How is Value Created? – By Clayton J. Shultz

The time-honored understanding of the purpose of a business is that it exists to maximize the wealth of its shareholders. Despite much agreement on this definition, there is relatively little agreement on how firms should go about maximizing this wealth. In fact, this is perhaps what makes business such a dynamic endeavor. This article focuses on two key areas of value creation: (1) short-term versus long-term orientation and (2) stockholder versus stakeholder orientation.

True economic value is created over the long run. Despite some well publicized (though artificial) gains made in the recent investment bubbles, public and private markets continue to demonstrate that short-term gains are no substitute for strategic, long-term investments that create a sustainable, competitive advantage.

Given the preceding, one might wonder whether or not privately-held firms enjoy some key advantages over their publicly-traded counterparts in today’s troubled economic times. Clearly, there are benefits to going public. Public firms have considerably more access to capital through the stock and bond markets. Going public also provides an exit opportunity for founders and other original investors of the firm in addition to generally increased valuation multiples as compared to privately-held companies.

On the other hand, public firms are at the mercy of the market. Due to the publicly-traded status of their stock, these companies must report earnings on a quarterly basis. This constant cycle of earnings announcements may shift the chief executive’s focus away from the long-term and toward the short-term. Often, the toughest pressure comes from activist investors who have taken large equity positions in firms and who lobby for short-sighted strategies such as the disposal of key assets or one-time dividends.

To illustrate this tension consider the example of a company in need of investment with a long-term payoff such as a branding initiative. It may take several years to realize a pay off from this project. One can see that it may be more attractive to invest in smaller projects with modest, but immediate returns, which will be rewarded by Wall Street.

Another key issue central to the creation of value is the stockholder versus stakeholder view of the corporation. Stockholder theory says that the company must focus entirely on the value it is creating for the equity owners of the firm. Stakeholder theory says that a company must seek to maximize the benefits for all stakeholders of the firm. A stakeholder group is any party that is engaged in helping the business operate. These groups would include shareholders, employees, customers, suppliers, communities, and others.

While the two theories may appear mutually exclusive, there is room for compromise. One opinion is that by following a stakeholder approach, the company will ultimately maximize the wealth of the shareholders. For example, if a corporation is too aggressive with suppliers, treats employees unfairly, or uses unethical marketing tactics with customers, mistreating these stakeholders will ultimately prove troublesome for the corporation. Suppliers will find other customers, key employees will leave, and customers will resent the brand. Any of these may negatively impact the value of the company in the long run. By focusing on all its stakeholders, the company will maximize the wealth of the shareholders.

This article explored two key considerations in creating value: (1) short-term versus long-term orientation and (2) stockholder versus stakeholder orientation. In the end, a firm can create greater economic value, and potentially a sustainable, competitive advantage, by focusing on long-term strategies and considering their impact on all stakeholders.