Shareholder value

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Shareholder value is a business term, sometimes phrased as shareholder value maximization or as the shareholder value model, which implies that the ultimate measure of a company's success is the extent to which it enriches shareholders. It became popular during the 1980s, and is particularly associated with former CEO of General Electric, Jack Welch.

General Electric American industrial company

General Electric Company (GE) is an American multinational conglomerate incorporated in New York City and headquartered in Boston. As of 2018, the company operates through the following segments: aviation, healthcare, power, renewable energy, digital industry, additive manufacturing, venture capital and finance, lighting, and oil and gas.

Jack Welch American executive: General Electric CEO

John Francis "Jack" Welch Jr. is an American business executive, author, and chemical engineer. He was chairman and CEO of General Electric between 1981 and 2001. During his tenure at GE, the company's value rose 4,000%. In 2006, Welch's net worth was estimated at $720 million. When he retired from GE he received a severance payment of $417 million, the largest such payment in history.

Contents

The term can be used to refer to:

Market capitalization total value of a public companys outstanding shares

Market capitalization is the market value of a publicly traded company's outstanding shares.

Wealth abundance of value

Wealth is the abundance of valuable financial assets or physical possessions which can be converted into a form that can be used for transactions. This includes the core meaning as held in the originating old English word weal, which is from an Indo-European word stem. A community, region or country that possesses an abundance of such possessions or resources to the benefit of the common good is known as wealthy.

In Economics and Accounting, the cost of capital is the cost of a company's funds, or, from an investor's point of view "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

Definition

For a publicly traded company, Shareholder Value (SV) is the part of its capitalization that is equity as opposed to long-term debt. In the case of only one type of stock, this would roughly be the number of outstanding shares times current shareprice. Things like dividends augment shareholder value while issuing of shares (stock options) lower it. This shareholder value added should be compared to average/required increase in value, making reference to the organizations cost of capital.

Debt deferred payment, or series of payments, that is owed in the future

Debt is when something, usually money, is owed by one party, the borrower or debtor, to a second party, the lender or creditor. Debt is a deferred payment, or series of payments, that is owed in the future, which is what differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.

Stock financial instrument

The stock of a corporation is all of the shares into which ownership of the corporation is divided. In American English, the shares are commonly known as "stocks". A single share of the stock represents fractional ownership of the corporation in proportion to the total number of shares. This typically entitles the stockholder to that fraction of the company's earnings, proceeds from liquidation of assets, or voting power, often dividing these up in proportion to the amount of money each stockholder has invested. Not all stock is necessarily equal, as certain classes of stock may be issued for example without voting rights, with enhanced voting rights, or with a certain priority to receive profits or liquidation proceeds before or after other classes of shareholders.

Dividend payment made by a corporation to its shareholders, usually as a distribution of profits

A dividend is a payment made by a corporation to its shareholders, usually as a distribution of profits. When a corporation earns a profit or surplus, the corporation is able to re-invest the profit in the business and pay a proportion of the profit as a dividend to shareholders. Distribution to shareholders may be in cash or, if the corporation has a dividend reinvestment plan, the amount can be paid by the issue of further shares or share repurchase. When dividends are paid, shareholders typically must pay income taxes, and the corporation does not receive a corporate income tax deduction for the dividend payments.

For a privately held company, the value of the firm after debt must be estimated using one of several valuation methods, s.a. discounted cash flow or others.

Valuation (finance) process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted by using cost of capital to give their present values (PVs). The sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value of the cash flows in question.

History

On August 12, 1981, Jack Welch made a speech at The Pierre in New York City called ‘Growing fast in a slow-growth economy’. [1] This is often acknowledged as the "dawn" of the obsession with shareholder value. Welch's stated aim was to be the biggest or second biggest market player, and to return maximum value to stockholders.

The Pierre luxury hotel in Manhattan

The Pierre is a luxury hotel located at 2 East 61st Street, at the intersection of that street with Fifth Avenue, in Manhattan, New York City, facing Central Park. Designed by Schultze & Weaver, the hotel opened in 1930 with 100+ employees, now with over a thousand. In 2005, the hotel was acquired by Taj Hotels Resorts and Palaces of India. Standing 525.01 feet (160.02 m) tall, it is located within the Upper East Side Historic District as designated in 1981 by the New York City Landmarks Preservation Commission.

New York City Largest city in the United States

The City of New York, usually called either New York City (NYC) or simply New York (NY), is the most populous city in the United States. With an estimated 2018 population of 8,398,748 distributed over a land area of about 302.6 square miles (784 km2), New York is also the most densely populated major city in the United States. Located at the southern tip of the state of New York, the city is the center of the New York metropolitan area, the largest metropolitan area in the world by urban landmass and one of the world's most populous megacities, with an estimated 20,320,876 people in its 2017 Metropolitan Statistical Area and 23,876,155 residents in its Combined Statistical Area. A global power city, New York City has been described as the cultural, financial, and media capital of the world, and exerts a significant impact upon commerce, entertainment, research, technology, education, politics, tourism, art, fashion, and sports. The city's fast pace has inspired the term New York minute. Home to the headquarters of the United Nations, New York is an important center for international diplomacy.

In March 2009, Welch criticized parts of the application of this concept, calling a focus on shareholder quarterly profit and share price gains "the dumbest idea in the world". [2] Welch then elaborated on this, claiming that the quotes were taken out of context. [3]

Mark Mizruchi and Howard Kimeldorf offer an explanation of the rise in prominence of institutional investors and securities analysts as a function of the changing political economy throughout the late 20th century. The crux of their argument is based upon one main idea. The rise in prominence of institutional investors can be credited to three significant forces, namely organized labor, the state and the banks. The roles of these three forces shifted, or were abdicated, in an effort to keep corporate abuse in check. However, “without the internal discipline provided by the banks and external discipline provided by the state and labor, the corporate world has been left to the professionals who have the ability to manipulate the vital information about corporate performance on which investors depend”. [4] This allowed institutional investors and securities analysts from the outside to manipulate information for their own benefit rather than for that of the corporation as a whole.

Though Ashan and Kimeldorf (1990) admit that their analysis of what historically led to the shareholder value model is speculative, their work is well regarded and is built upon the works of some of the premier scholars in the field, namely Frank Dobbin and Dirk Zorn.

During the 1970s, there was an economic crisis caused by stagflation. The stock market had been flat for nearly 12 years and inflation levels had reached double-digits. Also, the Japanese had recently taken the spot as the dominant force in auto and high technology manufacturing, a title historically held by American companies. [5] This, coupled with the economic changes noted by Mizruchi and Kimeldorf, brought about the question as to how to fix the current model of management.

Though there were contending solutions to resolve these problems, the winner was the Agency Theory developed by Jensen and Meckling, which will be discussed in greater detail later in this entry. As a result of the political and economic changes of the late 20th century, the balance of power in the economy began to shift. Today, “…power depends on the capacity of one group of business experts to alter the incentives of another, and on the capacity of one group to define the interests of another. [6] As stated earlier, what made the shift to the shareholder value model unique was the ability of those outside the firm to influence the perceived interests of corporate managers and shareholders.

However, Dobbin and Zorn argue that those outside the firm were not operating with malicious intentions. “They conned themselves first and foremost. Takeover specialists convinced themselves that they were ousting inept CEOs. Institutional investors convinced themselves that CEOs should be paid for performance. Analysts convinced themselves that forecasts were a better metric for judging stock price than current profits”. [7] Overall, it was the political and economic landscape of the time that offered the perfect opportunity for professionals outside of firms to gain power and exert their influence in order to drastically change corporate strategy.

Agency theory and shareholder value

Agency theory is the study of problems characterized by disconnects between two cooperating parties: a principal and an agent. [8] Agency problems arise in situations where there is a division of labor, a physical or temporal disconnect separating the two parties, or when the principal hires an agent for specialized expertise. [9] In these circumstances, the principal takes on the agent to delegate responsibility to him. [10] Theorists have described the problem as one of “separation and control”: [11] agents cannot be monitored perfectly by the principal, so they may shirk their responsibilities or act out of sync with the principal's goals. [12] The information gap and the misalignment of goals between the two parties results in agency costs, [13] which are the sum of the costs to the principal of monitoring, the costs to the agent of bonding with the principal, and the residual loss due to the disconnect between the principal's interests and agent's decisions. [14]

Lastly, the shareholder value theory seeks to reform the governance of publicly owned firms in order to decrease the principal-agent information gap. The model calls for firms’ boards to be independent from their corporate executives, specifically, for the head of the board to be someone other than the CEO and for the board to be independently chosen. [15] An independent board can best objectively monitor CEO undertakings and risk. [16] Shareholder value also argues in favor of increased financial transparency. By making firms’ finances available to scrutiny, shareholders become more aware of the agent's behavior and can make informed choices about with whom to invest. [17]

Maximizing shareholder value

This management principle, also known as value-based management or managing for value, states that management should first and foremost consider the interests of shareholders when making management decisions. [18] [19] [20] [21] Under this principle, senior executives should set performance targets in terms of delivering shareholder returns (stock price and dividends payments) and managing to achieve them. [22] [23]

The concept of maximizing shareholder value is usually highlighted in opposition to alleged examples of CEO's and other management actions which enrich themselves at the expense of shareholders. Examples of this include acquisitions which are dilutive to shareholders, that is, they may cause the combined company to have twice the profits for example but these might have to be split amongst three times the shareholders. Although the legal premise of a publicly traded company is that the executives are obligated to maximize the company's profit, [24] this does not imply that executives are legally obligated to maximize shareholder value.

As shareholder value is difficult to influence directly by any manager, it is usually broken down in components, so called value drivers. A widely used model comprises 7 drivers of shareholder value, [25] giving some guidance to managers:

Looking at some of these elements also makes it clear that short term profit maximization does not necessarily increase shareholder value. Most notably, the competitive advantage period takes care of this: if a business sells sub-standard products to reduce cost and make a quick profit, it damages its reputation and therefore destroys competitive advantage in the future. The same holds true for businesses that neglect research or investment in motivated and well-trained employees. Shareholders, analysts and the media will usually find out about these issues and therefore reduce the price they are prepared to pay for shares of this business. This more detailed concept therefore gets rid of some of the issues (though not all of them) typically associated with criticism of the shareholder value model.

Based on these seven components, all functions of a business plan and show how they influence shareholder value. A prominent tool for any department or function to prove its value are so called shareholder value maps that link their activities to one or several of these seven components. So, one can find "HR shareholder value maps", "R&D shareholder value maps", and so on.

Criticism

The sole concentration on shareholder value has been widely criticized, [26] particularly after the late-2000s financial crisis. While a focus on shareholder value can benefit the owners of a corporation financially, it does not provide a clear measure of social issues like employment, environmental issues, or ethical business practices. A management decision can maximize shareholder value while lowering the welfare of third parties. Shareholder value coupled with short-termism has also been criticized as lowering the overall rate of economic growth due to reduced business capital accumulation. [27]

It can also disadvantage other stakeholders such as customers. For example, a company may, in the interests of enhancing shareholder value, cease to provide support for old, or even relatively new, products.

Additionally, short term focus on shareholder value can be detrimental to long term shareholder value; the expense of gimmicks that briefly boost a stocks value can have negative impacts on its long term value.

Disadvantages of the shareholder value model

Shareholder value may be detrimental to a company's worth. When all of a company's focus and strategy is concentrated on increasing share prices, the practice and ethics of the firm can become lost because of the following problems with the shareholder value model.

Lack of transparency

The value of the company's share depends on how much profit they have made in a given time. In the shareholder value system, the firm's main concern is getting the share value to be as high as possible. To do this, companies found ways to make it seem like they were making far more profit than they actually were. These strategies to make the company seem profitable were often fraudulent. When the companies’ reports of their own finances are untrue, there becomes a lack of transparency: investors and employees alike do not know what profit was actually made and what profit was born from fraudulent schemes.

An example of how a company can appear profitable to investors without actually being profitable is the use of subsidiary companies. The firm has one parent company for which they are concerned about the shareholder value, and the firm also has one or more smaller subsidiary companies that has no substance and is only used as facade. The smaller companies are made to lose money so that the parent company may gain money. Debt and profits can be transferred between companies in such a way that financial reports claim the parent company is making a profit when it's actually nothing more than a scheme. [28]

This is a disadvantage to companies and the market at large because it allows profit to be made without any successful business practice being conducted. The ethics of firms are compromised in the interest of increasing share value. [29]

Increased risk

In the shareholder value model, companies often take on much more risk than they otherwise would. The acquisition of debt makes the company unstable and at risk of bankruptcy. Plentiful debt is conducive to increasing share value because the company has greater potential to increase value when starting at a lower baseline. This however is a detrimental to the stability of the company.

Debt financing, or the purposeful acquisition of debt, causes the debt to equity ratio of the company to rise. Without shareholder value, this would normally be considered negative because it means that the company is not making money. In the shareholder value system, high debt to equity ratios are considered an indicator that the company has confidence to make money in the future. [30] Therefore, debt is not something to avoid but rather something to embrace and having debt will actually gain the company investors. Taking on large risk attracts investors and increases potential value gain, but puts the company in danger of bankruptcy and collapse.

Short term strategy

When companies use the shareholder value model, firm behavior is focused on increasing the shareholder value rather than the long-term success of the company. Because employees are given stock options instead of salaries, it is in their interest for the share value to go up. In order for it to go up repeatedly, a strategy would be to allow the share price to alternate rising and falling. After the value has fallen, the amount of increase can be maximized. This type of oscillation is not beneficial to the long-term success of the company. Repeatedly decreasing share value so that it can be again increased generates profit for shareholders, but does not generate profit for the company; instead the company could become stagnant and fragile. Short-term strategies to increase share value are beneficial to investors and employees with stock options but are a disadvantage to sustained success of the company. [31]

Alternatives

While shareholder value is the most common framework for measuring a company's success and financial viability, a number of alternatives have been proposed. Indeed, maximizing shareholder value is not always the goal of successful companies.

Stakeholder value

The broad idea of "stakeholder value" is the most common basis of alternative frameworks. The intrinsic or extrinsic worth of a business measured by a combination of financial success, usefulness to society, and satisfaction of employees, the priorities determined by the makeup of the individuals and entities that together own the shares and direct the company. This is sometimes referred to as stakeholder value. Stakeholder value heavily relies on corporate social responsibility and long-term financial stability as a core business strategy. [32]

The stakeholder value model is prevalent in regions where limited liability laws are not strong. Some companies, choosing to prioritize social responsibility, elect to prioritize the social and financial welfare of employees and suppliers over shareholders; this, in turn, shields shareholders, the owners of the company, from liability when the law would not be lenient should the company engage in poor behavior. [32]

Despite its high potential social benefit, this concept is difficult to implement in practice because of the difficulty of determining equivalent measures for usefulness to society and satisfaction of employees. For instance, how much additional "usefulness to society" should shareholders expect if they were to give up $100 million in shareholder return? In response to this criticism, defenders of the stakeholder value concept argue that employee satisfaction and usefulness to society will ultimately translate into shareholder value.

Another related criticism is that it is difficult to determine how to equitably distribute value to stakeholders. The question of "who deserves what and how much" is a difficult one to answer.

Social enterprise

A company may choose to disregard shareholders completely. A social enterprise instead focuses its objectives on goals other than the profitability of its owners; indeed, the legal body of a social enterprise often precludes issuing dividends to shareholders. Social enterprises require significant investment in financial stability and long-term profitability, in the meantime taking very little risk. [32]

Social enterprises manifest themselves in the UK as community interest companies or limited by guarantee. In the United States, California allows companies to incorporate as flexible purpose corporations. [32]

See also

Related Research Articles

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Equity (finance) difference between the value of the assets/interest and the cost of the liabilities of something owned

In accounting, equity is the difference between the value of the assets and the value of the liabilities of something owned. It is governed by the following equation:

Corporate governance is the collection of mechanisms, processes and relations by which corporations are controlled and operated. Governance structures and principles identify the distribution of rights and responsibilities among different participants in the corporation and include the rules and procedures for making decisions in corporate affairs. Corporate governance is necessary because of the possibility of conflicts of interests between stakeholders, primarily between shareholders and upper management or among shareholders.

Corporate social responsibility is a type of international private business self-regulation. While once it was possible to describe CSR as an internal organisational policy or a corporate ethic strategy, that time has passed as various international laws have been developed and various organisations have used their authority to push it beyond individual or even industry-wide initiatives. While it has been considered a form of corporate self-regulation for some time, over the last decade or so it has moved considerably from voluntary decisions at the level of individual organisations, to mandatory schemes at regional, national and even transnational levels.

Capital structure

Capital structure in corporate finance is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.

In a corporation, a stakeholder is a member of "groups without whose support the organization would cease to exist", as defined in the first usage of the word in a 1963 internal memorandum at the Stanford Research Institute. The theory was later developed and championed by R. Edward Freeman in the 1980s. Since then it has gained wide acceptance in business practice and in theorizing relating to strategic management, corporate governance, business purpose and corporate social responsibility (CSR).The definition of corporate responsibilities through a classification of stakeholders to consider has been criticised as creating a false dichotomy between the "shareholder model" and the "stakeholders model" or a false analogy of the obligations towards shareholders and other interested parties.

In corporate finance, the return on equity (ROE) is a measure of the profitability of a business in relation to the equity, also known as net assets or assets minus liabilities. ROE is a measure of how well a company uses investments to generate earnings growth.

An agency cost is an economic concept concerning the fee to a "principal", when the principal chooses or hires an "agent" to act on its behalf. Because the two parties have different interests and the agent has more information, the principal cannot directly ensure that its agent is always acting in its best interests.

In management, business value is an informal term that includes all forms of value that determine the health and well-being of the firm in the long run. Business value expands concept of value of the firm beyond economic value to include other forms of value such as employee value, customer value, supplier value, channel partner value, alliance partner value, managerial value, and societal value. Many of these forms of value are not directly measured in monetary terms.

Michael Cole "El Choro Mike" Jensen, an American economist, works in the area of financial economics. Between 2000 and 2009 he worked for the Monitor Company Group, a strategy-consulting firm which became "Monitor Deloitte" in 2013. He holds the position of Jesse Isidor Straus Professor of Business Administration, Emeritus, at Harvard University.

Within the theory of corporate finance, bankruptcy costs of debt are the increased costs of financing with debt instead of equity that result from a higher probability of bankruptcy. The fact that bankruptcy is generally a costly process in itself and not only a transfer of ownership implies that these costs negatively affect the total value of the firm. These costs can be thought of as a financial cost, in the sense that the cost of financing increases because the probability of bankruptcy increases. One way to understand this is to realize that when a firm goes bankrupt investors holding its debt are likely to lose part or all of their investment, and therefore investors require a higher rate of return when investing in bonds of a firm that can easily go bankrupt. This implies that an increase in debt which ends up increasing a firm's bankruptcy probability causes an increase in these bankruptcy costs of debt.

Management is a type of labor but with a special role-coordinating the activities of inputs and carrying out the contracts agreed among inputs, all of which can be characterized as "decision making." Managers usually face disciplinary forces by making themselves irreplaceable in a way that the company would lose without them. A manager has an incentive to invest the firm's resources in assets whose value is higher under him than under the best alternative manager, even when such investments are not value-maximizing.

Financial management focuses on ratios, equities and debts. It is useful for portfolio management,distribution of dividend,capital raising,hedging and looking after fluctuations in foreign currency and product cycles.Financial managers are the people who will do research and based on the research, decide what sort of capital to obtain in order to fund the company's assets as well as maximizing the value of the firm for all the stakeholders. It also refers to the efficient and effective management of money (funds) in such a manner as to accomplish the objectives of the organization. It is the specialized function directly associated with the top management. The significance of this function is not seen in the 'Line' but also in the capacity of the 'Staff' in overall of a company. It has been defined differently by different experts in the field.

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Milton Friedman takes a shareholder approach to social responsibility. This approach views shareholders as the economic engine of the organization and the only group to which the firm must be socially responsible. As such, the goal of the firm is to maximize profits and return a portion of those profits to shareholders as a reward for the risk they took in investing in the firm. He advocates that the shareholders can then decide for themselves what social initiatives to take part in rather than having their appointed executive, whom they appointed for business reasons, decide for them.

Strategic financial management

Strategic financial management is the study of finance with a long term view considering the strategic goals of the enterprise. Financial management is nowadays increasingly referred to as "Strategic Financial Management" so as to give it an increased frame of reference.

Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.

Corporate finance area of finance dealing with the sources of funding and the capital structure of corporations

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

Benefit corporation

In the United States, a benefit corporation is a type of for-profit corporate entity, authorized by 35 U.S. states and the District of Columbia that includes positive impact on society, workers, the community and the environment in addition to profit as its legally defined goals, in that the definition of "best interest of the corporation" is specified to include those impacts. Traditional C Corporation law does not specify the definition of "best interest of the corporation" which has led to profit motivations being used as the main driver for best interests. Benefit corporations may not differ much from traditional C corporations. A C corporation may change to a B corporation merely by stating in its approved corporate bylaws that it is a benefit corporation.

References

Citations

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Sources

Further reading