The simple assumption that firms seek to maximise profits is insufficient for our purposes. It:
Ignores the amount of capital used to generate the profit. By putting their wealth into the business the owners forego the alternative benefits their wealth could have given them.
Ignores the risks being suffered by the investors. If there is a high potential for losses occurring and eating away at the investors capital this would need to be compensated by higher profits.
Gives no indication of the time period over which the profit is to be measured.
Consequently it is assumed that profit-seeking organizations seek to maximize shareholder value.
Approaches to Measuring shareholder wealth
Measuring shareholder wealth is hard in practice. Some approaches are:
The increase in the value of a share over a period
Present value of forecast free cash flows when discounted by an appropriate risk-adjusted cost of capital (this value is assumed to be reflected in the share price)
Economic profit: the excess of actual profit in a given year over the minimum necessary to compensate the shareholder for investing the funds in the business.
The concept of shareholder wealth maximization is relied on in several ways:
As a decision-making criterion: techniques such as NPV and IRR assume this as the goal of the business
As a criterion to evaluate divisional managers: using performance measures such as Return on Capital Employed (ROCE or sometimes ROI) which should exceed cost of capital and rise from year to year
As the basis for financial incentives for managers. Bonuses may be based on improvements in the ROCE, EPS or share price from year to year
As a benchmark against which to evaluate the board. Investment analysts and ‘active value’ investors use shareholder value measures to evaluate corporate performance and some newspapers publish league tables to name and shame underperforming boards.
