Shareholder Value: The World's Dumbest Idea

The 'innovation' of shareholder value, despite its major flaws, still endures

Jack Welch, the CEO and Chairman of GE during its most prosperous period of growth, has been held up as the ideal leader. The numbers speak for themselves. The company's value rocketed over 4000% during his tenure between 1981 and 2001, his own net worth was predicted to be around $720 million by the time he retired, and he was seen as the model for how company leaders should run their companies.

Welch was almost single-handedly responsible for the 'shareholder value' movement that still exists among some of the world's largest companies today. However, this idea has done huge damage to the world and created considerable issues for businesses. The idea behind the movement spread after a speech given by Welch in 1981 prompted others to follow the same model.

The model essentially consists of making as much money as possible in a short amount of time then judging the success of it by the amount of money paid out to shareholders. It is this idea that saw the company share price grow from 1.28 to 46 during his tenure. It led to him becoming something of celebrity for his success, with Fortune magazine naming him as 'Manager of the Century' in 1999.

Many of his fans also point to the results of the company under Jeff Immelt, who followed him, as the genius of Welch because Immelt's GE failed to reach the same heights as Welch in terms of share price, with a brief high of 41.4 before crashing down to 8.51 less than 18 months after this peak. However, despite all the perceived success that this strategy and innovative ideas brought to GE under Welch, the reality is that what was introduced was not a fantastic business idea, it has done immeasurable damage to the business landscape for the past 30 years.

This idea isn't coming from journalists, rivals, or those who adopted the strategy and failed though, it comes directly from Welch himself. At a Financial Times event in 2009 he said 'It is a dumb idea...The idea that shareholder value is a strategy is insane. It is the product of your combined efforts – from the management to the employees.' This is of course correct, the idea that shareholder value is the strategy is the epitome of putting the cart before the horses, shareholder value is the result of a strong strategy, it should never be the strategy itself.

Since leaving GE, Welch has clearly come to this realization, or at least communicated it more clearly than he ever did when he was at the helm of the company. Unfortunately, it is an idea that still persists today. It is why we see companies still firing thousands of people to decrease overheads, offer substandard products to increase sales over the short-term, and implement new plans that maximize profits in the short-term with little thought to long-term gain.

One of the most controversial policies adopted by Welch was what is often referred to as 'rank and yank'. The idea behind this is that managers or employees are ranked based on their profits across a financial year, with the top 20% rewarded with bonuses and shares, but the bottom 10% were fired. It played into the idea that Welch believed that unless GE was the best or second best performers within an industry, they shouldn't be in it.

The idea of Shareholder Value is still around today, especially with the number of private equity buyouts taking place, which often puts additional pressure on company leaders to repay the investment as quickly as possible.

However, it is an idea that Welch no longer believes and it very nearly had a devastating impact on GE in 2007. When the financial crash hit, GE Capital needed to be bailed out by the government, at which point it became clear that the pursuit of a shareholder value had led GE to take financial risks with GE Capital in order to increase the value of the company.

The idea of shareholder value was first conceived by Milton Friedman in an article for the New York Times on September 13, 1970, and it was fundamentally flawed from the outset. One of the perceived truths of this 'innovation' was that 'In a free-enterprise, private-property sys-tem, a corporate executive is an employee of the owners of the business' (in this case the owners are the shareholders) which is not correct. In reality, the executive is as much of an employee of the corporation as anybody else. Friedman actually goes further, saying of any money spent for societal good over profit would 'be spending someone else's money… Insofar as his actions in accord with his ‘social responsi-bility’ reduce returns to stockholders, he is spending their money.'

In Friedman's thinking, the corporation was not a strict legal entity, it was simply the mechanics through which the owners (shareholders) made money. This is an idea that unfortunately has not died in the minds of many company leaders. For instance, if their company is bought by a private equity company, they work almost exclusively to create value for the private equity company, not for the other stakeholders.

It is something that Welch, the poster boy of shareholder value has recognized, saying 'Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers, and your products. Managers and investors should not set share price increases as their overarching goal… Short-term profits should be allied with an increase in the long-term value of a company.'

This evolution to stakeholder value over shareholder value is something that is gaining in popularity and given the devastating consequences that Friedman's strategy had in the late 2000's, it is little surprise. It is a purpose that millennials push for within their workplaces, it is something that the concept of CSR demands, and it aims to provide genuine long-term business success.

Ultimately the jury is still out on whether Welch was a force for good or bad in business whilst he was in charge of GE, but one thing that most can agree on is that moving away from shareholder value is something all but the most stubborn or stupid have accepted as a necessity. 

This article originally appeared on the Innovation Channel