Last fall, Forbes.com published an article that reviews the book Fixing the Game by Roger Martin, Dean of the Rotman School of Management at the University of Toronto. In our initial comments on that article we made the case that creating sustainable shareholder value is still a good idea. Today we will build on the idea that serving all stakeholders (customers, employees, suppliers, etc.) well, will also serve shareholders well. Indeed, you cannot create long-term value for shareholders without creating value for your customers, in a strong partnership with your employees and suppliers.
Mathematically, the value of a business is derived from, and highly correlated with, the future returns it is expected to generate for its shareholders. But this formula doesn’t go far enough. In order to maximize shareholder value, we need to explain where those returns come from and how to increase them.
A simple equation for shareholder returns is:
Less Cost of Sales
Less Operating Costs
Less Cost of Capital
= Returns to Shareholders
To sustainably increase shareholder return, a management team must do one or more of the following:
- Increase revenue by choosing the right customers, offering them differentiated products and services, and treating them well
- Improve gross profits by choosing the right suppliers and working with them to create win-win partnerships
- Increase returns on operating cost investments by choosing the right employees and working with them to maximize their productivity and creative ability
- Lower the cost of capital and improve returns on capital by optimizing use of assets and leverage
A management team cannot create sustainable shareholder value by ignoring customers, abusing suppliers, and mistreating or stifling employees. In our experience, any short-term gain from doing so is more than offset by long-term value destruction.
For example, a clothing retailer experienced declining gross profit margins due to a growing level of price discounting. The CEO sought to improve gross margins by reducing inventory in the stores. As a result, price discounting was significantly curtailed and gross margins did indeed improve. However, same-store sales dropped as customers were not able to find the sizes and colors they desired. Instead, those customers migrated to the retailers’ competitors. As a result, the CEO was inadvertently helping to create shopping occasions for his main competitors!
This is a classic example of a CEO acting to “goose” near-term results at the expense of long-term customer value. In this case, the negative impact of this strategy was readily apparent. The market quickly reacted to lagging same-store sales and punished the stock, and the CEO quickly reversed course.
Instead, the CEO might have created long-term value by improving his team’s ability to predict or react to fashion trends. Had he done so, his customers would be better served and the merchandise would be moving off the shelves.