Should Shareholder Wealth Maximisation be the objective of companies?

It has been widely argued that the ultimate objective of any company should be to maximise shareholder wealth which involves the long term increase of share price and dividend stream. However, alternative objectives often arise that take a more stakeholder considered approach. Should companies only strive for shareholder wealth or should corporations consider the views of their wider stakeholders?  The corporate objectives of companies will be discussed through the case of Tesco following the revelations regarding their overstated profit figures in 2014 and their subsequent actions at the beginning of 2015.

In September, Tesco announced that they had overstated their half-year profit guidance by over £250m (BBC News, 2014). This was due to accounting errors that arose from the way they were recognising income from suppliers. Essentially, accounting for revenue too early and delaying the recording of costs until a later date. It became apparent to Tesco’s shareholders that Tesco’s managers had been focusing on maximising profits in the short term and employing accounting techniques that effectively manipulated figures to do so. Shareholders showed their feelings with their feet as the share price dropped considerably after this announcement (BBC News, 2014), as shown on the Share Price Graph that I have constructed below.

Graph 1 – Tesco’s Six Month Share Price

(Share Price Figures sourced from http://www.tescoplc.com/index.asp?pageid=36#tabnav)

The drop in share price also demonstrates stock market efficiency, the theory that the price of securities fully and fairly reflects all relevant available information (Watson & Head, 2013). When news of the overstatement of profit figures broke in the media, shareholders quickly voiced their views with a sudden decrease in the share price as shown above.

It could be argued that Tesco’s managers’ decision to use these accounting techniques to manipulate profit figures was not consistent with the objective to maximise shareholder wealth. This demonstrates the Agency problem (Watson & Head, 2013) as the goals of the managers (agents) clearly differed from those of the shareholders (principals) as they were seeking to maximise their own wealth rather than create value for shareholders. I believe Tesco’s managers were trying to reach their profit targets in order to secure rewards and bonuses for themselves instead of maximising shareholder wealth. 

Tesco have been heavily criticised for these actions in the media, but were they the only ones to blame? Jenson’s (2010) “enlightened” value maximisation theory suggests that the problem lies with government in not setting rules and regulating companies effectively. Tesco confirmed that there was no chief financial officer (CFO) in place after Alan Stewart resigned and his replacement was not due to start until December (BBC News, 2014). This could lead to people questioning how the company is run, questioning the board of directors and the company’s auditors. However, as Jenson suggests maybe we should be blaming the government for not enforcing harsher and stricter laws and boundaries regarding these matters.

More recently, Dave Lewis the newly appointed CEO and the man deemed with the responsibility to bring Tesco out of the dark and rebuild its market reputation announced plans to close 43 unprofitable stores in order to reduce overheads by 30% (Felsted & Oakley, 2015). This could be viewed as an attempt to create value for their suffering shareholders whilst demonstrating one of the 5 actions that managers take as part of the value action pentagon. Lewis has chosen to divest assets from negative spread units to release capital for more productive use (Arnold, 2013). This will release resources from unprofitable units which can them be employed more productively elsewhere, leading to significant cost reductions, an urgently needed action for Tesco. The news was welcomed by investors as demonstrated by a 15% increase in share price (as shown in the share price graph); with shareholders saying the decision will allow Tesco to regain some competitiveness (Felsted & Oakley, 2015). Again, also demonstrating stock market efficiency. 

However, Tesco’s recent actions have this time been criticised by their wider stakeholders, saying these actions will affect communities and diminish their relationships further (Felsted & Oakley, 2015).  Freeman (1984) presents the idea of Stakeholder theory which argues that managers must take into account the interests of any group or individual who can effect or be affected by the actions of the company. Should Tesco be concerned by their other stakeholders when they are finally managing to satisfy shareholders and create value for them?

It would appear that they should. Tesco is currently locked in a vicious price war with competitors as they battle the rise and increasing success of discount retailers such as Aldi and Lidl (Felsted & Oakley, 2015). Can Tesco really afford to disappoint and aggravate local communities, their potential customers? Dave Lewis must consider this when deciding his strategy to cut costs as falling sales have been a prevalent problem for Tesco, suffering further drops over the Christmas trading period (Felsted & Oakley, 2015). This is clearly the time that Tesco needs every little bit of help they can get.

I believe it is imperative that Tesco seek to satisfy shareholders as they are currently in a poor state and struggling to compete within the market. Contractual theory (Arnold, 2013) supports this as shareholders invest money into the business at high risk; there is no guarantee that they will receive a return like other stakeholders. Due to this unfair balance of risk, it is deemed reasonable that these investors should be entitled to any surplus returns from the business. Furthermore, as we operate in a free market system (Arnold, 2013); if a company chooses to reduce returns to shareholders, shareholders have the right to sell their shares and walk away from the business. Watson & Head (2013) suggest that financial managers should focus on making ‘good’ financial decisions that in turn increase shareholder wealth as the market will interpret these actions and the share price will adjust appropriately. Another considerable drop in share price could be very damaging for Tesco therefore I believe it is essential to satisfy their shareholders.

Additionally, Adam Smith expressed the argument, over 200 hundred years ago, that benefits are created for society when the business focuses on returns to the owner (Arnold, 2013). Therefore, in creating value for their shareholders, Tesco will in turn produce benefits for their wider stakeholder. 

To conclude, I believe that a company’s main objective should be to maximise shareholder’s wealth. However, I recognise that achieving this goal is where the problem lies. Aligning manager's and shareholders’ interests is key to success but this is clearly a difficult task as the case of Tesco has highlighted. Furthermore, will a company ever be able to really win and keep everyone happy? Tesco’s latest step has clearly satisfied shareholders as demonstrated by the rise in share price, however has led to wider stakeholders questioning if Tesco can really be trusted (Felsted & Oakley, 2015).

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

BBC News. (2014, September 22). Tesco suspends execs as inquiry launched into profit overstatement. BBC News, Business. Retrieved from http://www.bbc.co.uk/news/business 

Felsted, A. & Oakley, D. (2015 January 8). Tesco soars 15% on news of biggest overhaul in retailer’s 96-year history. Financial Times. Retrieved from http://www.ft.com 

Freeman, R.E. (1984). Strategic Management: A Stakeholder Approach. Boston: Pitman

Jenson, M.C. (2010). Value Maximisation, stakeholder theory, and the corporate objective function. Journal of Applied Corporate Finance, 22(1), 32-42. Doi: 10.1111/j.1745-6622.2010.00259.x

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.