From Managers to Markets: Valuation and the Shareholder Wealth Paradigm

James J. Park is Professor of Law at UCLA School of Law. This post is based on his recent paper. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Toward Fair and Sustainable Capitalism by Leo E. Strine, Jr (discussed on the Forum here).

The shareholder wealth paradigm displaced a managerialist model where investors deferred to managers with the expertise to efficiently allocate resources within the firm. The corporate managers who administered such internal capital markets faced less pressure to generate profits than they do today. Managers viewed themselves as trustees with duties to balance the interests of various corporate stakeholders.

What happened to managerialism? The prevailing account is that ideology changed. Some scholars point to the 1970 publication of Milton Friedman’s vigorous defense of shareholder wealth maximization in the New York Times Magazine as a turning point. Corporate scandals during the 1970s reinforced the idea that corporate governance should focus on protecting shareholders from predatory managers.

This paper develops a new account of the shift from managers to markets as the primary drivers of corporate purpose. It shows that managerialism became less influential not because of shifts in ideology but because of fundamental changes in the methods investors used to value public companies. As management became viewed as a science that could be mastered, it became evident that stock values depended on the ability of management teams to generate corporate earnings over time. Investors became more confident that a company’s earnings could be projected over time and the value of those earnings discounted to present value should determine the fundamental value of that company’s stock.

By the 1960s, there were two major methods companies used to signal the extent of their future earnings. The first, which was largely discredited by the 1980s, was forming a corporate conglomerate. There was a belief that superior management of a wide array of businesses could consistently deliver smooth increases in earnings. Markets trusted strong internal capital markets to efficiently move resources within the conglomerate to their best use. The second was to consistently meet market projections of company earnings and revenues. By the 1960s, research analysts who followed company stocks issued predictions of company earnings and revenue. Companies developed their own projections based on internal information that were often selectively conveyed to market participants. By consistently meeting forecasts of revenue and profits companies demonstrated the skill of their managers and validated market predictions of earnings trajectories that were incorporated into stock prices.

Of these two methods, projections became the more influential and now powerfully align the interests of managers with shareholders. Projections permit shareholders to: (1) assess managerial competence and (2) assess the commitment of managers to maximize the value of a company’s assets. Even if managerial skill is difficult to directly observe, investors can evaluate managers based on their ability to meet market forecasts. Projections serve as both a carrot and a stick. Companies that make ambitious projections and consistently meet them can be rewarded by a higher market value. Companies that fail to meet projections can be punished by markets who question the competence of their management.

While projections are an imperfect mechanism for assessing managers and can be manipulated, they reduce the transaction costs of valuing public companies. As a result, shareholders have less reason to defer to the valuations of internal capital markets as they did during the managerialist era. Other mechanisms such as takeovers and executive compensation have developed to reduce the agency costs between managers and shareholders. But projections originated before those methods and have been the most persistent mechanism by which shareholders monitor management.

As valuation shifted from managers to markets, the power of stock markets to define corporate purpose increased. The irony of projections was that they were initially a way that shareholders relied on the superior knowledge of management to value companies, and over time evolved to become a heuristic that tests managerial competence. Rather than deferring to managerial expertise, markets sought to evaluate it based on whether managers could set ambitious goals and meet them. Managers of many public companies have little choice than to work to continue generating corporate earnings to maintain their company’s valuation. Projections helped change a world in which shareholders had little power relative to management to one in which they wield significant influence over the goals of the public corporation.

If the transition from managerialism to shareholder wealth maximization was driven primarily by changes in valuation, it is possible that changes in valuation methods could support a world where the shareholder wealth paradigm plays a lesser role. While projections have powerfully shaped corporate purpose, some public companies have escaped the pressure to maximize shareholder wealth in the short-term, especially in recent years. As companies have become even larger and more complex, markets increasingly defer to the expertise of their managers out of necessity. Investors give companies with significant market power more leeway in demonstrating immediate profitability because they are confident in their long-term prospects. Investors have permitted companies with strong business models to adopt dual class structures that lessen their ability to change managers for failing to generate short-term performance. As investors have become more diversified and concerned with social responsibility, they may focus less on short-term profitability. Public company managers have argued that markets should move away from projections as a way of valuing companies on the ground that they emphasize short-term results that do not reflect long-term corporate value. For companies that are able to escape the treadmill of projections, commitments to consider the interests of stakeholders have the potential to be meaningful.

The complete paper is available for download here.

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