contemporary business organization (in addition to providing an overview of the concept). The author will now address the question of whether the management should primarily seek to increase the wealth of the shareholders or not.
Should the Primary Objective of the Management be to Increase the Wealth of Shareholders? Supporting Arguments
This author would like to reiterate that they fully agree with the fact that the primary objective of the management should be to increase the wealth of shareholders in the company and extension, the wealth of the owners. This position is in line with Friedman’s premise as espoused in his 1970’s controversial article identified earlier in the paper. This author observes that the arguments made by the scholars opposing Friedman’s position are fallacious and shallow, to say the least.
Friedman’s opponents (and in extension the opponents of the shareholder wealth maximization concept) fail to recognize the context of his (Friedman’s) arguments. As a result, their arguments are anything but factual. These are scholars, such as Ahlstrom (2010) and Beurden & Gossling (2008) among others, who advocate for corporate social responsibility.
There is a need for managers to fully understand the goals and objectives of the entity. This is to help them in making effective decisions that are likely to benefit or improve the performance of the business entity. Moyer et al. (2008) pose the question, “….what objectives should guide business decision making (process)?” (p. 5). In other words, the scholars are arguing that the management should be fully aware of the expectations of the owner(s) of the business entity. The owners of the business are the shareholders. According to Moyer et al. (2008), maximization of the value of the business organization for the shareholders is the most obvious and widely accepted primary objective of the management.
What this author is trying to say here is that maximizing the wealth of the shareholders is the default and logical objective of any given business entity in contemporary society. The management should take it upon itself to make sure that the interests of the shareholders are taken care of.
Chief executives of major global corporations are in support of this point of view. Take the case of Warren Buffett, an iconic figure in the corporate world and the leader of Berkshire Hathaway. According to Moyer et al. (2008), Buffett is one of the most outspoken proponents of this perspective. According to Buffett (and as cited in Moyer et al. 2008),
“…..(the management’s) long term economic goal (……..) is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. (The management) do not measure the economic significance or performance (of a company) by its size; (the management) measures (it) by per-share progress” (p. 5).
Now, the value of the shareholders’ investment is measured using the price of the shares in the market. According to Moyer et al. (2008),
Shareholder wealth = Number of shares outstanding x Market price per share (p. 5).
This means that by increasing the price of the shares in the market, the management is effectively increasing the wealth of the shareholders. This should be the management’s most important (if not the only) objective in running the organization (Husted & Salazar 2006).
The primary objective of management should be to increase the wealth of the shareholders and owners. This is given that the business entity belongs to the individuals who have invested their capital (Lupa 2011). Friedman agrees with this position when he argues that shareholders are the owners of the said organization. Given that the firm is operating in a capitalist society- a society that recognizes the right to private ownership of the property- the management should endeavor to maximize the wealth of the owners.
Opponents such as Stout (2002) argue that the shareholders are not the sole owners of the business entity. They argue (and rightly so) that the organization is using land and other forms of resources that are co-owned with other stakeholders, such as the community within which the organization is operating. As such, they argue that management should also recognize the interests of the other stakeholders (Stout 2002). However, it is important to note that the shareholders are the major stakeholders in the business. As such, their interests should precede those of the other stakeholders (Bainbridge 1993).
Conclusion
In this essay, the author argued that the primary objective of the management should be to increase the wealth of the shareholders. The author defined the concept of shareholders’ wealth maximization and provided an analysis of the theory supporting this concept. It was argued that the shareholders are the owners of the business entity. As such, their interests should precede those of the other stakeholders. It was also argued that the maximization of the shareholders’ wealth is the default and logical objective of the management.
References
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