Maximizing Shareholder Value: The Goal of Corporate Finance

There has been a long debate over the proper goal of corporate finance. Some argue for the stakeholder approach. Others argue that a corporation should have a social conscience and exist to better society. But, most scholars of finance have accepted the theory that the ultimate objective of a corporation should be to maximize shareholder value. To this end, corporations have looked for ways to align the interests of top executives with the goal of maximizing shareholder value. One method for doing so has been to provide top management with large stock option grants, which will provide them with big bonuses if they succeed in increasing the value of the stock. At first glance, this seems to make a great deal of sense, but when you do the math you discover that shares of stock and stock options are very different things. The interests of an option holder are not the same as the interests of a shareholder. In fact, compensating executives with options can give them the incentive to take risks that can destroy shareholder value.

Why Maximize Shareholder Value?

            Why have scholars generally agreed on maximizing shareholder value as the ultimate goal of the corporation? It sounds so greedy. Goals like helping the poor or improving the environment sound so much nicer. But, maximizing shareholder value ultimately is the superior goal, because shareholders are the last to be paid. If shareholder value is maximized it means the corporation has produced products demanded by the public, it has met its payroll and provided people with jobs, it has paid its creditors, keeping banks and bondholders healthy, it has paid its taxes and thus contributed to society, it has been law abiding and not met with serious sanctions, and it is financially healthy and able to continue indefinitely into the future creating and providing people with the goods and services that they demand. When all this has been accomplished, the shareholders of the corporation own what remains. To place any goal before maximizing shareholder value would undermine this system and ultimately create weak corporations capable of much less good than corporations in a system that demands that maximizing shareholder value be the ultimate goal.  

Share Price and Shareholder Value 

            While related, share price and shareholder value are not the same thing. Former Enron CEO testified before the Senate Committee on Commerce, Science and Transportation in February of 2002 that everything he had done was for the benefit of Enron’s shareholders. While Enron executives managed to push the stock price higher and higher and managed to accumulate hundreds of millions for themselves, they did not maximize shareholder value. Shareholder value is a long-term concept. Shareholder value is something that builds year after year. In contrast, share price can be manipulated. Actions can be taken to “pop the stock price” without adding to shareholder value. For example, reducing the number of shares trading in the market may increase the share price but ultimately add nothing to shareholder value.  

Valuing Shareholder Value 

            As mentioned above, shareholders own that value of what remains after everyone else has been paid. Each share of stock represents a portion of that value. Thus, if there are a million shares outstanding, each share represents one millionth of that value.  

            The most common method of valuing a corporation is through the use of Net Present Value (NPV). To do an NPV calculation, we must first estimate the future cash flows which will be produced by the corporation. NPV then calculates the present value of each future cash flow and then adds these values together. However, to calculate the present value of future cash flows, we must first calculate a discount rate to apply to the cash flows. While there are different methods used for calculating the appropriate discount rate, the most widely used method is the Capital Asset Pricing Model (CAPM). The CAPM equation is as follows: 

ER = R_F + β (R_m - R_F) 

ER is the expected rate of return, also known as the discount rate. R_F is the risk free rate of return. Interest rates on sovereign debt with no possibility of default are normally used for the risk free rate, for example in the US the 10 year Treasury bond rate is often used. (R_m - R_F) is known as the “risk premium.” This is the difference between the average market rate of return and the risk free rate of return in an economy. Since it would be impossible to actually calculate the average rate of return on all assets in an economy, a proxy such as the S&P 500 is used for the market rate of return. The difference between the proxy and the risk free rate is the average additional rate charged in the economy to reflect the average risk associated with risky assets. (Ross, 2005) 

Beta (β) is used to reflect the relative risk of the particular asset relative to the average risk of assets in the economy, which is reflected in the risk premium. The equation for β is: 

β _i =Cov(R_i , R_m) / σ²(R_m) 

β is the covariance of the expected rate of return on asset i to the expected average rate of return on the market as a whole over the variance of the market as a whole. In other words β measures how relative volatility of a particular asset in comparison with the average volatility of assets in the economy as a whole. Thus, as a general rule, the more volatile the rate of return for a particular firm, the higher its β will normally be. The exception to this rule has to do with the hedging effect of corporation with returns which are at least in part counter-cyclical to the economy as a whole.  If a particular business tends to do well in a recession its β will tend to be lower because of it hedging characteristics than its volatility would otherwise indicate. This is because CAPM assumes that assets are held in portfolio and not as stand-alone assets. For purposes of this paper, it is the general rule which matters, riskier (more volatile firms) result in a higher β, and thus a higher discount rate pursuant to the Capital Asset Pricing Model. (Ross, 2005) 

The Effect of Volatility on Shareholder Value 

The assumption is made in finance that variability of return is a good proxy from risk. The more variable the return is on an investment, the riskier that investment is assumed to be. Further, scholars assume that returns on investments are “normally distributed.” In other words, rates of return from year to year fall into a bell shaped curve pattern in which rates of return tend to fall symmetrically about the mean. There is historical support for this assumption. Returns on different US stock market indices do roughly fall into a bell curve pattern. (Ross, 2005)  Thus, a stock which might be up 30% one year may be just about as likely to be down 30% the next year. In contrast the ten-year Treasury bond is considered risk free, because it will produce the same return consistently year after year with no risk of default of a lower rate of return. In this way of looking at risk, variance (or volatility of return) is an excellent proxy for the risk associated with a particular investment. The more volatile the return is on an investment, the riskier the investment. Thus, generally the more volatile the returns for a particular investment, pursuant to the Capital Asset Pricing Model, the higher the discount rate that must be applied to the projected cash flows from the investment to calculate the investment’s value. 

The Linear Relationship between Risk and Reward 

            People often mistake the casual direction in the relationship between risk and reward. You will even hear sophisticated investors talk as if risk creates reward. In reality the opposite is true. Given the choice between earning a sure 4.5% return on a Treasury bond or a possible 4.5% on a risky asset, a rational person will take the risk-free Treasury bond. In order to entice the rational investor to select the risky investment, there must be the possibility of a higher return. Since investors will not select a riskier investment when a less risky investment offers the same possibility of reward, only those risky investments with correspondingly high expected rates of return will be purchased by investors. The effect of this interplay in the market is to create a linear relationship between risk and expected rate of return. The greater the risk, the higher the expected rate of return must be in order to attract investors to the investment. This also means that the higher the expected rate of return (also known as the discount rate) the lower the value of the investment.  

            In order to calculate the value of an investment, the forecasted cash flows from the investment must be discounted to their present value. This is the NPV calculation. The formula for calculating present value is C_t / (1 + r)^t. C_t is the cash flow at time period t. 1 + r is one plus the discount rate per period. t is the period. For example, if we assume that annual periods are used and the cash flow is for year 3, then t would be 3 and (1 + r) would be cubed. Notice that the discount rate (r) in this equation is in the denominator. (Ross, 2005) This means that as the discount rate increases, the value of the cash flows decrease. Therefore, the NPV (the value) of the investment decreases. If we apply this to a corporation, the higher the volatility of the returns produced by the corporation (i.e., the riskier the corporation is as an investment) the lower its value will be. Risk and value are inversely related. Thus, the basic relationship is this: Decisions made by executives, which increases the volatility (riskiness) of a corporation’s returns, destroy shareholder value.

Valuing Options 

In contrast to shareholder value, volatility increases the value of options. Option pricing is a very complicated area with different types of instruments and methods of valuation. In this section, we will be discussing call options and the Black-Scholes equation for pricing options. However, the result is the same for all methods of option pricing.  

Call Options 

A call option is like a grocery store coupon. It grants the holder of the coupon the right, but not the obligation to purchase a product at a particular price during a specific period of time. If you have a coupon from a store allowing you to purchase a gallon of milk for $2.00 with an expiration date of December 31^st, you have all of the elements of a call option. The $2.00 price is known as the strike price. A gallon of milk is the underlying asset. December 31^st is the expiration date. Like an option, if you go to the store and milk is selling for $1.90 per gallon, you will not use your coupon. It has no value to you if you use the coupon when the underlying asset price is below the strike price. However, if you go to the store and the price of a gallon of milk is $3.00, then the coupon is worth $1 in saving to you on the purchase of the milk. If you walk into the store on January 1^st and try to use your coupon, it has no value, because the expiration date was December 31^st.  Like a store coupon, options given to executives as an incentive are call options granting the right to purchase shares of the company. (Mahar, 2008) 

The holder of a call option owns the upside potential of the underlying shares. If the option holder has an option with a strike price of $100, the option holder holds all potential value from the underlying share of stock above $100. Assume that the option writer purchased a share of ABC company stock at $75 and sells an option to the option holder with a strike price of $100. If the stock price climbs to $150, the option holder can now demand that the option writer sell the share of stock to him for $100. The option writer claims the first $25 in the appreciation of the stock by selling it to the option holder for $100. However, the option holder can sell the share of stock for $150 in the market can claim all of the appreciation in the stock price above $100.  

Options Produce Short-sightedness 

            However, options do not last for an indefinite period of time. Many options are written for a matter of days. In the case of options offered as incentives to executives, the length is longer, but still usually limited to a period of three to five years. This means if the options are not exercised within that time frame, the executive receives no benefit from the options.  

            Thus, imagine that you are the CEO of a corporation. You have been given options on 500,000 shares of your company’s stock. The options expire three years from today. The Strike price is $100 and the current share price is $80. You have two strategies which you can pursue. Strategy A is a ten-year strategy to pursue promising R&D and develop a revolutionary new product. The strategy could, over a ten-year period, place your company at the top of the industry. Strategy two takes the $2 billion which you would have spent on R&D and uses the money to buy the company’s stock in the market to raise the share price by increasing demand for the shares. Which strategy do you pursue?  

            If you are thinking about your 500,000 options, which expire in three years, the ten-year R&D strategy may not do you much good at all. At best you hope that the market will take into account of your efforts in some positive way and not penalize your stock price from lower earning caused by increased R&D expenses. In contrast, the significant increase in demand caused by your intervention in the market may pop the stock price, at least temporarily and allow you to exercise your options in the near future at a price significantly above the strike price. In this way, options encourage short sightedness. They encourage strategies that result in short-term spikes in stock prices and not long-term sustain growth in shareholder value.  

All Upside and No Downside 

            One reason that option holders are risk seekers while shareholders are risk averse is the option holders have no downside. An option holder has nothing until the share price exceeds the strike price. In contrast, a shareholder can continue to lose value as the result of bad decisions all the way down to a share price of zero. If an executive holding a hundred thousand options with a strike price equal to the current share price has to decide whether to accept a particularly risky strategy with a 30% chance of sending the share price up by $20 and a 70% chance of sending the share price down by $20, the options may convince him to go with the risky strategy. After all, if it succeeds he will cash in his options and make $2 million. A 30% chance at $2 million is worth approximately $600,000 (100,000 X $20 X 30% = $600,000). Since he has no downside, the 70% chance that the strategy will result in a $20/share loss will potentially costs him nothing.  

            In contrast, imagine that the executive owns 100,000 shares of the company stock. In this case the value of the upside is still be worth approximately $600,000, but since he also owns the downside, the potential loss is worth approximately -$1.4 million (100,000 X $20 X 70%) to the executive. The 70% possibility of a $2 million loss should give the executive pause before he approves the strategy.  

The Effect of Volatility on Options 

Interestingly, these effects are clear when we look at option pricing. As explained above, volatility (risk) kills shareholder value. However, volatility increases the value of options. For an option to realize value, all that needs to happen is for the share price to temporarily swing into the money, at which time the option holder can exercise the option. An option does not become more valuable to the option holder because the underlying share price remains in the money for years. Once the option is exercised or expires, the option has no more value.   

There are several option price calculators available on the Internet. I particularly like the calculator offered by Hoadley Trading & Investments, located at: http://www.hoadley.net/options/optiongraphs.aspx?    In addition to simply providing the user with a price, it provides the user with different graphical depictions and also allows the user to analyze different variables that go into the Black-Scholes equation, including volatility. The chart, below, analyzes the effect of volatility on the price of an option with a share price of $81.00, a strike price of $85.00, a risk free interest rate of 4%, and a 60 day expiration date. It is clear from this chart that increasing volatility from 5% to55% increases the price of the option from near zero to just below $6.00. 

   Call Option Price & Time Value by Volatility

 These results are also shown by this table.  

         Volatility Analysis

Graphically, the effect of volatility is clear. Increased volatility greatly enhances the value of an option. (Hoadley, 2008)

Conclusion 

            Superficially, the use of options as executive compensation makes sense. You want executives to act for the benefit of shareholders, so giving them a stake in the price of the company’s shares seems to make sense. However, as we have discovered owning shares and owning options are not the same thing. Increasing risk without a corresponding increase to potential cash flows destroys shareholder value. However, the effect is just the opposite for call option values. Increasing volatility increases the value of the option. Granting executives options as a significant part of their compensation provides executives with an incentive to indulge in risky strategies, which diminish shareholder value.   

                                                                   References 

Damodaran, Aswath (2006). Applied Corporate Finance: A User's Manual.

Hoboken, NJ: John Wiley & Sons, Inc.. 

Damodaran, Aswath Retrieved February 19, 2008, from Damodaran Online

Hoadley, Peter Black-Scholes Pricing Analysis. Retrieved February 19, 2008, from

Mahar, Jim Retrieved February 19, 2008, from FinanaceProfessor

Web site: http://www.financeprofessor.com/ 

Ross, A. Stephen, Westerfield, Randolph W., Jaffe, Jeffrey (2005). Corporate Finance.

New York, NY: McGraw-Hill Irwin.