Value Maximization and Stakeholder Theory

Many managers, says HBS Professor Michael C. Jensen, are caught in a dilemma: between a desire to maximize the value of their companies and the demands of "stakeholder theory" to take into account the interests of all the stakeholders in a firm. The way out of the conflict, says Jensen, lies in a new way of measuring value.
by Michael C. Jensen

"Every organization attempting to accomplish something has to ask and answer the following question," writes HBS professor Michael C. Jensen in the introduction to his recent working paper: "What are we trying to accomplish? Or, put even more simply: When all is said and done, how do we measure better versus worse? Even more simply, How do we keep score?

"At the economy wide or social level," he continues, "the issue is the following: If we could dictate the criterion or objective function to be maximized by firms (that is, the criterion by which executives choose among alternative policy options), what would it be? Or, even more simply, How do we want the firms in our economy to measure better versus worse?"

It's tempting to consider value simply as a matter of maximizing the short-term financial performance of the organization, says Jensen. Contending with that value maximization approach is "stakeholder theory" which says that managers should make decisions so as to take into account all of the interests of all stakeholders in a firm.

(Stakeholders, he notes, include not only financial claimants, but also employees, customers, communities, governmental officials, "and, under some interpretations, the environment, terrorists, blackmailers, and thieves.")

But by failing to specify how managers should make the necessary tradeoffs among competing interests, writes Jensen, advocates of stakeholder theory fall short, just as do those who narrowly focus on short-term financial gain.

In the excerpt below, Jensen describes a new scorecard to help business leaders and managers keep pace. A firm cannot maximize value, Jensen writes, if it ignores the interests of its stakeholders. But a melding of new interpretations of both value maximization and stakeholder theory is necessary, he writes, to make possible the "long-run maximization of the value of the firm as the criterion for making the requisite tradeoffs among its stakeholders."

. . .

Enlightened Value Maximization

Enlightened value maximization recognizes that communication with and motivation of an organization's managers, employees, and partners is extremely difficult. What this means in practice is that if we tell all participants in an organization that its sole purpose is to maximize value, we would not get maximum value for the organization.

Value maximization is not a vision or a strategy or even a purpose, it is the scorecard for the organization. We must give people enough structure to understand what maximizing value means in such a way that they can be guided by it and therefore have a chance to actually achieve it. They must be turned on by the vision or the strategy in the sense that it taps into some desire deep in the passions of human beings—for example a desire to build the world's best automobile or to create a movie or play that will affect humans for centuries. All these can be consistent with value maximization.

I believe there is a serious semantic issue here. Value maximizing tells the participants in an organization how they will assess their success in achieving a vision or in implementing a strategy. But value maximizing says nothing about how to create a superior vision or strategy. And value maximizing says nothing to employees or managers about how to find or establish initiatives or ventures that create value. It only tells us how we will measure success in the activity.

Defining what it means to score a goal in football or soccer, for example, tells the players nothing about how to win the game. It just tells them how the score will be kept. That is the role of value maximization in organizational life. It doesn't tell us how to have a great defense or offense, or what kind of plays to create or practice, or how much to train and practice, or whom to hire, and so on. All of these critical functions are part of the competitive and organizational strategy of any team or organization. Adopting value creation as the scorekeeping measure does nothing to relieve us of the responsibility to do all these things and more in order to survive and dominate our sector of the competitive landscape.

This means, for example, that we must give employees and managers a structure that will help them resist the temptation to maximize the short-term financial performance (usually profits, or sometimes even more silly, earnings per share) of the organization. Such short-term profit maximization is a sure way to destroy value. This is where enlightened stakeholder theory can play an important role. We can learn from the stakeholder theorists how to lead managers and participants in an organization to think more generally and creatively about how the organization's policies treat all important constituencies of the firm. This includes not just financial markets, but employees, customers, suppliers, the community in which the organization exists, and so on.

Indeed, it is obvious that we cannot maximize the long-term market value of an organization if we ignore or mistreat any important constituency. We cannot create value without good relations with customers, employees, financial backers, suppliers, regulators, communities, and the rest. But having said that, we can now use the value criterion for choosing among those competing interests. I say competing interests because no constituency can be given full satisfaction if the firm is to flourish and survive. Moreover, we can be sure, externalities and monopoly power aside, that using this value criterion will result in making society as well off as it can be.

Resolving externality and monopoly problems is the legitimate domain of the government in its rule-setting function. Those who care about resolving these issues will not succeed if they look to firms to resolve these issues voluntarily. Firms that try to do so either will be eliminated by competitors who choose not to be so civic minded, or will survive only by consuming their economic rents in this manner.

Enlightened Stakeholder Theory

Enlightened stakeholder theory is easy to explain. It can take advantage of most that stakeholder theorists offer in the way of processes and audits to measure and evaluate the firm's management of its relations with all important constituencies. Enlightened stakeholder theory adds the simple specification that the objective function of the firm is to maximize total long-term firm market value. In short, changes in total long term market value of the firm is the scorecard by which success is measured.

I say long-term market value to recognize that it is possible for markets not to know the full implications of a firm's policies until they begin to show up in cash flows over time. In such a case the firm must lead the market to understand the full value implications of its policies, then wait for the market to catch up and recognize the real value of its decisions as they become evidenced in market share, employee loyalty, and finally cash flows and risk. Value creation does not mean succumbing to the vagaries of the movements in a firm's value from day to day. The market is inevitably ignorant of many of our actions and opportunities, at least in the short run. It is our job as directors, managers, and employees to resist the temptation to conform to the pressures of equity and debt markets when those markets do not have the private competitive information that we possess.

In this way enlightened stakeholder theorists can see that although stockholders are not some special constituency that ranks above all others, long-term stock value is an important determinant (along with the value of debt and other instruments) of total long-term firm value. They would see that value creation gives management a way to assess the tradeoffs that must be made among competing constituencies, and that it allows for principled decision making independent of the personal preferences of managers and directors. Importantly, managers and directors also become accountable for the assets under their control, because the value scorecard provides an objective yardstick against which their performance can be evaluated.

Measurability And Imperfect Knowledge

It is worth noting that none of the above arguments depend on value being easily observable. Nor do they depend on perfect knowledge of the effects on value of decisions regarding any of a firm's constituencies. The world may be complex and difficult to understand. It may leave us in deep uncertainty about the effects of any decisions we may make. It may be governed by complex dynamic systems that are difficult to optimize in the usual sense. But that does not obviate the necessity of making choices (decisions) on a day-to-day basis. And to do this in a purposeful way we must have a scorecard.

The absence of a scorecard makes it easier for people to engage in intense value claiming activities at the expense of value creation. We can take random actions, and we can devise decision rules that depend on superstitions. All of these are unlikely to serve us well in the competition for survival.

We must not confuse optimization with value creation or value seeking. To create value we need not know exactly where and what maximum value is, but only how to seek it, that is how to institute changes and strategies that cause value to rise. To navigate in such a world in anything close to a purposeful way, we have to have a notion of "better," and value seeking is such a notion. I know of no other scorecard that will score the game as well as this one. It is not perfect, but that is the nature of the world. We can tell (even if not perfectly) when we are getting better, and when we are getting worse.

If we are to pay any attention to the nihilists who call themselves stakeholder theorists, they must offer at least some way to tell when we are "better" other than their own personal values. In the meantime we should use their theory only in the form of enlightened stakeholder theory as I describe above. In this way it is a useful complement to enlightened value maximizing (or value seeking or value creating, for those who argue the world is too complex to maximize anything).