How Shareholder Primacy Wards Off Short-termism

Leaders Err When They Confuse Value Creation, Income Maximization

Nov 02, 2018
Finance

SMITH BRAIN TRUST – Companies have built-in incentives to avoid short-termism, the excessive focus on immediate outcomes. But leaders fall into the myopia trap when they confuse shareholder value creation with current income maximization. Finance professor Michael Faulkender, associate dean of master’s programs at the University of Maryland’s Robert H. Smith School of Business, says the two mindsets are not compatible.

“There is very much this perception that finance rewards strong current activity,” Faulkender says. “That is an incorrect understanding because if you look at where stocks are trading these days, they are trading approximately 12 to 18 times earnings.”

Investors pay a multiple of current earnings because they believe actions today will generate cash flow in the future. In other words, shareholder primacy — putting the interests of investors above all other stakeholders — incentivizes long-term thinking.

What People Get Wrong About Short-termism: Finance professor Michael Faulkender says companies that want to maximize shareholder value have built-in incentives to avoid short-term thinking. Leaders fall into the trap of short-termism, he says, when they confuse shareholder value creation with current income maximization.

“If what you do is engage in short-term activities that are going to destroy the long-term outcome, why will your stock trade at 12 to 18 times its earnings?” Faulkender says. “Investors will only be willing to continue to buy those shares if they think the actions are not only going to continue, but are going to improve.” 

Companies that want to keep shareholders happy, therefore, must invest in activities that run contrary to the notion of short-termism, such as long-term customer retention, employee training and new product development.

Incentives get misaligned when the focus shifts to current income maximization. “While shareholder value creation is about maximizing long-term outcomes, if companies incentivize short-term activities — like reward short-term earnings per share or reward short-term sales growth — you could potentially get myopic activity,” Faulkender says. “But that is not shareholder value creation. That is current income maximization.”

He says media commentators often miss the distinction. “Value is the present value of all perpetual activity — all the future activities brought back to present,” he says. “That’s very different from maximizing the current outcome.”

Faulkender, nominated in 2018 as assistant secretary of the U.S. Treasury for economic policy, explains the principles in a Maryland Smith video, What People Get Wrong About Short-termism (2:16)...

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About the Expert(s)

Michael Faulkender's research focuses on empirical corporate finance in the areas of capital structure, risk management, corporate liquidity, and executive compensation. His work has been published in the Journal of Finance, Journal of Financial Economics, and Review of Financial Studies and has been cited in the Wall Street Journal, Washington Post, and The New York Times. He was awarded the Barclay's Global Investors / Michael Brennan Best Paper Award in the Review of Financial Studies in 2013, was runner up for that prize in 2006, and won the Jensen Prize for Corporate Finance – Second Prize in the Journal of Financial Economics in 2013.

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