Stakeholder vs Shareholder Theory

Stakeholder vs Shareholder Theory

Initial Overview

The traditional Anglo American assumptions on finance is that shareholders own companies, they are only liable for the company’s actions to the extent of their investment, and that if the company becomes insolvent then they will not lose more than the amount they invested into the company. Therefore the assumed overall objective according to this view is that a company should strive to create maximum shareholder wealth. In addition, the Financial Times released an article which stated that capital gains plus strong dividends are ultimately what shareholders are interested in (ft.com) – so why is this topic so debated? Is either of these theories solely correct or can they be combined?

Problems with traditional assumptions

The question needs to be asked…what would a shareholder prefer – volatility or stability? How about if profits for both companies were the same?

If I was to invest I certainly know which company I would prefer to invest in! A company with a steady income would be valued highly in comparison with a company with volatility.

Shareholder Theory in detail

This theory was initially introduced by Milton Friedman who suggested that managers and employees are employed as agents for the shareholders and that the sole responsibility of a company is to maximise profits thus creating maximising shareholder wealth (Ronnegard D, 2006). This theory (almost) makes sense as shareholders have more to lose than other stakeholders as they have sacrificed their capital to inject into the company. Therefore, it’s reasonable to assume that the sole interests should be to repay the investors back. Agency Theory goes hand in hand with Shareholder Theory as they both discuss how managers and directors are employed as agents for the shareholders (and therefore in theory act on behalf of the shareholders). Therefore if there is a problem with the shareholder theory there is a problem in the agency theory whereby if managers aren’t acting in the interests in their shareholders then they are not acting as correct agents for their shareholders and therefore they maximising shareholder wealth (Eisenhardt, 1989). However, is this always the correct approach to take or is the alternative better for the company? Is this the best strategy to adopt in order to achieve the maximum potential for a business?

Stakeholder theory

Stakeholder theory originated from Edward Freeman and is much broader as it strives to keep more stakeholders happy as opposed to only one. It states that in order to be successful they need to keep many stakeholders (customers, suppliers, shareholders etc) satisfied and that their interests should be aligned and in the same direction (ft.com). Stakeholder theory has recently been highlighted when the liked of Starbucks attempted to use loopholes in the system to avoid paying higher tax. The scandal has resulted in Starbucks agreeing to pay more tax which society views as ‘the right thing’ to win back customers as some of the public said they would ‘boycott’ some of their outlets (bbc.co.uk). Therefore they are essentially adopting the stakeholder theory as they are not maintaining their old regime whereby they are acting legally but unmorally (paying out less and keeping shareholders happy), they are more interested in enticing customers back by acting in the way which is viewed as morally correct by society.

Enlightened Shareholder Value (ESV)

This is the newest theory which essentially combines both shareholder and stakeholder theory and has now been incorporated into UK Law (Keay A, 2013) Essentially it states that the overall objective should be to maximise shareholder wealth in the long term, but by taking other stakeholders and the relationship with employees and suppliers etc into account (Attenborough D, 2013). ESV has been looked at as a new compromise between Shareholder and Stakeholder Theory. Originally academics and companies who adopted the shareholder approach noted that ultimately it is shareholders who should be rewarded for their investment into the business, however with this ultimate goal in mind it could not be achieved without long term relationships with stakeholders (Keay A, 2013). Take Apple for example - Apple is a successful company which rewards their shareholders generously. However, their success would not be present without a long term relationship with customers and reliable suppliers. Therefore in order to supply shareholders with the maximum wealth they have had to take into account their stakeholders to achieve the success that they have today.

In conclusion

Many people believe that examples like the scandal at Enron and the concerns about the independence of accountants are evidence of a failure of the shareholder theory. Furthermore this would lead to stakeholder theory being more favourable whereby they have all stakeholder interests in mind – even if this results in shareholder returns being less. However, stakeholder theory is also criticised as many academics wonder whether it is actually possible to act in a way which keeps all stakeholders happy.

Overall, taking the above into account I believe that Enlightened Shareholder Value is the best approach to take as it is a combination of both the original theories. By keeping stakeholders content you will achieve:

a more productive workforce as they will be happy to stay within the business





happier customers who will have learnt from experience that the company is a good company to deal with – thus enticing them to come back in the future





happier suppliers as they will realise that the company is a good company to do business with and therefore a business relationship will become apparent.

In theory if these stakeholders are all satisfied then profits will fall into place for the company and shareholders will maximise their wealth.

References

Attenborough, D., (2013). Andrew Keay, The Enlightened Shareholder Value Principle and Corporate Governance.　The Modern Law Review. 76 (5), pp.940

BBC (2012).　Starbucks agrees to pay more corporation tax. [ONLINE] Available at: http://www.bbc.co.uk/news/business-20624857. [Last Accessed 11/12/2014].

Eisenhardt, K. M., (1989). Agency Theory: An Assessment and Review.　The Academy of Management Review. 14 (1), pp.58

Financial Times (2009).　Shareholder Value Re-Evaluated. [ONLINE] Available at: http://www.ft.com/cms/s/0/293fc3c4-1196-11de-87b1-0000779fd2ac.html#axzz3OWgJiqj2. [Last Accessed 11/12/2014].

Financial Times (2014).　Definition of Stakeholder Theory. [ONLINE] Available at: http://lexicon.ft.com/Term?term=stakeholder-theory. [Last Accessed 11/12/2014].

Keay, A., (2013). The Enlightened Shareholder Value Principle and Corporate Governance. 1st ed. New York: Routledge.

Ronnegard, D., (2006).　Corporate Moral Agency and the Role of the Corporation in Society. 1st ed. England: Lulu.

Portfolio Theory with Capital Asset Pricing Model. Do they work hand in hand or is Portfolio Theory better on it's own?

Portfolio Theory with Capital Asset Pricing Model. Do they work hand in hand or is Portfolio Theory better on it's own?

There are several academics that have different opinions on how investors should choose their investments. Some investors choose their investments based on the idea that the larger the risk the larger the expected returns, whereas others choose to accept a smaller return for a less risky project. For example, a young entrepreneur who is not dependent on income from investment may choose a more risky investment; whereas someone older who depends on the income could possible choose something less risky with more certain and stable returns. However, is it possible to find an optimum point whereby you can receive the maximum gains for a specific level of risk?

Harry Markowitz certainly thought so when he introduced the portfolio theory. The thinking behind his theory was that any unexpected bad news with one firm would be compensated by unexpected good news from another (Arnold, 2013) therefore you are reducing risk by not putting all of your eggs in one basket. With Markowitz’ portfolio theory he suggested an investor could find the optimum portfolio of investments and therefore could find the ‘efficient frontier’.

What is the efficient frontier?

According to Markowitz the efficient frontier is the optimal point that offers the highest expected return for a specific level of risk given the volatility they are willing to accept (Investopedia). Alternatively it can be looked at as the lowest risk for an expected level of return. The theory takes into consideration the risk of the investment and what returns can potentially be made from it.

(Watson & Head, 2013)

To explain in more detail, point A, E and F are the more efficient points for a diversified portfolio. Point G means that they are receiving smaller returns for the level of risk than they could at point E. Therefore from point A – G this would be classed as being inefficient, and likewise anything in the blue area and below would also be classed as being inefficient. This theory also suggests that anything above the efficient frontier is impossible.

Adding the Capital Asset Pricing Model Line…

When the Capital Asset Pricing Model (CAPM) is included the optimal portfolio can then be found. It can be applied to decide investment in the financial markets for portfolio selection. It also calculates the required rate of return on an investment project which therefore works alongside portfolio theory.

As viewed above, when the CAPM line is calculated and applied alongside the efficient frontier it provides an optimum point whereby the portfolio is at its most efficient. However, although portfolio theory has much credibility, there are a few limitations to the CAPM which are highly controversial. Firstly, this method only looks at one period, therefore needing to be recalculated for any others (therefore making it extremely time consuming). Additionally CAPM requires the use of Beta to calculate the line – a highly controversial topic surrounding Beta is whether it is valid for determining future decisions when Beta is based on past events.

Overall…

The overall theory of the portfolio theory model appears to be credible with a clear underlining formula stating what is efficient and what is inefficient. It takes into consideration different investors and what would be optimal for their level of risk. However, the underlying formula is complicating and time consuming so therefore there is some difficulty in implementing the model. Furthermore there is more difficultly in attempting to calculate the CAPM line with more controversial topics surrounding this.

Overall it appears that when calculated correctly both of the theories work well together in finding the optimum point for an overall portfolio. However, when taking into consideration the different types of investors and the levels of risk they would be willing to take, the portfolio theory on it’s own appears to be a better model to follow.

References

Arnold, G (2013). 'Valuing Shares'. In: Corporate Financial Management. 5th ed. Great Britain: Pearson.

Investopedia (2015). Efficient Frontier. [ONLINE] Available at: http://www.investopedia.com/terms/e/efficientfrontier.asp. [Last Accessed 03/12/2014].

Watson,D and Head, A, (2013). 'Mergers and Takeovers '. In: Corporate Finance Principles and Practice. 6th ed. United Kingdom: Pearson.

Dividends vs Capital Gains

Dividends vs Capital Gains

Companies giving high dividends are somewhat of a controversial topic. There are several debates on whether companies giving dividends are performing well - or whether they are simply signalling to attract investors. In today’s blog I will discuss whether investors would prefer capital gains (therefore meaning dividends are irrelevant) or whether investors value dividends.

In the UK companies pay out 2 dividends throughout their financial year. The first is an interim dividend which is paid half way through the year and is generally the smallest dividend of the two. The second dividend is after their company accounts have been published and is usually larger than the first dividend. According to Porterfield, a company’s dividend policy should aim to maximise shareholder wealth – otherwise what is the point?

Dividends and retained profits are decided by the investment and financing decisions of a company (Watson & Head). They are only payable through any retained profits the company may have whether this be recent profits or historical. Realistically a company should only pay dividends if it creates more wealth. Porterfield created a model for analysing dividend payments which suggested that dividends only create higher shareholder wealth when ‘the cash dividend paid to shareholders’ + ‘the expected ex dividend share price’ > ‘market price before the dividend was announced’.

Just how important are dividends?

The most common theory in relation to dividends is the dividend irrelevance theory. This is derived from Modigliani and Millar’s capital irrelevance and suggests that under perfect market conditions shareholders are indifferent to whether they receive returns on dividends or capital gains (Brennan & Thakor, 1990).  They also argued that share price is determined by future earning potential and not what is paid in dividends now which therefore results in share value being determined in their investment policy – and not the level of dividend paid out. M&M argued that shareholders are more interested in a company who invests in projects with a positive Net Present Value (NPV) and therefore increasing the market value of their shares. Therefore by doing this the company is increasing its wealth generation thus increasing the shareholders capital gains. This results in shareholders not being concerned about any dividends as they are gaining by other means. Is this true in reality?


Bird in the hand…



An alternate theory is the ‘Bird in the Hand’ theory. This idea suggests that investors actually are interested in dividends as they are more certain than capital gains. In other words, dividends are a ‘sure thing’ whereas the future share price of a company is not, therefore due to the certainty of these dividends a company would increase the firm value (Baker et al, 2002). However, Bhattacharya argues that the riskiness of a projects cash flows affects a firms risk and an increase in dividends now will result in a drop in the stocks ex-dividend price. Therefore overall the counter-argument suggests that by increasing the dividend today will not increase a firms value.



Tax Preference Policy



Alternatively, there is the tax preference policy. Capital gains are taxed at a lower rate than dividends so this is an important factor for investors to take into consideration. Therefore based on this, this could assist with M&M Dividend Irrelevance theory if investors are worried about paying higher taxes on dividends.


Centrica


Centrica's dividends have increased continuously over the past 5 years, however their share price has not reflected this and has been extremely volatile throughout the same period, thus supporting Modigliani and Millars theory that they aren't related. Furthermore the current share price has reacted to market information which would suggest it is at a price determined by future earning potential (share price has dropped in correlation with P.E Ratio of the industry, thus suggesting that due to the market having less confidence in the industry, share price has followed). Therefore this example supports M&M's theory.



Overall…



In conclusion the existing theories appear to suggest that overall investors prefer capital gains as opposed to dividends, with the only problem being the uncertainty of the capital gains on share price. With M&M’s dividend irrelevance theory I appreciate that this theory is based on ‘perfect market conditions’ (which is another debated topic and relates to my previous post of EMH whereby investors question how efficient the market is) and therefore cannot be solely relied on for a thorough conclusion. With the addition of the Tax Preference Policy, my personal opinion is that investors would prefer capital gains as they pay less tax and they are gaining on their investment, but as suggested in the ‘bird in the hand’ theory, capital gains are less certain. Personally I would be indifferent if I received the same returns over a 5 year period from dividends as I would to capital gains, as long as there was a gain overall. My opinion therefore coincides with M&M so I would deem that theory to be most correct whereby under perfect market conditions shareholders are indifferent to whether they receive returns on dividends or capital gains

References

- Baker, H. K., Powell, G. E., & Veit, E. T. (2002). Revisiting managerial perspectives on dividend policy. Journal of Economics and Finance, 26(3), 267-283. Retrieved from http://search.proquest.com/docview/215589529?accountid=12860

- Brennan, M.J. & Thakor, A.V., (1990). Shareholder Preferences and Dividend Policy. The Journal of Finance. 45 (4), pp.993-1018

- Investopedia, https://www.boundless.com/accounting/textbooks/boundless-accounting-textbook/reporting-of-stockholders-equity-12/dividend-policy-80/investor-preferences-364-8369/ retrieved 24/11/14

-Watson. D, Head. A, (2013), Corporate Finance: Principles and Practice, 6th Ed, Chapter 10, pp 317-347

How valid is Efficient Market Hypothesis and are there any better alternatives?

Throughout this blog I will discuss Efficient Market Hypothesis and will the validity using other theories.

Eugene Fama

Efficient Market Hyposthesis (EMH) was first evolved in the 1960’s by Eugene Fama. It states that all securities prices reflect all information available (due to people acting rationally to the data provided) and therefore it is impossible to beat the market – making the market ‘informationally efficient’. According to this theory there are 3 degrees to:

Weak (this reflects all past information which has been provided and the market has already reacted rationally to this information)

Semi-strong (this reflects all past and current information and market reacts instantly and rationally to new information which is published)

Strong (reflects all information including any information which may not be public - including insider information)

Fama’s EMH theory states that all security prices reflect all known information and the pricing of stocks and bonds are efficient as people have reacted rationally to the information provided and therefore have acted accordingly. In practice, most academics believe in at least the weak form of EMH (including Lars Peter Hansen who also won the Nobel Prize in 2013 alongside Fama - and agrees that markets are efficient) and numerous studies have found that prices do not move in trends based on the past. However, numerous traders dispute this theory and traders such as Michael Steinhardt and Warren Buffet have managed to beat the market which would suggest that markets are not always efficient. Therefore this would lead me to question – how valid is this hypothesis and are there any other theories which could be deemed more valid?

Robert Shiller

Robert Shiller, a third winner of the Nobel Prize in 2013, questioned EMH and stated that asset prices are too volatile to be reconciled by rationality and efficient portfolio theory. His paper "Do stock prices move too much to be justified by subsequent changes in dividends?” challenged Fama’s view of EMH and took a more behavioural approach by suggesting that people act irrationally to information and therefore share prices move accordingly. He also suggested that in a rational stock market people would base stock prices on future returns whilst also taking into account the Net Present Value of their investment.

So which of the above views are ‘more valid’?

The debate…

There appears to be supporting evidence for both theories – as previously mentioned Lars Peter Hansen and other academics believe there to be at least a weak form of efficiency in the market. Furthermore the ‘random walk’ theory supports Fama and states that you cannot predict future movements based on past trends as stock price changes have the same distribution and are independent of each other. This theory also received criticism as investors did find trends over past price movement so therefore Fama’s view of EMH is questionable. As for Shillers view, traders managing to beat the market would suggest that there is more validity in his theory.

Based on the above I think both theories can be used to a certain extent. There is evidence to show that the market reacts to past information so therefore has at least weak form of efficiency – but for traders to be able to beat the market and gain abnormally large returns there must be some inefficiency and that investors are predicting future prices (which could be based on past prices and historic movements).

http://www.morningstar.com/InvGlossary/efficient_market_hypothesis_definition_what_is.aspx

Best Advice: Fama is the Spur, Money Marketing, May 2007, pg58

Burr, B. B. (2013). Nobel award validates different market viewpoints. Pensions & Investments, 41(22), 28-n/a. Retrieved from http://search.proquest.com/docview/1447240436?accountid=12860

http://www.chicagobooth.edu/capideas/magazine/winter-2013/eugene-fama-efficient-markets-and-the-nobel-prize

Is Employee Ownership (EO) a good model to base a business on?

Is Employee Ownership (EO) a good model to work on?

Throughout this blog I will be discussing the advantages and disadvantages of employee owned businesses including examples of where this model has proved to be effective or ineffective.

Introduction

The debate on Employee Owned Companies is a hot topic, with many companies adopting the model – some finding this successful whilst others are struggling to find the benefits. Literature has described employee ownership as an organizational arrangement in which a significant proportion of the employees hold rights to organizational equity, information, and influence. This model has been used in an attempt to avoid outsourcing to other countries as, according to Halogen Corp, outsourcing accounted for declines in hiring. But can we safely say that this model is a route to success?

Pro EO

The Employee Ownership Association website has a variety of benefits of why this model is beneficial to businesses – but they would be biased and in favour wouldn’t they?! However, some studies can support these businesses and have found positive results. For example, Mccarthy Reeves and Turner found that the model created substantial financial returns and had more influence at strategic level. Further research has supported this and found that employee owned businesses have a more strategic approach and are interested in long term growth. Staff are willing to put in extra time and effort over busy period to be successful – which in turn rewards both the business and the employees with dividends. Large multinational companies (such as John Lewis) have found this to be extremely effective, which has resulted in advocates such as Nick Clegg and other politicians encouraging more businesses to consider this approach to unlock economic growth and improve productivity. In fact, they support it so much they have included several additions in their bill to encourage employee ownership. Examples are:

1.       Chancellor has set aside £75m per annum to support growth of employee ownership in the 2013 budget
2.       New Tax Incentives have been included in the 2014 bill
3.       From October 2014, certain bonuses paid for trusts are now exempt from income tax for up to £3600.

 Furthermore it has been found that employee owned businesses are successful in recruiting skilled staff and retaining them. This model works well for John Lewis as they are recording high profits, as well as employees reaping the rewards from their additional effort.

Anti EO

Alternatively this model doesn’t appear to be as effective for all businesses. In contradiction to the above points, researchers investigated whether employee ownership is counterproductive in 2005 and they found less investment and smaller growth. This could be explained by their analysis that employee owned companies tended to prefer low risk strategies, stable cash flow and job security. Another researcher (Durso) found that not all employee owned companies do equally well and that in some cases companies actually did worse than their competitors. Durso’s findings also indicated there is higher production when employees were given the opportunity to be involved. Therefore these studies suggest that there are other factors to consider when analysing the effectiveness of employee ownership. Further findings have suggested that if the company’s share price does not increase (and the employee feels they have no control over the share price outcome) then it can affect morale. Therefore the employee may not be acting in the code of the company. Finally, this model needs to be monitored closely as it can contribute heavily towards bankruptcy. An example of this is Delta Airlines whereby they had financial difficulty in 2005 but employees agreed to a pay cut in order for Delta to cut costs.

Employee Ownership – A route to success?

To conclude on the above, it appears that John Lewis and other companies have effectively adapted this model and have the results to prove the model is beneficial to their business. However, after taking Durso’s study into consideration I feel that, whilst the model may be beneficial to certain companies, it also needs to take into consideration other variables. For example, John Lewis is a highly recognised and respected retailer so therefore this strong image may also be a contribution towards their sales – not just how hard their employees are working. It appears that the companies who have adopted this model correctly have everything else right including products and marketing – so therefore it would be hard to distinguish whether they owe their success to their marketing mix as a whole, or whether it is solely credit to the employees. Finally there seems to be a contradiction in results in relation to performance for growth and investment. In this case, I can only assume that these studies were compiled over different time periods to be able to come to their conclusions as the overall trend seems to point towards long term growth but more safe investments (thus taking both arguments into account).

References

BBC News - http://www.bbc.co.uk/news/uk-16570840

Dermot McCarthy Eoin Reeves Tom Turner, (2010),"Can employee share ownership improve employee attitudes and behaviour?", Employee Relations, Vol. 32 Iss 4 pp. 382 – 395

Employeeownership - http://employeeownership.co.uk/employee-ownership/the-evidence/

Gianna Durso, (1991),"Employee Stock Ownership Plans: Popularity, Productivity, and Prospects", Management ResearchNews, Vol. 14 Iss 3 pp. 10 – 12

Growth Business - http://www.growthbusiness.co.uk/growing-a-business/business-tools/2472152/employee-ownership-trusts-could-prove-valuable-for-succession-planning.thtml

Halogen CorpJon L. Pierce, Candace A, Furo. (1990). Employee Ownership: Implications for Management. Organizational Dynamics. 18 (Issue 3), 1-3.

Morck R. (2005). Is Employee Ownership Counter Productive?. Management Review. 46 (4), 8-9.