Last fall, 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.

The article’s author, Steve Denning, dissects the main theme of Martin’s book, which is that the current practices around maximizing shareholder value actually do more harm than good:

  • In practice, CEOs do not focus on creating long-term value for shareholders, but instead focus on managing near-term earnings expectations. They do this because:
    • Stock options and other incentive compensation reward near-term focus rather than creating sustainable value
    • Current accounting standards actually require CEOs to manage earnings and expectations
  • As a result, shareholder value is being destroyed
    • Return On Assets (ROA) has dropped significantly since shareholder value management practices have been adopted
    • Real annual returns on the S&P 500 have dropped from 7.5 percent in 1933-1976 to 6.5 percent from 1976 through today
    • Customers are being ignored, which over the long term harms shareholders
    • Managers are no longer building for the long run, but merely exploiting a series of near-term opportunities. In doing so they are missing opportunities to create sustainable value
  • Also, the shareholder value philosophy has given rise to a number of dubious behaviors
    • CEO compensation per dollar of net earnings doubled in the 1980s and quadrupled in the 1990s
    • Accounting scandals (such as Enron, WorldCom and Tyco International) and the sub-prime meltdown have plagued the corporate world
    • Hedge funds create significant volatility, which is dangerous for shareholders but lucrative for the hedge funds

The result, Martin writes, is catastrophic: “Our theories of shareholder value maximization and stock-based compensation have the ability to destroy our economy and rot out the core of American capitalism.”

This is a stinging indictment of the shareholder value movement, but is it justified? In our view, CEOs and their management teams should focus on increasing shareholder value. But there’s a right way and a wrong way to do so. The right way:

  • 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

In an increasingly challenging global competitive environment, these are challenging objectives. The only way to make them work is by aligning executive compensation with these goals. Many of the problems Martin cites with shareholder value models stem from incentive-laden compensation packages that are built around increasing stock value. We agree with Martin that large option awards can create serious mis-incentives for executives. As Martin notes, this may inspire executives toward excessive risk-taking and short-term share price management. We share Martin’s concern that option-based compensation may drive destruction rather than creation of shareholder value.

But if boards take steps to properly align executive incentives around sustainable shareholder value growth–not one-off quarterly or annual gains–everyone (customers, suppliers, employees, shareholders, executives and outside stakeholders) will be better off. You don’t have to throw the baby out with the bathwater.