What is a company and should it only maximize shareholder value?

Martin Wolf writes an interesting piece on companies.

He reviews all the basic ideas regarding what a company is and what it is expected to do:

What is a company? What is its purpose? Who owns it? What should be its goal? These are four closely related questions. The answers society gives will determine the future of capitalism. Those answers are also hard to find, because the limited liability company, though an extraordinarily successful institution, is a hybrid institution: it is in the market economy, but not of it.

So what is a company? As the late Ronald Coase, a Nobel laureate in economics, taught, if one wants to organise production and sales of complex products and services, a (semi)-permanent institution will outperform an array of small businesses forced to deal with one another through market contracts. Companies exist because hierarchies — ‘command and control’ — beat markets. The genius of the company is to import the hierarchical structure of older institutional forms — bureaucracies and armies — into the market economy.

The advantage companies possess is the mirror image of the costs of creating and monitoring a vast number of detailed contracts under uncertainty about future requirements. Organising economic processes successfully often requires the scale of an army and the longevity of a tortoise.

A life insurer is of little use if it will not meet its obligations 80 years hence. A maker of jet engines is of little use if it will be unable to service and replace its engines over their lifetime. A car manufacturer is of little use if it is unable to use what it has learned from today’s models to build tomorrow’s. A company is built upon a set of relational, or implicit, contracts.

These say something like the following: ‘we will purchase your services for a more or less indefinite period; we will look after you; and, in return, you will do what we tell you’.
The corporate form was a brilliant innovation. But, like many innovations, it has created new challenges. In order to work, such entities need vast amounts of capital. In the beginning, these funds are mainly provided by shareholders. Thereafter, they mostly come from retained earnings and further borrowing.

In return for providing risk capital, shareholders are entitled to the stream of corporate profits, whether paid out as dividends or share buy-backs, or retained within the company. If things go well, shareholders have a profitable investment. Under limited liability, if things go badly, they will lose their investment, but no more than their investment.

Hmm. Well put and need to be thought through.

On to the most controversial part of a company. Is it only about profit maximisation?

Finally, what should the operational goal of a company be? Should it be to maximise shareholder value, defined, as it should be, as ‘maximising the present value of free cash flows from now until infinity, discounted at a rate that reflects the risks of these cash flows’?

The answer is yes if and only if two conditions hold. The first is that the prices of the goods and services (including labour services) that a company buys and sells reflect their true social costs and benefits. The second is that the goal can be made operational in a beneficial rather than a perverse way. Neither is plausible. The biggest difficulty with the first of these conditions lies in the labour market. The social costs of lay-offs are not internalised by the company. But that can be dealt with by imposing a regulation or tax. A far greater difficulty is the second. Shareholders do not know what policies will maximise the present value of a company’s free cash flow to infinity. In fact, they have virtually no idea. Most of them also have no incentive to invest in the relevant knowledge either. Unless they own a large share of the company, they will suffer from the collective action problem described by the late Mancur Olsen: the costs of investment in knowledge is borne by each of them, but the benefits are shared amongst all. As a public good, knowledge is always undersupplied in the market. This is, note, not the same as saying stock markets are inefficient in their ability to evaluate the prospects of one company vis-à-vis another (though they are certainly inefficient at the aggregate level). That is because shareholder ignorance is likely to shape what the company does. It is a self-fulfilling prophecy.

A kind of article which os pretty rigorous without any math and quant stuff..

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