The Shareholder Value Form of Capitalism - Essay Example

The Case against the Shareholder Value Form of Capitalism THE CASE AGAINST THE SHAREHOLDER VALUE FORM OF CAPITALISM In economic terms, shareholder value can be defined as the implication that an organization’s ultimate measure of success is dependent on the extent to which the company manages to enrich its shareholders. The term is also at times referred to as the shareholder value model or shareholder value maximization and was popularized by Jack Welch, the former General Electric CEO, in the late 1980s. In some cases, shareholder value can also refer to a company’s market capitalization (Mason, 2010: p13). In addition, it may also be used in reference to the concept of an organization’s basic objective being the increase of its shareholders’ wealth by causing an increase in stock prices and/or paying dividends. Moreover, shareholder value can also refer to the concept that shareholder returns and the management’s planned actions must outperform cost of capital and other specific benchmarks. Essentially, shareholder value for the latter definition holds that the shareholders’ money must earn them higher returns than could be earned through their investment in other assets carrying similar risks (Mason, 2010: p14). However, as will be seen from a case study of Cadbury’s and Meltdown (2010), there is a theoretical case against the shareholder value form of capitalism. Shareholder value as a form of capitalism is detrimental to the worth and eventual success of organizations as shown by Mason (2010). When the organization focuses all its strategic actions towards increasing their share prices, they may lose their ethical and practice foundation due to various problems that plague the shareholder value model of capitalism. Mason (2010: p23) contends that the shareholder value model of capitalism lacks transparency. An organization’s share value is dependent on the amount of profit that a company makes over a specific period. With regards to the shareholder value model, the main focus of the organization is the attainment of the highest possible share value. In order to accomplish this, organizations, especially financial institutions, seek ways to enhance their profits, sometimes even making it seem that that they were more profitable than was actually the case. Often fraudulent, these strategies taken by organizations to artificially increase their profitability lack transparency (Mason, 2010: p24). This is because the employees and shareholders are unaware about the profits resulting from fraudulent activity and those actually made by the organization. Mason (2010: p33) gives an example of how financial institutions managed to convince investors that they were profitable through the utilization of subsidiary organizations. In this case, there is a parent company for the entire firm that is concerned with the maximization of shareholder value, while the firm also possesses more than one subsidiary organization that is a façade and has minimal substance. The latter smaller organizations are allowed to lose funds in order for the bigger parent company to be profitable. It then becomes possible to transfer profits and debt between the parent company and the smaller subsidiary company, which enables the firm’s financial reports to claim profits for the parent company when it is only a scheme. This model of shareholder value maximization acts as a disadvantage to the entire market and to the companies, especially since it allows the firm to make profit sans there being any successful business practice. In addition, it will also compromise the firm’s ethics as they seek to increase the value of shares (Mason, 2010: p33). Mason (2010: p59) also posits that the shareholder model of capitalism increases risk as companies normally undertake risks that they would usually not take on. By taking on more risk and acquiring debt, the company is increasingly destabilized and their risk of bankruptcy increases, as was the case with American banks like Fannie Mae. Having a lot of debt is not always a disadvantage when the firm is seeking to increase the value of its shares since its potential to improve value is greater, particularly as it will start from a much lower level. In spite of this, the firm’s stability could be harmed as the debt: equity ratio increases with the firm’s actions to acquire debt purposefully, also referred to as debt financing. Usually, this would be considered as a negative outcome in the absence of shareholder value as it indicates that the firm is not profitable (Mason, 2010: p59). In the shareholder value model of capitalism, however, higher levels of debt: equity are taken as evidence that the firm is confident of its ability to make profit going forward. As a result, debt becomes desirable rather than undesirable, which makes it easier for the firm to attract investors (Mason, 2010: p60). While excessive risk taking increases potential gain of value and attracts investors, firms have a higher potential for collapse due to bankruptcy. In addition, another case against the shareholder value model of capitalism is that the behavior of the firm is mainly focused on improving value to the shareholder, instead of the firm’s success in the long term. Mason (2010: p72) focuses on the strategy to give employees stock options in companies, rather than paying them a salary, which means that the firm is under pressure to ensure that the value of shares is on the up. One strategy used by firms before the financial crisis to make share value repeatedly go up was to allow the price of their shares alternately fall and rise. As a result, it becomes possible to maximize the increase of share value after it falls. Continuous oscillation of share prices does not aid the firm over the long run. While decreasing the value of shares repeatedly in order to increase it down the road will generate profits and value for the shareholders, the company does not generate significant profits. This makes the firm fragile and stagnant in the long term. Therefore, although employees and investors benefit from such short-term strategies aimed at increasing the value of shares, the firm is at a disadvantage with regards to its ability to sustain success over the long term (Mason, 2010: p72). Mason (2010: p18) gives a unified definition for shareholder value as the total sum of a firm’s decisions that impact on its operations and ability generate an attractive ROI for investors and to raise its free cash flow over a specific time period. However, as has been discussed above, this form of capitalism has various disadvantages, which are evident in the Cadbury’s case study. Cadbury’s was the target of a bid by Kraft in August of 2009 with the latter making a £10.2 billion offer to buy the former, in which each share was valued at 745 p in stock and cash. However, it was Cadbury’s view that Kraft had undervalued the organization, which informed their refusal to sell up to Kraft (Mason, 2010: p88). As a result, Kraft increased its offer in January of 2010 to 850 p for each share, resulting in an about-turn by Cadbury’s major shareholders and acceptance of the offer. This led to Cadbury’s being absorbed into the larger conglomerate that was Kraft, resulting in a loss of its practice as a pure manufacturer of chocolate confectionary. While the takeover of Cadbury’s by Kraft boosted the shareholders’ value, one may also argue that it was a decision that was made with short-term goals in mind with the sacrifice of long-term interests. The fact that the price-earnings during Cadbury’s sale were dependent on an increase of share price and value indicates that the markets did not purely rely on present value (Mason, 2010: p89). In fact, the manner in which the value of Cadbury’s shares increased evidenced increased investment as a result of short term cash flows in disregard of future income and cash flows. While taking Kraft Foods after their purchase of Cadbury’s, it can be seen that their growth has slowed down and the firm is now facing hefty debts that stood at £24 billion in 2012. Thus, this highlights the fact that the new Cadbury’s shareholders are not, in effect, the real long-term owners of the company. Instead, rational hedge funds have a critical role in the long-term future of Cadbury’s as they sought to maximize profits using Kraft’s takeover (Mason, 2010: p89). It is, therefore, clear that shareholder value was maximized in the short-term at the expense of the firm’s objectives in the end. As aforementioned, the shareholder value model of capitalism ends up hurting the ethical standing of a company and this is evident in the case of Cadbury’s. Cadbury’s is a well-known and respected brand in the UK with a long history of adhering to ethical tenets of capitalism. For example, the company has always cared about its employees on the basis of Quaker values, rather than treating them as a means to profit and production (Mason, 2010: p90). However, Cadbury’s lost its ethical standing due to the manner of its sale, which harmed its long term viability and objectives. From Kraft Food’s perspective, taking over Cadbury’s was necessary on the basis of its financialization economic tendencies, while it also acted to increase the value and price of Kraft Food’s shares. However, the takeover was a decision made with short-term interests in mind by Cadbury’s, which sacrificed its long-term objectives and interests profits (Mason, 2010: p90). In addition, although Kraft Food’s gained maximum financial benefits from the deal in the short-term, it ended up losing the essence of ethics that had driven Cadbury’s success up to that point in the long term profits (Mason, 2010: p97). As a long established company, Cadbury’s had successfully surpassed most of its competitors due to its adherence to Quaker values that had increased their employee’s loyalty to the company. As a result, these Quaker values had enabled Cadbury’s to overcome various difficulties it had faced for over a hundred years. This was in the long-term objectives of the firm and helped Cadbury’s initially overcome the financial crisis. While financial success is one of the vital components of any company’s strategy, it is clear from the Cadbury’s case study that its biggest influence is on the firm’s external operations. It is essential for successful firms to have specific internal values, which Cadbury’s lost as it decided to maximize on shareholder value in the short term and sacrificed the long term viability of the company as part of a conglomerate profits (Mason, 2010: p99). References Mason, P. (2010). Meltdown: The end of the age of greed. London: Verso. Read More