From Managers to Markets: Valuation and Shareholder Wealth Maximization.

• Author: Park, James J.

1. INTRODUCTION 436 II. THE MANAGERIALIST CORPORATION 441 A. Internal Capital Markets and Professional Managers 442 B. Managerialism and Corporate Purpose 446 III. THE INCOMPLETE EXPLANATIONS FOR THE TRANSITION TO 450 SHAREHOLDER WEALTH MAXIMIZATION A. Law 450 B. Ideology 452 C. Executive Compensation 455 D. Institutional Investors 455 IV. THE PROBLEM OF VALUING FUTURE EARNINGS 457 A. The Shift to Assessing Earnings 457 B. The Problem of Predicting Earnings 459 V. SIGNALING FUTURE EARNINGS 461 A. Conglomerates 462 B. Projections 464 1. Internal Projections 464 2. Market Projections 468 i. From Internal to External Projections 468 ii. Insider Trading Law and the Increasing 472 Importance of Projections VI. VALUATION AND CORPORATE PURPOSE 476 A. Projections and Agency Costs 477 B. The New Managerialism? 481 VII. CONCLUSION 485 I. INTRODUCTION

   It is now difficult to imagine a time when public company managers did not work primarily to increase returns for shareholders. For decades, it has been widely accepted that public corporations should strive to increase their earnings to satisfy stock markets with little regard for the interests of corporate stakeholders--a practice that has generally been referred to as shareholder wealth maximization. (1) But that was not always the case. As U.S. public corporations came to dominate the economic landscape after World War II, leading economists and commentators observed that corporate managers were not compelled to maximize profits. This managerialist era was characterized by investor deference to managers of large companies who were in the best position to allocate resources to promising projects through internal capital markets. (2) Without the constant pressure of markets, managers viewed themselves as trustees obligated to balance the interests of various corporate stakeholders.

   What happened to the managerialist model? The prevailing account is that ideology changed. (3) Some scholars point to the 1970 publication of Milton Friedman's vigorous defense of shareholder wealth maximization in the New York Times Magazine as a turning point in redefining the purpose of the corporation. (4) In addition, corporate scandals during the 1970s contributed to the belief that corporate managers tended to benefit themselves rather than shareholders. (5) Scholars came to associate managerialism with ineffective and inefficient empire building. In their 2001 article noting the wide acceptance of the norm that corporations should increase shareholder value, Henry Hansmann and Reinier Kraakman briefly noted that "[t]he collapse of the conglomerate movement in the 1970s and 1980s... largely destroyed the normative appeal of the managerialist model." (6)

   If corporate purpose is defined primarily by a set of ideological beliefs, then it should be possible to redefine such purpose by adopting a broader conception of the ends of the corporation. (7) Rather than focusing exclusively on shareholder wealth maximization, corporations could simply recommit to giving serious weight to the interests of stakeholders. Another ideological shift could result in the displacement of shareholder wealth maximization as the primary goal of public companies. (8)

   But shareholder wealth maximization is much more than an ideology. (9) Its influence cannot be explained simply as a normative commitment to a theory about how corporations should be run. Indeed, managers have consistently resisted the idea that they should only maximize profits for shareholders. Many corporate managers would prefer a world in which they have wide discretion that is not constantly questioned by shareholders. They understand that corporations have a wide range of stakeholders that are essential to their success. They do not strive to maximize shareholder wealth solely because they have defined the corporation's purpose too narrowly.

   This Article develops a new account of the shift from managers to markets as the primary driver of corporate purpose. It shows that managerialism became less influential not just because of shifts in ideology but because of fundamental changes in the methods investors used to value public companies. As management came to be viewed as a science that could be mastered, (10) it became evident that stock values were linked to the ability of management teams to develop efficient internal capital markets that generated predictable corporate earnings over time. Investors became more confident that they could develop reliable projections of public company earnings and that stock valuations should depend largely on an assessment of a company's earnings power. (11)

   By the 1960s, companies used two major methods to signal the extent of their future earnings. The first, which was largely discredited by the 1980s, was forming a corporate conglomerate. There was a belief that a company that assembled a diverse range of businesses could deliver smooth increases in earnings. The second was to consistently meet market projections of company earnings and revenues. As internal capital markets became more sophisticated, they generated predictions of company financial performance. Market participants began developing their own forecasts of corporate profits, which were often shaped by information obtained from corporate managers. By consistently meeting projections of revenue and profits, companies demonstrated the skill of their managers and validated market predictions of earnings trajectories that had been incorporated into their stock prices.

   Of these two methods, projections became the more influential in affecting corporate incentives. Projections of financial performance permit shareholders to: (1) assess managerial competence and (2) assess the commitment of managers to maximize the value of a company. Investors will reward companies that issue ambitious projections of growth and consistently meet them. A company that fails to meet market projections will signal that its managers are not able to competently predict its earnings trajectory. A company that issues unambitious projections will signal that its management is not committed to increasing corporate value. By providing a metric for assessing the ability of corporate managers to increase earnings over time, projections eventually allowed shareholders to seize control over the purpose of the corporation. (12)

   Corporate managers mainly strive to increase shareholder wealth not because of their ideological beliefs, but because of the reality that investors constantly assess their performance based on their ability to meet metrics of financial performance. other mechanisms such as takeovers, executive compensation, and shareholder activism have also played a role in encouraging shareholder wealth maximization. (13) But projections had a significant influence on public companies before those methods emerged and have been the most persistent and pervasive means by which shareholders monitor management.

   As valuation shifted from managers to markets, the power of stock markets to define corporate purpose increased. (14) As quarterly projections became the standard, a distinction between short-term and long-term shareholder wealth maximization was created. Companies faced pressure to meet short-term market expectations and often sacrificed stakeholder interests as a result.

   The irony of projections was that they were initially a way that shareholders relied on the superior knowledge of management to value companies, and over time evolved to become a heuristic that tested managerial competence. Rather than deferring to managerial expertise, markets sought to evaluate executives based on whether they could set ambitious goals and meet them. Managers of many public companies have little choice but to work to continue generating corporate earnings to maintain their company's valuation. Projections helped change a world in which shareholders had little power relative to management to one in which they wield significant influence over the goals of the public corporation.

   By emphasizing valuation over ideology, this Article provides a new lens for viewing corporate purpose. If the transition from managerialism to shareholder wealth maximization was driven primarily by changes in valuation, it is possible that another set of changes in valuation methods could support a New Managerialism. While projections have powerfully shaped corporate purpose, some public companies have escaped the pressure to maximize shareholder wealth in the short-term, especially in recent years. As companies have become even larger and more complex, shareholders increasingly defer to the expertise of their managers out of necessity. Investors give companies with significant market power more leeway in demonstrating immediate profitability because they are confident in their long-term prospects. Stock markets have permitted companies with strong business models to adopt dual-class structures that essentially eliminate the ability of public shareholders to install a new management team. Public company managers have argued that markets should move away from projections as a way of valuing companies on the ground that they emphasize short-term results that do not reflect long-term corporate value. (15) As investors have become more diversified and concerned with social responsibility, they may focus less on short-term profitability. For companies that can escape the treadmill of projections, (16) commitments to consider the interests of stakeholders have the potential to be meaningful.

   It is important to note at the outset that the primary goal of this Article is to provide a novel account of how public companies came to focus on maximizing shareholder wealth. It does not directly engage the broader normative question of whether shareholder wealth maximization increases social welfare or is a desirable norm. (17) It also does not attempt to resolve the related debate about whether a system...