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.