Thursday, June 17, 2010

Profit, Greed, and Stakeholders Theory

What is profit?

In its rude and original concept, "profit" comes from Latin pro-, meaning “forward” + facere, which means “to make.” That is, to make progress, to advance, to move forward, making things better. Activities or endeavors that make things better for the parties involved and for the whole system are “profitable.” Using up a resource is not profitable for the system unless more than what was already there is generated at the same time (Maximiano, 2007b).

Economists define profits as the difference, a “residual” between the value of output and other costs. These costs take the form of payments for labor (wages), property (rent), capital (interest) or payments for raw material purchases. Furthermore, the profit relationship is reflected in a linear relationship: Profit = value of output minus (wages + rent + interest) minus raw materials and other purchases. In our present day parlance, profit is always measured in terms of money equivalent (Philippine peso, US dollars, Malaysian ringgit, etc).

Profits are seldom evaluated in terms of social cost, which is at times hard to measure. It is logical to think, however, that profits may increase when business does not bear costs of its effects on environment and community, made possible through the externalized social cost of production. On the other hand, profits can decrease when social costs such as effluents and other waste matters released into the community by manufacturing processes, for example, are unabated. By the same token, profits can increase (by way of improved reputation = reputational value) when the activities of a company produce positive effects to many stakeholders, such as the community, environment, and other externalities.

What are some of the nuances of profits?

It might be well to discuss the other nuances of profits, such as retained profits, profits as dividends, and economic value added.

Retained profits refer to income from the previous period that, depending on strategies adopted by management, can be reinvested in the existing business or, if the company decides, reinvested in other businesses in order to pursue a diversification strategy. The particular orientation of its shareholders and various stakeholders has a bearing on the reinvestment activities of the firm. Rates of return, markets, sales, etc. are some factors that can drive the effort to reinvest profits.

Profits as dividends are those distributed to owners (shareholders or stockholders) to consume or reinvest as the owners see fit. The prospect of receiving cash dividends is a principal reason for investing in the stocks of a corporation. An increase or decrease in the rate of dividends has a corresponding effect in the market price of the company’s stock.

Economic value added, meanwhile, is an after tax profit that exceeds the average cost of capital in doing business. Economic value added is defined as after tax profit minus the annual cost of capital, which actually is a way of measure that takes into account the total cost of an operational capital. Capital is money tied up in heavy equipment, real estate, and working capital (mainly cash, inventories and receivables). The cost of capital includes interest on borrowings.

What is shareholder value?

Shareholder value (SV) may refer to the primary goal of business, which is to enrich or add value to its shareholders (owners) by paying dividends. This happens when the stock price increases. Shareholder value also refers to the result of a planned action by management when the returns to shareholders outperform certain benchmarks such as the cost of capital concept. In this book, shareholders value maximization is equal to profit maximization.

In essence, the idea is that shareholders’ money should be used to earn a higher return than they could earn themselves by investing in time deposit or risk free bonds. The term was introduced by Alfred Rappaport in his 1986 book Creating Shareholder Value.

In the next question I shall compare other values, such as freedom, family, honesty, social responsibility, which are spiritual or intangible, with shareholder value, which is material, monetary, or tangible.

What is VBM?

To achieve shareholders value maximization, business needs value-based management (VBM).

In finance, valuation is the process of estimating the market value of a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are required in many contexts including investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation. This kind of valuation is also known VBM.

Is VBM different from VBL?

Present management literature is crammed with scholarly articles on Value Based Management (VBM) that appear to recognize three definitions (Weaver & Weston, 2003). The first definition is focused on maximizing shareholder value (a material value). With emphasis on cash flow and growth potentials, VBM ensures that corporations are managed effectively to produce the highest shareholder value.

The second definition deals with semi-material values, as it aims to provide consistency in the following factors, namely: corporate mission, business philosophy, corporate strategy to achieve the corporate purpose, and corporate governance (who determines the corporate mission and regulates the activities of the corporation).

The third definition is focused on personal values, particularly moral values, and therefore nonmaterial values. In this study, Value Based Leadership (VBL) is embedded in the third definition of VBM.

The first and second definitions tend towards creating value or how the company can generate maximum future value, which is more or less equal to strategy, and towards measuring value or what is known as valuation. Today, the core of the strategy for corporate Philippines, and for that matter corporate world, is to restore investors’ confidence. To do this, businesses are urged to put into practice both VBM and VBL, that is, to manage corporations for long-term shareholder value in accordance with the first and second definitions—as well as lead them based on nonmaterial values. There is an increasing public expectation that boardroom culture, corporate laws, accounting and auditing methodologies, and executive compensation are all integrated into this paradigm (Weaver & Weston, 2003).

It is my belief that the personal nonmaterial values of the manager matter so much in creating and maximizing shareholders value. These values basically include demonstrating and communicating the importance of both “doing things right, and doing the right thing,” a managerial decision-making style otherwise known as VBL (Maximiano, 2006).

What do critics say about Shareholder Value Maximization?

The sole concentration on shareholder value (SV) has been widely criticized. While SV might be best for the owners of a corporation, in a bigger picture other stakeholders like environment, employees, consumers, community, and government play a higher role. They affect and are affected by business operations—hence they have values.

It can happen that, while a management decision maximizes SV for the owners, it is detrimental to global and social welfare. Some management decisions may also threaten the long-term health of a company, for instance, by emphasizing dividends and returning cash to shareholders rather than investment. This occurred in the case of Enron.

What do you mean by the Friedmanian Approach to business?

American economist and Nobel laureate Milton Friedman opines that, in a free enterprise, the manager or the corporate executive is an employee of the shareholders, who are the legal owners of the business.

Those who run business have a direct re­sponsibility to their employers. That responsi­bility is to conduct the business in accordance with owners’ collective desire, that is, to create SV and maximize profit as much as possible while con­forming to the basic rules of the society (Friedman, 1970).

The corporate executive is also a person in his own right. As a person, he may have many other responsibilities that he rec­ognizes or assumes voluntarily–to his family, his conscience, his feelings of charity, his church, his clubs, his city, his country. He may feel impelled by these responsibilities to de­vote part of his income to causes he regards as worthy, to refuse to work for particular corpo­rations, even to leave his job, for example, to join his country's armed forces.

Some of these responsibilities may be referred to as "social responsibilities." But in these respects he is acting as a principal, not an agent; he is spending his own money or time or energy, not the money of his employers or the time or energy he has contracted to devote to their purposes. If these are "social responsibili­ties," they are the social responsibilities of in­dividuals, not of business (Friedman, 1970).

From Capitalism and Freedom, Friedman (1982) presents the classical view:

“…there is one, and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”

What happens when profit maximization is accompanied by the driving force called greed?

The disregard of moral values and social responsibility in doing business usually leads to the undesirable. The 2001 case of Enron and Andersen speaks for itself.

Taken from its ethico-theological context, greed connotes insatiability, materialism, avarice, vices that are definitely morally unacceptable. From the motion picture Wall Street, I quote the stirring speech of a wicked CEO named Gordon Gekko, played by Michael Douglas, about the corporate definition of greed:

“Greed, for lack of a better word, is good. Greed is right because it works. Greed clarifies and captures the essence of the evolutionary spirit. Greed will not only save our paper company, but will also save another malfunctioning corporation called USA.” 

It is a situation of a vice becoming a virtue, an evil turning nice, wicked attitude transforming into acceptable behavior. What happens then? From the reel to the real—crime in the streets took a backseat to white-collar crime on Wall Street, as indictments exposed major scandals and brought both public and private figures before the courts. A web of illegal stock-trading schemes in civil and criminal charges produces corporate scandals, which involve not just rank and file staff but top executives.

Are there top executives who fall prey to greed?

Former CFO of Tyco International, Mark Swartz, was found guilty of looting the industrial company of hundreds of millions of dollars to fund an extravagant lifestyle. Major business areas of Tyco, no relations with Tyco Toys, include electronic components, health care, fire safety, security, and fluid control.

 

In 2005, on charges of grand larceny (stealing), securities fraud, and falsifying business records, Swartz was sentenced to 8 to 25 years and ordered to pay $72 million in fines and restitution.

Why do discussions on business ethics almost always mention the case of Enron?

Enron Corporation was an American energy company based in Houston, Texas. Before its bankruptcy in late 2001, Enron employed around 21,000 people and was one of the world's leading electricity, natural gas, pulp and paper, and communications companies, with claimed revenues of $111 billion in 2000. Fortune  named Enron “America's Most Innovative Company” for six consecutive years. It achieved infamy at the end of 2001, when it was revealed that its reported financial condition was sustained mostly by institutionalized, systematic, and creatively planned accounting fraud. Enron has since become a popular symbol of wilful corporate fraud and corruption—driven by greed.

Former CEO of Enron Corporation, Jeffrey Skilling, was convicted of US federal felony charges relating to Enron's financial collapse. After a 56-day trial ending with a jury verdict on May 25, 2006, Skilling was found guilty of 19 out of 28 counts against him, including one count of conspiracy, one count of insider trading in selling Enron stocks, five counts of making false statements to auditors, and twelve counts of securities fraud.

 

Andrew S. Fastow was the chief financial officer (CFO) of Enron Corporation until the US Securities and Exchange Commission opened an investigation into his conduct in 2001. In 2004, he pled guilty to two counts of wire and securities fraud, and agreed to serve a ten-year prison sentence. In the same year, his wife Lea Fastow, a former Enron assistant treasurer, pled guilty to a misdemeanor tax charge and was sentenced to one year in a federal prison in Texas.

What do you mean by governance of profits and transparency based on legislative standards?

In the United States, the Sarbanes-Oxley Act, signed into law in July 2002, is the single most important piece of legislation affecting corporate governance, financial disclosure, and the practice of public accounting since the US securities laws of the early 1930s. By strengthening standards for auditors and forcing companies to report on internal controls, the law has improved financial statements. In other words, legislative standards are important to ensure the governance of profits.

Hand in hand with external regulatory and legislative standards, internal management attitude called transparency is a must in business operations. Measures such as certification of business profit reporting systems by signature, honest reporting, and embedding integrity in business information systems are becoming imperatives, the objective of which is to ensure transparency, accountability, and integrity.

These measures are easy enough to describe, but frequently difficult to practice. There have been calls for the adoption of a set of generally accepted accounting principles (Global GAAP) as well as a need to establish standards for measuring and reporting information that are specific to respective industries, consistently applied, and in understandable form. In practice, these measures may be difficult to implement.

How do managers make capital out of profit?

When managers act as entrepreneurs, prior profit is made a capital that is available for investment in new value creation. In terms of cash dividends, stockholders are keenly interested in prospects for future dividends. As a group they are generally in favor of more generous dividend payments.

The Board of Directors, on the other hand, is primarily concerned with the long-run growth and financial strength of the corporation. The Board may prefer to restrict dividends to a minimum in order to conserve cash for the purchase of plant and equipment or for other needs of the company.

Many of the so-called “growth companies” plow back into the business most of their earning and pay only very small cash dividends.

Is the pursuit of profit legitimate?

The pursuit of profit is a legitimate exercise, provided, of course, that it is obtained in just and fair means. Profit is good “so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud” (Friedman, 1970).

However, profits are not an end per se, for they must be compatible with other social needs. Companies must acknowledge that the interests of stakeholders (in addition to those of the shareholders) are of intrinsic value and managers should behave accordingly.

Profits, held by economists as returns for risk taking behavior, are not the sole entitlement of owners. Other stakeholders are entitled to business profits. Even if returns were paid to each factor of production, we should remember that business operates neither in vacuum nor isolation. Therefore, business has to take into consideration its many stakeholders that affect or are affected by its operations.

What is the Stakeholder Theory?

The present concept of CSR has been substantially and fundamentally linked to the development of the stakeholder theory, which is originally propounded by Edward Freeman, and henceforth developed by such researchers and authors as Phillips (2003), Berman et al (1999), Clarkson (1995), and Jones (1995), inter alias.

Stakeholders include all internal, external, and environmental constituents of business. Other stakeholders, such as employees, consumers, community, and environment, may place demands upon the firm. Accordingly, firms must address these demands or else face negative confrontations from those stakeholders (non-shareholder groups), who have the capacity diminish shareholder value through boycotts, lawsuits, protests, etc. From a stakeholder theory perspective, CSR is assessed in terms of a company meeting the demands of its multiple stakeholders (Freeman, 1984).

Is the shareholder one among stakeholders?

The primary focus of stakeholder theory is that firms have a moral responsibility to take into account the interests of stakeholders, rather than just stockholders (shareholders or shareowners).

Of particular significance, Clarkson (1995) made an in-depth analysis of seventy field studies of corporate social performance or CSP between 1983 and 1993, an evaluation which was pegged on a framework based on the management’s relationship with stakeholders. In this particular study, the stakeholder theory places shareholders as one of the multiple stakeholder groups, a proposed working idea that management should consider in its decision making processes.

The shareholder is just one among the many stakeholders of business.

Why should a business corporation be socially responsible to its many stakeholders?

Teehankee (2005) supplies the answer.

·                     The corporation is a legal form authorized by the government to promote the common good.

·                     It has tremendous powers to amass capital and to affect the employment and lives of people.

·                     Therefore, it is duty bound to honor its social commitment as part of its license to exist.

The national economy is geared towards a more equitable distribution of opportunities, income, and wealth; and a sustained increase in the amount of goods and services produced by the nation for the benefit of the people. An expanding productivity is the key to raising the quality of life for all, especially the under-privileged.

·                     Private enterprises, including corporations, cooperatives, and similar pro-profit collective organizations, shall be encouraged to broaden the base of their ownership.

·                     Business corporations should practice corporate social responsibility because it is part of their “license to exist” as given by the government to contribute to national development in the social sphere and not just in the economic sphere. Hence, it is imperative that businesses practice social responsibility.

·                     In turn, business corporations benefit from practicing corporate social responsibility because they become more trustworthy to their stakeholders and to the general public.


Further Reading and References

Carroll, A. (1999). Corporate social responsibility: Evolution of a definitional construct. Business and Society. 38(3): 268-295.

De George, R. T. (1999). Business ethics. Prentice Hall.

Freeman, R.E. 1984, Strategic Management: A stakeholder approach. Boston: Pitman.

Friedman, M. (1970). The social responsibility of business is to increase its profits. The New York Times Magazine.

Friedman, M. and Friedman, R. (1982). Capitalism and freedom. Chicago: University of Chicago Press.

Georges, E. (1999). International business ethics. Univ. of Notre Dame Press

Griffin, J. J. (2000). Corporate social performance: Research directions for the 21st Century. Business & Society, 39(4): 479-491.

Maximiano, J. M. B. (2006). Value based leadership (VBL): Going beyond regulatory approach to institutionalizing CSR. International Center for CSR. Nottingham University, United Kingdom.

Maximiano, J. M. B. (2005). The state of corporate social responsibility in the Philippines. Paper presented at the Conference organized by the Australian Association for Professional and Applied Ethics (AAPAE), University of South Australia, Adelaide.

Maximiano, J. M. B. (2001). Global business ethics for Filipinos. Pasig City: Anvil Publishing, Inc.

Rothman, H. & Scott, M. (2004). Companies with a conscience. Denver, CO: MyersTempleton.

Seglin, J. L. (2003). The right thing: Conscience, profit, and personal responsibility in today's business. Spiro Press

Teehankee, B. L. (2005). Why are business corporations accountable to society? Paper presented Conference on Business Ethics and CSR, organized by De La Salle Graduate School of Business. Unpublished.

Weaver, S. & Weston, J. (2003). A unifying theory of value based management. eScholar Repository. University of California, Anderson School of Management. 

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