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What is Shareholder Wealth Maximization and Should Firms Pursue it?

Shareholder Wealth Maximization as the the Goal of Business Firm

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Who owns a business firm? The shareholders. Those individuals who have bought shares of stock, which indicate ownership in the firm. Even if your business is a one-person shop, you are the shareholder. If the business is a huge conglomerate, then it has a Board of Directors made up of the shareholders who own shares of the firm based on how much money they have invested. Because the shareholders own the firm, they are entitled to the profits of the firm.

Shareholder wealth is the appropriate goal of a business firm in a capitalist society. In a capitalist society, there is private ownership of goods and services by individuals. Those individuals own the means of production to make money. The profits from the businesses in the economy accrue to the individuals.

What is Shareholder Wealth Maximization?

When business managers try to maximize the wealth of their firm, they are actually trying to increase their stock price. As the stock price increases, the individual who holds the stock wealth increases. As the stock price goes up, the value of the firm increases and the net worth of the individual who owns the stock increases.

What About the Managers of the Firm

People often think that the managers of a firm own the firm. In the case of a very small business, that might be true if there is one owner that also manages the firm. Remember, however, that the one owner is a shareholder of the firm. In a larger business, there may be many levels of management and staff. They don't necessarily own the firm. Do they profit at all from the business except for their salaries and employee benefits? Only if they own shares of stock in the company. Some businesses offer shares of stock to their employees at a discount through an Employee Stock Purchase Plan (ESPP).

Conflicts Between Owners and Managers

Because the managers of a firm are directed by a Board of Directors regarding how they run the business firm and because they do not profit directly from the goal of shareholder wealth maximization unless they own stock, there is sometimes conflict between stockholders and managers. This conflict is called the agency problem.

Managers serve as agents of the shareholders. If there is an agency problem between the two groups, it is important to get it resolved as soon as possible as it can cause problems within the business firm that can impede performance.

What About Social Responsibility?

Can a business firm that is trying to maximize the wealth of their shareholders also be socially responsible? The answer is yes! Will they really care about the welfare of society as they try to increase their stock price?

Take the example of the 2008 Great Recession and one of the causes of it - the near big bank failures on Wall Street. Were those banks being socially responsible? No. They were worrying about their investment portfolios instead of loaning money to customers, which is their charge. Those investment portfolios were filled with toxic assets and eventually brought most of the big banks down. Their share prices fell right along with them. They were not being socially responsible.

On the other hand, look at General Motors. After almost failing in the Great Recession, GM turned itself around, repaid its debt, and developed "greener" vehicles. As it did that, it's share price started climbing. Why? GM was taking on the mantle of social responsible rather than just searching for profits. Business firms cannot exist and profit in the long run without being socially responsible.

Profit Maximization

Why are business firms not seeking profit rather than an increase in share price? One reason is that profit maximization does not take the concepts of risk and reward into account like shareholder maximization does. The goal of profit maximization is, at best, a short-term goal of financial management.

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