Blog 2

Shareholder Wealth Maximisation vs Profit Maximisation

As shareholders are the business owners, it is understandable that business managers should try to optimise shareholder wealth rather than profit maximisation.

So what exactly is shareholder wealth maximisation? Well according to Arnold, maximising wealth can be defined as maximising purchasing power. To maximise purchasing power, companies pay a flow of dividends to investors, who are interested in the long-term sustainability of the company rather than a quick payback. The idea of wealth maximisation is that business managers are trying to increase the stock price, which in turn increases the wealth for the holder of the stock. As stock prices rise, the value of the firm increases which also increases the worth of the shareholder. 

On the other hand, profit maximisation is said to be a short-term benefit, which will benefit managers not shareholers. One difference between profit maximisation and shareholder wealth is that, according to Arnold, “profit is a concept developed by accountants to aid decision making, one decision being to judge the quality of stewardship shown over the owner’s funds.” 

Also, profit maximisation is viewed as a get rich quick scheme which does not allow for long-term success of the company. On the other hand wealth creation is created in the long-term, which is what investors are looking for as it indicates business stability hence why business managers often use this as their objective.

 There are some extreme cases however, where bad decisions are made and behind closed doors, shareholders don't really know what is going on. The reliability of the figures shown in company accounts are not always accurate, and in some cases purposely manipulated. 

One recent example being Tesco’s overstated profit of £250million, which is currently under investigation by Deloitte and law firm Freshfields. This news has understandably caused a huge impact on Tesco’s share prices which plunged 11.06% lower at 203p effectively causing £2.2 billion wiped from Tesco’s value on the stock market. As such a large company on the FTSE 100, it is extraordinary for something like this to happen on such a large scale. Many shareholders have walked away from the company and the major shareholders have a lot of unanswered questions and frustration is building up as they judge and put down Tesco’s managers. According to The Sunday Telegraph, One of Tesco's largest shareholders, Harris Associates, has sold around two thirds of its stake, saying the retailer lacks a clear strategy. David Herro, the Chief Investment Officer of Harris’s international division said the risk factors relating to the investment were too high to justify the U.S. investment firm holding a big position in Tesco shares. This is just one of many examples of account manipulation and why accounting profit is not a good proxy for shareholder wealth. 

The value of shareholders will vary in different companies, where maximising shareholder wealth is a primary objective for some companies, for example Citigroup in their mission statement:

 "Our goal for Citigroup is to be the most respected global financial services company. Like any other public company, we're obligated to deliver profits and growth to our shareholders. Of equal importance is to deliver those profits and generate growth responsibly."

 They clearly mention shareholders indicating their importance, whereas many other companies including Apple, who is to return $130 billion of cash to shareholders by the end of next year, according to The Telegraph, do not mention shareholders or their importance in their mission statement:

“Apple designs Macs, the best personal computers in the world, along with OS X, iLife, iWork and professional software. Apple leads the digital music revolution with its iPods and iTunes online store. Apple has reinvented the mobile phone with its revolutionary iPhone and App Store, and is defining the future of mobile media and computing devices with iPad.”

This however, is not to say shareholders are not important, but rather they are focusing more on the quality and evolution of technological goods, which can be a positive factor, as according to John Kay who states, 

“Firms going directly for ‘shareholder value’ may do worse for shareholders than those that focus on vision and excellence first and find themselves shareholder wealth maximisers in an oblique way." 

 This statement fits in well with Apple, a company who have focused on product creation and their mission statement is entirely product-orientated, yet they effectively have become so successful that shareholders are expecting a large return on their investment in the coming year.