How reliable are share and company valuations?

Company and shares valuations are important for both investors and managers. In acquisition and merger analysis, valuation plays a crucial part (Damadoran 2012), it is therefore important for managers to be able to efficiently value the target company (Arnold 2013).  It is also essential for manages who wish to increase shareholder value (Grundy 2014). For investors, it can be used as a tool to compare similar equities in that sector. It is therefore clear that company and share valuations are significant, so how reliable are the methods used to calculate them? In today’s blog I will be analysing three basic valuation methods and assessing their reliability.

Stock Market Valuation

Stock market valuation is the number of issued ordinary shares multiplied by the company’s market price (Watson & Head 2010). This method of valuation is considered reliable if EMH applies. However, in merger and acquisition analysis it can be used as a starting point for estimating the purchase price of a potential target company (Grundy 2014).

Net Asset Valuation (NAV)

There are two different types of NAV: book value and net realisable value (NRV).

Book Value is a straight forward method which uses accounting measures to financially value the company’s assets (Arnold 2013). The main advantage of this method is that it uses historical costs that are both factual and easily available (Watson and Head 2013).

NRV is the residual value of a company’s assets.  It is calculated by working out how much cash would be received if a company’s assets were sold on the open market (Watson and Head 2013).  These values are particularly useful when looking at firms in financial difficulty (Arnold 2013) or firms where their main value comes from their underlying assets (Grundy 2014) e.g. property investment companies (Arnold 2013).

Income Based Valuation

Income based valuations are orientated towards the future, thus assuming the company will continue to remain a going concern (Grundy 2014). There are three main methods which can be used: dividend valuation models, price to earnings ratio model and discounted cash flows (DCF) (Arnold 2013).

Dividend valuation models (DVM)

The most common method is seen with Gordon’s Dividend Growth Model. This approach assumes the company’s growth rate will remain constant (Arnold 2013). The value is therefore calculated by using the present value of dividends in order to determine a price (Watson and Head 2013).

Price to earnings ratio model

PER is one of the most popular approaches to use as it determines the price investors are willing to pay for each unit of earnings (Arnold 2013). It is simply the market price of a share divided by the latest reported earnings per share (Grundy 2014). This ratio can also be used to understand the market’s expectations of that company.

Discounted Cash Flows (DCF)

DCF are based on future cash flows and discount rates (Damadaran 2012). It is the difference between the present values of its pre-and post-acquisition cash flows. This technique contrasts to all the others mentioned above, as it calculates the maximum amount the purchaser should be prepared to pay (Watson and Head 2013).

Issues

Each of the methods highlighted above, may provide managers with different options and techniques to use, however each methods has several issues due to the assumptions made (Fernandez 2005)
Firstly, stock market valuation can cause problems as listed company’s share price do not reflect the value of all shares as only a small proportion are traded daily ( Watson and Head 2013). Furthermore, stock market valuations are reliable if EMH applies. As discussed in my previous blog, are markets efficient? If not, how reliable is this method? It can be argued that these issues seriously question the credibility of this method.
Secondly, net asset valuation does not reflect current asset value. In fact, it ignores intangible assets such a human capital and brands (Watson and Head 2013). Therefore there is a miss- match between actual value and book value (Grundy 2014). Furthermore, NRV is hard to calculate due to the difficulty surrounding unique asset valuations and is only useful when used in liquidation.

Thirdly, all three methods under income based valuation share similar issues. DCF calculations rely on estimation, a common error can be seen with exaggerated optimism when forecasting cash –flows e.g. Enron (Fernandez 2005).  Looking at DVM’s, the  issues arising are due to the fact that the majority of the calculation is based on assumptions and estimates (Arnold 2013) Is the past really a good indicator of the future? Furthermore, PER does not recognise the time pattern of earnings growth (Grundy 2014) as well as the fact that the model is based on distributable earnings (Watson and Head 2013).

Finally, it can be argued that for all of the methods mentioned above these issues are brought to our attention when trying to value unquoted companies. This is because there is less information disclosed (Grundy 2014) making it difficult to estimate and forecast figures, highlighting their dependence on forecasts and estimations.

How reliable are these methods?

The use of valuations will ultimately impact the reliability of the method chosen. As an investor, using a stock market valuation may prove to be reliable when comparing two companies in the same industry. However, as a manager looking to acquire a company, stock valuation methods will not be sufficient enough to determine the value of the target company.

Another example can be seen with NRV. In theory, the market value of a company should be higher than its NRV. Therefore, using this technique only applies when valuing a company in financial distress. It is therefore unreliable to use for companies which are considered to be a going concern.

 Similarly DCF is an appropriate method to use for those firms with positive cash flows which can be easily estimated (Damadaran 2012). Due to the fact that this technique assumes the company is a going concern; it therefore does not work well on distressed firms with negative earnings (Damadaran 2012).

It can therefore be argued that using solely one method for valuation can result in an unreliable value being produced. Therefore, in order to increase the reliability of a company’s valuation, a combination of methods should be used, alongside an efficient management team who have the necessary skills to carry this out.

 References

Arnold, G (2013). 'Valuing Shares'. In: Corporate Financial Management. 5th ed. Great Britain: Pearson. pp.723-770

Damodaran, A, (2012). 'Approaches to Valuation'. In: (ed), Investment Valuation Tools and Techniques for Determining the Value of Any Asset. 3rd ed. New Jersey and Canada: John Wiley & Sons Inc. pp.(11-19).

Fernandez, P, (2005). Most Common Errors in Company Valuation. Investment Management and Financial Innovations. 2. pp.(133-136).

Grundy, D (2014). ‘Valuing Shares & Companies (Part 1).’ In: International Finance and Financial Management. United Kingdom: Newcastle Business School.

Grundy, D (2014). ‘Valuing Shares & Companies (Part 2).’ In: International Finance and Financial Management. United Kingdom: Newcastle Business School.

Watson,D and Head, A, (2013). 'Mergers and Takeovers '. In: Corporate Finance Principles and Practice. 6th ed. United Kingdom: Pearson. pp.(358-365).

 

 

How does a lower WACC proposed by regulators as a pricing benchmark affect shareholders?

The weighted average cost of capital (WACC) allows managers to see how much interest the company has to pay. WACC is therefore a useful tool in decision making. In today’s blog I will be looking at how industry regulators propose lower WACC’s for companies in order for them to reduce their prices. Are these WACC’s achievable, if not, what are the implications for the shareholders?  

Practical Application

For a company to grow, cash generated by the business ventures must exceed the returns paid to investors. The WACC can therefore be used as a benchmark; it helps managers make investment decisions and can be used by regulators. The most common use is seen in capital investment decision making: only those projects with a higher return than the company’s WACC will be accepted by management, thus the lower the WACC, the greater the investment opportunities. The knock on effects can be seen with an increase in shareholder returns. 

If a lower WACC is such a positive thing, how can lower WACC proposed by regulators be a problem? Regulators can use WACC as a benchmark for companies pricing models. They can enforce certain rules to companies based on their proposed WACCs.  Examples of this can be seen in the broadband, electricity and water industry.

Ofcom

Ofcom wanted BT to reduce the price of its wholesale broadband products in order to improve internet access in rural areas.  The basis for their proposed cuts in price comes from their estimation on BT’s WACC. As a result, Ofcom proposed a lower WACC of 8.6%.  Analysts said this would in turn cut the price of the subsidiary’s wholesale products across the country. However if BT were to reduce their prices, group revenue could be cut by £150million and earnings could decline by 8%.

Ofgem

Ofgem has allowed electricity distribution network companies to invest £7.2bn in the distribution network. The companies are keen to invest heavily in their networks as the returns they are allowed to earn are based on the size of their assets. However, Ofgem is only permitting price rises of just 5.6% per year on average. The industry argued that this may not be enough to deliver the investment. The decision for this came from the assumed WACC of 4.7%. This is significantly below anyone had anticipated.  Ofgem argued that those companies who manage themselves efficiently could earn up to returns of 13%, while those mismanaged companies could see a 3% return.  Is it really down to the performance of management? Or is the WACC too low?

Ofwat

Ofwat’s final determination foresees average water bills to decline by 1% over the next five years. This is based on Ofwat’s forecasted WACC of 4.5%, lower than companies’ request of 5%.Water companies have argued that this decision favoured customers; they argued that they did not come close to matching any of the price rises they had asked for. Instead they told them to expect a price decrease.

What are the implications to shareholders?

 The above example show how regulators forecasts of WACC are used to enforce new pricing policies. Although a lower WACC is beneficial for companies, enforcing them may have serious implications if they are not achievable. Looking at BT, assuming a lower WACC can be achieved in order to lower prices can have a damaging effect on the company, thus hindering shareholder wealth maximisation. The regulators forecasts are forcing companies to become more efficient to meet their demands, however is this fair? Looking at Ofwat’s terms, it may be difficult for the water companies to meet these requirements due to the high levels of debt most of these companies have. Debt is now more expensive, thus they face rising costs. Is it therefore fair for Ofwat to foresee a decline in water bills?

However, you could argue that Ofgem’s actions could benefit shareholders. Although their proposed WACC is lower than the industry expected, they have argued that those companies who are well managed and efficient could deliver returns of up to 13% to its shareholders. Therefore, could enforcing lower WACC’s benefit shareholders? Does this force companies to become more efficient?

 

Conclusion

It can be argued that for investment purposes a lower WACC is beneficial for companies and can increase shareholder returns due the range of available investment opportunities.  However, is this case when regulators are using this as a benchmark for pricing policies?  The real answer is how realistic are these proposed WACCs? In the case of BT it could be argued that their WACC was too low to achieve and would cause problems which as a result would destroy shareholder wealth.  Regulators should take this into account when setting benchmarks. However, it is also a way to force companies to become more efficient. It is easy to lower the WACC by restructuring a company’s capital structure, thus proposing lower WACC’s aren’t necessarily a bad thing. In Ofgem’s case, they argued that it was down to the management of the company, and those run efficiently would be able to deliver up to 13% in returns.

To conclude, using WACC as a benchmark for pricing policies can have both positive and negative implications to shareholders. It should therefore be emphasised that the proposed WACC’s should be realistic, which would allow companies to meet these levels and improve efficiency which as a result would benefit shareholders.

References 

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

Portfolio Theory Model: Why are the leading academics not following their own guidelines?

The portfolio theory model (PTM) was developed in 1952 by Markowitz. The idea behind this theory is simple: Investors can reduce risk by diversification and holding a portfolio of investments. If it is so simple, why are leading academics including Markowitz not following this approach? Today in my blog, I will be exploring as to why this is the case.

Portfolio Theory Model

Markowtiz argued that for investors to reduce their unsystematic risk, they would need to hold The diagram uses two parameters: standard deviations and the expected value of the portfolios return. 

 

The envelope curve is represented by the shaded area; investors can construct their portfolio anywhere in this shaded area by holding different combinations of available risky assets.

In order to select the right portfolio, investors risk level need to be taken into consideration as well as identifying the risk free rate of return and capital market line. Taking this into account, maybe adopting the portfolio theory isn’t so simple?

Practical Application

It is can be argued that most people understand the need to diversify; however, the million dollar question is how much?

The proper answer to this question is seen with applying PTM in practice. However, in reality this is not the case.  The vast majority of UK based academics maintain a sensible 60/40 splits between bonds and equities. Leading Academics adopt a similar approach; Markowitz admitted that instead of computing co-variances and drawing up the efficient frontier he split his contributions 50/50. Other examples can be seen with Bill Sharpe and Eugene Fama.  Even those that go that little bit further are only investing into a maximum of 6 funds.

Arnott takes this even further by arguing that most of the advantages of diversifying happen with three or four significant positions in seriously cheap assets.  If you go beyond ten you’re deluding the opportunity set as you are reducing your ability to add value. Tim Bond at BarCap supports this view by saying that in specific circumstances “diversification is the worst solution for your investment needs. Instead you need a narrowly focused portfolio where you are investing in the specific theme.” So why aren’t leading academics following their own advice?

Problems

There are several problems with trying to apply this theory in practice.  One main problem is that the theory is founded on a number of assumptions. Firstly, investors can borrow or lend at the risk free rate; realistically it is highly unlikely that investors can borrow at the risk free rate. Individuals and companies are not risk free thus they will be charged a premium.  Secondly, there are no transaction costs or taxes.  Practically, this is not the case and it can be argued that it is too expensive to construct due these costs. Thirdly, it assumes that utility maximisation is the object of all investors.

Aside from the problems associated with the assumptions made, the biggest question to ask is how easy is it to implement?

PTM is usually implemented using historic returns, standard deviations and correlations to aid decision making about future investments. The model relies on the predictability and stability of the possible profile of returns.  Predicting returns, standard deviations and covariance is a difficult and imprecise art, thus causing potential problems when implementing PTM.  Furthermore, the volume of computations for large portfolios can be inhibiting. 

Could the problems in the theory itself combined with the difficulty in practical implementation be the reasons as to why leading academics are not following their own advice?

Passive Vs. Active

It is clear that the problems mentioned above have significant implications when adopting PTM in practice. However, it should be highlighted that Passive vs. Active management also has an influence on what approach to take.  In fact, it can be argued that those academics, including Markowitz have taken a passive approach. 

Following a passive approach makes asset allocation and diversification easier. It can be argued to be a much simpler and cheaper method of investing as portfolio turnover is much lower thus making it cheaper.  Asset size is not a concern with index funds, and with portfolio turnover being low it explains why those who adopt this method are seen with investing into a total of 6 funds.

Active management involves much more work, and as a result it is argued that portfolio turnover is much higher than the latter thus making this approach more expensive.  However, actively managed funds provide excellent investing opportunities and there are a number of top rated funds which consistently deliver exceptional results. Despite their impressive long-term records, it should be emphasised that these funds can have bad years too. However, overall they best serve the long term interests of fund investors.  PTM can be used as a method of active management.

Conclusion

It is clear that the problems associated with the theory, the difficulty in practical implementation, the different type of investors and the different styles of management need to be taken into account. This can be used to explain why the majority of academics do not follow their own guidelines.  Practical application is a lot more complicated than it appears as other factors come into play.  portfolios consisting of a number of different shares.  As long as the returns of essential assets are not perfectly positively correlated, diversification can reduce risk. Different investors will be willing to take different levels of risk, so how would we choose our portfolio? The theory suggests constructing an efficient frontier of optimal portfolios offering the maximum possible return for a given level of risk. 

Efficient Market Hypothesis: Fama Vs Shiller

Today I will be looking at Eugene Fama and Robert Shiller’s view on Efficient Market Hypothesis (EMH). Both academics won the Nobel Prize in 2013 for the Science of Economics; however they have extremely contradicting opinions on EMH. EMH suggests that all information is incorporated into a stocks share price rapidly and rationally, thus implying that there is no opportunity available for traders to make abnormal returns (Arnold 2013).  Fama’s theory follows a neoclassical approach, which assumes people are fully rational. Whereas Shiller’s theory follows the behavioural approach, which recognizes that psychological imperfections cause people to act irrational.  Both academics are clearly contradicting one another, so how could both share the same award?

Eugene Fama
Fama (1970) identified three forms of efficiency: Weak form, Semi-strong from and strong-from efficiency.

Weak Form efficiency

Fama’s tests revealed that in weak form efficient markets, current share prices reflect all past movements and changes in the share price only occur when new information arrives on the market (Watson & Head 2013). This evidence supports Kendell’s Random Walks Hypothesis theory as it also agrees with the idea of share price movements being random (Kendell 1953).

Semi-Strong form efficiency

This level of efficiency suggests that share prices fully reflect all historic and publicly available information and react quickly and rationally to new information. Thus implying there is no advantage in analysing public information after it has been released (Arnold 2013). Similar findings were reached by Ball and Brown (1968) regarding earnings announcements and Kewon and Pinkerton regarding merger announcements. In fact mergers were found to be anticipated by the market up to three months prior to any announcement (Franks et al. 1997).

Strong form efficiency 

Strong form efficiency theory is based on the idea that share prices reflect all information, whether publicly available or not. This therefore assumed that no-one can make abnormal returns, including ‘insiders’. The tests used follow an indirect approach and examined how expert users of information perform when compared against a yardstick. It can be argued that capital markets are not strong form efficient.  In fact, Shiller’s work argues that that stock prices can be predicted over a longer period of time and concluded that markets were inefficient.

Robert Shiller 
Shiller’s research on behavioural finance stands in sharp contradiction to much of efficient market theory (Shiller 2003). Unlike Fama, Shiller’s research focuses on behavioural finances, which suggests that irrational investor behaviour can have significant and long-term lasting effects on share price movements.

Feedback theory

The feedback theory suggests that speculation increases stock prices and as a result could cause a speculative ‘bubble’.  These high prices are not sustainable as they are based on expectations, thus casuing the ‘bubble’ to burst, subsequently bringing down prices.  Shiffler, argues the natural self-limiting behaviour of bubbles and the possibility of negative feedback once the bubble has burst, could have a damaging effect on stock prices in the future.  Shefrin (2011) supports this view, acknowledging that bubbles challenge EMH. Furthermore, Krugman goes a step further; arguing the blame for the 2008 recession can be attributed to the commonly held belief that markets are somewhat efficient.  Is speculation in the market evidence of market inefficiency?

 EMH Anomalies

Fama discovered three anomalies: Time of the day effect, month effect and small companies. He claimed that these anomalies tended to appear to be as often under reaction by investors as overreaction. Secondly he stated that the anomalies tend to disappear either as time passed or the methodology improved.   What significance do these anomalies have on EMH? According to Fama’s research they don’t appear to be much of a concern.
Shiffler , however, is highly critical of Fama, arguing that his criticism reflect an incorrect view of the psychological underpinnings of behavioural finance. Furthermore, he argues the mere fact that anomalies disappear is no evidence that the markets are fully rational; in fact that is what you would expect to see happen in highly irrational markets.
Shiffler’s research emphasises that asset prices are far too volatile for markets to be efficient. Financial markets are vulnerable to asset pricing bubbles and that such bubbles are inconsistent with rational expectations. Is it therefore stupid to assume that all investors are rational? If so, are markets inefficient?

So, are stock markets efficient? 

If we adopt Fama’s approach and acknowledge that we are operating in efficient markets, those making returns will not be due to skill but by the randomness of price deviations from true economic value.  However there are a few stock pickers who seem to perform extraordinary well on a consistent basis over a long period of time, suggesting that there are some people who are able to exploit inefficiencies.  Warren Buffet has successfully outperformed the market for 40 years, some argue it is down to luck while others put it down to his superior stock picking.  Therefore there is evidence that stock markets exhibit inefficiency in some areas.   Buffet argues that there is much inefficiency in the market due to the fact that the price of a stock can be influenced by a ‘herd’ on Wall Street, supporting the idea of the feedback theory.  The assumption that people act rationally could altogether prove that markets aren't efficient.

We could argue that a weak form efficiency exists; Benjamin Graham supports this view, arguing that the one principal which is used by most technical approaches is that “one should buy because a stock or the market has gone up and should sell because it has declined… is the exact opposite of sound business sense everywhere else… We have not known a single person who has consistently or lastingly made money by just following the market.”  Maybe weak form has some credibility in practice?

There is evidence supporting the idea that there is some form of efficiency in markets, however, if it is true that returns are made by luck rather than skill, why are  there still fund managers and investment bankers with highly paid jobs claiming they have the right level of skills to outperform the market? It can therefore be concluded that markets are not strong form efficient.

Shareholder Vs Stakeholder Theory

As many of you are aware, there has been a constant debate on the Shareholder Vs Stakeholder theory. Various academics and professionals have joined this debate, however are these the only two options available? Today I will be analysing both theories and discussing the enlightened value maximisation view.

Shareholder Theory

Anglo –American companies are known to take a shareholder view.  In fact, over the last 200 years it has been argued that society is best served by businesses focusing on returns to the owner. Their assumed objective of corporate finance states that companies should make investment and financing decisions that maximise the wealth of its shareholders.   Adam Smith (1776) is a true supporter of this view. He submits that by acting in our own interests it will effectually benefit society.  Further support can be seen with Hayek and Friedman. Hayek argues the “only specific purpose corporations ought to serve is to secure the highest long term return.”  Friedman also supports this view, stating that companies do not have any moral obligations or social responsibilities other than to maximise their own profit. All three academics are in agreement; making shareholders’ interests the paramount objective will benefit both the firm and society .Why? Well, in practical terms how does this benefit companies? Firstly shareholders take on the most risk, it therefore seems reasonable that the owners should be entitled to any surplus returns.  Secondly, focusing solely on the benefits of shareholders allows a clear investment decisions to be made, making the decision making process easier and more efficient.  Finally, if they are unhappy with the way the company is being run, they have the right to sell their shares. This could cause a series of problems and could leave the company susceptible to a potential takeover. In practical terms you could argue that this is the way forward, should all companies adopt this view?

Stakeholder Theory

The stakeholder theory focuses on the importance of other stakeholders. The idea basis for this theory is the acknowledgement of a company’s responsibility to a number of interested parties. This not only includes shareholders but also customers, employees, suppliers, distributors, those concerned with the environment and the local community. Stemberg is a true believer stating that the business should be run to serve all of their stakeholders. Arguably, following this approach might lead to confusion and conflict with regards to the company’s objectives as each group of stakeholders have different needs. This could cause problems and as a result it could have negative effects on a company’s performance. However, Freeman argues that the groups and individuals who are affected by the company have legitimate interests that need to be taken into account. Furthermore, corporations who opt to place a strong emphasis on wealth maximisation risk upsetting stakeholders. Ignoring the needs of important stakeholders’ could have a detrimental effect on the business’ overall performance.  Is it beneficial to ignore the other stakeholders in order to achieve wealth maximisation?  . The case of General Motors (GM) demonstrates the impact that neglecting stakeholders can have.

General Motors: Case Study

In the 1970s GM discovered that the position of the fuel tanks in their cars caused an engineering failure which would result in the death of the passenger. GM calculated that repositioning the fuel tank would cost the company $8.59 per car, whereas paying compensation for those 500 casualties would cost the company $2.40 per car. Focusing on shareholder maximisation, GM went for the second option as it would reduce costs.  This information was made public and you can obviously imagine what those customers’ reactions would be.  The case was taken to court, however, surprisingly the court ruled in favour of GMs actions concluding that the company had acted in the interests of their shareholders.. Is this acceptable behaviour for such a large corporation?  If this were to occur today, it is likely that the negative press surrounding such a situation would have a devastating effect on the company’s share price and their customer base.

Maximisation Enlightenment Value

It is clear that both views have their advantages as well as their limitations, is it therefore possible to combine the two? Jensen brings an interesting view on both theories known as enlightened value maximisation.  This view is critical of both theories but acknowledges the importance of each one.  Jensen argues that shareholder value cannot be created if stakeholders are ignored.  However, Jensen then disputes this by saying that sometimes companies go too far in balancing all the stakeholder interests.  This theory recognises the importance of long-term value for the shareholders but utilizes much more of the structure of the stakeholder theory.   Is this the answer to the debate? It can be argued that most companies listed on the FTSE 100 follow this approach. Their mission statements and objectives focus on their stakeholders; however, they still aim to achieve long-term value.  An example of this can be seen with Xstrata plc objectives.

Xstrata plc

Xstrata plc is recognised as one of the best managed companies in the world. The reason behind this is due to its clear objectives:

We will grow and manage a diversified portfolio of metals and mining businesses with the single aim of delivering industry leading returns for our shareholders.”

We can achieve this only through genuine partnerships with employees, customers shareholders, local communities and other stakeholders, which are based on integrity, co-operation, transparency and mutual value-creation.

The example above supports Jensen’s theory; however it should by highlighted that a company’s objectives should be clear and not confused with their strategy. Companies who successfully implement this can achieve long-term value for its shareholders, whilst acting in the interest of its stakeholders. 

Corporate Finance: Problems associated with the Shareholder Theory,

Today,  as part of my trial blog I will be discussing the problems associated with the Shareholder Theory. I will begin by introducing the shareholder theory before moving on to an analysis of the issues surrounding this theory. 

The Anglo-American viewpoint argues that the ultimate objective of corporate finance should be to make investment and financing decisions that maximise the wealth of its shareholders.  Therefore, investment decisions will be based on those projects that deliver the highest return.  There are many academics who support this view by emphasising the importance of shareholders. Two examples can be seen with Hayek and Friedman. Hayek argues the “only specific purpose corporations ought to serve is to secure the highest long term return.”  Friedman also supports this view stating that companies do not have any moral obligations or social responsibilities other than maximise their own profit. Both acaedemics make it clear that wealth maximisation is the main priority.

Firstly, it is argued that the shareholder theory allows management to ignore the interests of other stakeholders, as its focus remains on delivering the highest return to its shareholders. The stakeholder theory can be used to support this view. The main problem is seen with the fact that stakeholders can have a significant impact on a companies’ performance. Freeman argues that the legitimate interests of these groups and individuals who are affected by the company need to be taken into account. Freedman stresses the importance of these groups; corporation's who opt to place a strong emphasis on wealth maximisation risk upsetting stakeholders such as employees or customers. Stemberg, takes this argument even further by stating that the business should be run to serve all of their stakeholders.  It is therefore clear that neglecting the needs of other stakeholders can have a negative impact on wealth maximisation; the Enron failure is a perfect example. The failure of this corporation strengthens the argument of a stakeholder theory and exposes the failures of the shareholder theory.

Furthermore, John Kay identifies another issue, where he argues that those directing focus on shareholder value may do worse for the shareholders in the long term. This mentality can be referred to as short-termism and has caused many problems. The 2008 recession is an example of the devastating effects that short-termism has on shareholder wealth maximisation.

Finally, Jensen & Meckling's Agency Theory highlights another problem. This theory identifies the gap between ownership and control. The theory argues that the agents (managers) may pursue objectives attractive to them at the expense of shareholders.  It shows the importance of employees in a company and how their actions can have a detrimental effect on shareholders wealth. Examples of this include the recent Tesco accounting scandal, where the £250m black hole in their accounts has resulted in a dramatic decrease in its share price, reducing its shareholders value.  Other examples can be seen with the former CEO of Merrill Lynch and the Directors at General Motors who would treat themselves with expensive perks at the cost of the shareholders.  These examples demonstrate the importance of employees in a corporation. Understanding this can help reduce the problems mentioned above and enable the company to generate long term value. 

In conclusion, the problems highlighted above give a clear indication of the effects this can have on shareholders wealth in the long term. It should be highlighted that shareholders are influential and can have an impact on the company, but solely focusing on the owners can cause many problems. In my next blog, I will be looking to discuss the problems associated with the stakeholder view and how companies can generate the long-term value in the most efficient manner.

Sources 

Hayek

Friedman 

Freenan 

John Kay

Jensen & Meckling 

Arnold