Sunday, May 07, 2006

Corporate Governance and Corporate Performance

With all the rage over corporate governance these days, I notice the omission of what I believe is the most important aspect of this function: oversight of the corporation's performance for shareholders. This historically has entailed some sort of "maximization of shareholder value," to use the phrase so many of us schooled at graduate schools of business were taught.

But what does that term really mean? When it's applied to a bond, the discounted cash flow formula is appropriate. It's not for equities. There are two reasons for this.

First, a very large number of equities experience growth in earnings which exceed the discount rate, causing the formula to be 'modified,' which, in essence, means it's the wrong formula for the job. Second, when applied to equities, the formula typically entails the use of an assumed "terminal value." This is done to make the math easier, as very distant cash flows begin to have apparently decreasing values, at a rather fast clip, due to the magic of compounding/discounting.

Over lunch with my partner the other day, our discussion of this topic clarified some nuanced points for me. Specifically, the concept or notion of running a company for some "maximized shareholder value" is wrong because of the terminal value implication. I've believed this for quite some time.What I believe is the proper valuation goal for a board, and a CEO, is "consistently superior (to the equity markets, i.e., S&P500) total returns over rolling 4-5 year periods." That is, ideally, a shareholder who buys a share of the firm at any time ought to have an equi-probably expectation of consistently superior total returns during a holding period of several years.

It is not sufficient, I believe, to simply choose, at some point in time, to 'maximize' the firm's value, at that time, for shareholders of record at that time. This would seem to contradict the notion of a continuing enterprise.Thus, if no single point in time is appropriate as that at which value is maximized, the firm should be managed to provide a consistently superior total return for as long a time as it can.

Saturday's Wall Street journal featured an interview with Charles Koch, CEO of the privately-held Koch Industries. Among other interesting passages was this, "...maintaining a business is, in reality, liquidating a business." He went on to refer to Schumpeterian dynamics in the internal management of a business. This is precisely my point. The business of managing a business is typically constant change- investment in, and destruction of, various parts of the business. This supposed ability to "maximize shareholder value" at some point in time is a fiction.

Rather, what should be targeted is as consistent as possible a total return performance which exceeds the market. This is because an investor can always buy the market return very inexpensively via an index fund. Thus, a CEO must offer an investor some reasonable expectation of outperformance of the index, on a consistent basis, in order to merit his company's stock being purchased, rather than the index. Stating that s/he has just "maximized shareholder value" for existing shareholders is hardlly going to attract new shareholders for the longer haul of a company's presumed existence.

Perhaps more companies would exhibit better total returns to investors if their boards focused on this challenge, rather than miscellaneous "governance" processes, or allowing a misguided focus on "maximized shareholder returns."

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