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Roger Martin

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Earning a Real Return on Real Investment

Posted: 01/17/12 09:43 AM ET

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.