Boards, executives and compensation consultants hold an almost fanatical attachment to the expectations market because they believe that the job of management should be to maximize the long-term value of the firm and the current stock price is considered the best proxy for that long-term value. Hence, boards and executives assume that if they increase the stock price of the firm today, they have contributed to the maximization of long-term value. That thinking has led to the tying of compensation to stock price through grants of stock options and restricted stock, which in turn has led to the shift in focus of executives away from building real companies and toward the manipulation of investor expectations.
Critics of eliminating the focus on stock price and stock-based compensation fear that doing so would leave companies without 'an objective function' -- something to guide their performance toward creating the value they are supposed to generate. They argue that focusing on measuring value on the basis of stock price and providing incentives that are stock-based may not be a perfect system, but it is the only one that can guide proper company behavior. And they argue that investors deserve a return on their investment in the company so it is the role of management to work assiduously at maximizing the stock price.
These arguments play fast and loose with logic. Let's say I start a company and take it public at $20/share. Ben, who helps me post these columns, buys a share for $20/share is part of the IPO. Let's imagine that Ben needs to earn 10% on his investment to account for its riskiness -- so I have to produce $2/share of net earnings for him, which would enable me to dividend it out to him and enable him to earn his targeted 10%. However, let's imagine that there is a LinkedIn-like frenzy after the IPO, the stock skyrockets to $100/share, and Arianna buys the share from Ben for $100. The prevailing theory says that I owe Arianna (who has the same desired return for her risk) $10/share of return.
But do I? Did Arianna give me $100 like Ben gave me $20? Did Ben turn around and return his $80 profit to the firm? No. Arianna gave an $80 profit to Ben who pocketed it. Did I promote or authorize or even know of the sale by Ben to Arianna? No. They decided on that transaction themselves -- my firm was not a party to it and the capital I have for investment is still $20.
So to satisfy Arianna's return requirement, I need to make $10/share based on an investment of $20 or 50% return on investment -- a very hard thing to do. All because she decided it was worth it to buy the share from Ben for $100.
She didn't give me a single dollar of investment capital -- and I don't owe her anything more than a return on the $20, which is the total capital I have ever received for the share that she now owns. That should be the only obligation to shareholders that companies ever accept: to earn them a return above their cost of capital for the capital actually provided by shareholders (plus any earnings on those shares retained by the company rather than paid out in a dividend) -- i.e., the book value of the shares. If shareholders want to trade those shares between themselves based on their expectations of the future, they should knock themselves out and do it. But those trades and the value they are made at should have no bearing on the obligations of executive management.
But because this is not the case and executives routinely accept the obligation to earn a return on the market price of the shares rather than the book value of the shares -- and have their incentives tied to the former, they engage in extremely risky actions when their share price rises. Michael Jensen wrote a very good article on the subject entitled "The Agency Costs of Overvalued Equity and the Current State of Corporate Finance", which argues that spectacular crashes including Enron, WorldCom and Nortel could be traced to this problem. Management feels the obligation to earn a spectacularly high return on the investment resources they were actually given in order to earn a minimally acceptable return on value based on the expectations of investors. That article was written in 2004, well before the 2008 crash, but the actions of the big American banks bore a great similarity. The stock price of Citibank went up by 15X during the 1990s and headed another 50% higher in the time before the crash. What did Chuck Prince think he needed to do when he took over as CEO in 2003? I suspect that it was to earn an acceptable return on the wildly inflated stock price of Citibank -- however risky that was to accomplish. And it was riskier than anyone could have imagined for Prince and the other "too big to fail banks".
At the very heart of the problem are two deeply flawed theories -- first, that the obligation of management is to earn a return on the expectations of shareholders, however insanely high those expectations happen to be: and second, that stock-based compensation provides a useful motivation for management to take care of their company. They both sound good on the surface, but shareholders would be better off in the long-run if management felt the obligation to earn a fair, risk-adjusted return on the investment capital they were given and if their performance incentives were based on their company's performance in the real game.
What should happen is that any risky deals should not be rewarded with payouts till after, say five years, until the deal is shown to have really panned out. They should also be required to put substantial money of their own into their deals.
Will those greedy mortgage dealers with their focus on commissions, including the high executives of Fanny and Freddie, get taken to court or not? They need to pay back for what the mess they got us into, right?
Why is it that you fail to mention the role Clinton played in this drama?
Do you not know? Don't understand history? Forgot to take off your horse blinders???
You owe own it your audience to present a fair and balanced story....
Clinton pushed legislation to limited the tax deductiblity of company's top management salary to $1 million per year.....so company's countered this by offering something new.....STOCK OPTIONS....as an incentive for top executives
Oh shoot......
If your really this big brainiac, super smart fella then respond to this
Double dog dare ya!!!!!
That said, stock price is not the way to generate value, it is just a guess on it. Long term improvements in book value, revenue, growth rates, and free cash to pay as dividends or reinvest is what the real goal should be, and having an incentive system based on the long term business fundamentals and not the stock price is far preferable to the current system.
If Social Security is privatized, our literal, direct dependence upon the owning royalty class will be complete.
He'll make sure the game is even further "fixed".
The best (?) solution is that companies should issue bonds rather than sell stock. This would keep the investors from telling the company what to do.
The flaw here is that company ownership is fixed. One solution to that would be run companies as partnerships (or a similar arrangement). Another might be that the stock can only be sold back to the company and the price is always the net worth of the company divided by the number of outstanding shares - I imagine that the company also stands ready to sell shares at the same price.
It is the odd notion that the stock market is a valid measure of the company's practical worth that needs to be exploded. In my opinion this idea only arose because the stockholders could force it upon the companies.
Tweak it at your peril though. Social engineering gave us root cause of the last bubble. Boy, just imagine the damage these type of exercises could wreak on the entire market based economy that feeds the world.
But what if you could wring this same home dry of equity and its value as collateral, and stick someone else with the bill? This is what many corporate raiders are permitted to do with companies. Or what if you could approve millions of unsound loans, homogenize them to the point that it became nearly impossible to track their quality, and sell them off as triple-A investment to suckers? And what if you were allowed to capture such a substantial portion of your nation’s financial intercourse that you effectively held the economy hostage – necessitating both a lavish financial rescue and a blanket pardon of criminal or negligent actions in the event of a self-induced catastrophe? In the absence of conscience, that’s a pretty sweet deal
We need to do a lot more thinking about how to incentivize planning and building for longer-term outcomes; as individuals, as companies, and for our nation, lest reality awaken us with the equivalent of a cry of “Checkmate!”
Because you know if they can only earn 6% on their money rather 12%, they'll just burn it to keep warm in the winter.
Meanwhile, they love to call the unemployed "lazy". They aren't lazy, they are merely discouraged at investing their time and effort by a low rate of return.
How about we tax investments at 35% and work at 15%.
That'll encourage them.
That's one psychic tax collector with their ear to the market.
I find it terribly ironic that the Michael Jensen mentioned in this article is the very same Michael Jensen who once vigorously touted stock-based compensation plans:
http://www.nytimes.com/2005/04/03/business/yourmoney/03guru.html
Why is this fact significant to me?
Well, for starters, I was once an eager and impressionable doctoral student of his and his University of Chicago-trained cohorts at the University of Rochester's William E. Simon Graduate School Of Business:
http://en.wikipedia.org/wiki/William_E._Simon_Graduate_School_of_Business_Administration
In my enthusiastic ignorance as a fledgling libertarian economist-in-training, I naively soaked up his emotionally appealing but theoretically primitive and fallacious arguments in support of aggressive stock-based compensation.
And if the above article from the "liberal-biased" New York Times doesn't convince you that Dr. Jensen once prodigiously peddled the mistaken notion that corporate executives should be aggressively compensated with highly addictive and company-destructive stock-based compensation, then check out these articles from THE premier mass-market media publication for the business elite, Forbes:
http://www.forbes.com/sites/evapereira/2011/02/16/malcolm-gladwell-on-why-income-inequality-is-the-next-big-issue-facing-america/
http://www.forbes.com/sites/stevedenning/2011/11/28/maximizing-shareholder-value-the-dumbest-idea-in-the-world/
http://www.forbes.com/sites/stevedenning/2011/12/19/kicking-the-addiction-to-managerial-heroin-the-new-bottom-line-of-business/
The Tightwire Guy
Your analysis is wrong.
You said that trading between third parties does not effect the original owners of the stock, this is wrong, it increases the market price, and the company and other stock holders can sell stock to get money, that's the whole point right?
You complaint should be focused on the regulation and accounting of the companies, for instance the borrowing against stock, the bets using SWAPS and derivatives, and the leveraged buyouts.
Enron and the other examples were fraud. Stocks may have been used in the fraud, but Enron was moving debt into shell companies, then borrowing against the "health" of the company that kept the good stuff. It also had multiple companies buying each others stuff to drive the price up.
http://en.wikipedia.org/wiki/Enron_scandal
Now it is all about Me, Me, Me.