Companies should maximize shareholder welfare not market value – Oliver
Hart and Luigi Zingales (2017)
Hart, Zingales (2017): Serving Shareholders Doesn’t Mean Putting Profit Above All Else Is the only responsibility
of business to maximize profits, as Milton Friedman famously argued in 1970? Many scholars and
businesspeople have criticized this idea on the grounds that companies should cater to employees and the
community, not just to shareholders. In a recent paper we offer a different perspective, one that we believe is
perfectly consistent with the fiduciary duties of corporate directors: Companies should maximize shareholder
welfare, not value.
Our starting point is that shareholders care about more than just money. The new mantra, especially in Europe,
is ESG: Companies should care about the environmental and social impact of their investments. In fact,
research has shown that the majority of shareholder proposals in the U.S. now concern ESG. Friedman
acknowledged that shareholders might have ethical concerns, but he implicitly assumed that a company’s profit
and social objectives are separable. This is true for the example he used in his article: corporate charity.
We agree with Friedman on this point. But we are interested in situations where profit and social consequences
are inextricably connected. Think about the shareholders of a company such as Walmart, who are concerned
about mass killings in the United States. Walmart’s ability to restrict the sale of high-capacity magazines or
assault ri„ es in its stores would be more effective than if it took the extra profits from those sales, returned them
to shareholders, and let shareholders donate to gun control advocacy. Therefore, if investors have some
objectives other than money, there is no reason why a company’s board should ignore them and pursue only
profit maximization. The fiduciary duty a board has to a company’s shareholders is to maximize their welfare, not
just the value of their pocketbook. This raises an important question: How can a board do that?
If shareholders care only about money, the system will produce the same result that we observe today. But if
many shareholders do have social objectives, as both data and intuition suggest, the system will allow them to
achieve these objectives and increase their utility. One concern is that adding social dimensions will overwhelm
investors.
To a casual observer, the difference between shareholder welfare and shareholder value might seem small. Yet
it is on the basis of the shareholder value principle that corporate boards and courts of law reject the ability of
shareholders to influence corporate policy on social issues that shareholders care about.
The figure below shows the percentage of Dow Jones Index companies that mention value maximization as an
objective in different decades. It has dramatically increased in the last three decades (7 to 37%).
The impact extends to asset management companies. Pension funds, foundation endowments, and university
endowments have been run on the basis of Friedman’s separation principle: Maximize the wealth of investors,
and let shareholders use the proceeds to achieve their goals. Some may object that our proposal is
antidemocratic. Social goals, the argument goes, should be left to the political system, where every vote is
treated equally. If we allow shareholders to vote on social issues involving their companies, the vote of wealthy
people will count more. We are sympathetic to this concern, but in our view it is misplaced. The same could be
said of sustainable consumerism, where the purchases of richer people “count” more in dollar terms. Moreover,
our proposal would make corporations more democratic, not less, by elevating the social concerns of the millions
of present and future pensioners. Finally, by restricting shareholder concerns to pure profit, we’re not simply
leaving values to the realm of politics; in practice, we’re often declining to consider those values at all.
,Chapter 1: The Corporation
Corporation: a legally defined, artificial being (a judicial person or legal entity), separate from its owners.
Limited liability: when an investor’s liability is limited to her initial investment.
Corporation: a legally defined, artificial being, separate from its owners.
Disadvantages: double taxation, separation of ownership and control
Objective of the firm/corporation: maximizing shareholder value → not perfect
Assumes:
1) Agency problem do not stand in the way.
Agency problem: when managers, despite being hired as the agents of shareholders, put their own self-interest
ahead of the interests of shareholders. Minimize the agency problem → Corporate governance: the system of
controls, regulations, and incentives designed to minimize agency costs between managers and investors and
prevent corporate fraud.
2) All externalities are correctly priced or sufficiently regulated.
Advantages: it is relevant for the firm to maximize shareholder value; it is a measure the firm can live up to.
Disadvantages:
- Ignores frictions (like agency problems).
- Rules and regulation often do not sufficiently protect interests of all stakeholders.
- Does not take into account impact on future generations.
- Externalities are not sufficiently internalized when not or insufficiently priced.
- Separation of ownership and control
Shareholder: residual claimant (last in line), hence should take into account interest of others.
Shareholders of a corporation exercise their control by electing a board of directors, a group of people who
have the ultimate decision-making authority in the corporation.
Chief Executive Officer (CEO): is charged with running the corporation by instituting the rules and policies set
by the board of directors. → not uncommon to also be chairman of board of directors. Most senior financial
manager → Chief Financial Officer (CFO)
Managers run the corporation, CEO top of the managers.
Firms have managers and shareholders who are often not the same people → separation of ownership and
control (shareholder = owner and manager = control)
,Within the corporation, financial managers are responsible for three main tasks:
1) Making investment decisions: financial manager must weigh the costs and benefits of all investments and
projects and decide which of them qualify as good uses of the money stockholders have invested in the firm.
2) Making financing decisions: how to pay for investments? decide whether to raise more money from owners
by selling more shares of stock (equity) or borrow the money (debt).
3) Managing the firm’s cash flows: ensure that the firm has enough cash on hand to meet its day-to-day
obligations. commonly known as managing working capital.
Hostile takeover: an individual or organization can purchase a large fraction of the stock and acquire enough
votes to replace the board of directors and the CEO.
When a corporation borrows money, the holders of the firm’s debt also become investors in the corporation. If
the corporation fails to repay its debts, the debt holders are entitled to seize the assets of the corporation in
compensation for the default.
Bankruptcy does not need to result in a liquidation of the firm. Liquidation: involves shutting down the business
and selling off its assets.
Private companies: have a limited set of shareholders and their shares are not regularly traded, the value of
their shares can be difficult to determine.
Public companies: shares are traded on organized markets (or a stock market).
These markets provide liquidity and determine a market price for the company’s shares. An investment is said to
be liquid if it is possible to sell it quickly and easily for a price very close to the price at which you could
contemporaneously buy it.
Primary market: corporation sells shares to investors.
Secondary market: shares continue to trade between investors.
Market makers: match buyers and sellers, they posted two prices for every stock:
▪ Bid price: the price at which they were willing to buy the stock.
▪ Ask price: the price at which they were willing to sell the stock.
Bid-ask spread: difference between ask prices(which are higher) and bid prices.
Dark pools: trading venues in which the size and price of orders are not disclosed to participants. Prices are
within the best bid and ask prices available in public markets, but traders face the risk their orders may not be
filled if an excess of either buy or sell orders is received.
Chapter 2: Financial Statement Analysis
Financial statements: accounting reports with past performance information that a firm issues periodically. →
U.S. companies are required to file their financial statements with the Securities and Exchange Commission
(SEC) on a quarterly basis (10-Q) and annually (10-K).
→ also useful for managers within the firm as a source of information for financial decisions.
Generally Accepted Accounting Principles (GAAP) provide a common set of rules and a standard format for
public companies to use when they prepare their reports.
Auditor: a neutral third party that corporations are required to hire that checks the annual financial statements to
ensure they are prepared according to GAAP, and to verify that the information is reliable.
Every public company is required to produce four financial statements:
1. Balance sheet (or statement of financial position): a list of a firm’s assets and liabilities that provides a
snapshot of the firm’s financial position at a given point in time.
Net working capital = current assets – current liabilities = cash + debtors + inventory – creditors
Market capitalization = Market Value of Equity = Shares outstanding * Market price per share
Market to book ratio = Market value of equity / book value of equity
→ successful firms exceeds 1, indicating that the value of the firm’s assets when put to use exceeds their
historical cost
Analysts often classify firms with low market-to-book ratios as value stocks, and those with high market-to-book
ratios as growth stocks.
, Enterprise value = market value of equity + debt – cash
Net debt = debt - cash
2. Income statement (or statement of financial performance): the
firm’s revenues and expenses over a period of time.
3. Statement of cash flows: how a firm has used the cash it earned
during a set period.
The statement of cash flows is divided into three sections:
▪ Operating activities: net income + all non-cash entries related tot
the firm’s operating activities – adjust for changes to net working
capital that arise from changes to accounts receivable, accounts
payable, or inventory.
▪ Investment activities: cash used for investment.
Capital expenditures: purchases of new property, plant, and
equipment.
▪ Financing activities: cash flow between the firm and its investors.
Retained earnings = net income - dividends
4. Statement of stockholders’ equity: breaks down the stockholders’ equity computed on the balance sheet
into the amount that came from issuing new shares versus retained earnings.
Change in Stockholders’ Equity = retained earnings + net sales of stock = net income – dividends + sales
of stock – repurchases of stock
Management discussion and analysis (MD&A): a preface to the financial statements in which a company’s
management discusses the recent year (or quarter), providing a background on the company and any significant
events that may have occurred.
Chapter 3: Financial Decision Making
Valuation Principle:
The value of an asset to the firm or its investors is determined by its competitive market price: The benefits and
costs of a decision should be evaluated using these market prices, and when the value of the benefits exceeds
the value of the costs, the decision will increase the market value of the firm.
Value: equal to present value of cash flows
Time value of money: the difference in value between money today and money in the future; also, the
observation that two cash flows at two different points in time have different values.
Net Present Value (NPV) = PV(Benefits) – PV(Costs) = PV(All project cash flows)
NPV Decision Rule: when making an investment decision, take the alternative with the highest NPV.
Choosing this alternative is equivalent to receiving its NPV in cash today.
Accept with positive NPV, reject with negative NPV.
Arbitrage: the practice of buying and selling equivalent goods in different markets to take advantage of a price
difference. True arbitrage: zero investment and zero risk
Arbitrage opportunity: possibility to make a profit (NPV>0) without taking any risk or making any net
investment.
No-Arbitrage Price of a security = PV(all cash flows paid by the security)
Normal market: a competitive market in which there are no arbitrage opportunities.
Law of One Price: If equivalent investment opportunities trade simultaneously in different competitive markets,
then they must trade for the same price in all markets.
